HealthSouth: A Wagon To

Disaster

TZU-YU LIN, PING-CHIEN CHEN, FANG-YI YANG


Introduction

HealthSouth is a large Alabama-based healthcare corporation in the United
States. It provides several service including diagnostic, surgery and especially
rehabilitation, and also runs over 90 rehabilitation hospitals, over 20 home
health care agencies, more than 1,800 facilities and 6 long- term care institutions
throughout the United States and abroad. However, the mismanagement caused
the grand scale fall of this billion dollar corporate.

Aaron Beam, the CFO and co-founder of HealthSouth, witnessed the rise and
fall of the epic public corporation. It gives an insight to the personality of Richard
Scrushy, CEO of HealthSouth, and also provides a very direct view from the top
insider of one of the largest tragedy in American financial history. The book
starts with how Aaron Beam met Richard Scrushy, how they established the
public company and how it ends in a notorious way. It details for the first time
Aaron met the young Richard Scrushy, a inspiring respiratory therapist who
seemed to be brilliant and had the talent to bring those around him toward
success. Richard and Aaron were colleagues in a regional hospital division in Life
Mark Corporation before they fund HealthSouth. Richard told Aaron that he saw
a great opportunity of a latest kind of rehabilitation health care company. So they
started to raise venture capital in the market. By 1995, HealthSouth expanded
rapidly in all the fifty states and had over 40,000 employees.

After the fantastic start of the company, Richard Scrushy kept estimating on the
existing business unrealistically high. To meet the expectation, he started to
command its officers, including Aaron, to perform fraud. Aaron did it against his
moral judgment and it strained him ever since. According to his statement, Aaron
said he and all other executives let Richard to bully and instruct them into the
scheme. I should have had the courage to stand up and say no, we cannot cross
the line. Said Aaron Beam. He decided to make an early retirement the next year
and thought he could walk away from the deception. HealthSouth was a large
white-collar crime, and as part of the fraud, Aaron went to jail for that.


The fraudulent scheme started from a small number and snowballed to an
incredible amount of 2.5 billion dollars during 1999 to 2003. By the third quarter
of 2002, HealthSouth inflated its assets by eight hundred million, according to
enforcement chief of SEC. Richard Scrushy began to manipulate accounting
fraud soon after HealthSouth went public in 1986. During the time, the stock
price kept rising, and Scrushy was constantly telling the analysts from Wall
Street that. It got more difficult to meet the revenue Scrushy promised investors.
Senior accountants of the company will have a meeting about how to make up
the numbers Richard expected. Also, they made several aggressive accounting,
capitalizing to meet the acceptable standard and false entries to the balance
sheet and revenue account to avoid the suspicion from the external accountants.
Finally, one of its internal officer advised CEO to stop it. But Scrushy refused and
told the officer not until I sold my stock. Scrushy obtained 9.2 million for
compensation and estimated to have pocketed about 6.5 million bonus from
artificial gains.

How?
After knowing the context of the whole scandal, lets look deeper into the
underlying accounting schemes. There were two major schemes at play:
Contractual Adjustments, and Overstatement of Assets.

Contractual Adjustments
Fraudulent contractual adjustments comprised more than 80% of
HealthSouths misstatements. A contractual adjustment is a part of a patient's bill
that a doctor or hospital must write-off because of billing agreements with the
insurance company. It is a contra-revenue account subject to estimation, which
implies that its difficult for auditors to confirm or verify its existence or value.
This is where management discretion and deceptive gimmicks came into play.
HealthSouth deliberately underestimated the contractual adjustment to inflate
revenue, and at the same time overstated its fixed assets to make it balance.

Overstatement of Assets

 Management would compare the companys true earnings to earnings expected

by Wall Street analysts, and decide how much adjustments would be necessary
to fill the gap.
A production line by the name of AP Summary was falsified for the purpose of
inflating fixed asset amount. Knowing that the auditors set the materiality for
transactions at $5,000, company employees would only make adjusting entries
with dollar amounts between $500 and $4,999 rather than one lump sum that
might attract attention from regulatory authorities. Besides, each adjustment
amounts were deliberately made different so as to lower suspiciousness.
Consider the nearly $5 Billion overstatement in HealthSouths revenue.
Assuming that the average journal entry was $2,500 to fend off auditor
detection, it would have required at least two million journal entries to cover the
fraud. This volume of work indicated severe collusion and lack of proper internal
control within the company.

In HealthSouth case, we believe that there are several deficiencies in the
internal control. Here is some suggestion for HealthSouth.

Management override
The most serious problem is management override.
Weston Smith had joined Scrushy in 1987 and in 2001 became CFO, manipulating
ledgers to scheme auditors and keeping sold assets on the balance sheets, among
other tricks.
The CFO himself should have monitored and ensured the implementation of
internal control. However, he overrode the internal control and manipulated the
financial reports.
To solve this problem, the board of director should set a hotline which will
guarantee confidentiality of whistleblowers. Besides board of director should
give ethic training to the managements and employees to create a control
environment of integrity.


Segregation of Duties

From the beginning, we were putting things on the balance sheet that probably
should have stayed on the profit and loss statement.
HealthSouth should design and implement internal control for segregation
of duty and the access to asset database. The board of director mist be
responsible to review and monitor their internal control frequently.
HealthSouth should separate approval of transaction from cash handing and
bookkeeping. These three functions must be separated under sound internal
control.