Case Study: 1. INTRODUCTION HealthSouth Corporation is a large, public healthcare company that operates 93 inpatient rehabilitation hospitals (and their 49 outpatient rehabilitation satellites), six long-term acute care hospitals, and 25 home health agencies.1 According to its website, HealthSouth is the nation's largest provider of inpatient rehabilitation services.2 The Company is headquartered in Birmingham, Alabama, and its operations are spread across 26 states and Puerto Rico.3 Its mission is to be the healthcare company of choice for patients, employees, physicians, and shareholders by providing high-quality care in the communities we serve.4 HealthSouths stock trades on the New York Stock Exchange (NYSE) under the ticker symbol HLS, with a June 8, 2009, closing price of $12.76, giving the Company a market capitalization of approximately $1.1 billion. 5 The Companys 2008 revenue was approximately $1.8 billion and its net income was $226.4 million, for basic earnings per share (EPS) of $2.73.6 About two-thirds of HealthSouths revenue comes from the Medicare program.7 HealthSouth is perhaps best known for the massive accounting fraud that was discovered in 2003 and almost led to the Companys bankruptcy. Although HealthSouth emerged from this experience and had so far had a successful recovery, the memory of this scandal is still fresh. The events surrounding the scandal, as well as a discussion of how the fraud was perpetrated and some key lessons to be learned, as a result, are the topics of this paper. 2. HISTORY AND BACKGROUND HealthSouth was founded in 1984 by a respiratory therapist and businessman Richard Scrushy and went public in 1986 with Scrushy as Chairman and Chief Executive Officer (CEO). The Company grew quickly throughout the 1980s and 1990s, mainly via acquisition. In 1997, it opened a brand-new, $50 million corporate campus on the outskirts of Birmingham. By the end of 1999, HealthSouth was already a $4 billion company and had expanded to 120 inpatient rehabilitation hospitals, five medical centers, 1,379 outpatient rehabilitation centers, 230 surgery centers, 129 diagnostic centers, and 124 occupational medicine centers. In the process of HealthSouths spectacular rise, Scrushy became one of the highest-paid CEOs in the country.9 From 1995-97, for example, he earned a total of $8.5 million in salary, $23 million in incentive bonuses, $4.8 million in stock option awards, and $700,000 in other compensation.10 By March of 2002, Scrushy owned approximately 20.9 million shares of HealthSouth common stock (representing 5.1% of the total shares outstanding) with a combined market value of more than $287 million.11 Problems at HealthSouth started to become evident in mid-2002. In May, Scrushy sold more than $75 million worth of HealthSouth stock, and in June he sold another $25 million back to the Company. HealthSouth then disclosed in August that a change in Medicare payment policy would significantly lower reimbursement, causing the Companys stock to lose more than half of its value and leading to shareholder lawsuits alleging that Scrushy had acted on insider information when selling his shares. Then, in February of 2003, the Federal Bureau of Investigation (FBI) announced the opening of a criminal investigation of HealthSouth for possible securities law violations. 3. ALLEGATIONS OF CORPORATE ACCOUNTING FRAUD After the close of business on March 18, 2003, the FBI used a search warrant to raid HealthSouths headquarters and seize the Companys financial records,13 and on March 19, the Securities and Exchange Commission (SEC) filed a civil complaint against HealthSouth for accounting fraud.14 The SEC, which had already been investigating the Company for six months, alleged that since 1999, at the insistence of Scrushy, [HealthSouth] systematically overstated its earnings by at least $1.4 billion to meet or exceed Wall Street earnings expectations.15 Although the SECs complaint only detailed the estimated earnings impact of the fraud between 1999 and the first half of 2002, as shown in the table below, it alleged that these practices began soon after HealthSouth went public in 1986. HealthSouth went public in 1986. Income (Loss) before Income Taxes and Minority Interests (in $ millions) / Actual reported Misstated Amount Misstateed percentage 1999 Form 10-K/ (191) 230 421 220% 2000 Form 10-K / 194 559 365 188% 2001 Form 10-K 9 434 425 4722% six months ended June 30, 157 340 183 119% According to the complaint, before HealthSouths earnings were released each quarter, management would brief Scrushy on the actual figures. If the figures were less than Wall Street analyst estimates, Scrushy would instruct the Companys senior corporate accountants to fix it to meet the Streets expectations.17 These accountants, known as the family, would then hold family meetings to determine how they could inflate the Companys quarterly earnings and make the necessary adjustments. Based on generally accepted accounting principles (GAAP), increases in earnings must be matched by corresponding increases in net assets, so that shareholders equity rolls forward properly and the balance sheet balances. The SEC alleged that HealthSouth was, therefore, able to increase its earnings while balancing its books by overstating assets and understating liabilities. This was done in a variety of ways, but certain accounts, in particular, were utilized most frequently in connection with the fraudulent reporting. First, on the income statement side of each fraudulent entry, the Companys senior accountants would either reduce expenses or the contractual adjustment contra revenue balance, which represented the estimated difference between gross patient billings and insurer reimbursements. (Such allowances are standard accounting for many healthcare providers and reflect proper revenue recognition practices. Since revenues are earned in the same period that services are provided, but reimbursements often do not occur until a subsequent period, an allowance based on the terms of the providers agreements with third-party payors is recorded, and later adjusted upon settlement.) Because HealthSouth only reported net revenues in its public filings, the impact of these adjustments was easier to conceal. Also, contractual adjustments are subject to a significant degree of management discretion, and the Company offered the little public clarity about how it determined these adjustments. For example, in disclosing the Companys accounting policy for such adjustments, HealthSouths 10-Q for the second quarter of 2002 stated only the following: We estimate contractual adjustments from non-governmental third-party payors based on historical experience and the terms of payor contracts. Our reimbursement from governmental third-party payors is based upon cost reports, Medicare and Medicaid payment regulations and other reimbursement mechanisms which require the application and interpretation of complex regulations and policies, and such reimbursement is subject to various levels of review and adjustment by fiscal intermediaries and others, which may affect the final determination of reimbursement. We estimate net realizable amounts from governmental payors based on historical experience and interpretations of such regulations and policies. If final reimbursement differs from our estimates, our actual revenues and net income, and our accounts receivable could vary from the amounts reported. Next, to make these entries balance, the accountants would need to make offsetting adjustments to HealthSouths balance sheet accounts. To do this, they would frequently create fictitious fixed assets. The cumulative impact of these fraudulent entries, according to the SECs complaint, resulted in an approximate $800 million overstatement to the Companys property, plant, and equipment balance by the end of third quarter of 2002,19 when the Company reported about $8 billion in total assets$3 billion of which represented the net book value of its fixed assets.20 Because HealthSouth owned hundreds of thousands of fixed assets spread across almost 2,000 facilities around the time that most of the fraud was alleged to have taken place, it was not overly difficult for the accountants to hide false assets in the Companys facility-level fixed asset sub-ledgers. So that they would not lose track of the fictitious assets, the accountants marked them as AP Summary on the sub-ledgers. To avoid red flags, these assets were recorded for varying amounts, and they were also intentionally recorded at amounts below the threshold that the Companys outside auditors used in selecting which assets to test. If the auditors requested a sub-ledger with fictitious assets, the Company would change any AP Summary items to a description that sounded more like a real fixed asset. Then, if the auditors nevertheless selected a nonexistent asset for testing, the accountants would create and provide the auditors with fictitious supporting documentation, which happened on at least one occasion.21 The SECs complaint alleged that the senior HealthSouth officers involved in the fraud had attempted over the years to convince Scrushy to put a stop to it, but that he consistently refused because he was concerned about the possible impact that doing so would have on the value of his stock. It was not until 2002 that Scrushy began to relent, when the officers were successful in convincing him to take steps to lower earnings expectations so as to remove the pressure to overstate earnings (although this too was done fraudulently, by intentionally overestimating the effect of a Medicare policy change on HealthSouths bottom line). Then, according to the complaint, Scrushy finally agreed to stop inflating earnings in mid-2002 out of concern for the new Sarbanes-Oxley provision requiring a sworn certification by company CEOs that the financial statements contained no untrue statement of a material fact.22 4. FALLOUT After the FBI raid on HealthSouths headquarters in March 2003, trading of the Companys stock on the NYSE was immediately suspended. HealthSouth was also removed from the S&P 500, and its stock was delisted the following week, after which times its shares were traded on over-the-counter pink sheets. (The stock price had closed at $19.55 on March 18; when trading resumed on March 25, the opening price was only $1.85, and it closed the day at just $0.60.23) J.P. Morgan Chase also froze HealthSouths $1.25 billion line of creditwhich the Company needed access to pay its bondholders the more than $350 million in principal and interest due on April 1thus raising the possibility of default and bankruptcy.24 Also, HealthSouths Board of Directors immediately placed Scrushy and Chief Financial Officer (CFO) William Owens on administrative leave.25 Both were later fired.26 Owens was just one of several HealthSouth CFOs who pled guilty to criminal charges in connection with the fraudall four of his predecessors did as well.27 Some other HealthSouth employees also confessed to their involvement in the scheme.28 Admitted and suspect participants in the fraud either resigned from the Company or were fired.29 Scrushy, however, claimed that the fraud was perpetrated without his knowledge. The Board of Directors also quickly established a Special Audit Review Committee and engaged PricewaterhouseCoopers (PwC) to conduct a forensic audit concerning the SECs fraud allegations. The Board also brought in turnaround specialists Alvarez & Marsal (A&M) to help stabilize operations, address financial and liquidity concerns and to position the company for successful restructuring as it moves forward.30 (Although HealthSouth did default on its debt obligations, it was ultimately able to avoid being forced into bankruptcy.31) Soon after that, HealthSouth fired its independent auditors, Ernst & Young (E&Y),32 and notified the SEC that it would not be able to file its 2002 10-K on time.33 The Company later replaced E&Y with PwC.34 5. FORENSIC AUDIT RESULTS The results of the PwC forensic audit were delivered to HealthSouths Board of Directors and filed with the SEC on June 1, 2004. The forensic auditors examined possible fraudulent activity and accounting irregularities between 1996 and 2002, with a focus on large or unusual accounting entries, particularly those involving round dollar amounts or adjustments after the close of a financial reporting period.35 The report, which adds further detail to the SECs description of how the fraud was perpetrated, found that during this period the Company knowingly inflated income by more than $2.7 billion, a breakdown of which appears in the table below. Impact On Income Before Minority Interest And Taxes (millions of dollars) Reduction of Contractual Allowances or Operating Expenses $ 2,203 Acquisition Accounting 421 Bonus Accounting 52 Investment Accounting 17 Facility Contractual Accounting 19 Third-Party Transaction Accounting 29 Total $ 2,741 Similar to the SECs civil complaint, the forensic audit report noted that the majority of the inflated earnings were the result of reductions to HealthSouths contractual adjustment contra-revenue account. According to the report, this practice began in the second quarter of 1996 and continued in every quarter through the middle of 2002. To a lesser degree, the Company also reclassified certain operating expenses to make it appear as if the expenses were never incurred.37 Instead of booking a corresponding adjustment directly to the balance sheet, however, the Company would record a series of intermediate transactions, typically through the use of corporate suspense accounts and intercompany transfers, which ultimately allocated the fictitious assets down to the facility level. Many of these fraudulent management entries were externally uploaded into the Companys accounting system and would self-reverse the following quarter.38 On the balance sheet side of the entries, the forensic audit report noted that slightly more than $1 billion of the fraudulent entries was related to nonexistent fixed assets, which, as noted, were primarily given the designation AP Summary. The Company also overstated its cash balance by adding unsubstantiated amounts to the monthly reconciliations of its corporate consolidation account, which accounted for the cash receipts and disbursements of the Companys approximately 2,000 bank accounts. Although HealthSouth told analysts in early March 2003 that it had $390 million in cash at the end of 2002,39 $373 million of this was fabricated, according to the report.40 Hundreds of millions of dollars of other current and intangible assets were further made up through various accounting schemes.41 HealthSouth also fabricated more than $400 million in income and assets through fraudulent acquisition accounting. One way it did this was to create artificial reserves on the books of the acquired company and balance the entry by increasing goodwill. This gave the Company the opportunity to recognize income by releasing the reserves in subsequent periods. For example, with one acquisition in 1999 HealthSouth added a $7 million accounts receivable allowance to the acquired companys books, which it then took down in 2000 and 2001 to increase income. Various other cookie jar reserves were established upon acquisition and later released in a similar fashion.42 Furthermore, as the above table indicates, HealthSouth also created false earningsthough on a much smaller scalethrough fraudulent accounting for bonuses, investments, facility-level contractual adjustments, and third-party transactions. In addition to the $2.7 billion in false earnings, the forensic audit report identified several categories of potential misstatements that while not necessarily the result of intentional fraud, nevertheless were sufficiently aggressive or questionable to warrant discussion.43 Examples include the improper capitalization of expenses, improper accounting for sale-leaseback transactions, and the failure to record various E&Y audit adjustments.44 The total estimated impact of such potential misstatements was $632 million. Based on these findings, the forensic audit report made some recommendations to prevent similar accounting and reporting problems from happening in the future. Examples include improvements to the Companys contractual allowance accounting, the implementation of various policies and procedures related to journal entries, stronger controls over fixed assets, and a robust internal audit department that reports directly to the Audit Committee.45 The report concluded that the accounting fraud at HealthSouth was by any standard both enormous and complex. Its concealment over the course of nearly seven years required considerable effort and, in some cases, luck. For all its size and complexity, however, the fraud shared much in common with other highly publicized earnings overstatement cases. 6. SCRUSHY In November 2003, Scrushy was indicted for his role in the HealthSouth accounting fraud. The 36-page, 85-count federal indictment47 charged him with conspiracy, mail, wire and securities fraud, false statements, false certifications and money laundering and sought approximately $278 million in asset forfeitures.48 For certifying financial statements that he allegedly knew to be materially false, Scrushy became the first-ever CEO to be charged with violating the Sarbanes-Oxley Act. Scrushy steadfastly maintained his innocence.49 Scrushys criminal trial began in January 2005.50 To prove Scrushys guilt; the government relied extensively on the testimony of several former HealthSouth executives involved in the fraud, including all five former CFOs, many of whom received lesser prison sentences in exchange for their cooperation in the investigation and testimony at the trial.51 Scrushys defense lawyers did not deny that fraud took place but instead argued that it was done without his knowledge, and they attacked the credibility of the governments witnesses.52 In June, after a lengthy trial and extended jury deliberations, Scrushy was acquitted on all charges. The verdict was a huge blow to the government, which had built a careful and extensive case against him. Nonetheless, prosecutors elected not to appeal the decision.53 Despite Scrushys acquittal, however, his legal problems have continued. In October 2005, he was indicted on bribery and mail fraud charges in federal court for allegedly having paid former Alabama Governor Don Siegelman $500,000 in 1999 for a seat on the board of a state hospital regulatory agency (Siegelman was also indicted).54 Scrushy (along with Siegelman) was convicted in June 2006,55 and was sentenced to almost seven years in prison, which he began serving in 2007.56 His appeal request was denied in May 2009,57 and he is currently incarcerated in federal prison in Texas. Scrushy has also been charged in civil court for his role in the HealthSouth accounting scandal. In 2007, he settled with the SEC for $81 million.58 He is currently the defendant in a shareholder lawsuit filed on behalf of HealthSouth as a company. In May 2009, Scrushy briefly returned to Birmingham to testify in the trial, where he continued to maintain that others carried out the fraud without his knowledge.59 A ruling on the lawsuit, which seeks $2.6 billion in compensatory damages, is pending.60 Also, Scrushy faces a class-action lawsuit from individual HealthSouth shareholders. 7. TURNAROUND AND RECOVERY Since the accounting scandal were first discovered in March 2003, HealthSouth has taken many steps to turn itself around and become a stronger company. It has a new senior management team, and the directors who presided over the Company when the fraud occurred have since been replaced. HealthSouth was also able to avoid bankruptcy by selling assets and reaching various agreements with lenders to refinance its debt. Hundreds of consultants were brought in to help reconstruct the Companys records, develop improved accounting and reporting policies, and establish a stronger, SarbanesOxley-compliant system of internal controls.62 HealthSouth took an important step forward on June 27, 2005, when it released audited financial statements for the four years ending December 31, 2003, the first time the Company had issued financials since the third quarter of 2002.63 In December 2005, HealthSouth issued its 2004 Annual Report,64 and in 2006, the Company reestablished itself as a current SEC filer when it issued its 2005 Annual Report and resumed its quarterly filings.65 HealthSouth was also relisted on the NYSE in October 2006 after shareholders approved a 1-for-5 reverse stock split. 66 As part of a corporate restructuring plan, the Company also sold its outpatient, surgery, and diagnostics divisions in 2007 (primarily for cash), thus preserving only its core inpatient rehabilitation business.67 With this new structure firmly in place, HealthSouth continues to move ahead while doing its best to leave the past behind. 8. CONCLUSION The lesson of HealthSouth offers a powerful reminder that, when it comes to financial reporting, things are not always as they seem. Whether the fraud should have been uncovered sooner is an open question.68 Regardless, analysts and investors should always be careful not to review companies financial statements with an uncritical eye, nor should they take management assertions about company health and various forward-looking projections at face value: there are simply too many incentives and pressures on public companies to report favorable results and give them a positive spinand sometimes people cross the line as a result. And although for practical reasons, a considerable degree of reliance on independent audit opinions is necessary, the HealthSouth experience, like Enron and many others, shows that auditors do not always do their job as well as they should. But can a fraud of this magnitude, scope, and duration still occur now that we are in the era of Sarbanes-Oxley? Will anybody even try? Only time will tell. Q1. State the business factors that pressurized Health South to manipulate earnings aggressively. Q2. State the opportunities that facilitated the Health South Fraud. Q3. How was the Health South fraud covered up? Q4. State the primary reasons that were observed for the audit failures in the various fraud cases (e.g. WorldCom, Phar-Mor) discussed in class? Q5. Define Information Risk and state the factors that increased information risk in the HealthSouth Fraud. Q6. Define managements responsibilities and assertions related to the financial statements.