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Case 4-8
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. The complaint alleged
that HealthSouth, under Scrushy’s direction and with the help of key employees, falsified its revenue to
inflate earnings and fimeet their numbers.” Specifically, false accounting entries were made to an account
called ficontractual 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 the Sarbanes-Oxley Act.
Allegedly, fiScrushy 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
fiBonus/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 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.
On June 28, 2005, Richard Scrushy, the former CEO of HealthSouth, was acquitted on all charges
despite the testimony of more than a half-dozen former lieutenants who said Scrushy 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 a CFO, William T. Owens, in March 2003
discussing balance sheet problems, with Scrushy asking fiYou’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, fiI believe you told the truth.” Blackburn called Scrushy’s acquittal a fitravesty.”
Nonetheless, Blackburn said white-collar criminals merit stiff sentences, if only to send a message of
deterrence to other business executives. -fiCorporate offenders are nothing more than common thieves
wearing suits and wielding pens,” Blackburn said.
EXHIBIT 1
MISSTATEMENT OF NET INCOME BY HEALTHSOUTH CORPORATION
Net
Income/ millions) 1999 10-K 2000 10-K 2001 10-K
For Six Months
Ended 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%
The Fraud Investigation—Implications of Whistleblowing
HealthSouth said a forensic audit by PricewaterhouseCoopers found fraudulent entries to raise the total to a
range of $3.8 to $4.6 billion, up from $3.5 billion, 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
fiaggressive 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, or at least
that’s the takeaway from a shareholder’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 audit 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. fiYou 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. fiHow 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: fiHow 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 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. fiYou people and I have been hoodwinked,” the shareholder concluded
in the memo. fiThis 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 discussion of HealthSouth to this effect: fiWhat 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 at every corner. 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 net income.
The individual expenses were relatively small—between $500 and $4,999 apiece, according to Vines’s
testimony—because 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
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. fiI 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 the 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 fiminor
equipment,” firepairs and maintenance” and fipublic 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 Ernst’s Birmingham office. Lamphron
testified that he had contacted William T. 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 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 argued that the company had done it for several years
and that it was an acceptable practice. Lamphron testified that Owens called Vines a fidisgruntled
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 fiaudit-related procedures” with the accounts Vines pointed
out. The result: Ernst fireached 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. Ernst defended itself by
stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior
executives and allegedly false documentation. Ernst wasn’t named or charged as a defendant in the
government cases 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 the charges. However, his 82-month sentence was cut short
after the Eleventh Circuit Court of Appeals threw our Scrushy’s convictions on fihonest 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, Richard 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 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 there were signs of a fraud that should have set off fialarm 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.
NOTES
This case discusses the HealthSouth scandal, which was one of the first cases under the Sarbanes Oxley
required that the CEO and CFO of a company certify the financial statements as non-misleading.
Ethical Issues
The ethical issue of this case is whether it is fair that the former CEO of HealthSouth was acquitted of
certifying misleading and false financial statements while the CFO is serving a five years for the same act.
VIDEO LINK: http://www.youtube.com/watch?v=Ds-BL8lzXuk
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.
The contractual allowance account is a contra-revenue account, which has a debit balance.
The account is similar to an allowance for sales returns or sales discounts. Under GAAP for health care
providers (ASC Topic No. 954-605 -25 -2 through 25-6), revenue is normally recorded when the service is
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.
Using the dissonance model from chapter 3, HealthSouth displayed low organizational ethics. Scrushy also displayed
low individual ethics. Scrushy would hire executives with low individual ethics so that they would go along with the
schemes and cover-ups. If an individual with high individual ethics worked for HealthSouth, he or she would leave
3. Small concessions lead to greater compromises and, unchecked, will lead to serious ethical
lapses and even crime. As detailed in the case, nobody sets out to end their career in prison.
Several people from HealthSouth in fact did end their career that way; it all started with small,
seemingly insignificant, compromises. Comment on this statement from the perspective of ethical
decision-making.
This is an example of the slippery slope where one small unethical act snowballs into on-going or large
unethical acts. Individuals at HealthSouth may have rationalized that the small acts were one-time or for a
short time. Then the short term became longer term; it was easier to do another unethical act after the first
4. Looking at the findings of Craig Greene, the certified fraud examiner who investigated the
HealthSouth fraud, explain why so-called fired flags” are important in an independent audit. In
other words, what is the purpose of an auditor looking for financial information to sense the fialarm
bells” that warn of danger ahead?
Auditors should look at the small the details of the audit evidence, as well as the big picture, for clues
whether unethical actions are taken. To be sensitive to possible red flags, auditors should continuously ask:
Does the cash flow support financial statements; do the financial statements parallel the cash flows; do
