In 1979, the year it first sold stock to the public, American Management Systems Inc. of Arlington told shareholders it had earned a $2.18 million pre-tax profit for the year.

A footnote in the AMS annual report explained that $3 million of its annual earnings was money the company said was due for its work and it expected to collect in a lawsuit.

Last week in Boston federal court, a U.S. magistrate issued a recommendation that throws into doubt whether AMS will ever collect the disputed money.

The magistrate recommended that a federal judge rule against AMS on several significant motions in the law suit. Though the ruling is not final, it prompted AMS to establish a $3 million reserve.

The reserve is simply a bookkeeping transaction that will have no effect on cash flow or business operations, AMS executives said Friday. They said they still believe the company ultimately will prevail and collect the funds.

"For financial reporting purposes, the effect of establishing such a reserve is to reduce income before tax by $3.007 million and income after tax by $1.518 million, or 93 cents a share," the company said in a statement.

AMS had reported first-half net income of $343,000 (21 cents) on revenues of $33.8 million.

"It's certainly not a favorable ruling from our standpoint," said AMS President Charles O. Rossotti. "But this litigation has been going on for three years," he said. "It's really unpredictable how long it will continue to go on. This is just one set of recommendations from a magistrate."

Rossotti said the firm will object, which means that the U.S. District judge must consider all the motions afresh.

"It's not a favorable recommendation...but on the other hand, it's certainly not the last word in the case," he said.

AMS is an Arlington-based computer systems firm started in 1970 by five "whiz kids" who served under Robert McNamara in the Defense Department. Among other things, the company helped set up financial management systems for the District of Columbia and New York City when those cities faced financial crises.

In the lawsuit filed in Boston, AMS had claimed $4.1 million for work it had done as a subcontractor on a project for the state of Illinois, designing and installing a computerized Medicaid managment system. AMS ceased work on the project in October 1979, and later filed a claim for money to cover work that it had done that it said was out of the scope of the contract but necessary for correct performance or was required because some things were not in the condition promised.

The suit was filed against Delphi Associates Inc., the contractor, and its parent company, Arthur D. Little Inc. Delphi had denied the claims and filed a countersuit seeking nearly $7 million, charging AMS with breach of contract, among other things.

Last week in Boston, the magistrate recommended dropping Arthur D. Little as a defendant in the case. AMS had raised questions about Delphi's ability to meet judgment, arguing that, unless ADL was also held liable, AMS might win the case but be unable to collect from Delphi.

The magistrate also recommended a ruling that would prohibit AMS from collecting any money from Delphi that had not been previously collected from the state of Illinois.

In still another recomendation, the magistrate suggested that AMS should be considered in breach of contract for walking off the job and be held liable for damages. Delphi has claimed that AMS should pay it $5 million for breach of contract.

The fact that AMS counted a portion of its disputed claim as money on the books is a normal, even slightly conservative, accounting practice and the company fully expects to collect the money, AMS Chairman Ivan Sellin said a few weeks ago. Robert Leyes, a partner in Price Waterhouse's Washington office who handles the AMS account, agreed with that assessment.

Unlike the cash accounting system, the accrual method requires a company to include in its financial statements money it has earned but not yet received.

"It's very standard accounting," said Sellin. "You do some work and make an estimate of how much you will collect." No one looked at the accounting entry from the standpoint of the impact it would have on profitability, he said.

AMS' financial statement, including its treatment of the $3 million, was audited and approved by Price Waterhouse. The accounting firm relied, at least in part, on an opinion from the firm's legal counsel that said, in effect, that AMS was likely to collect at least part of the money it claimed it earned.

AMS' handling of the money claimed in the law suit is disclosed in documents AMS has filed periodically with the Securities and Exchange Commission. "When it comes to business, the question is disclosure," said Sellin. "It's all laid out quite clearly."

AMS, which claimed to be owed $4.1 million by Delphi, estimated it would not collect all that amount. "The company believes that inclusion in revenues of only approximately $3 million of the approximately $4.1 million claimed by it is an adequate provision for any loss that may be sustained because of the uncertainties inherent in the litigation process," according to an AMS statement filed with the SEC.

"An opinion concerning the litigation given by Shaw, Pittman, Potts & Trowbridge, counsel for the company, supports the company's belief," it continues. "However, the company cannot guarantee that any specific amount will be recovered in the litigation."

In contrast, Arthur D. Little Inc., in its accounting of the lawsuit, has said that it anticipates that ADL and Delphi "have meritorious defenses to AMS' claims in addition to substantial counterclaims in amounts in excess of the asserted claims of AMS." ADL accrued no revenues based on that contention, nor did it provide for a possible loss.