ACG 6686 Fraud Accounting

GROUP 3
Maria Fernandez de Castro
Sonia Canessa-Gonzalez
Andres Suarez
Anatom o! a Financial Fraud "ealt#Sout#$ %nc&
'#e Com(an and its #istor
Richard Scrushy and a few close associates founded HealthSouth in 1984. In 1986 their
company went public, and by 1991, two maret analysts at Smith !arney, Harris and "orello,
be#an a lucrati$e career #i$in# stron#ly positi$e stoc e$aluations to HealthSouth and a number
of associated corporations. %his brou#ht in billions of dollars of business from HealthSouth for
them and Smith !arney, arran#in# loans and floats to support the company&s e'pansion.
HealthSouth&s stoc $alue increased as a result enablin# it to secure ban loans and use stoc in
taeo$er endea$ors. !etween 199( and 1998 the stoc $alue would increase by )(*+ reachin#
,S -.* in 1998. %he alle#ations about this relationship with "orello su##est that it was Harris&
optimistic profit pro/ections which HealthSouth&s accountants were re0uired to match. If it failed
to do so its share price would fall and it would be unable to #row.
Harris and "orello built their reputations around HealthSouth. !y 1998 HealthSouth had
been far more successful than any of the other successful corporations. It had come to dominate
the for1profit rehabilitation and out patient sur#ery maretplaces by ac0uirin# competitors. %here
were only a $ery few small for profit rehabilitation pro$iders still competin# with it. It was busy
buyin# up outpatient sur#ery from its competitors includin# Sur#ical Health, 2olumbia3H24,
and 5ational Sur#ery 2enters.
HealthSouth and HealthSouth directors also formed 6ed7artners, which was the lar#est
and most successful physician mana#ement in the health care corporate cra8e. 9nly one other
company, 7hycor, could compete. 6edpartners had also entered the pharmacolo#y business
buyin# up the company 2aremar. HealthSouth:s directors were in$ol$ed in nursin# home and
post acute care holdin# positions on Inte#rated Health Ser$ices: board. %hey had entered Home
2are when they /oined with Inte#rated Health Ser$ices and bou#ht Hori8on326S. %hey had
mo$ed into 6ana#ed 2are buyin# 6edSolutions. ;ith 2olumbia3H24 in the midst of a massi$e
fraud in$esti#ation it looed as if Scrushy and HealthSouth were poised to tae o$er the entire
,S Health System. Scrushy and his close associates would ti#htly control the companies and
their directors. 2onflicts of interest would simply be i#nored.
;hile HealthSouth was successful and considered the darlin# of the maretplace no one
0uestioned these arran#ements. Scrushy and his associates rewarded themsel$es $ery
handsomely. 9$er the succeedin# years Scrushy built his reputation as an eccentric
multimillionaire and ma#nanimous philanthropist. His local !irmin#ham, 4labama community
came to worship him.
<urin# the late 199*s, HealthSouth:s raid of ac0uisitions for all inds of healthcare,
pharmaceutical and rehabilitation companies ran#es in billions of dollars. %he company, always
with Scrushy at the helm, e$en taes to other countries, includin# 4ustralia.
4midst the e'cesses, se$eral of the subsidiaries or associate companies are bein#
in$esti#ated for 6edicare fraud. In 1998, Scrushy reor#ani8es an implodin# 6ed7artners
)
mana#ement in =anuary and taes o$er as chairman until 5o$ember but he remains on the board.
6ed7artners refuses to address demands made by insurers alle#in# 2aremar had defrauded
them. %wenty1three insurers #o to court claimin# a ,S -... billion fraud by 2aremar. %he
7hysician 6ana#ement business collapses and a decision is made by 6ed7artners to abandon it.
Shares ha$e plummeted and in$estors ha$e lost many millions. 2rawford, a turn around
specialist who has been brou#ht into HealthSouth, becomes chairman. 6edpartners switches
direction to its 2aremar pharmaceutical business.
%he new 6edicare fundin# arran#ements desi#ned to pre$ent e'ploitation of the system
are commenced mid 1998. !y the end of the year profits ha$e dropped 9.+ but Scrushy blames
mana#ed care contracts for this. Scrushy remains supremely confident while sellin# shares. He
then announces that the promised e'pectations will not be met. Share prices fall, and a number of
class action suits are commenced by an#ry stocholders, alle#in# insider tradin#. It will later be
su##ested that this down#rade was artificial and an attempt to hide some of the fraud. 2racs
be#in to appear in HealthSouth&s in$incible ima#e. %he first ma/or indications of 6edicare fraud
and simpin# on patient care appear.
In )***, Scrushy is indi#nant about a threat by 6oody&s In$estors Ser$ice to down#rade
HealthSouth&s ,S -. billion debt sayin# >;e&re doin# #reat, . . . 9ur cash is #reat, our earnin#s
are stron# . . . and shareholder $alue is impro$in# e$ery day>. %he accountin# fraud is continuin#
and the company is perhaps trapped by its commitment to #row, and the en$y of the maretplace,
which it dare not disappoint.
4 year later, the many corporate failures ha$e forced the #o$ernment to restore some
6edicare fundin# and the prospects looed better. HealthSouth starts raisin# money from the
maret in order to pay down debt. HealthSouth pays ,S -8.) million 6edicare fraud for
.
ille#ally billin# 6edicare for e0uipment purchased from its own companies. ?o$ernment /oins a
whistle blower @ui %am action alle#in# 6edicare fraud. Scrushy sells his shares in 2aremar.
<urin# )**), howe$er, thin#s be#in to rapidly unra$el and HealthSouth finds itself on a
slippery slide with serious problems. In 6ay the =ustice department /oins a whistle blower
initiated action lawsuit accusin# HealthSouth of seein# indi$idual payment for ser$ices #i$en to
#roups and pro$ided by unlicensed employees includin# interns and students. %his means that
the #o$ernment taes o$er the case, in$esti#ates and prosecutes. %he #o$ernment seldom /oints
these suits unless it is confident of a lar#e settlement.
Scrushy seems to see the writin# on the wall. He e'ercises (.. million options at -..A8
and sells them for ,S -14.*( the same day. 4lto#ether he sells ,S -1.. million in stoc in 6ay
and =uly. In 4u#ust the company announces a profit down#rade blamin# minor chan#es to
6edicare re#ulations which it has nown about for a lon# time but which they claim they ha$e
only recently become aware of. It will later be alle#ed that this down#rade was inflated in
another attempt to hide the missin# money in the accounts. %his e'planation is not plausible and
in the 7ost1Bnron en$ironment is not accepted. %he share price tumbles and a host of class
actions alle#in# insider tradin# are commenced.
In 4u#ust Scrushy steps down as chief e'ecuti$e but remains as chairman. He announces
plans to split off profitable sur#ery centers as a separate company, which he will chair. 4 witness
will later indicate that he planned to tae the rump pri$ate and bury the fraud there.
%he HealthSouth corporate faCade be#ins to brea up as post1Bnron in$estors and
analysts start to loo critically at its 0uality of ser$ices with claims that care was pro$ided by
un0ualified staff. %he 9ffice of the Inspector ?eneral of the <epartment of Health and Human
4
Ser$ices, which in$esti#ates 6edicare and 6edicaid fraud, confirmed that it was looin# at
HealthSouth.
%here are also alle#ations about its financial practices, insider stoc sales, business
dealin#s amon# company officials and the independence of the board. It has a credibility
problem and shares tumble. %he company claims it is committed to transparency.
<etails of Scrushy&s ,S -1*.( million Dincludin# bonusE )**1 remuneration and his la$ish
philanthropy are reported in the press.
%he SB2 starts an in$esti#ation of the share sales made in =uly )**) shortly before the
stoc collapsed, by Scrushy and 9wens. 4 host of shareholder class actions accuse Scrushy and
others of not disclosin# ad$erse information about stoc&s potential decline in 1998 and a#ain in
)**) when they sold stoc. %he SB2 will later claim that these pro/ected losses were deliberately
o$erstated to hide the fraud.
Scrushy and 9wens deny insider tradin#. HealthSouth announces that an independent
national law firm has cleared Scrushy&s sale of shares. HealthSouth employed the firm and its
report was ne$er made public. In 9ctober HealthSouth abandons plans to split company in the
face of criticism by in$estors and lenders. It starts looin# for thin#s to sell. %he end for
HealthSouth and Scrushy comes rapidly. 7ost Bnron in$esti#ators tar#et HealthSouth and in
February )**. it is ser$ed with a subpoena as part of an in$esti#ation into criminal practices.
Re#ulators e'amine documents and inter$iew many HealthSouth employees. %he family of
accountants who, it is alle#ed, carried out the accountin# fraud start meetin# daily or more often.
(
;eston ". Smith, a former chief financial officer approaches prosecutors and offers to
mae audiotapes of his collea#ues. It is liely that this is the ey to the multiple #uilty pleas that
follow. %he company&s current 2F9 ;illiam 9wens also cooperates with in$esti#ators and tape
records incriminatin# con$ersations with Scrushy. %he ne't day F!I a#ents raid HealthSouth
head0uarters.
In a ci$il action the SB2 and the =ustice department char#e the company and Scrushy
with a massi$e fraud between 1999 and )**.. HealthSouth had o$erstated its earnin#s by ,S
-1.4 billion and its assets by ,S -8** million. 4uthorities indicate that the fraud started as lon#
a#o as 1986 when the company went public. ;eston Smith, 2hief Financial 9fficer D2F9E
pleads #uilty and is helpin# authorities. %he authorities obtain a court order to free8e Scrushy&s
assets and bar him from actin# as a director of any company.
HealthSouth&s shares are suspended on the stoc e'chan#e and subse0uently remo$ed. It
is remo$ed from the SG7 (** inde'. %he share price has already fallen from -.* fi$e years a#o
to -4. It is soon tradin# for as little as 14 cents o$er the counter. %he bans free8e the company&s
,S 1.)( billion credit line ahead of a ,S -.4( bond payment due 4pril 1
st
. %he company
stru##les to a$oid banruptcy. It admits that its accounts cannot be relied on as an indication of
its financial position. It is unable to file its annual report with the SB2 and postpones its annual
meetin#.
HealthSouth cannot fire Scrushy as a director but they as him to resi#n, suspend him as
chief e'ecuti$e officer, and fire him as chairman, notifyin# him that his contract is >null and
$oid>. HealthSouth forms its own committee to in$esti#ate the alle#ations. %he press be#ins to
loo at Scrushy&s la$ish lifestyle, his e'tracurricular acti$ities, his philanthropy and his
6
a##ressi$e mana#ement style. %he effecti$eness and fre0uency of meetin#s of HealthSouth&s
audit committee is challen#ed. %he committee denies nowled#e of the fraud and employs
lawyers to protect it. In an attempt to restore credibility the company had appointed a new
director, !etsy 4dams and made her head of the committee to in$esti#ate the SB2 alle#ations of
fraud. She resi#ns after less than . wees.
4#ain to restore credibility the company loos for new directors not tainted with the
Scrushy brush. 9ne report indicates that the board is deadloced 4 to 4 as directors with
lon#standin# ties to 6r. Scrushy refused to appro$e a plan to add independent members who
would form a ma/ority.
%here is scepticism about the role played by the auditors #i$en the duration of the fraud.
Some belie$e that there were pointers to what was happenin# 1 which should ha$e aroused
suspicion. %his impression is reinforced when HealthSouth fires Brnst and Houn# and employs
new auditors.
Scrushy&s ma8e of pri$ate companies, the comple' relationships between them and the
businesses run by HealthSouth come under scrutiny. %he F!I loos to see if Scrushy has
established an off shore ta' ha$en. %here are concerns that the company has committed
6edicare fraud by hu#e and artificial increases in the company&s assets, which were then
included in claims for depreciation allowances from 6edicare. %his is the same sort of fraud as
that perpetrated by 2olumbia3H24 in its ,S -1.A million fraud settlement.
@uite separate to this the <epartment of Health and Human Ser$ices& inspector #eneral&s office
re$eals that 6edicare inspectors ha$e been in$esti#atin# HealthSouth for 6edicaid fraud >on a
few fronts> for se$eral years.
A
Insurance companies start e'aminin# their contracts to see their e'posure to HealthSouth
and determine if they ha$e been defrauded. 7ri$ate in$estors commence class actions a#ainst
Scrushy and the company.
!y the end of 4pril a total of 11 senior past and present staff plead #uilty to fraud
includin# all ( of the company&s past 2hief Financial 9fficers D2F9&sE. %he fraud is clearly
documented bac at least to 199A. 5ew pleas include 6ichael 6artin, who describes discussions
with Scrushy about fraud in 199. and 4aron !eam a co1founder of the company and the first
2F9 of HealthSouth.
%he e$idence some #i$e e'poses o$er ,S -1 billion additional fraud in 199A and 1998
brin#in# the total to ,S -).( billion. %hey re$eal that HealthSouth misstated assets of companies
it ac0uired to create >soc> reser$e accounts which were then >bled out> into HealthSouth to
falsely enhance its own earnin#s.
%hose who pleaded #uilty describe how they were suced into the fraud, often unaware
of what they were doin# or the e'tent until they were trapped by their own #uilt. %here was fear
and intimidation and they rised losin# their /obs. 5o one is disputin# the nature of the fraud or
its e'tent.
%he SB2 anticipated that Scrushy would be re0uired to pay bac o$er ,S -A** million
but his assets were only ,S -1(* million. %hey thou#ht that he mi#ht mo$e his funds into
offshore accounts and sou#ht a court order free8in# his assets. <efrauded shareholders would not
be able to reco$er e$en a fraction of their losses. Scrushy&s current personal accountant #i$es
8
e$idence about Scrushy&s web of pri$ate companies and the suicide of her predecessor, a matter
that is still bein# in$esti#ated.
Scrushy continues to deny the alle#ations claimin# that he was i#norant of the fraud and
is the sub/ect of #o$ernment $ictimi8ation. He claims that 9wens is framin# him. 4n assistant
$ice president for finance, Ielly 2oleman, testifies that she heard in a meetin# >last summer>
that Scrushy had baced a plan to end the fraud by en#ineerin# a corporate spinoff, sellin# assets,
and blamin# a 6edicare reimbursement chan#e. 4fterward she said the rest of the company
would be pri$ate.
%he web of inappropriate relationships between HealthSouth, Scrushy, Scrushy&s closely
associated directors and a web of companies in which they were all in$ol$ed be#ins to unfold. 4
report in the 5ew Hor %imes e'amines the conflictin# situation of an in$estor and close
associate of Scrushy, 6s ?i$ens, who is a lon#1term director and also on HealthSouth&s audit
committeeJ the body that is char#ed with monitorin# corporate practices. HealthSouth stru##les
to find new independent directors but there are few applicants. HealthSouth starts to lay off staff
at it head0uarters in order to reduce costs. It plans to sell hospitals. It sees to minimi8e the
dama#e by promotin# the inte#rity of its new 2hairman and by issuin# new #o$ernance
#uidelines. In the meantime, it also taes steps to reassure the doctors on whose support it
depends, payin# them promptly and also payin# their insurance. %he nature of HealthSouth&s
financial dealin#s with doctors is not re$ealed but it is clear that they co1own facilities and that
HealthSouth has e'tensi$e financial dealin#s with them. .(** doctors ha$e in$ested in sur#ical
centers. %he e'posure of these financial relationships with doctors raises concerns about conflicts
between the doctors& financial dependence on the company and their duty to their patients.
9
%he case a#ainst Scrushy and HealthSouth builds rapidly and analysts confidently predict
that Scrushy will soon face criminal char#es. ,nder the new Sarbanes19'ley corporate reform
law he would be looin# at 1* years behind bars.
%he SB2 launches an insider tradin# action a#ainst Scrushy looin# for ,S -A4. million
includin# the return of profits, ci$il penalty and interest. %he SB2 claims that Scrushy sold at
least 1..8 million shares of HealthSouth stoc worth more than -1A* million since 1991 based
upon his nowled#e of the company&s true results.
6ore information emer#es about Scrushy&s la$ish life style, his pri$ate businesses and his
autocratic style of control. His 6onday mornin# >beatin#s> were dreaded by employees whom
he would #rill and criticise, humiliatin# them publicly. %hose who #i$e e$idence indicate that
they would ha$e been dismissed had they not #one alon# with company practices. 4 past
employee describes how he was dismissed in 1989 after he 0uestioned accountin#. Scrushy
obtained his ob/ecti$es by intimidation and heaped contempt on his critics. He is alle#ed to ha$e
created an elaborate faCade by manipulatin# those around him. It was >lie a cult> and those
around Scrushy were >e'cessi$ely obedient and ea#er to please>. Bmployees in the hospitals
ha$e claimed that >security officers appeared to closely monitor the acti$ities of employees and
others>. Reporters describe the ti#ht control Scrushy e'erted o$er the media. He insisted on
bein# present at meetin#s with the media and answered the 0uestions himself.
Bmployees commence a class action claimin# the alle#ed fraud made company stoc a
poor in$estment for their retirement plan. 6ore stocholder class actions are lod#ed. Retirement
funds that purchased HealthSouth bonds are also suin#. 4 reporter writin# for the 5ew Hor
%imes e'amines the role which persistent positi$e reports by ?eoff B Harris a maret analyst
1*
worin# for Smith !arney and later for ,S! ;arbur# played in HealthSouth&s success by
boostin# its stoc $alue. <urin# this time Smith !arney did ,S -8 billion in business with
HealthSouth, a clear conflict of interest for Harris. <urin# this period Harris& salary rose from ,S
-4 million a year to ,S -)* million, a reflection of the business his reports brou#ht in. %hese
reports and the $alue of its stoc would ha$e facilitated HealthSouth&s taeo$ers, its ability to
raise loans from bans and to raise money on the stoc maret.
%he SB2 and the press continue to e'plore the worryin# relationship between directors,
Scrushy, HealthSouth and a number of related companies which reaped rich rewards for Scrushy
and collea#ues. %hese include 2apstone 2apital 2orporation, a publicly listed real estate
in$estment company founded by Scrushy and partners. It purchased and then leased bac
facilities from HealthSouth, Inte#rated Health Ser$ices DIHSE and other companies of which
Scrushy was a director. %his was one of the deals in which Smith !arney was implicated.
4n 4pril )* re$iew by the 5ew Hor %imes indicated that o$er the years, as HealthSouth
prospered, the company was repeatedly accused of cheatin# ta'payers and cuttin# corners. In
other reports a past hospital staff member describe how the hospital e'ecuti$es were instructed
by HealthSouth to accept 6edicare patients e$en thou#h they were too ill for the resources of the
facilities. 4s in %enet356B they understood that >if they did not eep the numbers up, they
would lose their /obs>. HealthSouth&s response to accusations that it admitted inappropriately was
to commence a defamation action.
4 former HealthSouth e'ecuti$e and co1founder, 4aron !eam&s prophetic 1996 statement
about meetin# )6 year old Scrushy in 1984 is reported. >I went home and told my wife that I /ust
inter$iewed with the bi##est con artist I e$er met, or the most brilliant youn# man I e$er met,> he
11
told %he !irmin#ham 5ews in 1996. >Bither way,> he said, >I was tain# the /ob because he was
really, really #ood at what he did.> !eam was HealthSouth&s first 2F9. 9n )4
th
4pril !eam
becomes the 11
th
person and the last of the fi$e 2F9&s to plead #uilty to fraud. !ecause the (1
year limitation is e'ceeded he is char#ed only with ban fraud. He is accused of de$isin# a
scheme to obtain loans and credit from !irmin#ham1based 4mSouth !an and other lenders by
filin# false and fraudulent financial information with the ban. %he char#e carries a ma'imum
penalty of .* years in /ail.
Federal in$esti#ators commence an in$esti#ation of HealthSouth&s ta' firm, I76?. 4
series of reports at the end of the month indicate that HealthSouth plans an orderly entry into
banruptcy and has already ne#otiated it. 9thers claim it can still a$oid this. HealthSouth&s
lenders refuse to e'tend their a#reement not to insist on payment beyond 6ay 1
st
but
HealthSouth does not e'pect them to do so.
%he Federal 2on#ressional House Bner#y and 2ommerce 2ommittee launches an
in$esti#ation into the financial fraud at HealthSouth, asin# the company and its auditor, Brnst G
Houn#, to pro$ide detailed documentation of their actions surroundin# the hospital chain&s -).(
billion o$erstatement of earnin#s. It wants to now why Brnst and Houn# failed to detect the
fraud when there were se$eral clues, e$en after they had been tipped off about fraud and told
where to loo.
%he 2ommittee in ;ashin#ton also demands and recei$es additional documents as it
loos at HealthSouth&s relationship with its in$estment baners and their analysts, as well as its
ta' consultants I76?. %his is the committee that in$esti#ated the Bnron scandal and cross1
e'amined ey Bnron staff. It also e'amined the conduct of in$estment baners and analysts in
1)
the Bnron and ;orldcom failures, an in$esti#ation that resulted in ,S -1.4 million fines and new
laws re#ulatin# the industry. It specifically wants to cross1e'amine 6r "orello.
4n interestin# twist emer#es when it is disco$ered that Bnron, ;orldcom, HealthSouth
and others that had o$erstated profits and paid ta' on these had already claimed a ta' refund or
else planned to do so. 7oliticians and others were an#ered and ur#ed prosecutors to ensure that
any ta' moneys refunded be added to any fines.
'#e Accounting
4 forensic audit conducted by 7ricewaterhouse2oopers concluded that HealthSouth
2orporation:s cumulati$e earnin#s were o$erstated by anywhere from -..8 billion to -4.6
billion, accordin# to a =anuary )**4 report issued by the scandal1ridden health1care concern.
HealthSouth acnowled#ed that the forensic audit disco$ered at least another -1.. billion dollars
in suspect financial reportin# in addition to the pre$iously estimated -).( billion. %he scandal:s
postmortem report found additional fraud of -(** million, and identified at least -8** million of
improper accountin# for reser$es, e'ecuti$e bonuses, and related1party transactions. %his billion1
dollar1plus admission failed to #arner financial media headlines, further e$idence of the public
#ettin# accustomed to financial reportin# scandals.
%he SB2 e'ecuted a court order, pursuant to section 11*. of the Sarbanes19'ley 4ct, that
K
Re0uired the company to place in escrow all e'traordinary payments to its directors,
officers, partners, controllin# persons, a#ents, and employeesJ
7rohibited the company from destroyin# documents relatin# to financial acti$ities or
alle#ations in the case a#ainst HealthSouth and ScrushyJ and
1.
7ro$ided for e'pedited disco$ery.
4ccordin# to the SB2, Healthsouth perpetrated the scheme to o$erstate earnin#s by doin# the
followin#L
If HR2:s actual results fell short of e'pectations, Scrushy would tell HR2:s mana#ement to
Mfi' itN by recordin# false earnin#s on HR2:s accountin# records to mae up the shortfall.
HR2:s senior accountin# personnel then con$ened a meetin# to Mfi'N the earnin#s shortfall.
!y 199A, the attendees referred to these meetin#s as Mfamily meetin#sN and referred
themsel$es as Mfamily members.N
4t these meetin#s, HR2:s senior accountin# personnel discussed what false accountin#
entries could be made and recorded to inflate reported earnin#s to match ;all Street
analysts: e'pectations. %hese entries primarily consisted of reducin# a contra re$enue
account, called Mcontractual ad/ustment,N and3or decreasin# e'penses, Deither of which
increased earnin#sE, and correspondin#ly increasin# assets or decreasin# liabilities.
%he contractual ad/ustment account is a re$enue allowance account that estimates the
difference between the #ross amount billed to the patient and the amount that $arious
healthcare insurers will pay for a specific treatment. HR2 deducted this account from #ross
re$enues to deri$e net re$enues, which were disclosed on HR2:s periodic reports filed with
the 2ommission.
%he correspondin# balance sheet entries were necessary because #enerally accepted
accountin# principles DM?447NE re0uire any increase in re$enue or decrease in e'penses to
be matched with either an increase in assets or decrease in liabilities.
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!e#innin# no later than 1999, HR2 falsified its fi'ed asset accounts to match the fictitious
ad/ustments to the income statement.
In particular, HR2 senior accountin# personnel recorded false entries to the fi'ed asset boos
of its numerous facilities. %he combined amount of the false entries e0ualed the total amount
of fictitious increases to the income statement for that 0uarter.
%he fictitious fi'ed asset line item at each facility was listed as M47 Summary.N In its Form
1*1@ for the third 0uarter ended September .*, )**), HR2:s fi'ed assets, listed on the
balance sheet as Mproperty, plant and e0uipment,N were o$erstated by appro'imately -8**
million, or 1* percent of the total assets reported.
HR2:s accountin# personnel desi#ned the false /ournal entries to the income statement and
balance sheet accounts in a manner calculated to a$oid detection by the outside auditors. For
e'ample, instead of increasin# the re$enue account directly, HR2 inflated earnin#s by
decreasin# the Mcontractual ad/ustmentN account. !ecause the amounts booed to this
account are estimated, there is a limited paper trail and the indi$idual entries to this account
are more difficult to $erify than other re$enue entries.
4dditionally, each inflation of earnin#s and correspondin# increase in fi'ed assets were
recorded throu#h se$eral intermediary /ournal entries in order to mae the false inflation
more difficult to trace.
Furthermore, HR2 increased the M47 SummaryN line item at $arious facilities by different
amounts because it new that across the board increases of e0ual dollar amounts would raise
suspicion.
HR2 also new that its outside auditors only 0uestioned additions to fi'ed assets at any
particular facility if the additions e'ceeded a certain dollar threshold. %hus, when artificially
1(
increasin# the M47 SummaryN at a particular facility, HR2 was careful not to e'ceed the
threshold.
HR2 also created false documents to support its fictitious accountin# entries. For e'ample,
durin# the audit of HR2:s )*** financial statements, the auditors 0uestioned an addition to
fi'ed assets at one particular HR2 facility. HR2 accountin# personnel, nowin# that this
addition was fictitious, altered an e'istin# in$oice Dthat reflected an actual purchase of an
asset at another facility that appro'imated the dollar amount of the fictitious additionE to
fraudulently indicate that the facility in 0uestion had actually purchased that asset. %his
altered in$oice was then #i$en to the auditors to support the recordin# of the fictitious asset
in 0uestion. 4lso, when the auditors ased HR2 for a fi'ed assets led#er for $arious
facilities, HR2 accountin# personnel would re1#enerate the fi'ed asset led#er, replacin# the
M47 SummaryN line item with the name of a specific fi'ed asset that did not e'ist at the
facility, while lea$in# the dollar amount of the line item unchan#ed.
;hile the scheme was on#oin#, HR2:s senior officers and accountin# personnel periodically
discussed with Scrushy the bur#eonin# false financial statements, tryin# to persuade him to
abandon the scheme. Scrushy insisted that the scheme continue because he did not want
HR2:s stoc price to suffer. Indeed, in the fall of 199A, when HR2:s accountin# personnel
ad$ised Scrushy to abandon the earnin#s manipulation scheme, Scrushy refused, statin# in
substance, Mnot until I sell my stoc.N
Scrushy has personally profited from the scheme to artificially inflate earnin#s. He has sold
at least A,A8),1.* shares of HR2 stoc since 1999, when HR2:s share price was affected by
HR2:s artificially inflated earnin#s.
16
6oreo$er, accordin# to HR2:s )**1 Form 1*1I, Scrushy recei$ed at least -6.( million from
HR2 durin# )**1 in M!onus34nnual Incenti$e 4wards.N %his bonus payment was based on
HR2:s artificially inflated earnin#s.
Further, accordin# to HR2:s )**1 Form 1*1I, from 1999 throu#h )**1, HR2 paid Scrushy
-9.) million in salary. 4ppro'imately -(.. million of this salary was based on HR2:s
achie$ement of certain bud#et tar#ets. HR2 attained these bud#et tar#ets throu#h its scheme
to artificially inflate earnin#s.
In 4u#ust )**), after certain senior HR2 officers con$inced Scrushy to tae steps to lower
;all Street e'pectations, Scrushy authori8ed a scheme to blame a 6ay )**) 6edicare
billin# #uidance, referred to as %ransmittal 1A(., for reduced future earnin#s. %ransmittal
1A(. re0uired certain healthcare pro$iders to bill 6edicare at the lower #roup therapy rate
when treatin# multiple patients in a sin#le time period, rather than at the more lucrati$e
indi$idual rate.
9n 4u#ust )A, )**), HR2 issued a press release statin# that it e'pected %ransmittal 1A(. to
reduce its annual earnin#s by appro'imately -1A( million.
%his -1A( million pro/ection was false and was primarily intended to lower ;all Street
e'pectations for HR2:s earnin#s. HR2:s internal accountin# personnel estimated that
%ransmittal 1A(. would reduce HR2:s e'pected earnin#s by only -)*1.* million dollars per
year on an on#oin# basis. Scrushy intended that, by lowerin# ;all Street e'pectations, this
press release would reduce the need to artificially inflate earnin#s in the future.
In mid1)**), certain HR2 senior officers and Scrushy discussed the impact of the scheme to
inflate earnin#s because they were concerned about the conse0uences of the 4u#ust 14, )**)
financial statement certification re0uired under 2ommission 9rder 5o. 4146*, 9rder
1A
Re0uirin# the Filin# of Sworn Statements 7ursuant to Section )1DaED1E of the Securities
B'chan#e 4ct of 19.4 D=une )A, )**)E. DM9rder 4146*NE. Scrushy a#reed that, #oin# forward,
he would not insist that earnin#s be inflated to meet ;all Street analysts: e'pectations.
Scrushy new or was recless in not nowin# that HR2:s financial statements materially
o$erstated its operatin# results. 5e$ertheless, on 4u#ust 14, )**), he and HR2:s 2hief
Financial 9fficer certified under oath that HR2:s )**1 Form 1*1I contained no Muntrue
statement of material fact.N In truth, the financial statements filed with this report o$erstated
HR2:s earnin#s, identified as MIncome !efore Income %a'es 4nd 6inority InterestsN on
HR2:s income statement, by at least 4,A** +.
a) '#e Auditors
HealthSouth paid the !irmin#ham office of Brnst G Houn# ""7 -..6 million for its )**1
financial statement audit and related ser$ices. Brnst G Houn# disa$owed nowled#e of the fraud,
citin# systemic deception on the part of HealthSouth e'ecuti$es, se$eral of whom ha$e pled
#uilty to fraud char#es. 2ommunication about 0uestionable acti$ities too place between the
health1care pro$ider and its auditor, howe$er. For e'ample, in a hearin# to decide if Scrushy:s
assets should be unfro8en, two Brnst G Houn# partners stated that the audit firm had recei$ed an
e1mail from a HealthSouth employee ad$isin# them to e'amine three specific accounts for
fraudulent entries related to asset capitali8ation.
Brnst G Houn# subse0uently contacted HealthSouth:s president and chief operatin#
officer, ;illiam %. 9wens, and the chairman of its audit committee, ?eor#e Stron#. 9wens
defended HealthSouth:s capitali8ation method, but a#reed that further in$esti#ation was needed.
!oth 9wens and Brnst G Houn# partner =ames "anthron e$entually concluded that no costs were
18
improperly capitali8ed. Brnst G Houn# did not detect or in$esti#ate beyond the scope of normal
audit procedures any other substanti$e 0uestionable acti$ities outside of the capitali8ation issue.
*) Meeting Analsts+ ,-(ectations
SB2 <irector of Bnforcement Stephen 2utler stated in a 6arch 19, )**., press release
that MHealthSouth:s standard operatin# procedure was to manipulate the company:s earnin#s to
create the false impression that the company was meetin# ;all Street:s e'pectations.N %his
moti$e is not a new one.
In #eneral, analysts: e'pectations and company predictions address two hi#h1profile
components of financial performanceL re$enue and earnin#s from operations. %he pressure to
meet re$enue e'pectations is particularly intense and may be the primary catalyst leadin#
mana#ers to en#a#e in earnin#s mana#ement practices that result in 0uestionable, improper, or
fraudulent re$enue1reco#nition practices. 4 Financial B'ecuti$es International DFBIE study, for
e'ample, found that improper re$enue reco#nition practices were responsible for one1third of all
$oluntary or forced restatements of income filed with the SB2 from 19AA to )***.
c) ,arl .arning Signs
%he systematic and substanti$e HealthSouth fraud raises certain 0uestionsL
Should the auditors ha$e suspected fraudO
6ore important, could the auditors ha$e detected the financial statement manipulations
and e'posed themO
19
?i$en that the auditors did not detect fraud, could the in$estment community ha$e done
so throu#h careful e'amination of the financial statementsO
If so, what tools would help financial statement users detect the fraudO
6a#rath and ;eld identified si' relationships that in$estors and auditors should consider as
early warnin# si#ns of abusi$e earnin#s mana#ementL
2ash flows that are not correlated with earnin#sJ
Recei$ables that are not correlated with re$enuesJ
4llowances for uncollectible accounts that are not correlated with recei$ablesJ
Reser$es that are not correlated with balance sheet itemsJ
4c0uisitions with no apparent business purposeJ and
Barnin#s that consistently and precisely meet analysts: e'pectations.
d) Analzing "ealt#Sout#/s 0isclosures
If analysts, in$estors, or auditors had e'amined these relationships, would there ha$e
been reason to suspect abusi$e earnin#s mana#ement at HealthSouthO In retrospect, the answer is
a 0ualified yes. In$estors or auditors mi#ht ha$e detected abusi$e earnin#s mana#ement if they
had understood the conte't of the financial statements as well as their content, and if they had
thorou#hly analy8ed specific early warnin# si#ns of earnin#s mana#ement.
4s HealthSouth:s credibility unra$eled in full public $iew, it became apparent that for
many years its financial disclosures had neither represented economic reality nor conformed to
?447. %he company acnowled#ed as much in its Form 81I filed with the SB2 on 6arch )6,
)**.L
)*
%he company also announced today that, in li#ht of the recent Securities and
B'chan#e 2ommission and <epartment of =ustice in$esti#ations into its financial
reportin# and related acti$ity callin# into 0uestion the company:s pre$iously filed
financial statements, such financial statements should no lon#er be relied upon.
;hether the auditors should ha$e detected a scheme that ori#inated at upper
mana#ement le$els remains a matter of con/ectureJ re#ardless, in$estors and other
financial statement users laced reliable data.
HealthSouth met the final indicator of earnin#s abuseL %he company matched analysts:
e'pectations for 48 consecuti$e 0uarters throu#h mid11998. %hat unerrin# trac record could
ha$e been attributed to predictable operations and acceptable income1smoothin# techni0ues, but
hindsi#ht pro$ed otherwise.
,pon e'amination of the techni0ues used by HealthSouth, the authors offer two
techni0ues that in$estors and auditors can use to raise red fla#s about abusi$e earnin#s
mana#ement practicesL a more detailed analysis of recei$ables, and a lin between cash flows
and an array of performance measures.
e) Accounts Recei1a*le Analsis
HealthSouth disclosed its recei$able1related acti$ities on the face of its financial
statements. %he relati$ely lar#e percenta#e of recei$ables estimated as uncollectible is not
surprisin#, #i$en an industry dependent on third1party payments from 6edicare and insurance
companies. %his component:s $olatility, ran#in# from .8.9+ of #ross accounts recei$able to
1).)+, is troublin#, howe$er. In addition to this $olatility, HealthSouth:s 1999 pro$ision for
)1
doubtful accounts is an outlier when compared to other years: bad1debt e'pense. It may be only
coincidental that 1999 was the first full year in which in$estors new the company would not
meet pre$iously announced earnin#s pro/ections.
4nnual write1offs for uncollectible recei$ables laced any consistency whatsoe$er.
6oreo$er, the amount of the accounts written off in any #i$en year did not correlate with the
allowance established for them. %o the e'tent that these disclosures were reliable, these data
indicate that HealthSouth used bad1debt reser$es to manipulate earnin#s. %his lac of correlation
could be an indirect indicator of the fourth warnin# si#n of abusi$e earnin#s mana#ementL
reser$es that are not correlated with balance sheet items.
2onsider two related items related to uncollectible accounts, to further understand
possible earnin#s mana#ement. First, there were disproportionately lar#e allowance for doubtful
accounts balances at the end of 1994 and 199(L nearly 4*+ of #ross recei$ables. %hese e'istin#
balances could ha$e been drawn down without the need to record an accurate pro$ision for
doubtful accounts. 2onse0uently, the year1end char#e to bad e'pense, re0uired to replenish the
depleted contra1asset account, could ha$e been less than normally e'pected if the unad/usted
allowance balance /ibed with economic reality. !y understatin# e'penses in this manner,
HealthSouth could ha$e manufactured earnin#s be#innin# in the mid1199*s. %hese data pro$ide
some e$idence of the classic Mcooie1/ar reser$eN ploy.
%he related issue is the amount of bad1debt e'pense matched a#ainst re$enues in 1999.
4s noted, that unusually lar#e char#e to earnin#s was made at the time when it became publicly
nown that HealthSouth could no lon#er hit its earnin#s tar#et. 2ompany officials may ha$e
decided to replenish the balance in the allowance account Dadd cooies to the cooie /arE or
))
reco#ni8e pre$iously understated le$els of bad1debt e'pense. In either case, the lar#e char#e
D8.4+ of re$enuesE occurred when ;all Street diminished its earnin#s e'pectations for
HealthSouth. %ain# this Mbi# bathN for bad debts merely e'acerbated 1999:s already poor
financial performance, information that was already discounted in the maretplace. %he 0uestion
arisesL <id HealthSouth bury this apparently inflated e'pense amount within a sea of red in in
an attempt to mana#e earnin#sO
4n analysis of recei$ables composition sheds li#ht on the potential to o$erestimate cash
collected from sales. !ad1debt e'pense is a noncash char#e, and has no bearin# on operatin#
cash inflowsJ nor has bad1debt write1offs. %hey must be subtracted from re$enues, howe$er,
alon# with the ad/ustment for chan#es in #ross recei$ables, to accurately determine cash
collected from customers. %he difference between cash flows determined by the net and #ross
methods can be material if write1offs are si#nificant, as they were in 1999. 2ash collections
should be constant o$er time, re#ardless of the method used, inasmuch as accounts written off
and the bad1debt e'pense reco#ni8ed are usually comparable in any #i$en reportin# period.
HealthSouth:s cumulati$e cash inflows as a percenta#e of sales e0ualed 9..(+ on an
ad/usted D#ross1recei$ableE basis, as opposed to 9A+ on an unad/usted Dnet1 recei$ableE basis.
%his translates into a reduction of -A)( million in cash collections from 1994 throu#h )**1,
which matches the write1offs. It is also interestin# to note that percenta#es of re$enues reali8ed
in cash impro$ed after HealthSouth announced its inability to meet earnin#s pro/ections in 1998.
In addition, the two measures of cash flows were more correlated from that point forward. 2ould
eliminatin# the need to meet earnin#s #oals ha$e affected mana#erial beha$iorO
!) 2in3ing 0isclosures 4it# Per!ormance
).
HealthSouth ac0uired numerous rehabilitation clinics and outpatient sur#ery centers
durin# the 199*s. Rollin# up the industry, howe$er, did not translate into #reater returns on
in$estment. %he purpose and $iability of business ac0uisitions is the fifth early warnin# si#n of
abusi$e earnin#s mana#ement.
4lthou#h one cannot infer causality to HealthSouth:s ac0uisitions, an auditor or
in$estment analyst could 0uestion the soundness of an a##ressi$e ac0uisition strate#y #i$en the
diminishin# rates of return. In addition, the data indicate a pronounced decrease in returns from
1998 to )**1, as compared to the precedin# four1year period. 4#ain, these declines coincide with
the year that HealthSouth admitted its inability to meet earnin#s forecasts. 2ash flow analysis
also calls into 0uestion HealthSouth:s ac0uisition strate#y. 9peratin# cash flows inade0uately
met the company:s re0uirements for sustainable operations. %he only year e'amined in which
HealthSouth:s annual cash flow ade0uacy ratio Ddefined as cash flows from operations di$ided
by the sum of payments for fi'ed assetsE e'ceeded 1 was 1996. 9ne mi#ht ar#ue that the annual
ade0uacy measures were #enerally below the le$el needed to co$er fi'ed commitments because
HealthSouth was e'pandin# durin# this period. %his was undoubtedly the case, but the #oal of
financin# acti$ities that deplete cash in an e'pansionary period is to build sound in$estments that
produce acceptable in$estment returns. Such was not HealthSouth:s e'perience, as discussed
abo$e. ;hat end did these ac0uisitions ser$eO
9peratin# cash flows and operatin# income were positi$ely correlated, but there was a
lac of comparability between these two amounts. %he operations inde' measures their de#ree of
correspondence by di$idin# cash flows from operations by operatin# income. 4n ideal ratio is 1,
indicatin# that income from HealthSouth:s core business acti$ity was bein# reali8ed in cash.
)4
HealthSouth:s annual operatin# inde' a$era#ed about *.( from 1994 throu#h )**1, e$en after
ad/ustin# operatin# income for the noncash char#es of depreciation and bad1debt e'pense. %hese
cash flow measures do not pro$e that HealthSouth:s ac0uisitions did not ser$e a le#itimate
purpose or were solely attributable for falterin# cash flows. %hey do, howe$er, point to pressure
on mana#ement to achie$e earnin#s tar#ets, somethin# which was not reali8ed in operatin# cash.
6ain# the numbers would ha$e benefited the company in its attempts to secure e'ternal
financin#. 4s e$idenced by the cash flow ade0uacy ratio and the operations inde', outside funds
were needed because internal sources of cash were insufficient to sustain operations.
g) .arning Signs "a1e 2imitations
4nalysis of inaccurate financials is a dicey proposition. 4uditors and in$estors are
unaware that they are erroneous when first encounterin# them. ;ell1concei$ed and 1e'ecuted
financial frauds plausibly articulate duplicitous financial statement items to other related
accounts. Such was the case as HealthSouth e'hibited hi#hly correlated earnin#s, re$enues, and
recei$ables. 5othin# specific stood out to tri##er alarm in the minds of in$estors and auditorsK
the usual warnin# si#ns were not apparent. 7erpetrators of fraud, howe$er, sometimes fail to
lo#ically articulate subcomponent account disclosures. HealthSouth:s bad1debt e'pense,
allowance for uncollectible accounts, and chan#es in o$erall recei$ables failed to match the
symmetry portrayed in net recei$ables. 6oreo$er, in$estment returns and cash flows could ha$e
called into 0uestion mana#ement:s operations. %he si' early warnin# si#ns of abusi$e earnin#s
can point to potential e$idence of abusi$e earnin#s mana#ement, but users must be $ery dili#ent
in e'aminin# all components of the financial statements and their relationships to each other.
)(
'#e 5erdict
B'12B9 Richard Scrushy has been ac0uitted of all .6 counts a#ainst him. %he $erdict, in
which the #o$ernment lost its first attempt to con$ict a 2B9 under Sarbanes19'ley, has
potentially hu#e ramifications. %he si'1month lon# trial pro$ided a full1blown case study on
how 59% to prosecute a hi#h1profile 2B9 whose wiles e'ceed e$en his net worth. DIn addition
to tryin# to imprison Scrushy, the #o$ernment was tryin# to #et him to dis#or#e -)A8 million of
his alle#edly ill1#otten assets.E 4t e$ery turn, the prosecutors played into the hands of the
defendant. Start, crucially, with the $enue. %he =ustice <epartment tries most white1collar cases
of this ma#nitude in 5ew Hor, because of the e'pertise and e'perience of the 6anhattan1based
prosecutors. %his one went to !irmin#ham, perhaps because of how a##ressi$ely the local ,.S.
4ttorney, 4lice 6artin, had pursued the case a#ainst Scrushy startin# in early )**.. %hat #a$e
Scrushy a hu#e homecourt ad$anta#e. Scrushy added to his homecourt ad$anta#e with a daily
%P blit8 on a local %P station owned by his son1in1lawKincludin# a tal show called
>Piewpoint,> in which he and wife "eslie taled scripture and chatted with local luminaries Dsuch
as pastorsE, and a daily trial1analysis show.
Scrushy&s ac0uittal is at first blush a shoc, but it&s simply a product of what happens
when an e'ceedin#ly uninspired prosecution meets an e'ceedin#ly unorthodo'Kand endlessly
cle$erKdefendant named Richard Scrushy.
)6
Final 4ords
%he whole sad sa#a blew up in 6arch )**.. HealthSouth imploded. 5ot only had
HealthSouth indul#ed in fraud but its #rowth and dominance was because its fraud was far
lar#er, had #one on for much lon#er, and was far more in#enious than any of its peers. In the (
years between 199A and )**. the sum in$ol$ed was ,S -).( billion. 5o one has estimated how
much was defrauded in the 1* years between 1986, when the fraud is alle#ed to ha$e started, and
199A.
HealthSouth had found a far cle$erer way of defraudin# the system and linin# the pocets
of its founder and his close associates. It was /ust so simple. It new the maretplace, the culture
and the interdependency of the whole system. It baned on the fact that its auditors and its
baners who made a lot of money doin# business with the company would not want to now,
would not loo and if they looed would not want to see. 4t most they would see only small
indi$idual discrepancies, which they could i#nore.
It did not mae the money it needed by defraudin# 6edicare and 6edicaid, which would
set the #o$ernment in motion, or defraudin# patients, which would set the community on fire.
Instead it methodically added the e'tra non1 e'istent money that it needed to boost its share price
to its income statements in multiple small amounts. It new that none of those it did business
with would want to see fraud. %hey would not loo too closely. It apparently started this soon
after the company listed on the stoc e'chan#e in 1986. It built its empire on this artificially
inflated income and the o$er$alued share prices that resulted.
!ut the world it:s a weird placeL Scrushy was ac0uitted thou#h the rest of his e'ecuti$es
pleaded #uilty, and HealthSouth is still ali$e and icin#Q.
)A
Resources6
1) httpL33www.nysscpa.or#3cpa/ournal3)**431**43essentials3p44.htm
Anatom o! a Financial Fraud - A Forensic Examination of HealthSouth - By Leonard G.
Weld, Peter M. Bergevin, and Lorraine Magrath
)E httpL33www.fortune.com3fortune3ceo3articles3*,1(114,1*A8*A*,**.html
.E httpL33www.uow.edu.au3arts3sts3bmartin3dissent3documents3health3accessRhealthsouth.htm
4E httpL33news.findlaw.com3cnn3docs3hsouth3sechsouth.19*.cmp.pdf
(E httpL33www.businesswee.com3ma#a8ine3content3*(R.13b.94(*).Rm8*)6.htmO
campai#nRidSrssRma#8n
)8