A Study on

HealthSouth
Accounting Scandal
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A Study on HealthSouth Accounting Scandal

Prepared for:

Muhammad Farid Hossain Patwary

Assistant Professor

Department of Finance

Faculty of Business Studies

University of Dhaka

Prepared by:

Group 02: Mind Mappers

27th Batch

Section: B

Department of Finance

Faculty of Business Studies

University of Dhaka

Date of submission:

December 31, 2023

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Group Profile

Group 02: Mind Mappers

27th Batch

SL. No. Name ID

1 Iftikher Alam Bhuiyan 27-053

2 Md. Abdus Samad Emon 27-059

3 Afia Zarin Biva 27-095

4 Musarrat Jabin Mimma 27-110

5 Sakawat Saberi Deen 27-202

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Letter of Transmittal
December 31, 2023

Muhammad Farid Hossain Patwary

Assistant professor

Department of Finance

Faculty of Business Studies

University of Dhaka

Subject: Report on HealthSouth Accounting Scandal

Dear Sir,

We are pleased to be submitting the report named, “A study on HealthSouth Accounting Scandal”
which was assigned to us as a requirement for the course F-301. We prepared this report after
conducting a thorough analysis of HealthSouth Corporation from its inception to till date operation.
We obtained information about its accounting scandal from various articles, blogs and related
websites and used our knowledge learned from the course to do an in-depth analysis.

We would like to thank you for authorizing this report and giving us the opportunity to explore the
real world. We have tried our best to ensure that we were using the valuable knowledge and
academic training you have provided us. We hope that you will ignore any mistakes in this report,
show your kind gesture, and acknowledge our hard work and dedication to learning more.

Sincerely yours,

Musarrat Jabin Mimma

On behalf of Group 02

Department of Finance

Faculty of Business Studies

University of Dhaka
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Table of Contents

Executive Summary ................................................................................................................... 5

Introduction ................................................................................................................................ 6

Chapter 1: Company Profile ....................................................................................................... 7

Chapter 2: About the Fraud ........................................................................................................ 7

Chapter 3: Fraud Process .........................................................................................................10

Chapter 4: Responsible Parties.................................................................................................12

Chapter 5: Fraud Discovery ......................................................................................................15

Chapter 6: Consequences of the Fraud ....................................................................................16

Chapter 7: Present Status of the Company ...............................................................................18

Conclusion ................................................................................................................................20

References ...............................................................................................................................21
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Executive Summary

HealthSouth Corporation was a prominent name in the healthcare sector of the USA for about 20
years. The company fell from grace in 2003 owing to the fraudulent accounting procedures it had
shown to keep the company attractive to investors and customers alike. The CEO of the company
started to pressurize the executives to inflate the amounts in the statements of financial position
of the company. The primary indicator of inflation was its earnings, which were reported as a
decrease in expenses and a reduction in a contra revenue account known as “contractual
adjustment,” with the resultant increase or decrease in liabilities. This way the company started
to “fix” the areas where it fell short of the investor’s expectations. At the end, the fraud amounted
to $2.7 billion.

The company bribed its auditors to turn a blind eye to their fraudulent activities which further
leveraged their courage to fool the tax authorities and other relevant authorities.

Furthermore, the company lacked a system of internal control that would have allowed it to be
checked and balanced in order to reduce financial reporting errors. It had neither periodical review
of control systems nor any year-end comparison of actual results to budgeted results.

The company CEO, COO and CFO all had an active role in the accounting scam which later
resulted in them being convicted for various periods. The auditors were incapable of performing
their duties for the reason that they were blinded by greed. Several board of directors and
employees were also punished as they also implicitly helped in the fraud.

Lastly, the company is currently recovering from the financial and societal blow it received
because of the fraud after changing its name to “Encompass Health Corporation”. It is directing
its activities in a way that would ensure quality services to its patients while maintaining the
accounting standards and procedures.
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Introduction

Background of the study

The report has been given to us by our honored course teacher Muhammad Farid Hossain
Patwary as part of the course named “Auditing”. Our course teacher has given us all the
instructions to make a report on “the HealthSouth Accounting Scandal.” which is also the title of
the report.

Objective of the study

The objective of the study is to investigate and to research the topic of the Healthcare accounting
scandal and how it became the biggest auditing fraud in the history of the health sector. In order
to make a report on it, we had to follow those instructions:
• What the HealthSouth scandal was
• Corporate fraud process in HealthSouth company
• The consequences of that incident
• The key parties attached to this fraudulent incident and The Affected people
• Present State of HealthSouth Company (Encompass Health Corporation)
To answer these questions, we needed to go through many websites, gather all the information
and analyze the information.

Limitations of the study

To make the report we have faced a few types of limitations. Those limitations include:
• Lack of availability of data
• Lack of credible and updated information due to the incapability of field research
• Unavailability of adequate internet research
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Chapter 1: Company Profile

Established in 1984, one of the top US providers of inpatient rehabilitation healthcare services
was HealthSouth Corporation.
What started as a young
entrepreneur’s aspiration to give
rehabilitation services a new
importance in the world, one that
would promote wellness and
healing, later became a big facility
with over 93 inpatient rehabilitation
hospitals, 225 outpatient
rehabilitation sites, and 2 home
nursing agencies. After its foundation by Richard Scrushy, the company grew rapidly in its initial
years of operation through aggressive acquisitions. The corporation had 40,000 workers, 10–12
jets, health facilities in all 50 states, and a Fortune 500 listing by 1995. The company continued
its streak of acquisitions till the end of 1990s when it started to face problems in the beginning of
2000s. The success of the company soared high all while the responsible accountants were being
forced to manipulate the financial statements by its owner. Allegations of accounting fraud against
HealthSouth began to surface in 2003 and soon the company filed for bankruptcy. By 2007, the
company settled all its debts and liabilities and started working for its revival. In an effort to
distance itself from the scandal and indicate a new beginning, HealthSouth changed its name to
“Encompass Health Corporation” in 2018. Currently, the company is working to affirm its
commitment to providing top-notch rehabilitation care services, including home health and
hospice care as well as inpatient rehabilitation facilities.
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Chapter 2: About the Fraud

The Securities and Exchange Commission declared that on March 19, 2003, it arranged
accounting fraud charges in federal district court in the Northern District of Alabama against
HealthSouth Corporation ("HRC"), the nation's hugest contributor of outpatient surgery, diagnostic
and rehabilitative healthcare services, and its Chief Executive Officer and Chairman Richard M.
Scrushy.

The Commission's complaint avows that since 1999, at the exhortation of Scrushy, HRC
methodically overemphasized its earnings by at least $1.4 billion in order to meet or exceed Wall
Street earnings presuppositions. The false increases in earnings were matched by false increases
in HRC's assets. By the third quarter of 2002, HRC's assets were overstated by at least $800
million, or approximately 10 percent. The complaint further alleges that, following the
Commission's order last year requiring executive officers of major public companies to certify the
correctness and completeness of their companies' financial statements, Scrushy certified HRC's
financial statements when he knew or was reckless in not knowing they were materially false and
deceiving.

According to the complaint:

• Shortly after HRC became publicly traded in 1986, and at Scrushy's instruction, the
company began to synthetically inflate its earnings to match Wall Street analysts'
expectations and maintain the market price for HRC's stock. Between 1999 and the
second quarter of 2002, HRC willfully overstated its earnings, identified as "Income Before
Income Taxes And Minority Interests," by at least $1.4 billion in reports filed with the
Commission. HRC also overstated earnings, identified as "Income Before Income Taxes
And Minority Interests," in the quarterly reports on Form 10-Q filed with the Commission
during these years.
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• Pursuant to the scheme, on a quarterly basis, HRC's senior officers would present Scrushy
with an analysis of HRC's actual, but as yet unreported, earnings for the quarter as
compared to Wall Street's anticipated earnings for the company. If HRC's actual results
fell short of expectations, Scrushy would tell HRC's management to "fix it" by recording
false earnings on HRC's accounting records to make up the deficiency.

• HRC's senior accounting workforce then convened a meeting to "fix" the earnings shortfall.
At these meetings, HRC's senior accounting personnel talk about what false accounting
entries could be made and recorded to inflate reported earnings to match Wall Street
analysts' expectations. These entries primarily consisted of reducing a contra revenue
account, called "contractual adjustment," and/or decreasing expenses, (either of which
increased earnings), and as well as increasing assets or decreasing liabilities.

• Scrushy has personally profited from the scheme to artificially inflate earnings. He has
sold at least 7,782,130 shares of HRC stock since 1999, when HRC's share price was
affected by HRC's artificially inflated earnings. Moreover, Scrushy received salary and
bonus payments based on HRC's artificially inflated earnings.

• Scrushy knew or was thoughtless in not knowing that HRC's financial statements
materially overstated its operating results. Nevertheless, on August 14, 2002, he and
HRC's Chief Financial Officer certified under oath that HRC's 2001 Form 10-K contained
no "untrue statement of material fact." In truth, the financial statements filed with this report
overstated HRC's earnings, identified as "Income Before Income Taxes And Minority
Interests" on HRC's income statement, by at least 4,700 %.

Pursuant to a unrelated Commission order issued on March 19, 2003, trading in the securities of
HRC was suspended for two business days due to the materially misleading information in the
marketplace.
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Chapter 3: Fraud Process

A multibillion-dollar fraud was committed by HealthSouth between 1996 and 2002 through direct
manipulation of the revenue accounts through the creation of phoney revenue accounts and
misstated accounts receivable.

The HealthSouth scandal were mainly committed by inflating company's revenues and
understating it's expenses. The company used to create fake patient records and bill insurance
companies as if they had paid money to receive services from another companies. HealthSouth
used to book it’s revenue for services before they actually performed for that service, violating
Accrual Principle of Accounting. As HealthSouth was a joint venture, it used to manipulate
accounting records so that the joint venture would look more lucrative for investor to invest money
and inflate the joint ventures assets to overstate firm's size.

Another way HealthSouth committed the fraud was by understating company's expenses. They
recorded a large number of their expense account falsely. These expenses were capitalized in
the statements of accounting position, reducing company's cost which ultimately resulted in higher
revenue. Company's bad debt policy was very ambiguous. Fake bad debt accounts were created
to showcase reported costs higher and accounts receivables lower. When the time was right the
amounts from bad debt were released into retained earnings to provide shareholders huge
dividend so that they don't question company activities.

Other activities performed by the company was intentionally making errors while making
accounting records and statements. Whenever someone or employees tried to question them for
the wrong accounting practices, executives intimated and threatened them to shut up. Some
employees remained silent because of fear that they might lose their job. Some of the former
employees such as Kimberly Landry were sued when they tried to shed light to the people about
how HealthSouth management is corrupted.

Auditors role in the fraud

HealthSouth paid the Birmingham office of for its 2001 financial statement audit and related
services. Ernst & Young LLP was paid $3.6 million. Ernst & Young denied knowing about the
scam, pointing to HealthSouth executives' systematic deceit. The health-care provider and its
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auditor exchanged information regarding dubious activities.. Though the auditors received
information about expense capitalization activities in the company, they ignored the matters and
performed normal control activity. Ernst & Young did not detect or investigate beyond the scope
of normal audit procedures any other substantive questionable activities outside of the
capitalization issue.

Weaknesses in Internal Control Structures

Internal control procedures, which serve as a check and balance to reduce errors in financial
reporting, were absent from HealthSouth. Internal controls might have contributed to ensuring
accuracy while reducing fraud and theft. Furthermore, HealthSouth's financial reports were
unreliable because a control system could have verified the accuracy of the data they presented.
Nevertheless, HealthSouth had no reporting procedures that compared actual performance
against budgets. It was difficult to determine whether the internal controls are current and efficient
because there were no regular evaluations of them.

Duties were not segregated because One of the executives took most of the financial work such
as approval of transactions and many other tasks.

Overall, the fraud was committed by inflating revenues by creating fictitious patient admission,
early recognition of revenues and improper accounting for joint ventures; understating expenses
by hiding operating cost by capitalizing a large part and false accounting for reserve. Auditors
played a big part as well to commit the fraud as they didn't assure a strong internal control system
and segregation of duties.
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Chapter 4: Responsible Parties

The employees of the HealthSouth company had widespread involvement in that fraud. However,
the main parties who were actively involved in the fraud were:

1.Ricard Scrushy

Richard Scrushy, the CEO, was the main person behind the fraud. He played a huge role in
allowing the fraud to take place for such a long period of time. All the employees were engaged
in such widespread fraudulent activities under his command. Company’s all operation used to run
on Scrushy’s command, whether be it taking security measures, recording transactions or making
decisions

HealthSouth committed the fraud by involving complex transactions, cooking the books. Few
employees have warned him about the consequence. However, Scrushy did not refrain from his
position. Scrushy ordered the managers to fix the difference of shareholder’s expectations and
their real financial results by manipulating the accounts.

After the company became public, Scrushy instructed to inflate its earnings as doing so would
increase their stock’s price in the market

Between 1999-2002, they overstated earnings by 1.4 billion.

2.Aaron beam- the former CFO.

At the time that the HealthSouth fraud was discovered, Aaron Beam was the CFO. He had the
opportunity to stop the scam at the very beginning. Still, he refused to speak of anything. He said
nothing out for his work. Beam almost lost his job at HealthSouth early in his career. In a media
interview, he was cited as making a disparaging comment about the business. The CEO and his
supervisor, Richard Scrushy, wasn't fond of it. Scrushy forbade him from speaking ill of the
corporation ever again. Beam never forgot that. Beam now admits that the business was
occasionally pushy and even dishonest in its early years. For instance, they capitalized start-up
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expenditures rather than deducting them from expenses. It sparked a movement. Thus,
manipulation persisted.

3.The Assistant controller (Ken Livesay) and the Controller (Mr. Crumpler)

Ken Livesay was an Assistant Controller at HealthSouth. He would download the company’s true
earnings into his computer, figure out how much adjustment (fraud) was needed to meet analyst’s
earnings expectations, and pass along the figures to two superiors in the Finance department.
Livesay first used to participate because his boss assured that the fraud was temporary. However,
this kept going on and he became a willing participant. He made a lot of money through his
actions.

Mr. Crumpler, VP & Division Controller for HealthSouth was a willing participant from the
beginning. He finds where the gaps are and assigns them to put fraudulent postings,

Once they were able to identify places to hide the fraud, he would give the staff accountant’s fake
journal entries to put on the company’s books. The accountant’s had to post thousands of entries
per quarter. As we know, to deceive the auditor’s they used to manipulate small entries. As the
entries over 5000 were detected for audit by the auditors, they used to make lots of small fictitious
transactions and Mr. Crumpler used to prepare those fictitious journal entries.

4.CFO, Western Smith

According to Jennings (2006), Weston Smith, the Chief Financial Officer, was also found guilty of
falsely certifying financial documents, conspiring to commission and lead fraud, and securities
fraud.

5.Emery Harris

The subordinate controller and vice president of finance, Emery Harris, entered a guilty plea to
charges of wire fraud, securities fraud, and submitting fraudulent financial reports that were
utilized to produce quarterly and yearly statements.
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6.Other financial executives

Other financial officers included in the conspiracy are group vice president Rebecca Morgan, vice
in charge of asset management Edwards Cathy, vice president of accounting and finance Ayers,
and assistant finance officer Valentine. In 1994, they were all involved in a plot. Ayers and
Valentine admitted to manipulating allowance accounts with patient costs by entering fraudulent
information. In a similar vein, Edward and Morgan acknowledged manipulating asset and cash
accounts.
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Chapter 5: Fraud Discovery

The auditors have been alerted to the fraud's existence by several warnings from outside sources
while it was taking place at HealthSouth. Michael Vines was HealthSouth's bookkeeper in charge
of equipment purchases. He was a law enforcement officer of integrity. He lodged a complaint to
the auditors. Richard Scrushy, the CEO, was able to persuade the auditors that there was no
fraud taking on, though. Michael Vines attempted to alert a few management personnel about the
way the asset-management division was keeping track of transactions. He was one of three staff
members in charge of the equipment acquisition. He eventually came to the conclusion that the
assets listed on the company's balance sheet were being falsely exaggerated.

Mr. Vines resigned from his post after notifying multiple members of management that his
warnings were ignored.

E&Y was repeatedly and specifically warned about the HealthSouth fraud, yet they did not
disclose it. The fraud wasn't found until a former CFO at HealthSouth came forward with evidence.
Former CFO Weston Smith alerted federal investigators to the HealthSouth fraud in 2003. Many
more workers who had taken part in the fraud soon after also surrendered themselves in.

The troubled HealthSouth group of hospitals and clinics has hundreds of millions of dollars in
previously undisclosed accounting fraud, according to auditors. The auditor discovers fraud
totaling between $3.8 billion and $4.6 billion during the audit. From 1996 to 2002, there were $2.5
billion in fraudulent accounting entries, $500 million in erroneous goodwill accounting, and other
fraudulent activities.
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Chapter 6: Consequences of the Fraud

Consequences Over shareholders :

Once the accounting scandal went public, HealthSouth’s share price tanked to as low as $0.35 a
share, costing their shareholders millions. Lawsuits were filed by shareholders against
HealthSouth, Scrushy, and E&Y. Although found not guilty on criminal charges, Scrushy paid $81
million to the SEC to settle civil charges related to the fraud and in 2009 as rule to owe almost $3
billion to shareholders in a class action lawsuit.1 E&Y also settled the shareholders’ class action
lawsuit for $109 million, reaffirming their gross laxness in their audit of HealthSouth.

Consequences Over company :

As soon as the fraud was detected, the board of directors of the company held an emergency
meeting to discuss the immediate actions that they can take to save the company. The first action
was to take off Scrushy from the position of the Chairman and CEO of the company. It was decided
that the company shall make all the payments and avoid bankruptcy. The company’s financial
problems were too large to be directed internally; therefore, the company hired a reconstructing
firm to help its reconstruction. The company prioritised payments, reassured all possible liabilities
and reorganised the finances of the company. By the end of 2003, the company was able to avoid
bankruptcy proceedings that were to be initiated against it. To vanquish the losses, the company
had to close various museums and stores. The company sold most of its corporate jets and
helicopters. It had to halt the construction of a digital hospital which left the company in losses
worth $400 million. The company made all efforts to disassociate itself with Scrushy. The Board
removed his name from the records of the company. The company sold all its underperforming
facilities, in order to minimise the losses. In the year 2004, the company restated its earnings and
filed returns again for the year 2000 to 2003, in order to again become a current filer with the
SEC. It could achieve its goal of becoming a current filer only in the year 2006 when it filed the
financial report of the first quarter of 2006.

HealthSouth launched a reconstructing plan to sell, spin-off and dispose its various departments
with a 1 for 5 reverse stock splits. The final step in the recovery of the company from the scandal
 17

was in October 2006 when the company relisted its stocks in the New York Stock Exchange once
again. In the year 2007, the company sold almost 600 of its outpatient centres for $245 million.
The company further sold and reconstructed its various divisions in the coming years. Eventually,
the huge HealthSouth Corporation branched into various offspring companies like MedPartners
Inc., Capstone Capital Corporation and Source Medical Solutions, etc.

Fired HealthSouth Corp. Chief Executive Richard Scrushy has reached an $81 million settlement
to end a lawsuit filed by the Securities and Exchange Commission blaming him for a $2.7 billion
accounting fraud at the heath care services company. U.S. District Judge Inge Johnson approved
the settlement Monday.
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Chapter 7: Present Status of the Company

Overall position of the Company

HealthSouth, now known as Encompass Health Corporation, had recovered from the accounting
scandal and emerged as a leading provider of post-acute healthcare services in the United States.
The overall position of the company can be seen from the points below:

Revenue: Encompass Health had reported consistent revenue growth. In 2021, their revenue
reached approximately $5.6 billion, representing an increase from the previous years.

Number of Facilities: The company operated numerous inpatient rehabilitation hospitals, home
health agencies, and hospice care centers across multiple states. By 2021, they managed over
140 hospitals and approximately 290 home health and hospice locations.

Employee Count: Encompass Health had a significant workforce. In recent years, they
employed over 42,000 people across their various facilities and administrative offices.

Financial Performance: While Encompass Health faced challenges due to the COVID-19
pandemic, the company demonstrated resilience in its financial performance, adapting its services
to meet the changing healthcare landscape.

Market position of the company

Encompass Health Corporation held a strong position in the market within the post-acute
healthcare services sector:

Market Capitalization: Encompass Health had a substantial market capitalization, reflecting its
market value as a publicly traded company. At that time, its market capitalization was
approximately several billion dollars.

Stock Performance: The company's stock performance had shown stability and growth over
recent years, though fluctuations occurred in line with broader market trends and healthcare
industry changes.
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Industry Ranking: Encompass Health was considered one of the largest and most influential
companies in the post-acute healthcare industry. Its expansive network of facilities and diversified
service offerings contributed to its significant standing in the market.

Competition: Within the post-acute healthcare sector, Encompass Health faced competition from
other major players, including companies providing similar rehabilitation, home health, and
hospice services. However, Encompass Health's scale, reputation, and diverse service portfolio
helped maintain its competitive edge.

Public acceptance of the company

Encompass Health Corporation, formerly HealthSouth, had garnered various perceptions among
the public, including patients, healthcare professionals, and investors.

Encompass Health focuses on providing quality care and rehabilitation services, aiming to
maintain high levels of patient satisfaction. Patient feedback and satisfaction ratings were typically
significant indicators of the company's performance in delivering healthcare services. The
company aimed to maintain a positive reputation among healthcare professionals, including
doctors, nurses, therapists, and caregivers. Professional referrals and collaborations with
healthcare practitioners often reflected the company's standing in the healthcare community.

Encompass Health's financial performance, transparency in operations, and adherence to

regulatory standards was factors contributing to investor confidence. The company's ability to
demonstrate resilience, growth, and profitability post-recovery from the accounting scandal
influenced investor perceptions.

Public perception of Encompass Health might have varied based on media coverage, corporate
communications, community involvement, and the company's efforts to rebuild trust post-scandal.
Community engagement, corporate social responsibility initiatives, and ethical business practices
played a role in shaping public perception.
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Conclusion

The HealthSouth Scandal shows the importance of audit function and ethical guidelines. However,
a management team that is intent and unified in its attempt to override the audit can easily do so.
Internal control system needs to be strongly developed. Weak internal control system allows
frauds inside the company. When the whole management of the company is actively involved in
the fraud, it becomes difficult even for the auditors to identify it. Personal morality and ethics
make up the collective morality and ethics of a corporation. Very often, in the media, companies
like HealthSouth are described as a monolithic entity that has a life of its own. In reality, as the
HealthSouth story illustrates, the culture of the company is simply the sum total of its leadership
and employees. Any of the people described here could have refused to participate in the fraud
and could have stopped, or severely impaired, the widespread operation to commit fraud and then
cover it up.
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References

SEC.gov | HealthSouth Corporation and Richard M. Scrushy. (2003, March 20).

https://www.sec.gov/litigation/litreleases/lr-18044

From Wall Street to prison: The HealthSouth Story. (n.d.). The University of Chicago Booth School
of Business. https://www.chicagobooth.edu/media-relations-and-communications/press-
releases/from-wall-street-to-prison-the-healthsouth-story

Studocu. (n.d.). Health South Scandal - misappropriation, cheating or stealing – whatever name
you give it, corporate - Studocu. https://www.studocu.com/ph/document/imus-national-
high-school/accounting/health-south-scandal/13644308

Jennings, M. (2006). Innovation like no other. The seven signs of ethical collapse (annotated ed.).
St. Martin’s Press: New York.

SEC.gov | HealthSouth Corporation and Richard M. Scrushy. (2003, March 20).

https://www.sec.gov/litigation/litreleases/lr-18044

HealthSouth Corporation Fraud Case - 2805 words | Research paper example. (2022, June 29).
IvyPanda. https://ivypanda.com/essays/healthsouth-fraud-case/