Accounting Fraud at HealthSouth

HEALTHSOUTH’S CORPORATE ACCOUNTING SCANDAL

A CASE STUDY IN FRAUDULENT FINANCIAL REPORTING

Kevin BarryManagement 226: Special Topics in Advanced AccountingUCLA Anderson School of ManagementJune 9, 2009

1. INTRODUCTION

HealthSouth Corporation is a large, public healthcare company that operates 93inpatient rehabilitation hospitals (and their 49 outpatient rehabilitation satellites), sixlong-term acute care hospitals, and 25 home health agencies.

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According to its website,HealthSouth is “the nation's largest provider of inpatient rehabilitation services.”

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TheCompany is headquartered in Birmingham, Alabama, and its operations are spread across26 states and Puerto Rico.

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Its mission is “to be the healthcare company of choice for patients, employees, physicians and shareholders by providing high quality care in thecommunities we serve.”

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HealthSouth’s stock trades on the New York Stock Exchange (NYSE) under theticker symbol HLS, with a June 8, 2009 closing price of $12.76, giving the Company amarket capitalization of approximately $1.1 billion.

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The Company’s 2008 revenue was

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HealthSouth 2008 10-K, p. 1.http://investor.healthsouth.com/secfiling.cfm?filingID=1442643-09-12.

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http://investor.healthsouth.com/

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Ibid.

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http://www.healthsouth.com/who_we_are/mission_statement.asp

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HealthSouth stock hit its peak on April 20, 1998, closing at $30.56 ($152.81 split-adjusted). It hit its low point on March 28, 2003, closing at $0.40 ($0.08). The split-adjusted figures reflect the 1-for-5 reverse

2approximately $1.8 billion and its net income was $226.4 million, for basic earnings per share (EPS) of $2.73.

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About two-thirds of HealthSouth’s revenue comes from theMedicare program.

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HealthSouth is perhaps best known for the massive accounting fraud that wasdiscovered in 2003 and almost led to the Company’s bankruptcy. Although HealthSouthemerged from this experience and has so far had a successful recovery, the memory of this scandal is still fresh. The events surrounding the scandal, as well as a discussion of how the fraud was perpetrated and some key lessons to be learned as a result, are thetopics of this paper.

2. HISTORY AND BACKGROUND

HealthSouth was founded in 1984 by respiratory therapist and businessmanRichard Scrushy, and went public in 1986 with Scrushy as Chairman and Chief ExecutiveOfficer (CEO). The Company grew quickly throughout the 1980s and 1990s, mainly viaacquisition. In 1997, it opened a brand-new, $50 million corporate campus on theoutskirts of Birmingham. By the end of 1999, HealthSouth was already a $4 billioncompany and had expanded to 120 inpatient rehabilitation hospitals, five medical centers,1,379 outpatient rehabilitation centers, 230 surgery centers, 129 diagnostic centers, and124 occupational medicine centers.

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stock split that HealthSouth completed in 2006. The collapse of the Company’s stock price in March 2003and the 2006 reverse stock split are discussed later in the paper. Historical prices per Yahoo! Finance,available athttp://finance.yahoo.com/q/hp?s=HLS&a=05&b=8&c=2009&d=05&e=8&f=2009&g=d,http://finance.yahoo.com/q/hp?s=HLS&a=03&b=20&c=1998&d=03&e=20&f=1998&g=d, andhttp://finance.yahoo.com/q/hp?s=HLS&a=02&b=28&c=2003&d=02&e=28&f=2003&g=d.

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Diluted EPS was $2.62. HealthSouth 2008 10-K, p. 25.

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HealthSouth 2008 10-K, p. 3.

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HealthSouth 1999 10-K, pp. 6-9, 24.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-00-430. At its height, the Company had four separate divisions: inpatient rehabilitation, outpatient

3In the process of HealthSouth’s spectacular rise, Scrushy became one of thehighest-paid CEOs in the country.

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From 1995-97, for example, he earned a total of $8.5million in salary, $23 million in incentive bonuses, $4.8 million in stock option awards,and $700,000 in other compensation.

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By March of 2002, Scrushy ownedapproximately 20.9 million shares of HealthSouth common stock (representing 5.1% of the total shares outstanding) with a combined market value of more than $287 million.

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Problems at HealthSouth started to become evident in mid-2002. In May,Scrushy sold more than $75 million worth of HealthSouth stock, and in June he soldanother $25 million back to the Company. HealthSouth then disclosed in August that achange in Medicare payment policy would “significantly lower reimbursement,” causingthe Company’s stock to lose more than half of its value and leading to shareholder lawsuits alleging that Scrushy had acted on insider information when selling his shares.Then, in February of 2003, the Federal Bureau of Investigation (FBI) announced theopening of a criminal investigation of HealthSouth for “possible securities lawviolations.”

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3. ALLEGATIONS OF CORPORATE ACCOUNTING FRAUD

After the close of business on March 18, 2003, the FBI used a search warrant toraid HealthSouth’s headquarters and seize the Company’s financial records,

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and on

rehabilitation, surgery centers, and diagnostic centers. It has since sold off all but the inpatientrehabilitation division.

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http://en.wikipedia.org/wiki/Richard_M._Scrushy

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HealthSouth 1997 10-K, p. 64.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-98-290.

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HealthSouth 2001 10-K, p. 79.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-02-448.Calculation based on March 22, 2002 share price of $13.74 per Yahoo! Finance, available athttp://finance.yahoo.com/q/hp?s=HLS&a=02&b=18&c=2002&d=02&e=18&f=2002&g=d.

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http://www.nytimes.com/2003/02/07/business/fbi-is-investigating-healthsouth-trades.html

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HealthSouth press release, March 19, 2009.http://investor.healthsouth.com/secfiling.cfm?filingID=1005150-03-613.