4/4/12 Anatomy of a Financial Fraud

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Anatomy of a Financial Fraud
A Forensic Examination of HealthSouth
Bv Leonard G. Weld, Peter M. Bergevin, and Lorraine Magrath
A Iorensic audit conducted by Pricewater- houseCoopers concluded that HealthSouth Corporation`s
cumulative earnings were overstated by anywhere Irom $3.8 billion to $4.6 billion, according to a January
2004 report issued by the scandal-ridden health-care concern. HealthSouth acknowledged that the Iorensic
audit discovered at least another $1.3 billion dollars in suspect Iinancial reporting in addition to the
previously estimated $2.5 billion. The scandal`s postmortem report Iound additional Iraud oI $500 million,
and identiIied at least $800 million oI improper accounting Ior reserves, executive bonuses, and related-
party transactions. This billion-dollar-plus admission Iailed to garner Iinancial media headlines, Iurther
evidence oI the public`s inurement to Iinancial reporting scandals.
Contemporary corporate Iraud in the United States has aIIected market values, decimated private 401(k)
plans, and devalued public pension Iunds. Tyco, Dynegy, WorldCom, and others joined Enron`s
Iraudulent accounting ranks in 2002. Birmingham, Alabamabased HealthSouth became a member oI that
disreputable group a year later. Moreover, numerous lesser-known companies have also engaged in a host
oI improper and illegal accounting activities.
The Magnitude of the Problem
On January 23, 2003, the SEC issued its 'Report Pursuant to Section 704 oI the Sarbanes-Oxley Act oI
2002. Section 704 directed the SEC 'to study enIorcement actions over the Iive years preceding its
enactment in order to identiIy areas oI issuer Iinancial reporting that are most susceptible to Iraud,
inappropriate manipulation, or inappropriate earnings management. The study period began July 31,
1997, and ended July 30, 2002.
Over the study period, the SEC Iiled 515 enIorcement actions Ior Iinancial reporting and disclosure
violations arising out oI 227 separate Division oI EnIorcement investigations. Those investigations Iell into
three categories:
Revenue recognition, including Iraudulent reporting oI Iictitious sales, inaccurate timing oI revenue
recognition, and improper valuation oI revenue.
Expense recognition, consisting
oI including improper capitalization or deIerral oI expenses, incorrect use oI reserves, and other
understatements oI expenses.
Business combinations, relating to myriad improper accounting activities used to eIIect and report
combined entities.
All but one oI these investigations included revenue-related issues, and many investigations identiIied
violations in two or all three oI these categories.
HealthSouth
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On March 19, 2003, the SEC charged HealthSouth and its CEO, Richard Scrushy, with accounting Iraud.
The SEC`s complaint alleged that HealthSouth had systematically overstated its earnings by at least $1.4
billion since 1999. Apart Irom the SEC`s Iinding, the U.S. Justice Department used inIormation gathered
Irom HealthSouth executives to identiIy another $1.1 billion oI overstated earnings. The
PricewaterhouseCoopers Iorensic study indicates these Iigures were underestimated, but the speciIics oI
those inaccuracies are not a matter oI public record because the company announced that reaudited
Iinancials would be disclosed no sooner than 2005.
FiIteen HealthSouth accounting and Iinance executives pled guilty by the end oI 2003, and Scrushy
remained under indictment in mid-2004 on 85 criminal charges.
The SEC executed a court order, pursuant to section 1103 oI the Sarbanes-Oxley Act, that
Required the company to place in escrow all extraordinary payments to its directors, oIIicers,
partners, controlling persons, agents, and employees;
Prohibited the company Irom destroying documents relating to Iinancial activities or allegations in
the case against HealthSouth and Scrushy; and
Provided Ior expedited discovery.
The Auditors
HealthSouth paid the Birmingham oIIice oI Ernst & Young LLP $3.6 million Ior its 2001 Iinancial
statement audit and related services. Ernst & Young disavowed knowledge oI the Iraud, citing systemic
deception on the part oI HealthSouth executives, several oI whom have pled guilty to Iraud charges.
Communication about questionable activities took place between the health-care provider and its auditor,
however. For example, in a hearing to decide iI Scrushy`s assets should be unIrozen, two Ernst & Young
partners stated that the audit Iirm had received an e-mail Irom a HealthSouth employee advising them to
examine three speciIic accounts Ior Iraudulent entries related to asset capitalization.
Ernst & Young subsequently contacted HealthSouth`s president and chieI operating oIIicer, William T.
Owens, and the chairman oI its audit committee, George Strong. Owens deIended HealthSouth`s
capitalization method, but agreed that Iurther investigation was needed. Both Owens and Ernst & Young
partner James Lanthron eventually concluded that no costs were improperly capitalized. Ernst & Young
did not detect or investigate beyond the scope oI normal audit procedures any other substantive
questionable activities outside oI the capitalization issue.
Meeting Analysts' Expectations
SEC Director oI EnIorcement Stephen Cutler stated in a March 19, 2003, press release that 'HealthSouth`s
standard operating procedure was to manipulate the company`s earnings to create the Ialse impression that
the company was meeting Wall Street`s expectations. This motive is not a new one.
In general, analysts` expectations and company predictions address two high-proIile components oI
Iinancial perIormance: revenue and earnings Irom operations. The pressure to meet revenue expectations is
particularly intense and may be the primary catalyst leading managers to engage in earnings management
practices that result in questionable, improper, or Iraudulent revenue-recognition practices. A Financial
Executives International (FEI) study, Ior example, Iound that improper revenue recognition practices were
responsible Ior one-third oI all voluntary or Iorced restatements oI income Iiled with the SEC Irom 1977 to
2000.
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The drive to meet analysts` expectations was brought to public attention in 1998 by then SEC Chairman
Arthur Levitt in his landmark speech 'The Numbers Game. Levitt expressed his concern that too many
corporate managers, auditors, and analysts let the desire to meet earnings expectations override good
business practices. He called Ior a Iundamental cultural change on the part oI corporate management and
the entire Iinancial community. Levitt identiIied several examples oI what he called accounting 'hocus
pocus: 'big bath restructuring charges, creative acquisition accounting, cookie-jar reserves, immaterial
misapplications oI accounting principles, and the premature recognition oI revenue.
Early Warning Signs
The systematic and substantive HealthSouth Iraud raises certain questions:
Should the auditors have suspected Iraud?
More important, could the auditors have detected the Iinancial statement manipulations and exposed
them?
Given that the auditors did not detect Iraud, could the investment community have done so through
careIul examination oI the Iinancial statements?
II so, what tools would help Iinancial statement users detect the Iraud?
The CPA Journal article 'Abusive Earnings Management and Early Warning Signs, by Lorraine Magrath
and Leonard G. Weld (August 2002), distinguished between earnings management activities that are
simply good business practices and abusive earnings management intended to deceive the Iinancial
community. Good business practices include the Iollowing activities:
CareIul timing oI capital gains and losses;
Use oI conIerencing technology to reduce travel costs; and
Postponement oI repair and maintenance activities when Iaced with unexpected cash Ilow declines.
On the other hand, abusive earnings management results Irom actions such as those cited in the SEC
section 704 Report:
Improper revenue recognition;
Improper expense recognition; and
Using reserves to inIlate earnings in years with Ialling revenues.
Magrath and Weld identiIied six relationships that investors and auditors should consider as early warning
signs oI abusive earnings management:
Cash Ilows that are not correlated with earnings;
Receivables that are not correlated with revenues;
Allowances Ior uncollectible accounts that are not correlated with receivables;
Reserves that are not correlated with balance sheet items;
Acquisitions with no apparent business purpose; and
Earnings that consistently and precisely meet analysts` expectations.
Analyzing HealthSouth`s Disclosures
II analysts, investors, or auditors had examined these relationships, would there have been reason to
suspect abusive earnings management at HealthSouth? In retrospect, the answer is a qualiIied yes.
Investors or auditors might have detected abusive earnings management iI they had understood the context
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oI the Iinancial statements as well as their content, and iI they had thoroughly analyzed speciIic early
warning signs oI earnings management.
As HealthSouth`s credibility unraveled in Iull public view, it became apparent that Ior many years its
Iinancial disclosures had neither represented economic reality nor conIormed to GAAP. The company
acknowledged as much in its Form 8-K Iiled with the SEC on March 26, 2003:
The company also announced today that, in light oI the recent Securities and Exchange
Commission and Department oI Justice investigations into its Iinancial reporting and related
activity calling into question the company`s previously Iiled Iinancial statements, such
Iinancial statements should no longer be relied upon.
Whether the auditors should have detected a scheme that originated at upper management
levels remains a matter oI conjecture; regardless, investors and other Iinancial statement users
lacked reliable data.
Correlation analysis would not have revealed 'accounting hocus pocus on the part oI HealthSouth.
Exhibit 1 presents correlation coeIIicients Ior 1993 through 2001 (the last year HealthSouth Iiled a Form
10-K). Exhibit 1 indicates a positive correlation between each pair oI accounts. Although their
relationships vary to a certain extent, HealthSouth`s accrual-based numbers were positively related to each
other, and cash Ilows mirrored income.
Lack oI inIormation precludes correlating reserves with balance sheet items, the Iourth early warning sign
oI abusive early management. HealthSouth met the Iinal indicator oI earnings abuse: The company
matched analysts` expectations Ior 48 consecutive quarters through mid-1998. That unerring track record
could have been attributed to predictable operations and acceptable income-smoothing techniques, but
hindsight proved otherwise.
Upon examination oI the techniques used by HealthSouth, the authors oIIer two techniques that investors
and auditors can use to raise red Ilags about abusive earnings management practices: a more detailed
analysis oI receivables, and a link between cash Ilows and an array oI perIormance measures.
Accounts Receivable Analysis
A detailed analysis oI credit sales can help unearth abusive earnings management, even iI the primary
accounts create an illusion oI successIul perIormance. This technique requires an investigation oI all oI the
accounts comprising net receivables, as well as their interrelationships, in order to identiIy potential
problems. Public disclosures, even in the most reliable Iinancial statements, do not provide such data in a
user-Iriendly Iormat. OIten, companies provide inIormation about bad-debt expense, the amount oI
accounts written oII as uncollectible, and estimates oI doubtIul accounts in an Item 14 valuation schedule
toward the end oI the 10-K, Iar removed Irom the Iinancial statements and the notes in Item 8.
Alternatively, some companies disclose estimated uncollectible accounts as a parenthetical disclosure to net
receivables, and break out bad-debt expense on the income statement. This method, however, neglects to
report the dollar amount written oII as uncollectible.
HealthSouth disclosed its receivable-related activities on the Iace oI its Iinancial statements. The relatively
large percentage oI receivables estimated as uncollectible is not surprising, given an industry dependent on
third-party payments Irom Medicare and insurance companies. This component`s volatility, ranging Irom
38.9 oI gross accounts receivable to 12.2, is troubling, however. Exhibit 2 extends the analysis oI
HealthSouth`s receivables, presenting the company`s allowance balance and expense disclosures and using
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those numbers to determine the dollar amount written oII as uncollectible.
In addition to this volatility, HealthSouth`s 1999 provision Ior doubtIul accounts is an outlier when
compared to other years` bad-debt expense. It may be only coincidental that 1999 was the Iirst Iull year in
which investors knew the company would not meet previously announced earnings projections. Exhibit 3
presents bad debt expense as a percentage oI annual sales.
Annual write-oIIs Ior uncollectible receivables lacked any consistency whatsoever. Moreover, the amount
oI the accounts written oII in any given year did not correlate with the allowance established Ior them. To
the extent that these disclosures were reliable, these data indicate that HealthSouth used bad-debt reserves
to manipulate earnings. This lack oI correlation could be an indirect indicator oI the Iourth warning sign oI
abusive earnings management: reserves that are not correlated with balance sheet items.
Consider two related items related to uncollectible accounts, to Iurther understand possible earnings
management. First, there were disproportionately large allowance Ior doubtIul accounts balances at the end
oI 1994 and 1995: nearly 40 oI gross receivables. These existing balances could have been drawn down
without the need to record an accurate provision Ior doubtIul accounts. Consequently, the year-end charge
to bad expense, required to replenish the depleted contra-asset account, could have been less than normally
expected iI the unadjusted allowance balance jibed with economic reality. By understating expenses in this
manner, HealthSouth could have manuIactured earnings beginning in the mid-1990s. These data provide
some evidence oI the classic 'cookie-jar reserve ploy.
The related issue is the amount oI bad-debt expense matched against revenues in 1999. As noted, that
unusually large charge to earnings was made at the time when it became publicly known that HealthSouth
could no longer hit its earnings target. Company oIIicials may have decided to replenish the balance in the
allowance account (add cookies to the cookie jar) or recognize previously understated levels oI bad-debt
expense. In either case, the large charge (8.4 oI revenues) occurred when Wall Street diminished its
earnings expectations Ior HealthSouth. Taking this 'big bath Ior bad debts merely exacerbated 1999`s
already poor Iinancial perIormance, inIormation that was already discounted in the marketplace. The
question arises: Did HealthSouth bury this apparently inIlated expense amount within a sea oI red ink in an
attempt to manage earnings?
An analysis oI receivables composition sheds light on the potential to overestimate cash collected Irom
sales. Exhibit 4 shows the trend oI cash collected Irom customers, determined by two diIIerent methods.
The Iirst metric is the conventionally simpliIied version used to convert indirect cash inIlows to direct ones.
It merely adjusts revenues Ior changes in net accounts receivable to determine cash collected Irom
customers in a given reporting period. The deIiciency in this method is that net receivables result Irom the
interaction oI account write-oIIs and bad-debt expense recognition. Taken together, these entries aIIect the
allowance`s ending balance, which, in turn, determines net receivables. Bad-debt expense, however, is a
noncash charge, and has no bearing on operating cash inIlows; nor has bad-debt write-oIIs. They must be
subtracted Irom revenues, however, along with the adjustment Ior changes in gross receivables, to
accurately determine cash collected Irom customers. The diIIerence between cash Ilows determined by the
net and gross methods can be material iI write-oIIs are signiIicant, as they were in 1999. Cash collections
should be constant over time, regardless oI the method used, inasmuch as accounts written oII and the bad-
debt expense recognized are usually comparable in any given reporting period.
HealthSouth`s cumulative cash inIlows as a percentage oI sales equaled 93.5 on an adjusted (gross-
receivable) basis, as opposed to 97 on an unadjusted (net- receivable) basis. This translates into a
reduction oI $725 million in cash collections Irom 1994 through 2001, which matches the write-oIIs Irom
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Exhibit 2. Annual percentages, however, diIIer Irom those geometric means, as evidenced by the data
points in Exhibit 4. Moreover, a visual inspection oI the graph reveals variability between the two methods,
which is attributable to HealthSouth`s history oI inconsistently writing oII uncollectable accounts and
recognizing bad debts. It is also interesting to note that percentages oI revenues realized in cash improved
aIter HealthSouth announced its inability to meet earnings projections in 1998. In addition, the two
measures oI cash Ilows were more correlated Irom that point Iorward. Could eliminating the need to meet
earnings goals have aIIected managerial behavior?
Linking Disclosures with Performance
HealthSouth acquired numerous rehabilitation clinics and outpatient surgery centers during the 1990s.
Rolling up the industry, however, did not translate into greater returns on investment. Exhibit 5 presents the
company`s return on total assets and equity during the period analyzed. The purpose and viability oI
business acquisitions is the IiIth early warning sign oI abusive earnings management.
Although one cannot inIer causality to HealthSouth`s acquisitions, an auditor or investment analyst could
question the soundness oI an aggressive acquisition strategy given the diminishing rates oI return. In
addition, the data indicate a pronounced decrease in returns Irom 1998 to 2001, as compared to the
preceding Iour-year period. Again, these declines coincide with the year that HealthSouth admitted its
inability to meet earnings Iorecasts. Although not exhibited in the graph, all oI the components oI
investment return decreased in the later Iour-year period. Net proIit margins, asset turnovers, and the
leveraging oI the asset base were all lower Irom 1998 through 2001 than they were Irom 1994 through
1997.
Cash Ilow analysis also calls into question HealthSouth`s acquisition strategy. Operating cash Ilows
inadequately met the company`s requirements Ior sustainable operations. The only year examined in which
HealthSouth`s annual cash Ilow adequacy ratio (deIined as cash Ilows Irom operations divided by the sum
oI payments Ior Iixed assets) exceeded 1 was 1996. One might argue that the annual adequacy measures
were generally below the level needed to cover Iixed commitments because HealthSouth was expanding
during this period. This was undoubtedly the case, but the goal oI Iinancing activities that deplete cash in
an expansionary period is to build sound investments that produce acceptable investment returns. Such was
not HealthSouth`s experience, as discussed above. What end did these acquisitions serve?
Operating cash Ilows and operating income were positively correlated, but there was a lack oI
comparability between these two amounts. The operations index measures their degree oI correspondence
by dividing cash Ilows Irom operations by operating income. An ideal ratio is 1, indicating that income
Irom HealthSouth`s core business activity was being realized in cash. HealthSouth`s annual operating
index averaged about 0.5 Irom 1994 through 2001, even aIter adjusting operating income Ior the noncash
charges oI depreciation and bad-debt expense. These cash Ilow measures do not prove that HealthSouth`s
acquisitions did not serve a legitimate purpose or were solely attributable Ior Ialtering cash Ilows. They do,
however, point to pressure on management to achieve earnings targets, something which was not realized
in operating cash. Making the numbers would have beneIited the company in its attempts to secure external
Iinancing. As evidenced by the cash Ilow adequacy ratio and the operations index, outside Iunds were
needed because internal sources oI cash were insuIIicient to sustain operations.
Warning Signs Have Limitations
Manipulating earnings requires disclosure oI plausible managerial assertions. Markets readily identiIy and
punish ill-conceived Iraudulent Iinancial reporting schemes that result in improbable Iinancial scenarios. In
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other words, annual disclosures must pass muster to deceive auditors, regulators, and investors.
HealthSouth`s Iinancial disclosures succeeded on this point: They metaphorically looked, walked, and
quacked like a duck. With the beneIit oI hindsight, however, the company`s Iinancials were more Ioul than
Iowl.
Analysis oI inaccurate Iinancials is a dicey proposition. Auditors and investors are unaware that they are
erroneous when Iirst encountering them. Well-conceived and -executed Iinancial Irauds plausibly articulate
duplicitous Iinancial statement items to other related accounts. Such was the case as HealthSouth exhibited
highly correlated earnings, revenues, and receivables. Nothing speciIic stood out to trigger alarm in the
minds oI investors and auditorsthe usual warning signs were not apparent. Perpetrators oI Iraud,
however, sometimes Iail to logically articulate subcomponent account disclosures. HealthSouth`s bad-debt
expense, allowance Ior uncollectible accounts, and changes in overall receivables Iailed to match the
symmetry portrayed in net receivables. Moreover, investment returns and cash Ilows could have called into
question management`s operations. The six early warning signs oI abusive earnings can point to potential
evidence oI abusive earnings management, but users must be very diligent in examining all components oI
the Iinancial statements and their relationships to each other.
Leonard C. Weld, PhD, is a professor of accounting and head of the department of accounting and
finance, at the Harlev Langdale, Jr., College of Business Administration at Jaldosta State Universitv,
Jaldosta, Ga, and Peter M. Bergevin, PhD, is a professor of accounting, at Redlands Universitv,
Redlands, Calif. and Lorraine Magrath, PhD, is an associate professor of accounting at the Sorrell
College of Business at Trov State Universitv, Trov, Ala.
Editor's Aote: The referenced August 2002 CPA Journal article written bv Professors Weld and Magrath
won the 2002 Max Block Distinguished Article Award, which each vear recogni:es the most outstanding
work published bv The CPA Journal.

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