2. What are several red flags that E&Y either was or should have been aware of i

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2. What are several red flags that E&Y either was or should have been aware of in the audit of HealthSouth?

In 1996, key executives of HealthSouth, one of the nation's largest providers of health care services, began a massive fraud that eventually amounted to $2.7 billion.4 HealthSouth is a textbook case of unbridled greed combined with a lack of corporate governance, which illustrates the difficult situation that auditors face when clients perpetrate a massive collusive fraud. HealthSouth was founded in 1984 by Richard Scrushy and coworkers at Lifemark, a Houston-based comppy that owned and managed hospitals 2 They took Health South public in 1986, and by 1996, the company's market value had grown to $12 billion According to the government's complaint, Scrushy, the chief executive officer, insisted that the company meet or exceed earnings expectations established by Wall Street analysts. Senior officers would present actual accounting earnings to Scrushy, and if they did not meet the forecasts, he reportedly told them to "fix it." Unbeknownst to Scrushy (according to his testimony at trial), a team of senior accounting personnel, known as "the family." held family meetings" to determine ways to increase accounting earnings. They would look for "holes" in the balance sheet to be filled. The fictitious accounting entries they used to plug those holes were referred to as "dirt." Methods included overestimating insurance reimbursements, overstating fixed assets, improperly capitalizing expenses, and overbooking reserve accounts The "family" members started by manipulating contractual allowances by consolidating entry adjustments after the end of each quarter. The allowances accounted for the differences between what Health South charged patients and the amounts the company could collect from the patients' health insurers. By lowering the allowances improperly HealthSouth improved its net revenue and bottom-line earnings. To offset the contractual allowances, the company increased inventory, intangible assets, fixed assets, and even cash. The fictitious fixed asset line item at each facility was listed as "AP summary." The company's CFO, William Owens, a former Ernst & Young (EY) senior manager and one of five CFOs who eventually pleaded guilty to the fraud, also used the acquisition of Horizon/CMS to book $400 million worth of goodwill as part of the cover-up. He pulled the trick off with the help of two HealthSouth colleagues and a finance executive from Horizon Oa paper, HealthSouth maintained impeccable corporate policies. The company established a confidential whistleblower hotline in 1997; developed a nonretaliation policy. which gave the compliance director direct access to the board; and established a centralized finance function. This centralized function seemed to be a particular advantage because other health care companies were falling apart as a result of problems in field offices. Reviewing these policies, it is not difficult to see why a massive fraud did not seem likely. Despite outward appearances, actual corporate governance was quite different. Many decisions were made at the executive level, which limited checks and balances along the way. The audit committee met only once a year. The accounting systems in the field did not interface with the corporate enterprise-resource-planning software, making it necessary for results to be consolidated at the corporate level, where it was easier to "cook" the numbers a Scrushy, a former gas station attendant, fit the profile of the domineering CEO who set the wrong tone at the top. He reportedly managed by fear and intimidation. Scrushy installed security cameras throughout headquarters to watch employees. He allowed rank-and-file employees into his executive suite only when he wanted to berate them 2 According to the government's complaint, accounting personnel advised Scrushy in 1997 to abandon the fraud, but he refused, ing. "Not until I sell my stock." The five CFOs realized the error of their ways, but most felt helpless to Page CIS stle or even leave the company. One, Michael Martin, testified he tried to quit, but Scrushy reportedly said, "Martin, you can't quit. You'll be the fall guy.-"II Later, when Treasurer Leif Murphy decided to leave the company because of the fraud, Martin punched him twice at his going-away party and wrote on his farewell card. "Eat lexpletive] and die. "IX AUDIT APPROACH

Explanation / Answer

There were three red flags that Ernst & Young were not aware during the audit.

1. The first red flag in Ernst & Young that the auditors should have been considered for only two years, the company’s net income grew about 1000 percent when the corresponding income grew for only 10 percent.

2. The second red flag for auditor to consider for the top management. The company’s CEO who controlled the company by fear. He set the wrong tone of the top management who had the ability to override the transactions and sidestep the accounting system’s checks. That’s why it made simple for the employees to improve/better the company position in the market. The audit committee met only once a year and performed its functions badly. The independent auditor at Ernst &Young knew that the company’s internal auditor had no access to the corporate books. The audit team to examine each transaction and document in the company as per accounting system.

3. The third red flag was through the company’s hotline from the Health South’s former employee. It seems that he was the independent auditor who ignore the messages. They accepted the explanation of allegations which might has revealed the fraud if he would has followed up on that red flag.

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