Question

Unhealthy Accounting at HealthSouth PROBLEM In 1996, key executives of HealthSouth, one of the nation’s largest providers of health care services, began a massive fraud that eventually amounted to $2.7 billion. HealthSouth is a textbook case of unbridled greed combined with a lack of corporate governance, which illustrates the difficult situation that auditors face when clients perpetrate a massive, collusive fraud. HealthSouth was founded in 1984 by Richard Scrushy and coworkers at Lifemark, a Houston-based company that owned and managed hospitals. They took HealthSouth public in 1986, and by 1996, the company’s market value had grown to $12 billion. According to the government’s complaint, Scrushy, the chief executive officer, insisted that the company meet or exceed earnings expectations established by Wall Street analysts. Senior officers would present actual accounting earnings to Scrushy, and if they did not meet the forecasts, he reportedly told them to “fix it.” Unbeknownst to Scrushy (according to his testimony at trial), a team of senior accounting personnel, known as “the family,” held “family meetings” to determine ways to increase accounting earnings. They would look for “holes” in the balance sheet to be filled. The fictitious accounting entries they used to plug those holes were referred to as “dirt.” Methods included overestimating insurance reimbursements, overstating fixed assets, improperly capitalizing expenses, and overbooking reserve accounts. The “family” members started by manipulating contractual allowances by consolidating entry adjustments after the end of each quarter. The allowances accounted for the differences between what HealthSouth charged patients and the amounts the company could collect from the patients’ health insurers. By lowering the allowances improperly, HealthSouth improved its net revenue and bottom-line earnings. To offset the contractual allowances, the company increased inventory, intangible assets, fixed assets, and even cash. The fictitious fixed asset line item at each facility was listed as “AP summary.” The company’s CFO, William Owens, a former Ernst & Young (EY) senior manager and one of five CFOs who eventually pleaded guilty to the fraud, also used the acquisition of Horizon/CMS to book $400 million worth of goodwill as part of the cover-up. He pulled the trick off with the help of two HealthSouth colleagues and a finance executive from Horizon. On paper, HealthSouth maintained impeccable corporate policies. The company established a confidential whistleblower hotline in 1997; developed a nonretaliation policy, which gave the compliance director direct access to the board; and established a centralized finance function. This centralized function seemed to be a particular advantage because other health care companies were falling apart as a result of problems in field offices. Reviewing these policies, it is not difficult to see why a massive fraud did not seem likely. Despite outward appearances, actual corporate governance was quite different. Many decisions were made at the executive level, which limited checks and balances along the way. The audit committee met only once a year. The accounting systems in the field did not interface with the corporate enterprise-resource-planning software, making it necessary for results to be consolidated at the corporate level, where it was easier to “cook” the numbers. Scrushy, a former gas station attendant, fit the profile of the domineering CEO who set the wrong tone at the top. He reportedly managed by fear and intimidation. Scrushy installed security cameras throughout headquarters to watch employees. He allowed rank-and-file employees into his executive suite only when he wanted to berate them. According to the government’s complaint, accounting personnel advised Scrushy in 1997 to abandon the fraud, but he refused, saying, page C15“Not until I sell my stock.” The five CFOs realized the error of their ways, but most felt helpless to blow the whistle or even leave the company. One, Michael Martin, testified he tried to quit, but Scrushy reportedly said, “Martin, you can’t quit. You’ll be the fall guy.” Later, when Treasurer Leif Murphy decided to leave the company because of the fraud, Martin punched him twice at his going-away party and wrote on his farewell card, “Eat [expletive] and die.” AUDIT APPROACH HealthSouth was the largest client of the Birmingham office of EY. The 2001 audit fee was $1.2 million, and the firm billed an additional $2.5 million for other services. Many of HealthSouth’s senior accounting staff had been EY employees. In hindsight, there had been red flags for the auditors to pursue. For example, from 1999 to 2001, net income rose nearly 500 percent while revenue grew only 5 percent. The audit team also took no action when members learned that internal auditors were denied access to the corporate books. Finally, the team did not sufficiently investigate employee complaints. The auditors were not oblivious to HealthSouth’s risky profile. Jim Lamphron, a partner on the audit, said they focused on two risk factors: (1) “Company officials harboring a strong interest in seeing a rising stock price” and (2) “Management ranks dominated [by] those at the top. . . . Specifically, we were focusing on Richard Scrushy.” Despite EY’s awareness of important fraud risks, the “family” was adept at the cover-up, making it difficult to detect certain aspects of the fraud. The SEC said that HealthSouth employees knew that EY questioned additions to fixed assets at any particular facility only if the additions exceeded a certain dollar threshold ($5,000), so the company avoided exceeding that dollar amount by spreading the adjustments below this materiality limit to various accounts and locations. When the auditors did question an accounting entry, HealthSouth officials created false documents to cover their tracks. When EY auditors asked for fixed assets ledgers for various facilities, accounting personnel would regenerate the ledgers, replacing the AP Summary line with the name of a specific fixed asset that did not exist at the facility.16 DISCOVERY The fraud scheme was noticed by company whistle-blowers, whose concerns seemed to be disregarded. One anonymous e-mail was sent to the auditors saying the company “fleeced shareholders” and listed four suspicious accounting practices. EY’s review determined that the issues raised by the author of the e-mail “did not affect the presentation of HealthSouth’s financial statements.” Another e-mail, from former employee Michael Vines and forwarded to audit partner Jim Lamphron, was passed to CFO William Owens and George Strong, the audit committee chairman. Owens provided fake invoices for the questioned entries and dismissed the seriousness of this e-mail, indicating that Vines was just a disgruntled former employee. (Vines had made frequent comments about the company’s accounting on the employee electronic chat room and was regarded as something of a pest.) In October 1999, Diana Henze, assistant vice president of finance, noticed that earnings would jump with each iteration of quarter-end consolidations. She confronted Owens, who was controller at the time, and accused him of fraud. When she went to Kelly Cullison, the company’s corporate compliance officer, she was told that the compliance officer “did not have access to the supporting documents” to determine whether or not the journal entries were legitimate. Henze brought the matter to her supervisor, cofounder Tony Tanner, who told her the entries were the result of page C16reversing out a number of reserves and that the matter was closed.19 Henze said that she was subsequently passed over for a promotion that would have given her more involvement with the books. When she asked why a less-qualified person got the job, Owens told her, “You have made it clear you won’t do what we asked.” William Owens finally went to the authorities when his wife threatened to divorce him because she thought (correctly) that he would end up in jail. Owens agreed to wear a wire when meeting with Scrushy. Scrushy is on tape as saying, “You got accountants signing off on all this.” In an impromptu meeting at a lake, Scrushy is recorded as telling Owens, “Just remember, I got eight kids. I got a bunch of babies at home. They need their daddy.” Scrushy also told Owens, “If you want to go public with all this, get ready to get fired, and everyone goes down with you,” according to the transcript of the recording that Owens made. Once Owens came forth, the investigation quickly uncovered the massive fraud as other employees quickly cut deals with prosecutors. Scrushy was a local hero in Birmingham with supporters in all corners. A lavish donor to local colleges, libraries, and medical centers, he was also a regular preacher at area churches. He even aired his own TV talk show each day before he appeared in court and hosted his own website (www.richardmscrushy.com). His defense attorneys sought to depict him as a detached leader and visionary rather than a micromanager with unchallenged influence. In the end, he was acquitted of all charges in what many see as a blow to enforcement of the Sarbanes—Oxley Act. (Scrushy had certified statements on the 10-K dated August 14, 2002, under the Sarbanes—Oxley Act.) Jurors said key witnesses were not credible, and the prosecution failed to present substantial evidence linking the fraud to Scrushy: “The smoking gun wasn’t pointing toward Mr. Scrushy.”25 Scrushy subsequently settled claims from the SEC by paying $81,000,000.26 However, in October 2006, he was convicted of improperly paying $500,000 to a campaign of former Alabama Governor Don Siegelman in exchange for a seat on a hospital regulatory board. He was sentenced in June 2007 to nearly seven years in prison. In July 2009, a jury awarded $2.88 billion in a civil suit brought by HealthSouth shareholders. It is believed to be the largest penalty ever levied against one executive. This case was brought before a lone judge, not a jury.28 In April 2011, the Alabama Supreme Court denied Scrushy’s appeal of the verdict.29 Scrushy was released from prison in 2012 and now is on the speaker circuit.

QUESTIONS

What are several red flags that E&Y either was or should have been aware of in the audit of HealthSouth?

What procedures can auditors perform to detect fraudulent entries made during the consolidation process?

How can auditors determine a company’s true “tone at the top”?

What is the appropriate response by auditors to information from “disgruntled” employees?

HealthSouth concealed the fraud by keeping the fraudulent transactions below $5,000. What recommendation would you have given to E&Y to improve its sampling practices?

Answer 1

Solution:

In comparison to many other industries, accounting rules are primarily private. What I mean here is that the administration is not writing the rules. However, it mainly has left the profession of accounting standards with the exception of the PCAOB and SEC. GAAP are laid up by the Financial Accounting Standards Board and the FASB, but the Federal Government can intervened and require companies to report financial information somehow. It is a private entity or association that defines the guidelines to follow in the accounting business. The GAAP Hierarchy has a wide range of accounting principles and concepts.