Cardinal Health 2012 Annual Report Download - page 23

Cardinal Health, Inc. and Subsidiaries
Management's Discussion and Analysis of Financial Condition and Results of Operations
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2012, and 2011, respectively) are stated at the lower of cost, using the
last in, first out ("LIFO") method, or market. These are primarily
merchandise inventories at the core pharmaceutical distribution facilities
within our Pharmaceutical segment. The LIFO impact on the consolidated
statements of earnings in a given year depends on pharmaceutical price
appreciation and the level of inventory. Prices for branded pharmaceuticals
tend to rise, which results in an increase in cost of products sold, whereas
prices for generic pharmaceuticals tend to decline, which results in a
decrease in cost of products sold.
The LIFO method presumes that the most recent inventory purchases are
the first items sold, so LIFO helps us better match current costs and
revenue. Using LIFO, if branded pharmaceutical inventory levels decline,
the result generally will be a decrease in future cost of products sold: prices
for branded pharmaceuticals tend to rise over time, so our older inventory
is held at a lower cost. Conversely, if generic pharmaceutical inventory
levels decline, future cost of products sold generally will increase: prices
for generic pharmaceuticals tend to decline over time, so our older
inventory is held at a higher cost. We believe that the average cost method
of inventory valuation reasonably approximates the current cost of
replacing inventory within the core pharmaceutical distribution facilities.
Accordingly, the LIFO reserve is the difference between (a) inventory at
the lower of LIFO cost or market and (b) inventory at replacement cost
determined using the average cost method of inventory valuation.
The remaining inventory is stated at the lower of cost, using the first in,
first out ("FIFO") method, or market. If we had used the average cost
method of inventory valuation for all inventory within the Pharmaceutical
distribution facilities, the value of our inventories would not have changed
in fiscal 2012 or 2011. Primarily because prices for our generic
pharmaceutical inventories have continued to decline, inventories at LIFO
were $72 million and $8 million higher than the average cost value as of
June 30, 2012, and 2011, respectively. We do not record inventories in
excess of replacement cost. As such, we did not record any changes in
our LIFO reserve in fiscal 2012 and 2011.
Inventories recorded on the consolidated balance sheets are net of
reserves for excess and obsolete inventory, which were $37 million and
$40 million at June 30, 2012, and 2011, respectively. We determine
reserves for inventory obsolescence based on historical experience, sales
trends, specific categories of inventory and age of on-hand inventory. If
actual conditions are less favorable than our assumptions, additional
inventory reserves may be required.
Business Combinations
The purchase price of an acquired business is allocated to the assets
acquired and liabilities assumed based on their estimated fair values as
of the date of acquisition, including identifiable intangible assets. The
excess of the purchase price over the estimated fair value of the net
tangible and identifiable intangible assets acquired is recorded as goodwill.
We base the fair values of identifiable intangible assets on detailed
valuations that require management to make significant judgments,
estimates and assumptions. Critical estimates and assumptions include:
expected future cash flows for trade names, customer relationships and
other identifiable intangible assets; discount rates that reflect the risk
factors associated with future cash flows; and estimates of useful lives.
When an acquisition involves contingent consideration, we recognize a
liability equal to the fair value of the contingent consideration obligation
at the date of acquisition. The estimate of fair value of a contingent
consideration obligation requires subjective assumptions to be made
regarding future business results, discount rates and probabilities
assigned to various potential business result scenarios. Subsequent
revisions to these assumptions could materially change the estimate of
the fair value of contingent consideration obligations and therefore could
materially affect our financial position or results of operations. See Note
2 of the “Notes to Consolidated Financial Statements” for additional
information regarding our acquisitions.
Goodwill and Other Intangibles
Purchased goodwill and intangible assets with indefinite lives are not
amortized, but instead are tested for impairment annually or when
indicators of impairment exist. Intangible assets with finite lives, primarily
customer relationships, trademarks and patents, and non-compete
agreements, are amortized over their useful lives.
Goodwill impairment testing involves a comparison of the estimated fair
value of reporting units to the respective carrying amount. If estimated fair
value exceeds the carrying amount, then no impairment exists. If the
carrying amount exceeds the estimated fair value, then a second step is
performed to determine the amount of impairment, if any, which would be
recorded as an expense to our results of operations. Application of goodwill
impairment testing involves judgment, including the identification of
reporting units and estimating the fair value of each reporting unit. A
reporting unit is defined as an operating segment or one level below an
operating segment (also known as a component).
We have two operating segments which are the same as our reportable
segments: Pharmaceutical and Medical. These operating segments are
comprised of divisions (components), for which discrete financial
information is available. Components are aggregated into reporting units
for purposes of goodwill impairment testing to the extent that they share
similar economic characteristics. Our reporting units are: Pharmaceutical
operating segment (excluding our nuclear and pharmacy services division
and Cardinal Health China - Pharmaceutical division); nuclear and
pharmacy services division; Cardinal Health China - Pharmaceutical
division; and Medical operating segment.
Fair value can be determined using market, income or cost-based
approaches. Our determination of estimated fair value of the reporting
units is based on a combination of the income-based and market-based
approaches. Under the market-based approach, we determine fair value
by comparing our reporting units to similar businesses or guideline
companies whose securities are actively traded in public markets. Under
the income-based approach, we use a discounted cash flow model in
which cash flows anticipated over several periods, plus a terminal value
at the end of that time horizon, are discounted to their present value using
an appropriate rate of return. To further confirm the fair value, we compare
the aggregate fair value of our reporting units to our market
capitalization. The use of alternate estimates and assumptions or changes
in the industry or peer groups could materially affect the determination of
fair value for each reporting unit and potentially result in goodwill
impairment.
We performed annual impairment testing in fiscal 2012, 2011 and 2010
and concluded that there were no impairments of goodwill as the fair value
of each reporting unit exceeded its carrying value. For our fiscal 2012
testing, we elected to bypass the optional qualitative assessment, as
permitted by the amended accounting guidance adopted during the year.
See Note 6 of the “Notes to Consolidated Financial Statements” for
additional information regarding goodwill and other intangible assets.