HealthSouth Can 5 CFOs Be Wrong?On March 19, 2003, the U.S Securities and Exchange Commission (SEC) filed accounting fraud charges in the Northern District of Alabama against HealthSouth Corporation and its CEO Richard Scrushy. Scrushy was also charged with knowingly miscertifying the accuracy and completeness of the companys financial statements. Consequently, Scrushy become the first CEO to be charged under the governance reforming Sarbanes Oxley Act of 2002. Although five HealthSouth CFOs testified that Scrushy had knowingly directed the fraud, on June 28, 2005, the Alabama jury acquitted him of all thirty six criminal charges, and later some civil charges were initially dismissed. In contrast, the five CFOs were initially sentenced to receive a total of 115 years in prison and $11.2 million in fines. One of the CFOs, Weston Smith, had become a whistle blower who had launched a qui tam lawsuit under the False Claims Act against HealthSouth, and first told prosecutors about the financial statement falsification process. He was sentenced to twenty five years and a $2.2 million fine. How did all this happen?According to the SEC Complaint, HealthSouth was founded in 1984 and grew to become the largest provider of outpatient surgery, diagnostic, and rehabilitative healthcare services in the United States. By 2003, it owned or operated over 1.800 different facilities with worldwide revenues and earnings of $4 billion and $76 million respectively in 2001. HealthSouths stock was listed on the New York Stock exchange (NYSE), trading under the symbol HRC. Scrushy, who founded HRC, served as its Chairman and CEO from 1994 to 2002. He relinquished the CEO title on August 27, 2002, but reassumed it on January 6, 2003.The SEC claim states that Scrushy instructed that HRC earnings be inflated as early as just after the companys stock was listed on the NYSE in 1986. Specifically, during the forty two month period between 1999 and the six months ended on June 30, 2002, HRCs Income (loss) before Income Taxes and Minority Interests was inflated by at least $1.4 billion.Each quarter, HRCs senior officers would meet with Scrushy and compare HRCs actual results with those expected by Wall Street analysts. If there was a shortfall, Scrushy would tell HRCs management to fix it by recording false entries on HRCs accounting records. HRCs senior accounting personnel then convened a meeting referred to as family meetings to fix the earnings. How this was done, and how the auditors were deceived, is outlined in the SEC Complaint as follows.At these meetings, HRCs senior accounting personnel discussed what false 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 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. (This difference was, in reality, never to be received by HealthSouth). HRC falsified its fixed asset accounts (at numerous of its facilities) to match the fictitious adjustments to the income statement. The fictitious fixed asset line item at each facility was listed as AP Summary.HRCs 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 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 HRCs 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 of 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, HRCs senior officers and accounting personnel periodically discussed with Scrushy the burgeoning false financial statements, trying to persuade him to abandon the scheme continue because he did not want HRCs stock price to suffer. Indeed, in the fall of 1997, when HRCs accounting personnel advised Scrushy to abandon the earnings manipulation scheme, Scrushy refused, stating in substance, not until I sell my stock.This manipulation were testified to during the trial by the five men who served as CFO during the interval under review, all of whom pled guilty to charges such as conspiracy to commit securities and wire fraud, and falsification of financial records. On August 14, 2002, Scrushy and HRCs CFO certified under oath that HRCs 2001 form 10-K contained no untrue statement of material fact even though this report overstated HRCs earnings by at least 4.700%.The SEC Complaint did not detail all of the fraud at HealthSouth, estimated to total $3.8 - $4.6 billion, which was reportedly made up of:Fraudulent entries$2.5 billionAcquisition accounting/goodwill 0.5 billionImproper (non-GAAP) accounting0.8-1.6 billionTotal$3.8-4.6 billionThe same special report stated that HRC profit was overstated by $2.74 billion from 1996-2002 inclusive, and that Scrushy received $265 million in remuneration, consisting of 21.9 million salary, $34.5 million in bonuses, and $208.9 million from the sale of shares. In 2002, Scrushys remuneration totals $112.3 million, including $99,3 million from sale of shares.The timing of Scrushys 2002 stock sales in of interest. In May 2002, the U.S. Justice Department joined the qui tam whistle blower lawsuit of Bill Owens, which accused HealthSouth of fraudulently seeking payments for services provided by unlicensed employees, including interns and students. On the same day, Scrushy exercised 5.3 million stock options at $3.78 and sold them for $14.05 for a gain of over $54 million.The major Scrushy directed HealthSouth fraud is not the first or only one to take place in Scrushys companies. Earlier frauds, bankruptcies, or questionable business dealings are part of the history of several companies owned at least in part by Scrushy and/or HealthSouth, and controlled by Scrushy with interlocking boards of directors to HealthSouth. These companies include Med-Partners, Caremark National, Integrated Health Services, Capstone Capital, and HealthSouth for Medicare frauds ($1 million paid in 2000; $8.2 million in 2001). It is alleged, however, that Scrushy began to fix earnings in the early 1990s, and it is evident that he became involved in questionable business dealings during the same time frame. Significantly, the people involved with Scrushy in these and other questionable business dealings were often current and/or former HealthSouth employees, or members of the HealthSouth board of directors. Scrushy, however, appears to have been the common link among the corporations involved.In spite of the SECs evidence on HealthSouth manipulations, which was supported by the testimony of five CFOs and ten other employees (all of whom pled guilty to the fraud), the jury of seven black and five white jurors voted to acquit Scrushy. Why was this?According to the Report on Fraud, the reasons were multifaceted, as follow:Surrounded by reporters as he left the courtroom, an elated Scrushy said: Thank God for this. It was not a throwaway line, for his acquittal was partly due, to a defense strategy that focused on Scrushys religious devotion (in fuller flourish during the trial), an unusual racism tactic, smear campaigns against key witnesses, an over abundance of prosecution documents (six million) but no smoking gun, and a victory for southern charm over northern sophistication.More than any contributing factor to Scrushys acquittal, however, was location. New York juries, like those in other metropolitan areas, often include people who have worked in the financial field and are more skeptical of CEOs who claim ignorance. one of the questions in a very complex case like this in : How much did they understand?Another was: who did they believe? . Scrushy was a prominent and respected figure in Birmingham, where HealthSouth employed thousands of residents. Perceived as local boy made good, as he was often described, he donated lavishly to community causesFaced with the enormous evidence against their client, how could his defense team convince a jury their client was not guilty?Step number one: combine race and religion. It was a strategy led by defense counsel Donald Watkins, a black civil rights lawyer turned energy tycoon and banker As part of the defense strategy, Scrushy, who is writing, left his suburban evangelical church and joined a black congregation in a blue-collar neighborhood, reported the Washington Post. The Guiding Light congregation was the recipient of a $1 million donation from Scrushy. He bought a half-hour of local TV for a morning prayer show featuring himself and his wife, and frequent guest spots by black ministers. He had a prayer group praying for him every day of the trial. Also during the trial, Scrushys son in law bought a small TV station and began broadcasting daily reports bolstering the defendants case, says USA Today; Many members of Guiding Light turned up at Scrushys trial and sat directly behind him At the same time . His defense team successfully maneuvered to have seven blacks on the jury and five whites, all from working class backgrounds.Faced with five former CFOs testifying to Scrushys guilt, his defense team decided to impugn their credibility, all negotiated lenient sentences prior to testifying Characterized one witness as looking clean as a Winn-Dixie chitin portrayed prosecution star witness William Owens, as a rat who squeals trust me, believe me A witness was ridiculed because he used antidepressants, Another witness was accused of faking tears on the stand. Yet another was forced to admit that he often cheated on his wife and lied about it. The defense teams goal was to treat the group of CFOs as one . Comprised [of] a group of liars and cheats a bold move, but it worked, according to jurors.Several jurors speaking after the trial said they wanted to see fingerprints on any of the evidence documents, or a smoking gun that would tie Scrushy directly to the fraud. Two poorly made audio were not sufficient, and defence lawyers argued that Scrushy never employed words such as fraud or illegal and no documents or e-mails produced during the trial implicated their client. It took twenty one days for the jury to reach a verdict. Originally, seven jurors wanted acquittal, but the number grew to ten. One of the jurors who wanted a guilty verdict was replaced due to recurring migraine headaches, and since the replacement juror wanted an acquittal, only one holdout remained. She was finally convinced to vote for acquittal.The issue of credibility who to believe seemed to be paramount. The words of one juror and one author probably captured the essence of the trial best:There were five CFos testified against Scrushy and they all seemed to have some reason to lie Based on that conclusion, he said, he had to vote acquit.[Scrushy] never took the stand. He chose, instead, to preach at his new congregation during the trial, although his pastor said he didnt attend the service following his acquittal.Expert observers do not view this verdict as a problem for the future enforcement of the Sarbanes Oxley Act. They view it as a defeat for these particular prosecutors in this particular case.Question:1. What were the major flaws in HealthSouths governance?2. What sould HealthSouths auditors, Ernst & young, have done if they had perceived these flaws?3. How-in accounting terms did the manipulation of healthsouths financial statements take palce?4. Why did all the people who knew about the manipulation keep quiet?5. What is the auditors responsibility in a case of fraud?6. What are the proper audit prosedurea to ensure existence of assets in the financial statements? What are the proper audit procedures to validate estimates?7. What areas of risk can you identify in healthSouths control environment before 2003?