ACG 6686 – Fraud Accounting

GROUP 3

Maria Fernandez de Castro

Sonia Canessa-Gonzalez

Andres Suarez

Anatomy of a Financial Fraud – HealthSouth, Inc.

The Company and its history

Richard Scrushy and a few close associates founded HealthSouth in 1984. In 1986 their

company went public, and by 1991, two market analysts at Smith Barney, Harris and Lorello,

began a lucrative career giving strongly positive stock evaluations to HealthSouth and a number

of associated corporations. This brought in billions of dollars of business from HealthSouth for

them and Smith Barney, arranging loans and floats to support the company's expansion.

HealthSouth's stock value increased as a result enabling it to secure bank loans and use stock in

takeover endeavors. Between 1995 and 1998 the stock value would increase by 250% reaching

US $30 in 1998. The allegations about this relationship with Lorello suggest that it was Harris'

optimistic profit projections which HealthSouth's accountants were required to match. If it failed

to do so its share price would fall and it would be unable to grow.

Harris and Lorello built their reputations around HealthSouth. By 1998 HealthSouth had

been far more successful than any of the other successful corporations. It had come to dominate

the for-profit rehabilitation and out patient surgery marketplaces by acquiring competitors. There

were only a very few small for profit rehabilitation providers still competing with it. It was busy

buying up outpatient surgery from its competitors including Surgical Health, Columbia/HCA,

and National Surgery Centers.

HealthSouth and HealthSouth directors also formed MedPartners, which was the largest

and most successful physician management in the health care corporate craze. Only one other

company, Phycor, could compete. Medpartners had also entered the pharmacology business

buying up the company Caremark. HealthSouth’s directors were involved in nursing home and

post acute care holding positions on Integrated Health Services’ board. They had entered Home

Care when they joined with Integrated Health Services and bought Horizon/CMS. They had

moved into Managed Care buying MedSolutions. With Columbia/HCA in the midst of a massive

fraud investigation it looked as if Scrushy and HealthSouth were poised to take over the entire

US Health System. Scrushy and his close associates would tightly control the companies and

their directors. Conflicts of interest would simply be ignored.

While HealthSouth was successful and considered the darling of the marketplace no one

questioned these arrangements. Scrushy and his associates rewarded themselves very

handsomely. Over the succeeding years Scrushy built his reputation as an eccentric

multimillionaire and magnanimous philanthropist. His local Birmingham, Alabama community

came to worship him.

During the late 1990s, HealthSouth’s raid of acquisitions for all kinds of healthcare,

pharmaceutical and rehabilitation companies ranges in billions of dollars. The company, always

with Scrushy at the helm, even takes to other countries, including Australia.

Amidst the excesses, several of the subsidiaries or associate companies are being

investigated for Medicare fraud. In 1998, Scrushy reorganizes an imploding MedPartners

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management in January and takes over as chairman until November but he remains on the board.

MedPartners refuses to address demands made by insurers alleging Caremark had defrauded

them. Twenty-three insurers go to court claiming a US $3.3 billion fraud by Caremark. The

Physician Management business collapses and a decision is made by MedPartners to abandon it.

Shares have plummeted and investors have lost many millions. Crawford, a turn around

specialist who has been brought into HealthSouth, becomes chairman. Medpartners switches

direction to its Caremark pharmaceutical business.

The new Medicare funding arrangements designed to prevent exploitation of the system

are commenced mid 1998. By the end of the year profits have dropped 93% but Scrushy blames

managed care contracts for this. Scrushy remains supremely confident while selling shares. He

then announces that the promised expectations will not be met. Share prices fall, and a number of

class action suits are commenced by angry stockholders, alleging insider trading. It will later be

suggested that this downgrade was artificial and an attempt to hide some of the fraud. Cracks

begin to appear in HealthSouth's invincible image. The first major indications of Medicare fraud

and skimping on patient care appear.

In 2000, Scrushy is indignant about a threat by Moody's Investors Service to downgrade

HealthSouth's US $3 billion debt saying "We're doing great, . . . Our cash is great, our earnings

are strong . . . and shareholder value is improving every day". The accounting fraud is continuing

and the company is perhaps trapped by its commitment to grow, and the envy of the marketplace,

which it dare not disappoint.

A year later, the many corporate failures have forced the government to restore some

Medicare funding and the prospects looked better. HealthSouth starts raising money from the

market in order to pay down debt. HealthSouth pays US $8.2 million Medicare fraud for

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illegally billing Medicare for equipment purchased from its own companies. Government joins a

whistle blower Qui Tam action alleging Medicare fraud. Scrushy sells his shares in Caremark.

During 2002, however, things begin to rapidly unravel and HealthSouth finds itself on a

slippery slide with serious problems. In May the Justice department joins a whistle blower

initiated action lawsuit accusing HealthSouth of seeking individual payment for services given to

groups and provided by unlicensed employees including interns and students. This means that

the government takes over the case, investigates and prosecutes. The government seldom joints

these suits unless it is confident of a large settlement.

Scrushy seems to see the writing on the wall. He exercises 5.3 million options at $3.78

and sells them for US $14.05 the same day. Altogether he sells US $1.3 million in stock in May

and July. In August the company announces a profit downgrade blaming minor changes to

Medicare regulations which it has known about for a long time but which they claim they have

only recently become aware of. It will later be alleged that this downgrade was inflated in

another attempt to hide the missing money in the accounts. This explanation is not plausible and

in the Post-Enron environment is not accepted. The share price tumbles and a host of class

actions alleging insider trading are commenced.

In August Scrushy steps down as chief executive but remains as chairman. He announces

plans to split off profitable surgery centers as a separate company, which he will chair. A witness

will later indicate that he planned to take the rump private and bury the fraud there.

The HealthSouth corporate façade begins to break up as post-Enron investors and

analysts start to look critically at its quality of services with claims that care was provided by

unqualified staff. The Office of the Inspector General of the Department of Health and Human

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Services, which investigates Medicare and Medicaid fraud, confirmed that it was looking at

HealthSouth.

There are also allegations about its financial practices, insider stock sales, business

dealings among company officials and the independence of the board. It has a credibility

problem and shares tumble. The company claims it is committed to transparency.

Details of Scrushy's US $10.5 million (including bonus) 2001 remuneration and his lavish

philanthropy are reported in the press.

The SEC starts an investigation of the share sales made in July 2002 shortly before the

stock collapsed, by Scrushy and Owens. A host of shareholder class actions accuse Scrushy and

others of not disclosing adverse information about stock's potential decline in 1998 and again in

2002 when they sold stock. The SEC will later claim that these projected losses were deliberately

overstated to hide the fraud.

Scrushy and Owens deny insider trading. HealthSouth announces that an independent

national law firm has cleared Scrushy's sale of shares. HealthSouth employed the firm and its

report was never made public. In October HealthSouth abandons plans to split company in the

face of criticism by investors and lenders. It starts looking for things to sell. The end for

HealthSouth and Scrushy comes rapidly. Post Enron investigators target HealthSouth and in

February 2003 it is served with a subpoena as part of an investigation into criminal practices.

Regulators examine documents and interview many HealthSouth employees. The family of

accountants who, it is alleged, carried out the accounting fraud start meeting daily or more often.

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Weston L. Smith, a former chief financial officer approaches prosecutors and offers to

make audiotapes of his colleagues. It is likely that this is the key to the multiple guilty pleas that

follow. The company's current CFO William Owens also cooperates with investigators and tape

records incriminating conversations with Scrushy. The next day FBI agents raid HealthSouth

headquarters.

In a civil action the SEC and the Justice department charge the company and Scrushy

with a massive fraud between 1999 and 2003. HealthSouth had overstated its earnings by US

$1.4 billion and its assets by US $800 million. Authorities indicate that the fraud started as long

ago as 1986 when the company went public. Weston Smith, Chief Financial Officer (CFO)

pleads guilty and is helping authorities. The authorities obtain a court order to freeze Scrushy's

assets and bar him from acting as a director of any company.

HealthSouth's shares are suspended on the stock exchange and subsequently removed. It

is removed from the S&P 500 index. The share price has already fallen from $30 five years ago

to $4. It is soon trading for as little as 14 cents over the counter. The banks freeze the company's

US 1.25 billion credit line ahead of a US $345 bond payment due April 1st. The company

struggles to avoid bankruptcy. It admits that its accounts cannot be relied on as an indication of

its financial position. It is unable to file its annual report with the SEC and postpones its annual

meeting.

HealthSouth cannot fire Scrushy as a director but they ask him to resign, suspend him as

chief executive officer, and fire him as chairman, notifying him that his contract is "null and

void". HealthSouth forms its own committee to investigate the allegations. The press begins to

look at Scrushy's lavish lifestyle, his extracurricular activities, his philanthropy and his

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aggressive management style. The effectiveness and frequency of meetings of HealthSouth's

audit committee is challenged. The committee denies knowledge of the fraud and employs

lawyers to protect it. In an attempt to restore credibility the company had appointed a new

director, Betsy Adams and made her head of the committee to investigate the SEC allegations of

fraud. She resigns after less than 3 weeks.

Again to restore credibility the company looks for new directors not tainted with the

Scrushy brush. One report indicates that the board is deadlocked 4 to 4 as directors with

longstanding ties to Mr. Scrushy refused to approve a plan to add independent members who

would form a majority.

There is scepticism about the role played by the auditors given the duration of the fraud.

Some believe that there were pointers to what was happening - which should have aroused

suspicion. This impression is reinforced when HealthSouth fires Ernst and Young and employs

new auditors.

Scrushy's maze of private companies, the complex relationships between them and the

businesses run by HealthSouth come under scrutiny. The FBI looks to see if Scrushy has

established an off shore tax haven. There are concerns that the company has committed

Medicare fraud by huge and artificial increases in the company's assets, which were then

included in claims for depreciation allowances from Medicare. This is the same sort of fraud as

that perpetrated by Columbia/HCA in its US $1.7 million fraud settlement.

Quite separate to this the Department of Health and Human Services' inspector general's office

reveals that Medicare inspectors have been investigating HealthSouth for Medicaid fraud "on a

few fronts" for several years.

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Insurance companies start examining their contracts to see their exposure to HealthSouth

and determine if they have been defrauded. Private investors commence class actions against

Scrushy and the company.

By the end of April a total of 11 senior past and present staff plead guilty to fraud

including all 5 of the company's past Chief Financial Officers (CFO's). The fraud is clearly

documented back at least to 1997. New pleas include Michael Martin, who describes discussions

with Scrushy about fraud in 1993 and Aaron Beam a co-founder of the company and the first

CFO of HealthSouth.

The evidence some give exposes over US $1 billion additional fraud in 1997 and 1998

bringing the total to US $2.5 billion. They reveal that HealthSouth misstated assets of companies

it acquired to create "sock" reserve accounts which were then "bled out" into HealthSouth to

falsely enhance its own earnings.

Those who pleaded guilty describe how they were sucked into the fraud, often unaware

of what they were doing or the extent until they were trapped by their own guilt. There was fear

and intimidation and they risked losing their jobs. No one is disputing the nature of the fraud or

its extent.

The SEC anticipated that Scrushy would be required to pay back over US $700 million

but his assets were only US $150 million. They thought that he might move his funds into

offshore accounts and sought a court order freezing his assets. Defrauded shareholders would not

be able to recover even a fraction of their losses. Scrushy's current personal accountant gives

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evidence about Scrushy's web of private companies and the suicide of her predecessor, a matter

that is still being investigated.

Scrushy continues to deny the allegations claiming that he was ignorant of the fraud and

is the subject of government victimization. He claims that Owens is framing him. An assistant

vice president for finance, Kelly Coleman, testifies that she heard in a meeting "last summer"

that Scrushy had backed a plan to end the fraud by engineering a corporate spinoff, selling assets,

and blaming a Medicare reimbursement change. Afterward she said the rest of the company

would be private.

The web of inappropriate relationships between HealthSouth, Scrushy, Scrushy's closely

associated directors and a web of companies in which they were all involved begins to unfold. A

report in the New York Times examines the conflicting situation of an investor and close

associate of Scrushy, Ms Givens, who is a long-term director and also on HealthSouth's audit

committee; the body that is charged with monitoring corporate practices. HealthSouth struggles

to find new independent directors but there are few applicants. HealthSouth starts to lay off staff

at it headquarters in order to reduce costs. It plans to sell hospitals. It seeks to minimize the

damage by promoting the integrity of its new Chairman and by issuing new governance

guidelines. In the meantime, it also takes steps to reassure the doctors on whose support it

depends, paying them promptly and also paying their insurance. The nature of HealthSouth's

financial dealings with doctors is not revealed but it is clear that they co-own facilities and that

HealthSouth has extensive financial dealings with them. 3500 doctors have invested in surgical

centers. The exposure of these financial relationships with doctors raises concerns about conflicts

between the doctors' financial dependence on the company and their duty to their patients.

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The case against Scrushy and HealthSouth builds rapidly and analysts confidently predict

that Scrushy will soon face criminal charges. Under the new Sarbanes-Oxley corporate reform

law he would be looking at 10 years behind bars.

The SEC launches an insider trading action against Scrushy looking for US $743 million

including the return of profits, civil penalty and interest. The SEC claims that Scrushy sold at

least 13.8 million shares of HealthSouth stock worth more than $170 million since 1991 based

upon his knowledge of the company's true results.

More information emerges about Scrushy's lavish life style, his private businesses and his

autocratic style of control. His Monday morning "beatings" were dreaded by employees whom

he would grill and criticise, humiliating them publicly. Those who give evidence indicate that

they would have been dismissed had they not gone along with company practices. A past

employee describes how he was dismissed in 1989 after he questioned accounting. Scrushy

obtained his objectives by intimidation and heaped contempt on his critics. He is alleged to have

created an elaborate façade by manipulating those around him. It was "like a cult" and those

around Scrushy were "excessively obedient and eager to please". Employees in the hospitals

have claimed that "security officers appeared to closely monitor the activities of employees and

others". Reporters describe the tight control Scrushy exerted over the media. He insisted on

being present at meetings with the media and answered the questions himself.

Employees commence a class action claiming the alleged fraud made company stock a

poor investment for their retirement plan. More stockholder class actions are lodged. Retirement

funds that purchased HealthSouth bonds are also suing. A reporter writing for the New York

Times examines the role which persistent positive reports by Geoff E Harris a market analyst

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working for Smith Barney and later for USB Warburg played in HealthSouth's success by

boosting its stock value. During this time Smith Barney did US $8 billion in business with

HealthSouth, a clear conflict of interest for Harris. During this period Harris' salary rose from US

$4 million a year to US $20 million, a reflection of the business his reports brought in. These

reports and the value of its stock would have facilitated HealthSouth's takeovers, its ability to

raise loans from banks and to raise money on the stock market.

The SEC and the press continue to explore the worrying relationship between directors,

Scrushy, HealthSouth and a number of related companies which reaped rich rewards for Scrushy

and colleagues. These include Capstone Capital Corporation, a publicly listed real estate

investment company founded by Scrushy and partners. It purchased and then leased back

facilities from HealthSouth, Integrated Health Services (IHS) and other companies of which

Scrushy was a director. This was one of the deals in which Smith Barney was implicated.

An April 20 review by the New York Times indicated that over the years, as HealthSouth

prospered, the company was repeatedly accused of cheating taxpayers and cutting corners. In

other reports a past hospital staff member describe how the hospital executives were instructed

by HealthSouth to accept Medicare patients even though they were too ill for the resources of the

facilities. As in Tenet/NME they understood that "if they did not keep the numbers up, they

would lose their jobs". HealthSouth's response to accusations that it admitted inappropriately was

to commence a defamation action.

A former HealthSouth executive and co-founder, Aaron Beam's prophetic 1996 statement

about meeting 26 year old Scrushy in 1984 is reported. "I went home and told my wife that I just

interviewed with the biggest con artist I ever met, or the most brilliant young man I ever met," he

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told The Birmingham News in 1996. "Either way," he said, "I was taking the job because he was

really, really good at what he did." Beam was HealthSouth's first CFO. On 24th April Beam

becomes the 11th person and the last of the five CFO's to plead guilty to fraud. Because the 5-

year limitation is exceeded he is charged only with bank fraud. He is accused of devising a

scheme to obtain loans and credit from Birmingham-based AmSouth Bank and other lenders by

filing false and fraudulent financial information with the bank. The charge carries a maximum

penalty of 30 years in jail.

Federal investigators commence an investigation of HealthSouth's tax firm, KPMG. A

series of reports at the end of the month indicate that HealthSouth plans an orderly entry into

bankruptcy and has already negotiated it. Others claim it can still avoid this. HealthSouth's

lenders refuse to extend their agreement not to insist on payment beyond May 1st but

HealthSouth does not expect them to do so.

The Federal Congressional House Energy and Commerce Committee launches an

investigation into the financial fraud at HealthSouth, asking the company and its auditor, Ernst &

Young, to provide detailed documentation of their actions surrounding the hospital chain's $2.5

billion overstatement of earnings. It wants to know why Ernst and Young failed to detect the

fraud when there were several clues, even after they had been tipped off about fraud and told

where to look.

The Committee in Washington also demands and receives additional documents as it

looks at HealthSouth's relationship with its investment bankers and their analysts, as well as its

tax consultants KPMG. This is the committee that investigated the Enron scandal and cross-

examined key Enron staff. It also examined the conduct of investment bankers and analysts in

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the Enron and Worldcom failures, an investigation that resulted in US $1.4 million fines and new

laws regulating the industry. It specifically wants to cross-examine Mr Lorello.

An interesting twist emerges when it is discovered that Enron, Worldcom, HealthSouth

and others that had overstated profits and paid tax on these had already claimed a tax refund or

else planned to do so. Politicians and others were angered and urged prosecutors to ensure that

any tax moneys refunded be added to any fines.

The Accounting

A forensic audit conducted by PricewaterhouseCoopers concluded that HealthSouth

Corporation’s cumulative earnings were overstated by anywhere from $3.8 billion to $4.6

billion, according to a January 2004 report issued by the scandal-ridden health-care concern.

HealthSouth acknowledged that the forensic audit discovered at least another $1.3 billion dollars

in suspect financial reporting in addition to the previously estimated $2.5 billion. The scandal’s

postmortem report found additional fraud of $500 million, and identified at least $800 million of

improper accounting for reserves, executive bonuses, and related-party transactions. This billion-

dollar-plus admission failed to garner financial media headlines, further evidence of the public

getting accustomed to financial reporting scandals.

The SEC executed a court order, pursuant to section 1103 of the Sarbanes-Oxley Act, that

—

Required the company to place in escrow all extraordinary payments to its directors,

officers, partners, controlling persons, agents, and employees;

Prohibited the company from destroying documents relating to financial activities or

allegations in the case against HealthSouth and Scrushy; and

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Provided for expedited discovery.

According to the SEC, Healthsouth perpetrated the scheme to overstate earnings by doing the

following:

If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to

“fix it” by recording false earnings on HRC’s accounting records to make up the shortfall.

HRC’s senior accounting personnel then convened a meeting to “fix” the earnings shortfall.

By 1997, the attendees referred to these meetings as “family meetings” and referred

themselves as “family members.”

At these meetings, HRC’s senior accounting personnel discussed what false accounting

entries could be made and recorded to inflate reported earnings to match Wall Street

analysts’ expectations. These entries primarily consisted of reducing a contra revenue

account, called “contractual adjustment,” and/or decreasing expenses, (either of which

increased earnings), and correspondingly increasing assets or decreasing liabilities.

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

healthcare insurers will pay for a specific treatment. HRC deducted this account from gross

revenues to derive net revenues, which were disclosed on HRC’s periodic reports filed with

the Commission.

The corresponding balance sheet entries were necessary because generally accepted

accounting principles (“GAAP”) require any increase in revenue or decrease in expenses to

be matched with either an increase in assets or decrease in liabilities.

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Beginning no later than 1999, HRC falsified its fixed asset accounts to match the fictitious

adjustments to the income statement.

In particular, HRC senior accounting personnel recorded false entries to the fixed asset books

of its numerous facilities. The combined amount of the false entries equaled the total amount

of fictitious increases to the income statement for that quarter.

The fictitious fixed asset line item at each facility was listed as “AP Summary.” In its Form

10-Q for the third quarter ended September 30, 2002, HRC’s fixed assets, listed on the

balance sheet as “property, plant and equipment,” were overstated by approximately $800

million, or 10 percent of the total assets reported.

HRC’s accounting personnel designed the false journal entries to the income statement and

balance sheet accounts in a manner calculated to avoid detection by the outside auditors. For

example, instead of increasing the revenue account directly, HRC inflated earnings by

decreasing the “contractual adjustment” account. Because the amounts booked to this

account are estimated, there is a limited paper trail and the individual entries to this account

are more difficult to verify than other revenue entries.

Additionally, each inflation of earnings and corresponding increase in fixed assets were

recorded through several intermediary journal entries in order to make the false inflation

more difficult to trace.

Furthermore, HRC increased the “AP Summary” line item at various facilities by different

amounts because it knew that across the board increases of equal dollar amounts would raise

suspicion.

HRC also knew that its outside auditors only questioned additions to fixed assets at any

particular facility if the additions exceeded a certain dollar threshold. Thus, when artificially

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increasing the “AP Summary” at a particular facility, HRC was careful not to exceed the

threshold.

HRC also created false documents to support its fictitious accounting entries. For example,

during the audit of HRC’s 2000 financial statements, the auditors questioned an addition to

fixed assets at one particular HRC facility. HRC accounting personnel, knowing that this

addition was fictitious, altered an existing invoice (that reflected an actual purchase of an

asset at another facility that approximated the dollar amount of the fictitious addition) to

fraudulently indicate that the facility in question had actually purchased that asset. This

altered invoice was then given to the auditors to support the recording of the fictitious asset

in question. Also, when the auditors asked HRC for a fixed assets ledger for various

facilities, HRC accounting personnel would re-generate the fixed asset ledger, replacing the

“AP Summary” line item with the name of a specific fixed asset that did not exist at the

facility, while leaving the dollar amount of the line item unchanged.

While the scheme was ongoing, HRC’s senior officers and accounting personnel periodically

discussed with Scrushy the burgeoning false financial statements, trying to persuade him to

abandon the scheme. Scrushy insisted that the scheme continue because he did not want

HRC’s stock price to suffer. Indeed, in the fall of 1997, when HRC’s accounting personnel

advised Scrushy to abandon the earnings manipulation scheme, Scrushy refused, stating in

substance, “not until I sell my stock.”

Scrushy has personally profited from the scheme to artificially inflate earnings. He has sold

at least 7,782,130 shares of HRC stock since 1999, when HRC’s share price was affected by

HRC’s artificially inflated earnings.

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Moreover, according to HRC’s 2001 Form 10-K, Scrushy received at least $6.5 million from

HRC during 2001 in “Bonus/Annual Incentive Awards.” This bonus payment was based on

HRC’s artificially inflated earnings.

Further, according to HRC’s 2001 Form 10-K, from 1999 through 2001, HRC paid Scrushy

$9.2 million in salary. Approximately $5.3 million of this salary was based on HRC’s

achievement of certain budget targets. HRC attained these budget targets through its scheme

to artificially inflate earnings.

In August 2002, after certain senior HRC officers convinced Scrushy to take steps to lower

Wall Street expectations, Scrushy authorized a scheme to blame a May 2002 Medicare

billing guidance, referred to as Transmittal 1753, for reduced future earnings. Transmittal

1753 required certain healthcare providers to bill Medicare at the lower group therapy rate

when treating multiple patients in a single time period, rather than at the more lucrative

individual rate.

On August 27, 2002, HRC issued a press release stating that it expected Transmittal 1753 to

reduce its annual earnings by approximately $175 million.

This $175 million projection was false and was primarily intended to lower Wall Street

expectations for HRC’s earnings. HRC’s internal accounting personnel estimated that

Transmittal 1753 would reduce HRC’s expected earnings by only $20-30 million dollars per

year on an ongoing basis. Scrushy intended that, by lowering Wall Street expectations, this

press release would reduce the need to artificially inflate earnings in the future.

In mid-2002, certain HRC senior officers and Scrushy discussed 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 Commission Order No. 4-460, Order

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Requiring the Filing of Sworn Statements Pursuant to Section 21(a)(1) of the Securities

Exchange Act of 1934 (June 27, 2002). (“Order 4-460”). Scrushy agreed that, going forward,

he would not insist that earnings be inflated to meet Wall Street analysts’ expectations.

Scrushy knew or was reckless in not knowing that HRC’s financial statements materially

overstated its operating results. Nevertheless, on August 14, 2002, he and HRC’s Chief

Financial Officer certified under oath that HRC’s 2001 Form 10-K contained no “untrue

statement of material fact.” In truth, the financial statements filed with this report overstated

HRC’s earnings, identified as “Income Before Income Taxes And Minority Interests” on

HRC’s income statement, by at least 4,700 %.

a) The Auditors

HealthSouth paid the Birmingham office of Ernst & Young LLP $3.6 million for its 2001

financial statement audit and related services. Ernst & Young disavowed knowledge of the fraud,

citing systemic deception on the part of HealthSouth executives, several of whom have pled

guilty to fraud charges. Communication about questionable activities took place between the

health-care provider and its auditor, however. For example, in a hearing to decide if Scrushy’s

assets should be unfrozen, two Ernst & Young partners stated that the audit firm had received an

e-mail from a HealthSouth employee advising them to examine three specific accounts for

fraudulent entries related to asset capitalization.

Ernst & Young subsequently contacted HealthSouth’s president and chief operating

officer, William T. Owens, and the chairman of its audit committee, George Strong. Owens

defended HealthSouth’s capitalization method, but agreed that further investigation was needed.

Both Owens and Ernst & Young partner James Lanthron eventually concluded that no costs were

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improperly capitalized. Ernst & Young did not detect or investigate beyond the scope of normal

audit procedures any other substantive questionable activities outside of the capitalization issue.

b) Meeting Analysts' Expectations

SEC Director of Enforcement Stephen Cutler stated in a March 19, 2003, press release

that “HealthSouth’s standard operating procedure was to manipulate the company’s earnings to

create the false impression that the company was meeting Wall Street’s expectations.” This

motive is not a new one.

In general, analysts’ expectations and company predictions address two high-profile

components of financial performance: revenue and earnings from operations. The pressure to

meet revenue expectations is particularly intense and may be the primary catalyst leading

managers to engage in earnings management practices that result in questionable, improper, or

fraudulent revenue-recognition practices. A Financial Executives International (FEI) study, for

example, found that improper revenue recognition practices were responsible for one-third of all

voluntary or forced restatements of income filed with the SEC from 1977 to 2000.

c) Early Warning Signs

The systematic and substantive HealthSouth fraud raises certain questions:

Should the auditors have suspected fraud?

More important, could the auditors have detected the financial statement manipulations

and exposed them?

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Given that the auditors did not detect fraud, could the investment community have done

so through careful examination of the financial statements?

If so, what tools would help financial statement users detect the fraud?

Magrath and Weld identified six relationships that investors and auditors should consider as

early warning signs of abusive earnings management:

Cash flows that are not correlated with earnings;

Receivables that are not correlated with revenues;

Allowances for uncollectible accounts that are not correlated with receivables;

Reserves that are not correlated with balance sheet items;

Acquisitions with no apparent business purpose; and

Earnings that consistently and precisely meet analysts’ expectations.

d) Analyzing HealthSouth’s Disclosures

If analysts, investors, or auditors had examined these relationships, would there have

been reason to suspect abusive earnings management at HealthSouth? In retrospect, the answer is

a qualified yes. Investors or auditors might have detected abusive earnings management if they

had understood the context of the financial statements as well as their content, and if they had

thoroughly analyzed specific early warning signs of earnings management.

As HealthSouth’s credibility unraveled in full public view, it became apparent that for

many years its financial disclosures had neither represented economic reality nor conformed to

GAAP. The company acknowledged as much in its Form 8-K filed with the SEC on March 26,

2003:

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The company also announced today that, in light of the recent Securities and

Exchange Commission and Department of Justice investigations into its financial

reporting and related activity calling into question the company’s previously filed

financial statements, such financial statements should no longer be relied upon.

Whether the auditors should have detected a scheme that originated at upper

management levels remains a matter of conjecture; regardless, investors and other

financial statement users lacked reliable data.

HealthSouth met the final indicator of earnings abuse: The company matched analysts’

expectations for 48 consecutive quarters through mid-1998. That unerring track record could

have been attributed to predictable operations and acceptable income-smoothing techniques, but

hindsight proved otherwise.

Upon examination of the techniques used by HealthSouth, the authors offer two

techniques that investors and auditors can use to raise red flags about abusive earnings

management practices: a more detailed analysis of receivables, and a link between cash flows

and an array of performance measures.

e) Accounts Receivable Analysis

HealthSouth disclosed its receivable-related activities on the face of its financial

statements. The relatively large percentage of receivables estimated as uncollectible is not

surprising, given an industry dependent on third-party payments from Medicare and insurance

companies. This component’s volatility, ranging from 38.9% of gross accounts receivable to

12.2%, is troubling, however. In addition to this volatility, HealthSouth’s 1999 provision for

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doubtful accounts is an outlier when compared to other years’ bad-debt expense. It may be only

coincidental that 1999 was the first full year in which investors knew the company would not

meet previously announced earnings projections.

Annual write-offs for uncollectible receivables lacked any consistency whatsoever.

Moreover, the amount of the accounts written off in any given year did not correlate with the

allowance established for them. To the extent that these disclosures were reliable, these data

indicate that HealthSouth used bad-debt reserves to manipulate earnings. This lack of correlation

could be an indirect indicator of the fourth warning sign of abusive earnings management:

reserves that are not correlated with balance sheet items.

Consider two related items related to uncollectible accounts, to further understand

possible earnings management. First, there were disproportionately large allowance for doubtful

accounts balances at the end of 1994 and 1995: nearly 40% of gross receivables. These existing

balances could have been drawn down without the need to record an accurate provision for

doubtful accounts. Consequently, the year-end charge to bad expense, required to replenish the

depleted contra-asset account, could have been less than normally expected if the unadjusted

allowance balance jibed with economic reality. By understating expenses in this manner,

HealthSouth could have manufactured earnings beginning in the mid-1990s. These data provide

some evidence of the classic “cookie-jar reserve” ploy.

The related issue is the amount of bad-debt expense matched against revenues in 1999.

As noted, that unusually large charge to earnings was made at the time when it became publicly

known that HealthSouth could no longer hit its earnings target. Company officials may have

decided to replenish the balance in the allowance account (add cookies to the cookie jar) or

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recognize previously understated levels of bad-debt expense. In either case, the large charge

(8.4% of revenues) occurred when Wall Street diminished its earnings expectations for

HealthSouth. Taking this “big bath” for bad debts merely exacerbated 1999’s already poor

financial performance, information that was already discounted in the marketplace. The question

arises: Did HealthSouth bury this apparently inflated expense amount within a sea of red ink in

an attempt to manage earnings?

An analysis of receivables composition sheds light on the potential to overestimate cash

collected from sales. Bad-debt expense is a noncash charge, and has no bearing on operating

cash inflows; nor has bad-debt write-offs. They must be subtracted from revenues, however,

along with the adjustment for changes in gross receivables, to accurately determine cash

collected from customers. The difference between cash flows determined by the net and gross

methods can be material if write-offs are significant, as they were in 1999. Cash collections

should be constant over time, regardless of the method used, inasmuch as accounts written off

and the bad-debt expense recognized are usually comparable in any given reporting period.

HealthSouth’s cumulative cash inflows as a percentage of sales equaled 93.5% on an

adjusted (gross-receivable) basis, as opposed to 97% on an unadjusted (net- receivable) basis.

This translates into a reduction of $725 million in cash collections from 1994 through 2001,

which matches the write-offs. It is also interesting to note that percentages of revenues realized

in cash improved after HealthSouth announced its inability to meet earnings projections in 1998.

In addition, the two measures of cash flows were more correlated from that point forward. Could

eliminating the need to meet earnings goals have affected managerial behavior?

f) Linking Disclosures with Performance

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HealthSouth acquired numerous rehabilitation clinics and outpatient surgery centers

during the 1990s. Rolling up the industry, however, did not translate into greater returns on

investment. The purpose and viability of business acquisitions is the fifth early warning sign of

abusive earnings management.

Although one cannot infer causality to HealthSouth’s acquisitions, an auditor or

investment analyst could question the soundness of an aggressive acquisition strategy given the

diminishing rates of return. In addition, the data indicate a pronounced decrease in returns from

1998 to 2001, as compared to the preceding four-year period. Again, these declines coincide with

the year that HealthSouth admitted its inability to meet earnings forecasts. Cash flow analysis

also calls into question HealthSouth’s acquisition strategy. Operating cash flows inadequately

met the company’s requirements for sustainable operations. The only year examined in which

HealthSouth’s annual cash flow adequacy ratio (defined as cash flows from operations divided

by the sum of payments for fixed assets) exceeded 1 was 1996. One might argue that the annual

adequacy measures were generally below the level needed to cover fixed commitments because

HealthSouth was expanding during this period. This was undoubtedly the case, but the goal of

financing activities that deplete cash in an expansionary period is to build sound investments that

produce acceptable investment returns. Such was not HealthSouth’s experience, as discussed

above. What end did these acquisitions serve?

Operating cash flows and operating income were positively correlated, but there was a

lack of comparability between these two amounts. The operations index measures their degree of

correspondence by dividing cash flows from operations by operating income. An ideal ratio is 1,

indicating that income from HealthSouth’s core business activity was being realized in cash.

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HealthSouth’s annual operating index averaged about 0.5 from 1994 through 2001, even after

adjusting operating income for the noncash charges of depreciation and bad-debt expense. These

cash flow measures do not prove that HealthSouth’s acquisitions did not serve a legitimate

purpose or were solely attributable for faltering cash flows. They do, however, point to pressure

on management to achieve earnings targets, something which was not realized in operating cash.

Making the numbers would have benefited the company in its attempts to secure external

financing. As evidenced by the cash flow adequacy ratio and the operations index, outside funds

were needed because internal sources of cash were insufficient to sustain operations.

g) Warning Signs Have Limitations

Analysis of inaccurate financials is a dicey proposition. Auditors and investors are

unaware that they are erroneous when first encountering them. Well-conceived and -executed

financial frauds plausibly articulate duplicitous financial statement items to other related

accounts. Such was the case as HealthSouth exhibited highly correlated earnings, revenues, and

receivables. Nothing specific stood out to trigger alarm in the minds of investors and auditors—

the usual warning signs were not apparent. Perpetrators of fraud, however, sometimes fail to

logically articulate subcomponent account disclosures. HealthSouth’s bad-debt expense,

allowance for uncollectible accounts, and changes in overall receivables failed to match the

symmetry portrayed in net receivables. Moreover, investment returns and cash flows could have

called into question management’s operations. The six early warning signs of abusive earnings

can point to potential evidence of abusive earnings management, but users must be very diligent

in examining all components of the financial statements and their relationships to each other.

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The Verdict

Ex-CEO Richard Scrushy has been acquitted of all 36 counts against him. The verdict, in

which the government lost its first attempt to convict a CEO under Sarbanes-Oxley, has

potentially huge ramifications. The six-month long trial provided a full-blown case study on

how NOT to prosecute a high-profile CEO whose wiles exceed even his net worth. (In addition

to trying to imprison Scrushy, the government was trying to get him to disgorge $278 million of

his allegedly ill-gotten assets.) At every turn, the prosecutors played into the hands of the

defendant. Start, crucially, with the venue. The Justice Department tries most white-collar cases

of this magnitude in New York, because of the expertise and experience of the Manhattan-based

prosecutors. This one went to Birmingham, perhaps because of how aggressively the local U.S.

Attorney, Alice Martin, had pursued the case against Scrushy starting in early 2003. That gave

Scrushy a huge homecourt advantage. Scrushy added to his homecourt advantage with a daily

TV blitz on a local TV station owned by his son-in-law—including a talk show called

"Viewpoint," in which he and wife Leslie talked scripture and chatted with local luminaries (such

as pastors), and a daily trial-analysis show.

Scrushy's acquittal is at first blush a shock, but it's simply a product of what happens

when an exceedingly uninspired prosecution meets an exceedingly unorthodox—and endlessly

clever—defendant named Richard Scrushy.

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Final words

The whole sad saga blew up in March 2003. HealthSouth imploded. Not only had

HealthSouth indulged in fraud but its growth and dominance was because its fraud was far

larger, had gone on for much longer, and was far more ingenious than any of its peers. In the 5

years between 1997 and 2003 the sum involved was US $2.5 billion. No one has estimated how

much was defrauded in the 10 years between 1986, when the fraud is alleged to have started, and

1997.

HealthSouth had found a far cleverer way of defrauding the system and lining the pockets

of its founder and his close associates. It was just so simple. It knew the marketplace, the culture

and the interdependency of the whole system. It banked on the fact that its auditors and its

bankers who made a lot of money doing business with the company would not want to know,

would not look and if they looked would not want to see. At most they would see only small

individual discrepancies, which they could ignore.

It did not make the money it needed by defrauding Medicare and Medicaid, which would

set the government in motion, or defrauding patients, which would set the community on fire.

Instead it methodically added the extra non- existent money that it needed to boost its share price

to its income statements in multiple small amounts. It knew that none of those it did business

with would want to see fraud. They would not look too closely. It apparently started this soon

after the company listed on the stock exchange in 1986. It built its empire on this artificially

inflated income and the overvalued share prices that resulted.

But the world it’s a weird place: Scrushy was acquitted though the rest of his executives

pleaded guilty, and HealthSouth is still alive and kicking….

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Resources:

1) http://www.nysscpa.org/cpajournal/2004/1004/essentials/p44.htm

Anatomy of a Financial Fraud - A Forensic Examination of HealthSouth - By Leonard G.

Weld, Peter M. Bergevin, and Lorraine Magrath

2) http://www.fortune.com/fortune/ceo/articles/0,15114,1078070,00.html

3) http://www.uow.edu.au/arts/sts/bmartin/dissent/documents/health/access_healthsouth.htm

4) http://news.findlaw.com/cnn/docs/hsouth/sechsouth31903cmp.pdf

5) http://www.businessweek.com/magazine/content/05_31/b3945023_mz026.htm?

campaign_id=rss_magzn

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