HealthSouth Corporation Fraud Case

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Table of Contents

Introduction
HealthSouth
Fraud Detection
Parties Involved in Crime
Crime and Charges
Weaknesses in Internal Control Structures
Fraud Prevention
Rationale for Case Selection
Conclusion
References

Introduction

HealthSouth Corporation owns and manages inpatient rehabilitative hospitals, and has offices in Birmingham and Alabama. The company initially operated in 26 states as Amcare Company. It had around 97 inpatient rehabilitation hospitals, 29 outpatient rehab clinics, and 25 home-based health agencies. Richard Scrushy and close friends started HealthSouth, which was among the best hospitals for patients suffering from stroke, brain, and neurological disorders. The company dominated in rehabilitation market and was able to acquire its competitors. Thus, the aim here is to analyze the HealthSouth fraud case.

In 1990s, several companies acquired more wealth at an unprecedented rate (Markham, 2006). This was due to technological advances and slack regulations that paved way for oversights in financial reporting. Thus, there were many unpredicted fraudulent transactions and information because investors were concerned with revenue rather than profitability. Many were focused on the sales and economic news and companies adopted destructive accounting policies. Consequently, some of the companies fabricated the revenue figures.

HealthSouth

HealthSouth was among the companies involved in fraudulent activities. The company started its operations in 1984 as Amcare Company and opened its first hospital in Little Rock, Arkansas,s, and Birmingham. The Company went public in 1986 and its IPO was on the NASDAQ Stock Exchange. By 1990, it had over 50 facilities in the US. In addition, it made its first acquisition in 1993 because it acquired 45 rehabilitation facilities and 28 hospitals for $300 (Hamilton, n.d).

According to Johnson, G and Johnson, M (2005), HealthSouth indicated a rapid expansion through mergers and acquisitions. The companies acquired include Surgical Health Corporations and Horizon CMS. It also purchased companies in Australia, the UK and Europe. Scrushy and his associates were doing well in all the countries they set their foot in. HealthSouth later changed its name to HealthSouth Corporation and announced that it was to build its head office in Birmingham on Highway 280. It later acquired the surgical health corporation and extended into diagnostics when it acquired Health Images Company.

In 2003, HealthSouth recorded almost $4.5 billion in earnings, it dominated in rehabilitation and other services and employed above 60,000 people in almost all the states in the US, became the largest health care company in the US, and second – based on earnings. HealthSouth operated for all those years and seemed to have no problems. However, in late 2002, an accounting fraud was detected when the CEO, Scrushy made a sale of $75 million in quite a few days before the company claimed a huge loss.

The US Securities and Exchange Commission (SEC) accused HealthCase of a scandal because the company’s income was inflated by $1.4 billion. The US SEC claimed that in 1996, HealthSouth’s CEO allegedly instructed the accountants to write a false report about the company’s earnings to meet investor expectations and have control over the stock. The SEC continued with the investigation in 2003 and its main concern was whether Scrushy’s stock sale was linked to the Company posting a huge loss. Therefore, it hired an external law firm to evaluate Scrushy’s stock sale, but the firm claimed that sales and losses were not related. Later in March 2003, the FBI agents performed search warrants at HealthSouth headquarters. With all these investigations, SEC decided to stop trading with the company on NYSE, claiming that it increased its earnings and exaggerated its profits to be $2.5 billion in 1999-2000. Owens pleaded guilty to fabricatina g financial statement. However, Scrushy and Owen were fired and the executives erased Scrushy’s name from HealthSouth’s conference center. The directors hired firms like Alvarez and Marsal to reorganize the Company’s finances to avoid bankruptcy (Markham, 2006).

Hamilton (n.d) affirms that books and other records indicated that HealthSouth had $674 million in cash, but as Alvarez and Marsal carried out financial remodeling, they found out that the company had only $117 million. Although there were many entries recorded on books, there was no balance sheet and nobody knew how much the company was owed as well as real assets. The team also worked with federal investigators and communicated with stakeholders. They wanted to restore trust in patients, salespeople, suppliers, doctors, and other partners because the Company’s crises threatened their names and practices.

Nevertheless, Alvarez and Marsal sold off underperforming units and many considerable upgrades were done on accounting, receivables, and billing systems. Although HealthSouth had started to peak again, the threat of bankruptcy continued to lower its progress. The company had failed to paya $344 million bond and chances were that the creditors could file a case. However, Alvarez and Marsal used the company’s cash to make interest payments to creditors. HealthSouth had managed to survive again because it was able to tackle its problems. Currently, its new independent auditors are PricewaterhouseCoopers. It has avoided bankruptcy by combining the operations and convincing their customers that they have a corporate governance policy that will help in preventing future frauds.

Fraud Detection

PricewaterhouseCoopers did a forensic audit on HealthSouth earnings and discovered that they were overstated from $3.8 billion to $4.6 billion. It also discovered $1.3 billion dollars in suspect financial reports. The investigation report also found another fraud of $500 million and about $800 million inappropriate accounting for reserves, management bonuses, and other transactions.

Parties Involved in Crime

Top company officials misappropriated HealthSouth’s books of accounts using a simple routine. They evaluated their real financial results and made a comparison of the market expectations. If the results were small, Scrushy ordered the managers to fix them. The accounting staff were involved with the manipulation of the reports that they called ‘filling the gap’. They created false entries and inflated both the assets and income.

Rossouw and Vuuren (2003) argue that Aaron Beam, the first Chief Financial Officer, could have stopped the fraud when it started, but since he was not willing to speak out it was not easy. He said that it was easy for them to change the numbers since nobody caught them. Aaron feared losing his job and thus could not question the CEO. He also avoided reporting anything negative and lost the courage or strength to resist the move.

The accountants were aware that the auditors were looking at any transactions over $5,000, and thus they could move small amounts as from $500 and $4,999. It seems that almost everybody in the Company knew about the fraud. However, some few people were honest, such as Michael Vines the bookkeeper. According to the investigators, Michael tried to warn the management about the improper recording of asset transactions. Since he got involved with the purchase of equipment, he was able to notice how the assets were being exaggerated on the balance sheet, but later resigned and got another job. In addition, he wrote an email to the auditors and informed them about the fraud. The auditors ignored him because as they called the CFO, he said that Michael was a discontented employee and that is why he quit his job.

According to Sridharan, Dickes, and Caines (2002), Ken Liversay, the assistant financial controller was also involved in the fraud because he used to download the real earnings and make fabrications until they meet the analyst’s earnings. He could pass the adjusted figures to two managers in finance department. Kelly, the accountant, said that overstatements totaled about $2.7 billion in seven years since 1996. He also pointed out that the hospitals and clinics submitted genuine financial reports in Birmingham. Workers in the main office inflated the reports and stored them in a program that generated HealthSouth’s combined corporate results. As he gave his testimony, he was using a computer display and writing charts. He also claimed that 80% of the false revenue figures were stored in a ‘contractual adjustments’ account and this made the company appear as if it collected more from patients than it really expected to get.

Moreover, HealthSouth did not record the sale of Source Medical Company, which added up to $29 million in overstatements by the end of 2001. The false entries were identified because the employees used a three-letter code to show bogus numbers. According to Kelly, other fraudulent numbers were found because some information was not recorded on account records. In addition, other fake assets totaled to $2 billion.

Crime and Charges

Scrushy and other executives committed many white-collar crimes, including fraud and false reports. Scrushy was charged with 85 counts, which included the charges of fraudulent accounts that lead to billions of fraud on investors because he reported fake profits. Federal officials accused Scrushy of making investors believe that HealthSouth met earnings targets to increase the stock price. They said that Scrushy’s aim was to sustain his extravagant lifestyle since he owned a 92-foot Lamborghini yacht, a large farm in Alabama, and seven jets.

At the time of the trial, the executives of HealthSouth gave evidence that Scrushy who ordered them to make fraudulent entries. However, since the executives had pleaded guilty of their offences, the federal officials took it as a lie because they thought that the executives testified against him to have their sentences reduced. The prosecutors did not have enough evidence to connect Scrushy to the fraud. Vogt (2004) confirms that the judge dismissed half of the charges against Scrushy and acquitted him on the remaining charges. In 2006, Scrushy was found guilty of bribery, mail fraud and conspiracy. He was sentenced to 82 months in prison with three years under probation and a fine. Mr. Scrushy’s 19 cars, house and other properties were later auctioned.

After Scrushy’s trial and conviction, he decided to appeal his conviction and sentences. As he awaited appeal, he was taken to jail in Oklahoma City but he did not stay there for long since he was later transported to his permanent location in Beaumont prison in Texas. He later filed an appeal in the US circuit court and requested them to release him on bond. However, the Circuit court rejected his appeal to be unconfined on bond because they referred to the ruling made earlier by District Judge Mark Fuller, which referred to Scrushy as a flight risk. On February and May 2008, he filed to be released but he was not successful.

Jennings (2006) contends that the Chief Financial Officer Weston Smith was also found guilty of securities fraud, plans to commit and lead fraud as well as false certification of financial documentations. Emery Harris, the finance vice and subordinate controller, also pleaded guilty of committing securities and wire fraud as well as giving false financial reports which were used in providing quarterly and annual statements. Other financial executives who were involved with conspiracy are: Rebecca Morgan – the group vice president, Edwards Cathy – the vice in management of assets, Ayers –the vice for accounting and finance, and Valentine – the assistant finance officer. They were all engaged in a conspiracy in 1994. Ayers and Valentine pleaded guilty in making false entries in allowance accounts that had patient charges. Similarly, both Edward and Morgan admitted to falsifying cash and asset accounts.

Weaknesses in Internal Control Structures

HealthSouth had no internal control systems that contain a check and a balance system to minimize errors in financial reporting. Internal controls could also have helped in minimizing fraud and misappropriation while maintaining accuracy. Furthermore, HealthSouth had no reliable financial reports because if there was a control system it could have double-checked the information depicted in the financial reports. Nevertheless, HealthSouth had no reporting procedures that compared actual performance against budgets. There were no periodical reviews on internal controls, and thus it was not easy to tell whether the systems are relevant and effective.

Duties were not segregated because Scruchy’s took most of financial work such as approval of transactions and many other tasks. Scruchy formed a culture of fear in the company because he was threatening his critics with retaliation and paid those who never criticized. According to Jennings (2006), Scruchy carried on his Monday meetings with other staff and could rebuke the employee who had failed him. He ruled through intimidation and did not appreciate other people’s opinions. He also rebuked financial analysts who tried to challenge his anticipations of continued growth. Scrushy carried out assessments on his own since he would pop up in a surprise for inspects. He would even touch picture frames on those centers to check dust and wipe the dust with the administrator’s coat and any dust could lead to potential dismissal. Some of the former employees such as Kimberly landry were sued when they tried to shed light to the people about how HealthSouth management is corrupted. According to Kimberly, being in HealthSouth was like being involved in a cult. Scrushy was exquisitely sensitive to a slight mistake. Besides, he required regular approval and adulation from those who worked under him.

Fraud Prevention

The CFOs of HealthSouth could have prevented the fraud right from the beginning but instead they passed it on. All the CFOs who were hired were involved in fraud cases and they did not question the CEO about it. Some of them feared losing their jobs, and thus they had to let that pattern to proceed without reporting it to the directors. The controls that could have been implemented to reduce fraud include prevention controls, detective controls, and corrective controls. Preventive controls are used for protecting assets and information by preventing frauds from taking place. Detective controls are focused on uncovering fraud when it occurs. Corrective controls are used to reduce or eliminate problems found (Rossouw & Vuuren, 2003).

Alsop (2004) suggests that a strong internal control must have a check and balance system to minimize errors in financial reporting, reduce fraud and misappropriation, and retain accuracy in reporting. When there is a strong control system, auditors will only audit few individual accounts and misappropriation is discerned and corrected internally. The strong internal control system will also provide reliable financial reports and this will give the auditors confidence on accuracy of financial reports.

In addition, the management could have used other ways of detecting fraud, such as transaction monitoring which is a computerized system that monitors the transactions. It not only detects fraud but it is the best method to prevent fraud since it detects fraud immediately. The management could also consider annual audits where an internal auditor is able to monitor the daily operations. This method enables the bookkeepers to be honest because they are aware that the auditor is on the look and may even review their daily documentation. The problem with HealthSouth Corporation is that Ernest and Young, who were also not honest about the financial results, audited the financial records. Both internal and external auditors could have helped the management to detect any frauds instead of relying on only one source. Moreover, the company could have also hired an expert who is not involved in daily transactions who will be able to do spot checks and reviews to ensure that nothing is incorrect and prevent fraudulent activities.

Rationale for Case Selection

The reason for the selection of this case is that HealthSouth is a big organization that was involved in fraudulent accounting practices and other unethical and illegal practices started by the top executives. It is among the largest healthcare companies charged under Sarbanes Oxley Act. The HealthSouth case enables one to learn more on the sophisticated scheme, which was used to overstate the company’s earnings in many years. The case is an effective tool that enables one to understand about Sarbanes-Oxley and helps individuals to become more ethically conscious. Due to these activities, both the managers and the executives damage the company as well as the stakeholders.

Conclusion

This paper has analyzed the HealthSouth fraud case, including the parties involved in the crime, the crimes committed, punishments, and damages caused. The paper has also discussed the weaknesses in the company’s internal controls. In this fraud case, it is clear that leaders are important force in forming and shaping the organization structures. It seems that there was no whistleblower in the company to alert the directors or the authority about fraud cases to covert mismanagement. Consequently, such people could have alerted outsiders about problematic activities. Someone like Beam who was the CFO regretted later because he was tempted to do wrong but later came to regret. He was caught in an ethical dilemma and since he chose to commit the crime, he ended in jail. Therefore, the CIOs need to go for ethical training to discover different fraudulent circumstances that they might avoid. Through training, they can make the right decisions when faced with fraud temptations. Moreover, there is a need for the authorities and federal government to curb these crimes because many companies such as Tyco, WorldCom. Enron, and Dynegy have also been involved with fraud scandal and they have affected market values and undervalued public pension funds.

References

Alsop, R. (2004). Corporate scandals hit home: Reputations of big companies tumble in consumer survey; ‘money can rob the goodness’. Wall Street Journal, B1.

Hamilton, C. (n.d). HealthSouth: A case study in corporate fraud. Arxis Financial, Inc. Web.

Jennings, M. (2006). Innovation like no other. The seven signs of ethical collapse (annotated ed.). St. Martin’s Press: New York.

Johnson, G. & Johnson, M. (2005). The case against Richard Scrushy and HealthSouth. Journal of Legal, Ethical and Regulatory, 8(1), 35-41.

Markham, J. (2006). A financial history of modern U.S. corporate scandals. Armonk, NY: M. E. Sharpe.

Rossouw, G.J. & Vuuren, L.J. (2003). Modes of managing morality: A descriptive model of strategies for managing ethics. Journal of Business Ethics, 46(4), 389-402.

Sridharan, U.V., Dickes, L., & Caines, W.R. (2002). “The social impact of business failure: Enron”. Mid-American Journal of Business, 17(2), 11-21.

Vogt, K. (2004). More charges against ex-HealthSouth chief. American Medical News, 47, 16.

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