Business Management

CIA 

 
HealthSouth Scandal   
(2003) 

​Philip George Oommen

2BCom F&A (D)
1912354
 Encompass Health Corporation (formerly HealthSouth Corporation), based in ​Birmingham,
Alabama​, is one of the United States' largest providers of post-acute healthcare services, offering
both facility-based and home-based post-acute services in 36 states and Puerto Rico through its
network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies.
Effective January 2, 2018, the organization changed its name to Encompass Health Corporation
and its ​New York Stock Exchange​ (NYSE) ticker symbol from HLS to EHC.
HealthSouth was involved in a corporate ​accounting scandal​ in which its ​founder​, ​chairman​, and
chief executive officer​, ​Richard M. Scrushy​, was accused of directing company employees to
falsely report grossly exaggerated company earnings in order to meet stockholder expectations.

The HealthSouth fraud occurred during an interesting period of economic growth and
lackadaisical regulations, which made committing accounting fraud much easier. The 1990s saw
investors and lenders who were less focused on profitability and more so on revenue. When
looking for capital as a company, growth was key. This pressured CEOs, like Scrushy, to
continue growing their companies and meeting analyst expectations quarter after quarter.
Combined with this increased pressure of growth was an environment of strange legalism. If
accounting procedures and policies did not directly violate Generally Accepted Accounting
Principles (GAAP), then they were considered legal, and in turn, morally and ethically adequate.
This allowed Scrushy and HealthSouth to meet analyst expectations for 40 consecutive quarters,
using creative accounting methods and ultimately fraudulent accounting.

Driven by this thirst to hit analyst expectations, Scrushy and HealthSouth’s “financial
family” (Scrushy and five HealthSouth CFOs) altered their earnings numbers; explained as:
plugging “holes” in the balance sheet with “dirt.” 1 The fraud, which included improperly
capitalizing expenses, overestimating insurance reimbursements, overvaluing fixed assets, and
using faulty reserve accountings, went undetected until 2003, when former HealthSouth CFO,
Weston Smith, revealed the fraud to federal investigators.1 Despite seemingly being the obvious
mastermind behind HealthSouth’s accounting fraud, Scrushy denied (and still denies to this day)
that he was involved in any way. Scrushy claimed that the other executives took part in the fraud,
and kept it hidden from him completely. Despite his expressed innocence, Scrushy was
convinced for accounting fraud and served a five-year sentence.
Business Model

Upon the founding of HealthSouth, Scrushy saw healthcare as a no-lose business under the
premise that large government reimbursements would continue to grow and to always be
available to hospitals operators. Scrushy saw two trends occurring in the United States: injuries
to feet, knees, and hips were becoming more frequent as the population grew older, and more
people were exercising later into life. This lead to a large percentage of HealthSouth patients
being eligible for Medicare, and because the government was in fact giving large health-care
subsidies to hospitals, Scrushy used this financing to engage in aggressive acquisition of
competing companies, with the plan of receiving more and more of the government’s money.
His strategy, initially, worked flawlessly, with HealthSouth posting yearly double-digit profit
increased and stock growth of 31% per year on average between 1987 and 1997. Scrushy was
able to use HealthSouth stock as currency to further expand on his core business of
rehabilitation, moving into outpatient surgery, occupational medicine, and hospital sectors.

However, in 1997 the government cut Medicare reimbursements to hospitals, which took a huge
toll on HealthSouth’s margins. With Medicare at the time accounting for 37% of HealthSouth’s
revenues, HealthSouth’s business immediately felt the effects of the subsidy cuts. With
HealthSouth no longer able to grow via acquisition, many of its flaws in operations began to
show. Scrushy tried to keep his company profitable off operations alone by upping the amount of
patients at each of his facilities, but HealthSouth still took an 86% hit to net income in 1998. Yet
HealthSouth “magically” found new life over the next few years. Although sales only grew by
5% from 1999 to 2001, HealthSouth’s net income inconceivably rose almost 500%.1 At the time,
Scrushy explained this rebound occurred from lowering costs while raising revenues through
increased efficiency in each hospital, but we now know that these magical earnings numbers
were magical for a reason: because they were almost completely fictitious.
Accounting Fraud

How did HealthSouth get away with a fraud so big for so long? Their executives followed three
basic steps while committing the fraud: 1) Company officials compared their internal financial
statements to see if they would meet analyst expectations. 2) If earnings appeared to be short,
managers were told to fix them and manipulate the results in any way necessary. 3) False
documents were created to conceal the false entries added to the financial statements.
HealthSouth’s executive “family” happened to be made up of many former Ernst & Young
(E&Y) auditors, which was the public assurance firm auditing HealthSouth, and thus were
especially well-positioned to keep the fraud from the public by deceiving the audit engagement
team. For example, management knew that E&Y’s materiality threshold for examining
fixed-asset additions was $5,000.1,4 This meant that as long as HealthSouth employees only
moved amounts of money less than $5,000 at a time, the fictitious transactions would not be
picked up in E&Y’s auditing procedures. However, this required a massive amount of work.
With an average fictitious journal entry of $2,500, in order to overstate income by $2.7 billion, it
would take over one million separate transactions. Not only did HealthSouth employees have to
create each individual journal entry, false documentation and fixed-asset ledgers were created to
show auditors in order to further conceal the fraud.1 The volume of work that was required to
pull off this fraud displays just how widespread the knowledge and participation of the fraud was
throughout HealthSouth. HealthSouth employees went above and beyond to conceal the fictitious
entries from the auditors, which was what allowed the fraud to exist for so long.

The organizational culture at HealthSouth also played a huge role in allowing the fraud to take
place for such a long period of time. Scrushy was clearly a CEO with an overbearing presence at
the top of his company. In their preliminary audit work papers, E&Y noted about HealthSouth
that: “management is dominated by one or a few individuals without effective oversight by the
board of directors or audit committee, management displays a cavalier attitude toward, and
inadequate monitoring of, significant business risks,” and “management has excessive interest in
maintaining or increasing the client’s stock price or earnings trend.” These qualities of
management all combine to create an environment at the top that is obsessed with earnings and
that has the power over their employees to allow a fraud of this size to occur. Scrushy had
complete control over his company; even going as far as to have security cameras installed
throughout headquarters to keep watch on his employees.

As in most cases of fraud, greed also was a significant motive for HealthSouth management to
inflate earnings. By manipulating earnings and stock price, Scrushy was able to secure stock
options for himself on the lowest trading day of HealthSouth stock, netting him the highest profit
possible.

Both Scrushy and Michael Martin, HealthSouth’s treasurer and CFO for three years, engaged in
large stock sales which provided them with plenty of motive to raise the company’s stock price.
In 1997, Martin sold $3 million worth of HealthSouth shares while Scrusy sold a hefty $100
million. While testifying in regards to this sale, Martin stated, “Even though we knew we were
committing fraud, we felt it was important to keep the stock price up for at least a year.”
HealthSouth executives were also very closely knit, which reinforced group loyalty over that of
the general public. HealthSouth’s executive “family” found it much easier to deceive and hurt a
nameless mass of investors than the other members of their internal group. Scrushy exploited the
psychological desire to help those you know over those you do not. For example, he told one of
his CFOs: “if you want to go public with all this, get ready to get fired, and everyone goes down
with you.” This created a culture at the top of HealthSouth where every executive was pressured
to keep quiet for fear of bringing down their close colleagues with them.

There were also characteristics of HealthSouth on the structural level which allowed for the
accounting fraud to occur. Proper checks and balances were not in place at HealthSouth, with
Scrushy making a large amount of the company’s decisions on his own. For example,
HealthSouth’s accounting systems did not sync properly with the corporate
enterprise-resource-planning software. This meant that the results had to be consolidated by hand
by executives, and allowed for an easy way to manipulate earnings figures. The internal audit
committee was also sneakily kept from doing their duties, and E&Y noted that “the internal
audit-function was understaffed, undertrained, and lacking in independence.”
Fraud Discovery

​ ​While the fraud was occurring at HealthSouth, there were multiple warnings from
outside sources to auditors that should have tipped them off to the fraud’s existence. Michael
Vines was a bookkeeper at HealthSouth who oversaw the purchase of equipment. After his
warnings to several members of management went unnoticed, Mr. Vines left his position at
HealthSouth for another job. Upon leaving HealthSouth, Mr. Vines sent a letter to the E&Y
auditors which read: “I know that HealthSouth based out of Birmingham, AL has severe
problems in the Accounting Department. In December 2001, HealthSouth moved expenses to
capital accounts. The following accounts need to be looked at as of 12-31-2001: 7000, 7200 and
7995.”

Mr. Vines identified three specific accounts for the auditors to look at to discover the fraud.
However, instead of investigating the e-mail on their own, E&Y called the CFO of HealthSouth
who claimed Mr. Vines was just a disgruntled employee and he was making his allegations up.
The auditors believed this explanation and never looked into the accounts Mr. Vines identified.

E&Y also received an e-mail from “Fleeced Shareholders” expressing concern about fraud
within HealthSouth. The e-mail read: “You bring the smoke, I’ll bring the mirrors. At least the
market has shown the wisdom to devalue HS stock. Wish I got out in time. I have a list of
questions, which I hope might interest you.

How can the HS outpatient clinics treat patients without precertification, book the revenue, and
carry it after being denied payment? How can the company carry tens of millions of dollars in
accounts receivable that are well over 360 days? How can some hospitals have NO bad debt
reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump
up the numbers, or something that a novice accountant could catch? You people have I have
been hoodwinked. This 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.”

Despite these multiple, specific warnings about the fraud at HealthSouth, E&Y still failed to
bring the fraud to light. It took a former HealthSouth CFO to come forward with information for
the fraud to be discovered. In 2003, Weston Smith, a former CFO, tipped off federal
investigators to the HealthSouth fraud. Soon after, many other employees who had participated
in the fraud turned themselves in as well.
 ​Recovery and New Healthsouth

When the scandal broke in March 2003 the world fell apart for HealthSouth. It was overwhelmed
by lawsuits. Its finances were a mess and no one knew what its position was. Its chairman and
CEO, its senior staff and its auditors were gone. Its bankers were discredited. Its disoriented
directors were left holding the baby. Few had any doubts that it was heading for bankruptcy.

Hopefully most sensible people think that bankruptcy is what should have happened, but it did
not happen. It was a monumental achievement that the company survived. While there was some
initial dispute the board accepted what had happened and their own untenable position. They
employed a large number of credible and very talented outside groups and handed the company
over to them. They made their directors positions vacant for others. HealthSouth not only
survived but by 2007 had regained the confidence of the market and was prospering.

Following the raid at the company's corporate headquarters, the board of directors held an
emergency meeting to discuss what actions needed to be taken. One of the first actions was the
termination of Richard Scrushy as Chairman and CEO, and Bill Owens as CFO. Robert P. May
was elected as interim CEO and Joel C. Gordon as Chairman. Another issue that was
immediately addressed by the board was the means by which it obtain the cash for interest
payments of senior bonds and principal payments due on a $344 million ​convertible bond​. The
board agreed that the company's cash flow problems were too great to tackle on its own. At the
advice of its lender ​JPMorgan Chase​, the company hired restructuring firm ​Alvarez and Marsal
to bring its finances in order and immediately appointed Bryan Marsal Chief Restructuring
Officer. By the end of 2003, the company had most of its finances reorganized and was able to
avoid ​Chapter 11​ ​bankruptcy​.
Efforts were made at the corporate headquarters to eradicate all signs of the prior existence of
Scrushy within the company. The board removed Scrushy's name from the conference center,
closed the company store and museum and opened the fifth floor executive offices to all
employees, which, during Scrushy's tenure, had been kept away. The board also sold all but a
few of the company's eleven corporate jets, which included a ​Gulfstream V​ and a ​Sikorsky S-76
C+​ helicopter. In an effort to save money, the company halted construction of its Digital
Hospital, for which building costs had doubled, to $400 million. On May 10, 2004, Jay Grinney
was chosen by the board as the company's permanent CEO. Soon after Grinney's appointment,
the company moved forward with its goal of again becoming a current filer with the SEC. By
doing so, the company restated earnings from 2000 to 2003. The company also sold or closed
many underperforming facilities, including its medical center division, in its effort to return to
profitability
On May 15, 2006, the company completed its goal of once again becoming a current filer with
the SEC when it filed its first quarter 2006 financial results. It was the first time the company had
filed a 10-Q since its accounting scandal began. On August 14, 2006, the company unveiled its
restructuring plan which included the sell, spin-off or other disposition of its surgery, outpatient,
and diagnostic divisions, along with a 1-for-5 reverse stock split, to coincide with its relisting on
the New York Stock Exchange under the symbol HLS. The reverse stock split was approved by
stockholders at a special meeting at the company's corporate headquarters on October 18, 2006.
The last step in HealthSouth's recovery from its accounting scandal occurred on October 26,
2006 when it was again relisted on the New York Stock Exchange.

Ethical Implications

​ ​Had any of the HealthSouth executives been acting under any sort of ethical framework,
it is hard to believe that this level of fraud would have occurred within the company. The
deontological framework requires decisions to be made based on what is “right” in a broad sense,
valuing principles such as honesty, promise keeping, fairness, loyalty, justice, and respect for
others. HealthSouth executives clearly held none of these values in high regard. Anytime a
corporate fraud is committed, there needs to be a disregard for moral values in favor of wealth
and greed. While some of the employees involved may have succumbed to intense pressure from
Scrushy or justified their actions by thinking it would only be a one-time occurrence, it is clear
that Scrusy and a majority of his executive family were well-aware of the wrong-doing they were
participating in.

It is also easy to see the ethical implications of the HealthSouth fraud when looking at it through
a Utilitarian framework. Utilitarianism states that an ethical decision should maximize benefits to
society and minimize harms. The HealthSouth accounting fraud did just the opposite.
HealthSouth executives put their own wealth and well-being before the rights of their
shareholders and creditors to have legitimate and trustworthy company financial data. Scrushy
kept his entire executive team close and exploited the psychological desire to help those you
know over those you do not.

The E&Y auditors on the HealthSouth account also failed to provide the public with
independently qualified financial statements. Although it can be argued that HealthSouth was
exceptionally skilled in deceiving the audit team, there were many instances and red flags that
should have led the auditors to discover the fraud. The audit team did not thoroughly consider
the ethical implications of their negligence on the public, and overlooked an enormous,
long-lasting accounting fraud that was right under their noses. Once the accounting scandal went
public, HealthSouth’s share price tanked to ​as low as $0.35 a share​, costing their shareholders
millions. Lawsuits were filed by shareholders against HealthSouth, Scrushy, and E&Y. Although
found not guilty on criminal charges, Scrushy paid $81 million to the SEC to settle civil charges
related to the fraud and in 2009 as rule to owe almost $3 billion to shareholders in a class action
lawsuit. E&Y also settled the shareholders’ class action lawsuit for $109 million, reaffirming
their gross negligence in their audit of HealthSouth.

Many lessons can be learned from the accounting scandal at HealthSouth. Accounting scandals
of this scale do not just occur on their own; they require multiple people to orchestrate. When the
tone at the top of a company deviates away from any sort of ethical framework, it should be a red
flag to other members of the company, to auditors, and to the public that fraud is more likely to
occur. Had Scrushy or any of his CFOs thoroughly thought about the long-term implications and
consequences for themselves, their company, and the public, the HealthSouth fraud may never
have occurred. Although it is easy to get caught in the pressure of corporate fraud, one cannot let
themselves blindly follow a CEO and be ethically deficient in their actions. As Scrushy himself
said, “The CEO is just a human; the mind can only absorb so much.”

Remedies and Prevention

The prerequisites of fraud include personal characteristics, situational pressure and available
opportunities.However it proves very difficult for a firm to mitigate the personal characteristics
of an employee outside of any red flags that may occur on application .Furthermore, situational
pressures often prove down to an individual's relationship with the company whether down to
work related stress caused by pressure to meet ambitious targets or poor working conditions
resulting in an employee wishing to take revenge on a company. Both prove strong perquisites
for fraudulent activity to occur. Looking beyond the initial situational pressures placed upon the
perpetuators such as Richard Scrushy a multitude of the situational pressures were cascaded
down to subordinates integrated within the importance of an organization's culture. It is known
that “organizational culture is known to influence the behavior of employees.” in particular
within HealthSouth “The culture in that part of the company was ‘you have to do this for the
family.’ therefore “people were duped into doing it and they paid the price.” McAdory, J. (2013)
Therefore modifying organisational culture, gearing it towards ethical practices by integrating
the importance of education of such ethical practices within the workplace. is of utmost
importance Such movements may occur through the creation of “non- negotiable standard within
the company” with a “code of includ[ing] guidelines and mechanisms for reporting suspicions of
unethical behaviour.It must be clear that there will be no retaliation against employees who
report co-workers,managers or executives.” Coenen, T. (2012)
 Moreover the significant overarching cause of fraudulent activity is the opportunities available
to such individuals.

Potential remedies for mitigating these opportunities is to erode levels of excessive trust and
power in one individual. Therefore a firm may wish to engage in the segregation of duties in
order to prevent scandal and control deficiencies. This is of utmost importance ,in particular,
when segregating bookkeeping from the approval of transactions. Had such controls been in
practice prior falsification of invoices by Cathy C. Edwards on fraudulent entries made by
Michael Vines may have been prevented. Furthermore, the level of employee engagement should
be monitored to ensure safe practice is occurring for example monitoring unusual hours or
employees who do not take holidays. The relationship an employee has with the firm are crucial
and played significantly in the downfall of the Healthsouth corporation along with the crucial
relationships employees have with suppliers and other colleagues. Following the de listing of
HealthSouth Corporation from the NYSE levels of transparency eroded. Moreover, financial
transparency within an institution is imperative in order to prevent and remedy such scandals as
the greatest remedy is through supervision and enforcement of control to ensure appropriate
business diligence.

Conclusion
​The downfall of Healthsouth under the reign of Richard Scrushy can be pinpointed down to
3 main reasons, greed, lack of morals throughout the company and failure of internal
controls. Richard Scrushy was obsessed with increasing the status of Healthsouth and
increasing his own personal profit, this drove him to do whatever he could to preserve the
companies reputation and keep the shareholders happy. This led him to pushing and
manipulating his own staff members into committing crimes for the benefit of everyone
involved in the company , this showed a lack of morals by all those who were involved.

This immorality could have even stretched as far as Ernst & Young who were possibly
bribed to not produce a report that was a true and fair representation of HealthSouth. It is
clear that although there may have been internal controls within HealthSouth to prevent
fraud, however these were not followed by those at the top, who thought they were above the
law. Precautions were not put in place to prevent such illegal actions which eventually led to
the downfall of Richard M.Scrushy and the reputation of the empire that he controlled,
HealthSouth.
BIBLIOGRAPHY

https://investor.encompasshealth.com/home/default.aspx

https://www.bmartin.cc/dissent/documents/health/access_healthsouth.html#R
ecovery

https://stakeholder11.wordpress.com/2014/11/24/healthsouth-inc-a-case-of-cor
porate-fraud/

https://sites.google.com/site/healthsouthscandalinfos6/home