HealthSouth, Inc.: An Instructional Case Examining Auditors' Legal Liability INTRODUCTION HealthSouth was founded in 1984 by Richard Scrushy and went public in 1986. By 1996, it had grown in market value to over $12 billion (Solomon et al. 2003). Despite the company's rapid growth, things were not quite as positive as they appeared to outsiders. Insiders, allegedly led by Scrushy, perpetrated a fraud that had grown to $2.7 billion before coming to light in 2003 (Stuart 2005) Driven by Scrushy's demands to meet or exceed analyst earnings expectations (which HealthSouth did for 40 consecutive quarters), the company's financial -family | (which included five current and previous CFOs and their staffs) -fixed | actual earnings by plugging -holes|| in the balance sheet with -dirt (fictitious accounting entries) (Voreacos and Davidson 2005). The fictitious entries included improperly capitalizing expenses, overestimating insurance reimbursements, overvaluing fixed assets and using -cookbook|| reserve accounts (SEC v. HealthSouth Corp. and Richard M. Scrushy 2003). The fraud was finally uncovered when Weston Smith, a former CFO, tipped off federal investigators to the fraud in 2003 (Hubbard 2011). William Owens, the then-current CFO, also revealed the fraud to authorities (Stuart 2005). Soon after, many others who participated in the fraud and cover-up turned themselves in. The controller made over 1500 fraudulent entries to create fictitious earnings for HealthSouth. Additionally, the founder and management team were paid billions in incentives and bonuses. HealthSouth's financial statements were audited by the Birmingham, AL office of Ernst & Young (E&Y) from 1984 to 2002. When the fraud was discovered, many shareholders wondered if the auditor-client relationship might have been too cozy, possibly impairing the firm's independence. The Birmingham office's largest client, HealthSouth generated over $3.5 million in annual audit and consulting fees for E&Y in 2001. Additionally, many of the public accounting firm's auditors left the firm to take senior accounting positions with HealthSouth (Weil 2003). In an attempt to recover some of their lost investment in HealthSouth, shareholders added E&Y to the class action lawsuit against Richard Scrushy alleging that the firm -knowingly turned a blind eye to the very fraudulent and illegal practices by which HealthSouth falsified its financial statements | (HealthSouth Corporation Stockholder Litigation 2004, p. 5). Was E&Y liable to HealthSouth investors? 1. Is there any possible breach of independence of E&Y and HealthSouth and its employees in this case? 2. What were the fraud risk factors (using the fraud triangle) occurring at Healthsouth