Cardinal Health 2013 Annual Report Download - page 24

Cardinal Health, Inc. and Subsidiaries
Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Allowance for Doubtful Accounts
Trade receivables are primarily comprised of amounts owed to us through
our distribution businesses and are presented net of an allowance for
doubtful accounts of $134 million and $126 million at June 30, 2013 and
2012, respectively. We also provide financing to various customers. Such
financing arrangements range from 120 days to 7 years, at interest rates
that are generally subject to fluctuation. Interest income on these
arrangements is recognized as it is earned. The financings may be
collateralized, guaranteed by third parties or unsecured. Finance notes
and accrued interest receivables are reported net of an allowance for
doubtful accounts of $17 million and $16 million at June 30, 2013 and
2012, respectively, and are included in other assets (current portion is
included in prepaid expenses and other). We must use judgment when
deciding whether to extend credit and when estimating the required
allowance for doubtful accounts.
The allowance for doubtful accounts includes portfolio and specific
reserves. We determine the appropriate allowance by reviewing accounts
receivable aging, industry trends, customer financial strength and credit
standing, historical write-off trends and payment history. We also regularly
evaluate how changes in economic conditions may affect credit risks.
Our methodology for estimating the allowance for doubtful accounts is
assessed annually based on historical losses and economic, business
and market trends. In addition, the allowance is reviewed quarterly and
updated if appropriate. We may adjust the allowance for doubtful accounts
if changes in customers’ financial condition or general economic conditions
make defaults more frequent or severe.
The following table gives information regarding the allowance for doubtful
accounts over the past three fiscal years:
(in millions, except percentages) 2013 2012 2011
Allowance for doubtful accounts $ 152 $ 143 $ 150
Reduction to allowance for customer deductions and
write-offs 34 30 22
Charged to costs and expenses 41 22 27
Allowance as a percentage of customer receivables 2.3% 2.2% 2.4%
Allowance as a percentage of revenue 0.15% 0.13% 0.15%
A hypothetical 0.1 percent increase or decrease in the reserve as a
percentage of trade receivables and finance notes receivables at June 30,
2013, would result in an increase or decrease in bad debt expense of $6
million.
We believe the reserve maintained and expenses recorded in fiscal 2013
are appropriate. At this time, we are not aware of any analytical findings
or customer issues that might lead to a significant future increase in the
allowance for doubtful accounts as a percentage of revenue.
Inventories
A substantial portion of our inventories (65 percent and 69 percent at
June 30, 2013 and 2012, respectively) are valued 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 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
2013 or 2012. Primarily because prices for our generic pharmaceutical
inventories have continued to decline, inventories valued at LIFO were
$97 million and $72 million higher than the average cost value as of
June 30, 2013 and 2012, 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 2013 and 2012.
Inventories presented in the consolidated balance sheets are net of
reserves for excess and obsolete inventory which were $40 million and
$37 million at June 30, 2013 and 2012, respectively. We reserve for
inventory obsolescence using estimates 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 assets acquired and liabilities assumed in a business combination,
including identifiable intangible assets, are based on their estimated fair
values as of the acquisition date. 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 customer
relationships, trade names 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 acquisition date. 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.