Case Analysis

HealthSouth Corporation

The HealthSouth case is unique because the CEO, Richard Scrushy, was initially acquitted on all accounts, while five former HealthSouth employees were sentenced by a federal judge for their admitted roles in a scheme to inflate revenues and reported earnings of the company from 1999 through mid-2002. These amounts are presented in Exhibit 1.

HealthSouth is one of the nation's largest providers of outpatient surgery, diagnostic imaging, and rehabilitative services. In 2003, the SEC filed a complaint against the company and Scrushy for violating provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934.1 The complaint alleged that HealthSouth, under Scrushy's direction and with the help of key employees, falsified its revenue to inflate earnings and "meet their numbers." Specifically, false accounting entries were made to an account called “contractual adjustment." The contractual adjustment account is a revenue allowance account that estimates the difference between the gross amount billed to the patient and the amount that various health care insurers will pay for a specific treatment. HealthSouth deducted this account from gross revenues to derive net revenues, which were disclosed on the company’s periodic reports filed with the SEC. The allowances were deliberately understated to help meet financial analyst earnings estimates.

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 Awards." Also, from 1999 through 2002, HealthSouth paid Scrushy $ 9.2million in salary. Approximately $5.3 million of this salary was based on the company's achievement of certain budget targets. On December 10, 2003, U.S. District Judge Inge P. Johnson sentenced former vice president of finance 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.2

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 the 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, "You're not wired, are you?"

In an ironic twist in the HealthSouth saga, Owens, who was the key prosecution witness in the

government's 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 company's 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 prosecutor's sentencing

request, stating to Owens, "I believe you told the truth.” Blackburn called Scrushy's 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.3

EXHIBIT 1

Misstatement of Net Income by HealthSouth Corporation

Net Income 1999 2000 2001 For Six Months Ended

(in millions) Form 10-K Form 10-K Form 10-K June 30, 2002

Actual $(191) $194 $9 $157

Reported $230 $559 $434 $340

Misstated amount $421 $365 $425 $183

Misstated percentage 220% 188% 4,722% 119%

1Securities and Exchange Commission, Civil Action No. CV-03-J-0615-S, U.S. District Court Northern District of Alabama, Securities and Exchange Commission v. HealthSouth Corporation and Richard M. Scrushy, Defendants.

2Department of Justice, "Five Defendants Sentenced in HealthSouth Fraud Case," www.usdoj.gov.

3Carrie Johnson, "5 Years for HealthSouth Fraud: Former Chief Financial Officer Was Key Witness," Washington Post, December 10, 2005, Dl.

The Fraud Investigation- Implications of Whistleblowing

HealthSouth said that a forensic audit by PwC 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 government's original estimate. The fraud included $2.5 billion in fraudulent accounting entries from 1996 to 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.

Allegedly, HealthSouth's 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 that's the takeaway from a share- holder's 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 (EY). In it, the shareholder alerts the auditing firm to alleged bookkeeping violations at the rehabilitation-services company. Reportedly HealthSouth's 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. "You bring the smoke, I'll bring the mirrors," the unnamed shareholder wrote in the memo.

The shareholder's 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 EY 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 EY, 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 HealthSouth's financial statements. "You people and I have been hoodwinked," the shareholder concluded in the memo. "This note is all that I can do about it. You all can do much more, if all you do is look into it to see if what I say is true." At 10:06 a.m. on February 13, 2003, someone made a sensational claim on the Yahoo bulletin board devoted to discus- sion of HealthSouth to this effect: "What I know about the accounting at HealthSouth will be the blow that will bring the company to its knees."

Michael Vines, a former bookkeeper in HealthSouth's accounting department, tried to spread the word about alleged questionable practices while at HealthSouth but was turned away everywhere he went. According to Vines's testimony at the April 2002 federal court hearing, 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 company's income statement-where the expenses would have to be deducted from profits immediately – to its balance sheet, where they wouldn't have to be deducted all at one time. Thus, the company's expenses looked lower than they should have been, which helped artificially boost income. The individual expenses were relatively small-between $500 and $4,999 apiece, according to Vines's testimony – for the express reason that EY 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 that he believed were fraudulent. He told his immediate superior, Cathy C. Edwards, a vice president in the accounting department, that he wouldn’t make such entries unless she first initialed them. "I wanted her signature on it," Vines testified. Edwards, according to Vines's testimony, signed off on the entries, and he logged them. Vines also testified that he saw Edwards falsifying an invoice, which according to his testimony was a way to cover up the larger fraud involving the accounts. 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 didn't mention specific incidents. Over time, Vines had grown more concerned about accounting practices, particularly in light of the scandal that had recently erupted at Enron. He quit his job and moved to the accounting office of a Birmingham country club. Not long afterward, he sent an e-mail to EY alleging fraudulent transactions and identified three account numbers that Ernst should investigate. The accounts covered expenses for "minor equipment," "repairs and maintenance," and "public information," which included costs for temporary workers and advertising job openings, he said in an interview and in court testimony.

Vines's e-mail was passed on to James Lamphron, a partner in EY's Birmingham office. Lamphron testified that he had contacted Owens, who was then president and chief operating officer at HealthSouth, and George Strong, who served as chair of the audit committee of HealthSouth's board. A HealthSouth

spokesperson said that Strong felt the matter was being resolved. According to Lamphron's testimony, Owens defended the company's accounting practices. He acknowledged that the company had moved expenses from one category to another, but he argued that the company had done it for several years and that it was an acceptable practice. Lamphron testified that Owens called Vines a "disgruntled employee." On March 26, 2004, Owens pleaded guilty to wire and securities fraud and certifying a false financial report to the SEC. Lamphron testified that EY had conducted "audit-related procedures" with the accounts that Vines pointed out. The result: EY "reached a point where we were satisfied with the explanation that the company had provided to us…. We then closed the process." According to Lamphron's testimony, Vines never specified that invoices were being falsified-only that there was a problem with the three accounts he mentioned. So EY never investigated the falsified invoices and didn't find any evidence of fraud. EY defended itself by stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. EY wasn't named or charged as a defendant in the government es, and the firm cooperated with investigators. What Happened to Scrushy? Four months after his acquittal in Birmingham, Scrushy 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. He was found guilty of these charges. However, his 82-month sentence was cut short after the Eleventh Circuit Court of Appeals threw our Scrushy's convictions on "honest services fraud," a concept that says executives and government officials can be found guilty of crimes when they deny the people they serve the intangible right to honest services. Thus, the court decided Scrushy did not deny that right to the shareholders and reduced his term to 70 months. While in jail, on June 18, 2009, Judge Allwin E. Horn ruled that Scrushy was responsible for HealthSouth's fraud and ordered him to pay $2.87 billion. On July 25, 2012, Scrushy was released from federal custody. Forensic Audit of HealthSouth It's hindsight now, but Craig Greene, a certified fraud examiner from Chicago who has investigated accounting scandals nationwide, says that the government 's lawsuit against HealthSouth points to many red flags in the company's financial statements that he believes auditor EY "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." One example: HealthSouth's reported net income rose almost 400 percent from 1999 to 2000, yet cash on hand only increased by 40 percent. "The old story is follow the money," said Greene. "Was cash really tracking earnings? " Greene also noted HealthSouth reported a $342 million adjustment in 1999 to an allowance for doubtful accounts, followed by only $98 million in 2000. "I believe this is the account that was manipulated for revenues," Greene 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 HealthSouth's books showed strong profit growth in 2000 and 2001. Questions

1. What is the nature of the contractual allowance account? Can you equate it to other allowance accounts? Explain the rules under GAAP to account for such allowances and why.

2. Personal morality and ethics make up the collective morality and ethics of a corporation. Given our discussion about the ethics of organizations in Chapter 3, evaluate the ethical climate at HealthSouth and the tone at the top established by key officers and company decisions.

3. Small concessions lead to greater compromises and, unchecked, will lead to serious ethical lapses and even crimes. Nobody sets out to end up in prison, but as detailed in the case, several people from HealthSouth in fact did end their careers that way; it all started with small,

seemingly insignificant, compromises. Comment on these statements from the perspective of ethical decision making.

4. Looking at the findings of Craig Greene, the certified fraud examiner who investigated the HealthSouth fraud, explain why so-called red flags are important in an independent audit. In other words, what is the purpose of an auditor looking for financial information to sense the "alarm bells" that warn of danger ahead?