A Clean Audit for HealthSouth

Ernst & Young (E&Y) were the independent auditors of HealthSouth between 2000 and 2002. They also conducted janitorial inspections of the companys facilities. These inspections were called pristine audits. E&Y advised HealthSouth to classify the payments for pristine audits as audit-related fees.

HealthSouth, headquartered in Birmingham, Alabama, USA, is the largest provider of outpatient surgery, diagnostic and rehabilitative healthcare services in the USA with approximately 1,800 worldwide facilities in the USA, Australia, Puerto Rico, and the UK. Its former CEO, Richard M. Scrushy, is under an 85-count federal indictment, accused of conspiracy, securities fraud, mail and wire fraud, and money laundering. (SEC 2003)

A US government indictment charged that between 1996 and 2002 HealthSouth managers, at the insistence of Scrushy, inflated profits by $2.74 billion. Scrushy certified the HealthSouth financial statements when he knew that they were materially false and misleading. On November 4, 2003, he became the first CEO of a major company to be indicted for violating the Sarbanes-Oxley Act, which holds executives personally accountable for their companies financial reporting. (Business Week 2003).

Six months elapsed from the start of the SECs investigation to the filing of its fraud suit against Scrushy in March 2003. It took just seven weeks, from March 19 to May 5, for the US Justice Department to accumulate 11 guilty pleas from Scrushy aides. All five CFOs in the companys history have admitted to cooking the books. (Helyar 2003)

Pristine Audits

Scrushy devised a facilities inspection program called Pristine Audits and hired E&Y to do the work. The primary purpose of the inspections was to check the cleanliness and physical appearance of HealthSouths surgical and rehabilitation facilities. Under the program, E&Y made unannounced visits to each facility once a year, using dozens of junior-level accountants who were trained for the inspections at HealthSouths headquarters. For the most part E&Y used audit personnel who were not members of the HealthSouth audit- engagement team to conduct the pristine audits.

The accountants carried out the reviews using as criteria a 50-point checklist designed by Mr. Scrushy. The checklist included procedures such as seeing if magazines in waiting rooms were orderly, the toilets and ceilings were free of stains, and the trash receptacles all had liners. Other items on the checklist included: check the walls, furniture, floors and whirlpool areas for stains; check that the heating and cooling vents are free of dust accumulation; that the floors are free of trash; and that the overall appearance is sanitary. A small portion of the checklist pertained to money matters, though none of it pertained to accounting. Assignments included checking if petty-cash drawers were secure and company equipment was properly tagged. The checklists did not cover insurance- billing procedures or the quality of the medical treatment. (Weil 2003a)

In 2002 E&Y ended their relationship with HealthSouth, and HealthSouth discontinued the pristine audits. Describing the pristine audits, Mr. Scrushy told an investor group: We believe one of the reasons that we have done so well has to do with the fact that we do audit all of our facilities, 100 percent, annually. And we use an outside audit firm, our auditors, Ernst & Young. They visit all our facilities, 100 percent. On its website, HealthSouth said the pristine audit, administered independently by Ernst & Young LLP ... ensures that all of our patients enjoy a truly pristine experience during their time at HealthSouth. The average score was 98 percent, with more than half of our facilities scoring a perfect 100 percent.

E&Y Fees Charged HealthSouth

HealthSouths April 2001 proxy (form DEF14A), filed with the SEC, said the company paid E&Y $1.03 million to audit its 2000 financial statements and $2.65 million of all other fees. The proxy said the other fees included $2.58 million of audit-related fees, and $66,107 of non-audit-related fees. In its April 2002 proxy, HealthSouth said it paid E&Y $1.16 million for its 2001 audit and $2.51 million for all other fees. The proxy said the other fees included $2.39 million for audit-related fees and $121,580 for non-audit-related fees.

Neither proxy described in any detail the audit-related or non-audit-related services for which E&Y was paid. Andrew Brimmer, a HealthSouth spokesman, was quoted as saying the audit-related-fee figures for each year included about $1.3 million for the pristine audits. Mr. Brimmer said HealthSouth paid E&Y $5.4 million for 2002, including $1.1 million for financial-statement audit services and $1.4 million for the pristine audits. (Weil 2003a)

Pristine Audits as Audit-Related Fees

A March 2002 E&Y report to HealthSouths Board of Directors included an attachment that summarized E&Ys fees and provided a suggested Proxy Disclosure Format. The attachment classified the pristine audits as audit-related services and the fees for them as audit-related fees. (Weil 2003a)

David Howarth, a spokesman for E&Y is quoted as saying: The audit-related category is not limited to services related to the financial statement audit per se. At the time of HealthSouths disclosures, there were no SEC rules that defined audit-related services. Describing operational audit procedures as audit-related services was reasonable. Howarth claimed that SEC ruled that audit-related fees would include assurance services traditionally performed by the independent auditor, including internal-control reviews. He maintained the pristine audit was an internal control review. Under the new SEC rules adopted in response to the Sarbanes-Oxley Act, these (internal control review) fees are specifically mentioned as ones that should be included in audit-related fees. (Weil 2003b)

After the Weil 2003b article appeared, Scott A. Taub, the Deputy Chief Accountant of the SEC wrote a letter to E&Y partner Ed Caulson. Taub wrote: The Commissions current rules state that registrants are to disclose, under the caption Audit-Related Fees, the aggregate fees billed in each of the last two fiscal years for assurance and related services by the principal accountant that are reasonably related to the performance of the audit or review of the registrants financial statements. (emphasis added) It is clear from a reading of the release text and related rules that the Commissions intent is that only fees for services that are reasonably related to the performance of an audit or review of the financial statements and that traditionally have been performed by the independent accountant should be classified as audit-related.(Taub 2003)

Discussion Questions

1. What criteria would the pristine audits have to meet to be considered an audit engagement?
2. What criteria would the pristine audits have to meet to be considered audit-related?
3. Can the pristine audits be considered an assurance service? How does the pristine audit meet the five criteria required to qualify an engagement as an assurance service?