The Journal reported last week that Cardinal Health met earnings estimates in the December 2000 quarter and the September 2001 quarter by including gains from a legal settlement totaling $35.3 million. The settlement was parsed and allocated, $10 million to the December 2000 quarter, $12 million to the September 2001 quarter, with the balance recorded in the June 2002 quarter -- the quarter in which the settlement was actually reached.

The company would have missed earnings estimates by 2 cents per share in both the December 2000 quarter and the September 2001 quarter, had the company not recorded the anticipated legal settlement gain as income. Cardinal says that this accounting treatment conformed with generally accepted accounting principles. I strongly disagree.

A litigation settlement shouldn't be recorded as income when the settlement is still pending. The fact that Cardinal sliced up the anticipated gain and recorded it as income over a couple of nonconsecutive quarters -- quarters where they would have missed expectations without its inclusion -- is compelling evidence of earnings management.

Cardinal has said that the accounting in this matter was appropriate because the litigation settlement was "virtually certain." Again, I disagree. As long as the settlement was pending, it shouldn't have been recorded as income. But even if Cardinal is right in recognizing contingent income, GAAP requires legal settlements like this to be separate from operating income because it is nonrecurring, unusual income.

Instead, Cardinal tucked the funds into operating income, as a reduction of the cost of sales, during the December 2000 and September 2001 quarters, without disclosing it until the filing of the 10-K in September 2002. Interestingly, after the September 2001 quarter, the company began recording legal-settlement income as an unusual item, separate from operating income.

The Overriding Issue

While I think Cardinal's management violated GAAP, the bigger issue for investors goes to the intent. Simply put, if management isn't trustworthy, the company shouldn't be granted its current premium valuation. This $26 billion (market value) medical-products distributor and drug wholesaler sells at 18 times estimated current earnings of $3.19 (assuming you trust these earnings). Here are the three major areas of risk confronting Cardinal shareholders: