HealthSouth is one of the nations largest providers of outpatient surgery, diagnostic imaging, and rehabilitative services. In 2003, the SEC filed a complaint against the company and its CEO, Richard Scrushy, for violating provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The complaint alleged that HealthSouth, under Scrushys direction and with the help of key employees, falsified its revenue to inflate earnings and meet their numbers.

The SEC contended that in mid-2002, certain senior officers of HealthSouth discussed with Scrushy the impact of the scheme to inflate earnings because they were concerned about the consequences of the August 14, 2002, financial statement certification required under Section 302 of SOX. Allegedly, Scrushy agreed that, going forward, he would not insist that earnings be inflated to meet Wall Street analysts expectations.

The filing also alleged that Scrushy received at least $6.5 million from HealthSouth during 2001 in Bonus/Annual Incentive Awards. Also, from 1999 through 2002, HealthSouth paid Scrushy $9.2 million in salary. Approximately $5.3 million of this salary was based on the companys achievement of certain budget targets. On December 10, 2003, U.S. District Judge Inge P. Johnson sentenced former vice president of fianc Emery Harris, who pleaded guilty in March 2003 to a charge of conspiracy and willfully falsifying books and records, to a term of five months in prison on each count (to run concurrently), three years of supervised release with five months of unsupervised house detention, and payment of a $3,000 fine and a $200 special assessment. Harris was also ordered to pay $106,500 in forfeiture.

On June 28, 2005, Scrushy was acquitted on all charges despite the testimony of more than a half-dozen former lieutenants who said that he had presided over a $2.7 billion accounting fraud while running HealthSouth national hospital chain. The jury had even heard secretly recorded conversations between Scrushy and the CFO, William T. Owens, in March 2003 discussing balance sheet problems, with Scrushy asking, Youre not wired, are you?

In an ironic twist in the HealthSouth saga, Owens, who was the key prosecution witness in the governments case against Scrushy, was sentenced on December 9, 2005, to five years in prison for his role in the accounting fraud at HealthSouth. Owens had manipulated the companys books and instructed subordinates to make phony accounting entries. He also falsely certified the 2002 financial statements filed with the 10-K report to the SEC.

U.S. District Judge Sharon Lovelace Blackburn knocked three years from the prosecutors sentencing request, stating to Owens, I believe you told the truth. Blackburn called Scrushys acquittal a travesty. Nonetheless, Blackburn said that white-collar criminals merit stiff sentences, if only to send a message of deterrence to other business executives. Corporate offenders are nothing more than common thieves wearing suits and wielding pens, Blackburn said.

The Unraveling

Michael Vines, was employed at HealthSouth as a bookkeeper in 1997 where he started in the companys asset-management division. The 31-year-old, who made about $39,000 a year in that position, had learned accounting by taking classes over several years at three Alabama colleges but hadnt yet completed his degree. He stated he enjoyed working with numbers and making sure everything balances at the end of the day. By late 2001, he had become uncomfortable with how the accounting department operated.

After leaving the company is 2002, Vines tried to spread the word about the questionable practices in the department but at every turn his attempts came to nothing. He sent an e-mail to HealthSouths auditor Ernest & Young, flagging one area of alleged fraud. And later, he tried to make his case online, where readers of the Yahoo forum dismissed his claims as typical Internet blather.

In Viness e-mail to E&Y he listed the accounts where the alleged fraud was occurring including minor equipment, repairs and maintenance, and public information, which included costs for temporary workers and advertising job openings, he said in interview and in court testimony. All these expense accounts would have amounts moved out and into a capital account. In an interview, Mr. Vines said he didnt send the information to a regulatory agency because he assumed Ernst would in turn get with the SEC and say, We have a problem here. Of course, that never happened.

Vines, did ultimately end up testifying on the matter at the April 2002 federal court hearing. He stated that during his time at the company he came to believe that people in the department were falsifying assets on the balance sheet. The accountants, he testified, would move expenses from the companys income statement where the expenses would have been deducted from income immediately- to its balance sheet, where they wouldnt have to be deducted all at one time. Thus, the companys expenses looked lower than they should have been, which helped artificially boost net income.

The individual expenses were relatively small between $500 and $4,999 apiece, according to Viness testimony for the express reason that E&Y examined expenses over $5,000. Overall, according to the SEC complaint, about $1 billion in fixed assets were falsely entered. In his testimony, Vines identified about $1 million in entries he believed were fraudulent. He told his immediate supervisor, Cathy C. Edwards, a vice president in the accounting department, that he wouldnt make such entries unless she first initialed them. I wanted her signature on it, Vines testified. Ms. Edwards, according to Viness testimony, signed off on the entries, and he logged them. Vines also testified that he saw Edwards falsifying invoices, which according to his testimony was a way to cover up the larger fraud involving the accounts. When auditors would later ask to view the invoices for the assets, no such invoices existed. So, Ms. Edwards ordered Mr. Vines to pull an invoice for a different purchase, at another HealthSouth facility, which roughly matched the assets price. She then scanned the invoice into her computer and altered the shipping cost and other information to make it fit the asset that Ernst was asking about, according to Mr. Viness testimony.

On April 3, Edwards pleaded guilty to conspiracy to commit wire and securities fraud. As part of the plea, she admitted to falsifying records, although the plea didnt mention specific incidents.

Additional Whistleblowing

Allegedly, HealthSouths auditors and maybe even government regulators- were tipped off to a possible massive accounting fraud at the company five years before it became public knowledge. At least thats the takeaway from a shareholders memo that was released by a congressional committee during its investigation. The memo, dated November 1998, was apparently written by an anonymous HealthSouth shareholder and sent to auditor Ernst & Young (E&Y). In it, the shareholder alerts the auditing firm to alleged bookkeeping violations at the rehabilitation-services company. Reportedly HealthSouths top lawyer assured its independent auditor that it would conduct an internal investigation of the allegations. The committee notes no record of such an inquiry, however.

The shareholders list of alleged violations at HealthSouth included an assertion that the company booked charges to outpatient clinic patients before checking that insurers would reimburse the claims. The shareholder also alleged that HealthSouth continued to record these charges as revenue even after payments were denied. How can the company carry tens of millions of dollars in accounts receivable that are well over 360 days? the shareholder asked in the letter.

More questions followed: how can some hospitals have no bad debt reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump up the numbers, or something that a novice accountant could catch? In a statement issued by E&Y, the firm stated that it had conducted a review at the time the allegations were made and determined the issues raised did not affect the presentation of HealthSouths financial statements.

Fall out for E&Y

James Lamphron, a partner in E&Ys Birmingham office, testified that E&Y had conducted audit-related procedures with the accounts that Vines pointed out. The result: E&Y reached a point where we were satisfied with the explanation that the company had provided to us We then closed the process. According to Lamphrons testimony, Vines never specified that invoices were being falsified only that there was a problem with the three accounts he mentioned. So E&Y never investigated the falsified invoices and didnt find any evidence of fraud. E&Y defended itself by stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. E&Y wasnt named or charged as a defendant in the government cases, and the firm cooperated with investigators.

HealthSouth said that a forensic audit, conducted by PricewaterhouseCoopers, found fraudulent entries to raise the total to a range of $3.8 to $4.6 billion, up from $3.5 billion, which had been the governments original estimate. The fraud included $2.5 billion in fraudulent accounting entries from 1996-2002, $500 million in incorrect accounting for goodwill and other items involved in acquisitions from 1994 to 1999, and $800 million to $1.6 billion in aggressive accounting from 1992 to March 2003.

Fall out for Scrushy

Though Scrushy was acquitted on June 28, 2005, he was indicted on October 28, 2005, by a federal grand jury in Montgomery, Alabama on charges of money laundering, extortion, obstruction of justice, racketeering, and bribery. While in jail, on June 18, 2009, Judge Allwin E. Horn ruled that Scrushy was responsible for HealthSouths fraud and ordered him to pay $2.87 billion. On July 25, 2012, Scrushy was released from federal custody.

Forensic Audit of HealthSouth

Though it is hindsight now, Craig Greene, a certified fraud examiner from Chicago who has investigated accounting scandals nationwide, says that the governments lawsuit against HealthSouth points to many red flags in the companys financial statements that he believes auditor E&Y should have picked up on. Greene investigated the HealthSouth fraud and concluded that officials at the company manipulated revenue figures, created phony invoices, and inflated the value of assets to overstate earnings by $1.4 billion between 1999 and mid-2002. Greene said that there were signs of a fraud that should have set off alarm bells.

Some examples included: HealthSouths reported net income rose almost 400 percent from 1999 to 2000, yet cash on hand only increased by 40 percent. As the story goes, follow the money, says Greene, was cash really tracking earnings?

Greene also noticed that HealthSouth reported a $342 million adjustment in its 1999 allowance for doubtful accounts but only $98 million adjustment in the next year. I believe this is the account that was manipulated for revenues, Green said. Why such a drastic change?

Moreover, HealthSouth reported significant capital expenditures between 1998 and 2001, but that did not translate into additional sales, as one might expect, he said. That is more equipment and property to treat more patients, which results in more revenue, Greene said.

Yet another red flag: the U.S. economy began to sour at the end of 1999, yet HealthSouths books showed strong profit growth in 2000 and 2001.

Case compiled from:

Steven M. Mintz and Roselyn E. Morris, Ethical Obligations and Decision Making in Accounting, 2013

Carrick Mollenkamp, An Accountant Tried in Vain to Expose HealthSouth Fraud, The Wall Street Journal, May 20, 2003

Question:

1.) Ernest & Young was HealthSouths external, independent auditor. What were their responsibilities in this role? Do you believe they fulfilled their role? Why or why not? Use examples from the case as well as the AICPA code and rules to justify your answer.