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PROBLEM In 1996, key executives of HealthSouth, one of the nation's largest providers of health care services, begain a massive fraud that eventually amounted to $2.7 billion. I HealthSouth is a textbook case of unbridled greed combined with a lack of corporate governance, which illustrates the difficult situation that auditors face when clients perpetrate a massive, collusive fraud. HealthSouth was founded in 1984 by Richard Scrushy and coworkers at Lifcmark, a Houston-based company that owned and manuged hospitals. 2 They took HealthSouth public in 1986, and by 1996, the company's market value had grown to $12 billion. 3 According to the government's complaint, Serushy, the chicf executive officer, insisted that the company meet or exceed earnings expectations established by Wall Street analysts. Senior officers would present actual accounting earnings to Scrushy, and if they did not meet the forecasts, he reportedly told them to "fix it." Unbeknownst to Serushy (according to his testimony at trial), a team of senior accounting personnel. known as "the family," held "family meetings" to determine ways to increase accounting earnings. They would look for "holes" in the balance sheet to be filled. The fictitious accounting entries they used to plug those holes were referred to as "dirt. "Methods included overestimating insurance reimbursements, overstating fixed assels, improperly capitalizing expenses, and overbooking reserve account 4 The "Family" members started by manipulating contractual allowances by consolidating entry adjustments after the end of each quarter. The allowinces accounted for the differences between what HealthSouth charged patients and the amounts the company could collect from the patients' health insurers. By lowering the allowances improperly, HealthSouth improved its net revenue and bottom-line carnings, To offset the contractual allowances, the company increased inventory, intangible assets, fixed assets, and even cash. The fictitious tixed asset line item at each facility was listed as "AP summary." The company's CFO, William Owens, a former Ernst \& Young (EY) senior manager and one of five CFOs who eventually pleaded guilty to the fraud, also used the acquisition of Horizon/CMS to book $400 million worth of goodwill as part of the cover-up. He pulled the trick off with the help of two HealthSouth colleagues and a finance executive from Horizon. 6 On paper, HealthSouth maintained impeceable corporate policies. The company established a confidential whistleblower hotline in 1997; developed a nonretaliation policy, which gave the compliance direetor direct access to the board; and established a centralized linance function. This centralized function seemed to be a particular advantage because other health care companies were falling apart as a result of problems in ficld offices. Reviewing these policies, it is not difficult to see why a massive fraud did not seem likely? Despite outward appearances, actual corporate governance was quite different. Many decisions were made at the executive level, which limited checks and balances along the way. The audit committee met only once a year. The accounting systems in the field did not interfuce with the corporate enterprise-resource-planning software, making it necessary for results to be consolidated at the corporate level, where it was easier to "cook" the numbers." Serushy, a former gas station attendant, fit the profile of the domineering CEO who set the wrong tone at the top. He reportedly managed by fear and intimidation. Serushy installed security cameras throughout headquarters to watch employees. He allowed rankund-file employees into his executive suite only when he wanted to berate them. 9 Aceording to the government's complaint, accounting personnel advised Serushy in 1997 to abandon the fraud, but he refused, saying. "Not until 1 sell my stock. 10 The five CFOs realized the Pase CIS error of their ways, but most felt helpless to blow the whistle or even leave the company. One, Michael Martin, testified be tried to quit, but Serushy reportedly said, "Martin, you can't quit. You'll be the fall guy."11 Later, when Treasurer Leif Murphy decided to leave the company because of the fraud, Martin punched him twice at his goingaway party and wrote on his faresell card, "Eat fexpletivel and dic."12 AUDIT APPROACH HealthSouth was the largest client of the Birmingham office of EY. The 2001 audit fee was $1.2 million, and the firm billed an additional \$2.5 million for other services. Many of HealthSouth's senior accounting staff had been EY employees. 13 In hindsight, there had been red Alugs for the auditors to pursue. For example, from I999 to 2001, net income rose nearly 500 pereenit while revenue grew only 5 percent. 14 The audit team also took no action when members learned that internal auditors were denied aceess to the corporate books. Finally, the team did not sufficiently investigate employee complaints. The auditors were not oblivious to HealthSouth's risky profile. Jim Lamphron, a partner on the audit, said they focused on two risk factors: (1) "Company officials harboring a strong interest in seeing a rising stock price" and (2) "Management ranks dominated [by] those at the top.... Specifically, we were focusing on Richard Serushy."15 Despite EY's awareness of important frud tisks, the "family" was adept at the coverup, making it difficult to detect certain aspects of the fraud. The SEC said that HealthSouth employees knew that EY questioned additions to fixed assets at any particular facility only if the additions exceeded a certain dollar threshold ( (5,000), so the company avoided exceeding that dollar amount by spreading the adjustments below this materiality limit to various accounts and locations. When the auditors did question an accounting entry, HealthSouth officials created false documents to cover their tracks. When EY auditors asked for fixed assets ledgers for various facilities, accounting personnel would regencrate the ledgers, neplacing the AP Summary line with the name of a specific fixed asset that did not exist at the facility 16 The fraud seheme was noticed by company whistleblowers, whose concerns seemed to be disregarded, One anonymous e-mail was sent to the auditors saying the company "fleeced shareholders" and listed four suspicious accounting practices. EY's review determined that the issues raised by the author of the e-mail "did not affect the presentation of HealthSouth's financial statements. "Another email, from former employee Michael Vines and forwarded to audit partner Jim Lamphron, was passed to CFO William Owens and George Strong. the audit committee chairman. Owens provided fake invoices for the questioned entries and dismissed the seriousness of this e-muil, indicating that Vines was just a disgruntled former employee, 17 (Vines had made frequent comments about the company's accounting on the employee electronic chat room and was regarded as something of a pest. )15 In Oetober 1999, Diana Henze, assistant vice president of finance, noticed that earnings would jump with each iteration of quarterend consolidations. She confronted Owens, who was controller at the time, and aceused him of fraed. When she went to Kelly Cullison, the company's corporate compliance officer, she was told that the compliance oflicer "did not have aceess to the supporting documents" to determine whether or not the journal entries were legitimate. Henze brought the matter to her supervisor, cofounder Tony Tanner, who told her the entries were the result of reversing out a number of reserves and that the matter was closed. Henze said that she Pae Ci6 Was subsequently passed over for a promotion that would have given her more involvement with the books. When she asked why a lessqualified person got the job, Owens told her, "You have made it clear you won't do what we asked."2e William Owens finally went to the authorities when his wifo threatened to divoree him because she thought (correcty) that he would end up in jail: 4 Owens agreed to wear a wire when meeting with Serushy. Serushy is on tape as saying, "You got accountants signing off on all this, "In an impromptu meeting at a lake, Serushy is recorded as telling Owens, "Just remember, I got eight kids. 1 got a bunch of babies at home. They need their daddy. "Serushy also told Owens, "If you want to go public with all this, get ready to get fired, and everyone goes down with you," according to the transeript of the recording that Owens made. 22 Once Owens came forth, the imestigation cuickly uncavered the massive fraud as other employees quickly cut deals with prosecutors. Serushy was a local hero in Birmingham with supporters in all corners. A lavish donor to local colleges, libraries, and medical centers, he was also a regular preacher at area churches. He even aired his own IV talk show cach day before he appeared in court and hosted his own Serushy was a local hero in Birmingham with supporters in all corners. A lavish donor to local colleges, libraries, and medical centers, he was also a regular preacher at area churches. He even aired his own TV talk show cach day before he appeared in court and hosted his cwn website ( www.richarduscrushy.cotn). 23 His defense attorneys sought to depict him as a detuched leader and visionary rather than a micromanager with unchallenged influence. In the end, he was acquitted of all charges in what many see as a blow to enforcemeat of the Sarbanes-Oxley Act. (Scrushy had certified statements on the 10-K dated August 14, 2002, under the Sarbanes-Oxiey Act.) 24 Jurors said key witnesses were not credible, and the prosecution failed to present substantial evidence linking the fraud to Serushy: "The smoking gua Wasn't pointing toward Mr Serushy. -25 Serushy subsequently settled claims from the SEC by paying $81,000,00026 However, in October 2006 , he was convicted of improperly paying $500,000 to a campaign of former Alabama Governor Don Siegelman in exchange for a scat on a hospital regulatory board. He was sentenced in June 2007 to nearly seven years in prison. 27 In July 2009 , a jury awarded $2.88 billion in a civil suit brought by HealthSouth shareholders. It is believed to be the largest penalty ever levied against one executive. This case was brought before a lone judge, not a jury. 28 In April 2011, the Alabama Supreme Court denied Scrushy's appeal of the verdict. 29 Serushy was released from prison in 2012 and now is on the speaker circuit. DISCUSSION QUESTIONS 1. What ape several red flags that EAY either was or should have been aware of in the audit of HealthSouth? 2. What procedures can auditors perform to detect fraudulent entries made during the consolidation process? 3. How can auditors determine a company's true "tone at the top" 7 4. What is the appropriate response by auditors to information from "disgruntied" employees? 5. HealthSouth concealed the fraud by keeping the fraudulent transactions below $5,000. What recommendation would you have given to ERY to improve its sampling practices