Question 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 flags for the auditors to pursue For example, from 1999 to 2001, net income rose nearly 500 percent while revenue grew only 5 percent 14 The audit team also took no action when members learned that internal auditors were denied access 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 Scrushy 15 Despite EY's awareness of important fraud risks, the family was adept at the cover up, 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 regenerate the ledgers, replacing the AP Summary line with the name of a specific fixed asset that did not exist at the facility 16 DISCOVERY The fraud scheme was noticed by company whistle blowers, 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 e mail, 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 mail, 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 ) 18 In October 1999, Diana Henze, assistant vice president of finance, noticed that earnings would jump with each iteration of quarter end consolidations She confronted Owens, who was controller at the time, and accused him of fraud When she went to Kelly Cullison, the company's corporate compliance officer, she was told that the compliance officer did not have access 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 19 Henze said that she was subsequently passed over for a promotion that would have given her more involvement with the books When she asked why a less qualified person got the job, Owens told her, You have made it clear you won't do what we asked 20 William Owens finally went to the authorities when his wife threatened to divorce him because she thought (correctly) that he would end up in jail 21 Owens agreed to wear a wire when meeting with Scrushy Scrushy is on tape as saying, You got accountants signing off on all this In an impromptu meeting at a lake, Scrushy is recorded as telling Owens, Just remember, I got eight kids I got a bunch of babies at home They need their daddy Scrushy 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 transcript of the recording that Owens made 22 Once Owens came forth, the investigation quickly uncovered the massive fraud as other employees quickly cut deals with prosecutors Scrushy 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 each day before he appeared in court and hosted his own website ( www richardmscrushy com ) 23 His defense attorneys sought to depict him as a detached 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 enforcement of the Sarbanes Oxley Act (Scrushy had certified statements on the 10 K dated August 14, 2002, under the Sarbanes Oxley Act ) 24 Jurors said key witnesses were not credible, and the prosecution failed to present substantial evidence linking the fraud to Scrushy The smoking gun wasn't pointing toward Mr Scrushy 25 Scrushy subsequently settled claims from the SEC by paying $81,000,000 26 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 seat 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 Scrushy was released from prison in 2012 and now is on the speaker circuit QUESTIONS 7 What analytical procedures could have been performed to help detect the fraud (Is the analytic you recommend a Planning, substantive, or conclusion analytics ) (Is the analytic a trend analysis, ratio analysis, reasonableness analytic, etc ) 8 Would the constant change in CFO raised any red alarms as part of the Acceptance continuance and Planning phases of the audit 9 HealthSouth officials created false documents to cover their tracks what is the auditors responsibility to detect if a document is real or fake provide reference to the PCAOB audit standard that answers this question 10 It was noted that Many of HealthSouth's senior accounting staff had been EY employees should this be a concern for auditors If so why How should the auditor change their audit approach to address this concern

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Question: 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

Question:

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 flags for the auditors to pursue. For example, from 1999 to 2001, net income rose nearly 500 percent while revenue grew only 5 percent.¹⁴ The audit team also took no action when members learned that internal auditors were denied access 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 Scrushy."¹⁵ Despite EY's awareness of important fraud risks, the "family" was adept at the cover-up, 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 regenerate the ledgers, replacing the AP Summary line with the name of a specific fixed asset that did not exist at the facility.¹⁶

DISCOVERY

The fraud scheme was noticed by company whistle-blowers, 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 e-mail, 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-mail, 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.)¹⁸

In October 1999, Diana Henze, assistant vice president of finance, noticed that earnings would jump with each iteration of quarter-end consolidations. She confronted Owens, who was controller at the time, and accused him of fraud. When she went to Kelly Cullison, the company's corporate compliance officer, she was told that the compliance officer "did not have access 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.¹⁹ Henze said that she was subsequently passed over for a promotion that would have given her more involvement with the books. When she asked why a less-qualified person got the job, Owens told her, "You have made it clear you won't do what we asked."²⁰

William Owens finally went to the authorities when his wife threatened to divorce him because she thought (correctly) that he would end up in jail.²¹ Owens agreed to wear a wire when meeting with Scrushy. Scrushy is on tape as saying, "You got accountants signing off on all this." In an impromptu meeting at a lake, Scrushy is recorded as telling Owens, "Just remember, I got eight kids. I got a bunch of babies at home. They need their daddy." Scrushy 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 transcript of the recording that Owens made.²² Once Owens came forth, the investigation quickly uncovered the massive fraud as other employees quickly cut deals with prosecutors.

Scrushy 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 each day before he appeared in court and hosted his own website (www.richardmscrushy.com).²³ His defense attorneys sought to depict him as a detached 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 enforcement of the Sarbanes-Oxley Act. (Scrushy had certified statements on the 10-K dated August 14, 2002, under the Sarbanes-Oxley Act.)²⁴ Jurors said key witnesses were not credible, and the prosecution failed to present substantial evidence linking the fraud to Scrushy: "The smoking gun wasn't pointing toward Mr. Scrushy."²⁵

Scrushy subsequently settled claims from the SEC by paying $81,000,000.²⁶ 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 seat 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 Scrushy was released from prison in 2012 and now is on the speaker circuit.

QUESTIONS:

7. What analytical procedures could have been performed to help detect the fraud? (Is the analytic you recommend a Planning, substantive, or conclusion analytics?) (Is the analytic a trend analysis, ratio analysis, reasonableness analytic, etc?)

8. Would the constant change in CFO raised any red alarms as part of the Acceptance/continuance and Planning phases of the audit?

9. "HealthSouth officials created false documents to cover their tracks"- what is the auditors responsibility to detect if a document is real or fake- provide reference to the PCAOB audit standard that answers this question.

10. It was noted that "Many of HealthSouth's senior accounting staff had been EY employees"- should this be a concern for auditors? If so why? How should the auditor change their audit approach to address this concern?