If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall.
– SEC vs. HealthSouth Corporation[HRC]

You look back and think, ‘What was I thinking? Why didn’t I just do the right thing?’ But when you’re caught up in the heat of the battle, it didn’t seem so simple.
– Aaron Beam, Former CFO of HealthSouth

Our next Roundtable (Wednesday, February 17th, at 11am ET) will feature Aaron Beam, who served four years in Federal prison for his role in HealthSouth’s massive accounting fraud, and is now sharing his thoughts and experience in his book Wagon to Disaster and in speaking engagements around the South.

The 2003 SEC complaint alleges a fairly straightforward fictitious entry:  HealthSouth would reduce a contra-revenue account called Contractual Adjustments, which would allow them to show higher net revenue in a way that would be less visible and harder to track than changing revenue directly.   HealthSouth balanced this entry with increases to a fixed asset account called AP Summary.  The relevant portions of the SEC complaint are provided below, and you can also see a summary here.

Accounting educators and researchers should find this a fascinating conversation for many reasons, and you might want to encourage your students to listen in.  But, you may be asking, how is this conversation relevant to research on financial reporting standards?  No doubt Mr. Beam has a great deal to say about auditing, but it is hard to see how blame for HealthSouth’s reporting problems can be laid at the feet of reporting standards.  Actually, I am hoping to get some insight into a couple of standard-setting issues.

First, what roles can financial reporting standards play in limiting the damage done by outright fraud?  Weld, Bergavin and Magrath have an interesting article in CPA Journal arguing that HealthSouth’s financial statements provided a number of clues that earnings were being managed.  Top-quality financial statements (including additional disclosure) can’t directly prevent firms from committing fraud and fooling their auditors, but they can provide investors with a last line of defense:  the ability to raise specific questions about management’s claims.  I would be very interested to hear Mr. Beam’s perspective on what features of the financial reporting environment allowed HealthSouth to avoid questions for so many years.

Second, much standard-setting research is influenced by the enormous literature on earnings management.  But I don’t think researchers yet have a very good handle on how earnings management actually occurs — whether fraudulent or not.  Large sample evidence makes me pretty confident that many firms manage their earnings through operational and accounting decisions in order to satisfy Wall Street and hit specific targets (like the average analyst estimate or a management forecast).  But we know very little about how top management’s intent to achieve earnings goals actually percolates through a large and complex organization.  For example, you might suspect that firms adjust research and development expenses in order to meet or beat analysts’ estimates.  But if this is to be accomplished through an actual reduction in spending (rather than an adjustment in accounting estimates), how does management accomplish this in short window between knowing the size of the reduction needed and the end of the quarter?  Does the CFO need to plan a series of spending cuts throughout the period, to be enacted depending on the resolution of uncertainty?  Given the great stress Mr. Beam’s boss (HealthSouth CEO Richard Scrushy) placed on satisfying Wall Street, I imagine we will get some interesting insights.

As a related point, more than a few academics have suggested that allowing more flexibility in reporting standards can improve communication, and also serve as a substitute for more costly operational forms of earnings management.  I wonder if Mr. Beam agrees, or whether he sees loose standards as easing the wagon’s way from earnings management to outright fraud.

Click here for details on how to attend the discussion.

The Accounting Scandal (from the SEC Complaint — see top of post for link)

25.  HRC’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. For example, instead of increasing the revenue account directly, HRC inflated earnings by decreasing the “contractual adjustment” account. Because the amounts booked to this account are estimated, there is a limited paper trail and the individual entries to this account are more difficult to verify than other revenue entries.

26.  Additionally, each inflation of earnings and corresponding increase in fixed assets were recorded through several intermediary journal entries in order to make the false inflation more difficult to trace.

27.  Furthermore, HRC increased the “AP Summary” line item at various facilities by different amounts because it knew that across the board increases of equal dollar amounts would raise suspicion.

28.  HRC also knew that its outside auditors only questioned additions to fixed assets at any particular facility if the additions exceeded a certain dollar threshold. Thus, when artificially increasing the “AP Summary” at a particular facility, HRC was careful not to exceed the threshold.

29.  HRC also created false documents to support its fictitious accounting entries. For example, during the audit of HRC’s 2000 financial statements, the auditors questioned an addition to fixed assets at one particular HRC facility. HRC accounting personnel, knowing that this addition was fictitious, altered an existing invoice (that reflected an actual purchase of an asset at another facility that approximated the dollar amount of the fictitious addition) to fraudulently indicate that the facility in question had actually purchased that asset. This altered invoice was then given to the auditors to support the recording of the fictitious asset in question. Also, when the auditors asked HRC for a fixed assets ledger for various facilities, HRC accounting personnel would re-generate the fixed asset ledger, replacing the “AP Summary” line item with the name of a specific fixed asset that did not exist at the facility, while leaving the dollar amount of the line item unchanged.

* Update: A video of this Roundtable, along with some follow-up comments can be seen here.