Forget about Enron-like special-purpose entities or exotic-sounding financial engineering. The accounting fraud to which HealthSouth’s former chief financial officer, Weston L. Smith, agreed to plead guilty in an Alabama federal court was as straightforward as accounting fraud gets. Yet, because it was so well hidden, according to prosecutors, outside investors barely stood a chance of detecting it.
Here is how the health-care provider’s scheme worked, according to prosecutors. Intent on not missing Wall Street analysts’ earnings estimates, HealthSouth Corp. executives made a series of adjustments that manipulated the company’s revenue line so revenue and earnings would appear larger than they were.
The executives made the adjustments to certain allowances on HealthSouth’s financial statements. The allowances accounted for the difference between what HealthSouth charged a patient and the amount the company could collect from the patient’s health insurer. By lowering the allowances improperly, HealthSouth improved its net revenue and bottom-line earnings.
At HealthSouth, for every dollar of illicit revenue that company executives recorded, they also had to make a corresponding entry on the company’s balance sheet. And if they plowed it all into one type of asset, the company’s auditors at Ernst & Young LLP’s Birmingham, Ala., office where Mr. Smith had been an auditor during the 1980s might detect it. So they spread the improper entries far and wide in tiny pieces across HealthSouth’s balance sheet.
According to the government, HealthSouth executives plumped such things as the company’s inventory and intangible assets and property, plant and equipment assets. They even overstated the company’s cash by $300 million, according to prosecutors. The improper entries, some of which dated to 1997, eventually piled up. HealthSouth’s deft handling of its balance sheet made it practically impossible for investors to detect the scheme before it was too late. (HealthSouth has said it is cooperating with the Justice Department’s criminal investigation.)
“The predominant evidence is not that the rules don’t work,” says Sean Coffey, a partner at New York law firm Bernstein Litowitz Berger & Grossman who specializes in pursuing class-action securities-fraud lawsuits. “It’s that people continue to break the rules, and the gatekeepers keep letting them get away with it. There were rules that prohibited just about everything this guy did, and he just did it anyway.”
The charges facing Mr. Smith include filing a false certification statement with the Securities and Exchange Commission, a violation of new laws established by last year’s Sarbanes-Oxley securities legislation aimed at improving corporate governance. Mr. Smith’s case underscores how Sarbanes-Oxley won’t stop fraudulent earnings management, though it likely will result in more criminal prosecutions for accounting fraud.
The parts of the financial statements that Mr. Smith and, allegedly, other HealthSouth executives exploited, for the most part, are areas where management has broad discretion to estimate asset values. As long as corporate managers are the ones determining those values, opportunities for abuse will abound. In any given period, small irregularities that look like normal variances often can go undetected.
By mid-2002, according to prosecutors, HealthSouth’s total assets were overstated by $1.5 billion. Property, plant and equipment assets were overstated by $1 billion, or more than 50%, and earnings for the first six months of 2002 were inflated by more than $150 million, the Justice Department said.
Nonetheless, Mr. Smith and HealthSouth’s chief executive, Richard Scrushy, on two occasions last year swore in public filings that the company’s financial statements fairly presented HealthSouth’s financial condition and operating results. Those quarterly certifications, which the Sarbanes-Oxley Act began requiring last year, appear to have made it much easier for prosecutors to build their case against Mr. Smith.
The SEC filed civil charges against Mr. Scrushy Wednesday, but he hasn’t been charged criminally. Prosecutors referred to HealthSouth’s CEO and other unnamed HealthSouth senior executives as co-conspirators throughout Wednesday’s court filings. Neither Mr. Scrushy nor his lawyer could be reached for comment.
HealthSouth’s latest quarterly report, like basically all such financial filings, warned that management’s estimates could be off the mark. “In preparing these financial statements, we are required to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses,” the report said. “Those reported amounts could differ, in some cases materially, if we made different estimates and judgments with respect to particular items in our financial statements.
We make such estimates and judgments based on our historical experience and on assumptions that we believe are reasonable under the circumstances in an effort to ensure that our financial statements fairly reflect our financial condition and results of operations.”
As it turns out, according to prosecutors, HealthSouth’s estimates and judgments weren’t reasonable at all. Mr. Smith, and possibly other executives later on, could face jail time. But that will be little comfort to outside investors whose HealthSouth shares have lost much of their value.
Auditors are supposed to try to catch such chicanery before they sign off on a company’s financial statements. But if they only are spot-checking a company’s accounts, they may not notice suspiciously ballooning balances, Lehman Brothers accounting analyst Robert Willens says.
Generally, sample testing of accounts is all many accounting firms perform, barring evidence of acute problems that should spur further digging. Ernst & Young says the firm is cooperating with the SEC’s requests for documents. It also said HealthSouth’s “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.” An Ernst spokesman declined further comment.
“It sounds like they were creating assets that didn’t exist,” Mr. Willens says. “And they were smart enough to realize that, as long as the increases weren’t dramatic, the auditors were not going to deviate from the sampling approach that they typically take.”
Some prominent accountants, including former SEC chief accountant Walter Schuetze, have proposed changing the financial-reporting system, so that every asset and liability on a public company’s balance sheet would have to undergo independent appraisals by outside valuation professionals. “We need to take control of the numbers out of the hands of management of the reporting enterprise by requiring that the numbers for assets and liabilities come from the market place,” Mr. Schuetze said in a Houston speech this month to members of the American Accounting Association. So far, Mr. Schuetze’s idea hasn’t gained much momentum among investors or regulators.