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HealthSouth operates in the physical rehabilitative healthcare services industry. The company's target patients are people with physical disabilities, senior citizens, and young people with mainly sports-related injuries. HealthSouth provides interdisciplinary treatment programs for patients who have suffered from a variety of disabilities caused by stroke, orthopaedic problems, head injury, neuromuscular disease and sports-related injuries (Annual Report, 2009).
HealthSouth operates in five business segments. The company's inpatient rehabilitation hospitals provide patient care services to patients after they are discharged from traditional acute care hospitals. HealthSouth's outpatient rehabilitation facilities' helps restore patients' mobility. It is an extension of the care service provided by the inpatient rehabilitation hospitals. HealthSouth's long-term acute care hospitals focus on managing complex medical problems and satisfy multiple long-term health care needs. HealthSouth's home health program provides service for patients who need home-based care. This program involves sending skilled nurses and therapeutic specialists to patients' homes to provide physical, occupational or speech therapy. HealthSouth is also a provider of rehabilitation technology to patients (HealthSouth, 2010).
Market Structure: Highly Competitive
The healthcare service industry in the United States is highly competitive, but because of the aging U.S. population and the prevalence of functional disability it is still a growing market. Companies in the healthcare industry have to struggle not only with decreased reimbursement from patients and their insurance companies, but also with price competition from firms providing similar services (Porter & Teisberg, 2004). Mergers and acquisitions are very common in the American healthcare industry. To remain the largest provider of inpatient and outpatient rehabilitative services, HealthSouth carried out a series of mergers and acquisitions across America. These significant acquisitions brought HealthSouth to more than 2,000 locations across the United States (Chaubey, 2006). Generally, small companies have a hard time surviving in this highly competitive market and large companies owned by investors absorb these small, less organized healthcare companies and then make them part of their own nationwide chains. All companies in this industry have to face the problem of controlling their operating costs while maintaining their quality of service in order to remain competitive within the industry. As a result of healthcare payment policy changes, all rehabilitation hospitals have been marketing themselves to the large payors and this situation has made the price competition much fiercer. The healthcare industry is not limited to for-profit companies. Not-for-profit organizations are also HealthSouth's competitor. These Not-for-profit organizations provide rehabilitation services as well and just like for-profit rehabilitation centres, the NFPs also increase their market presence through mergers and acquisitions (Wheatle, De Jong, & Sutton, 2005).
HealthSouth and Competitors
HealthSouth's competitors include nursing homes, senior residential living facilities, sport
related injury facilities, psychiatric solutions, and other facilities providing inpatient and
Outpatient care. Select Medical Holdings, Sun Health Care Group, Rehab Care Group, and
National Healthcare Corporation are HealthSouth's key competitors.
HealthSouth Business Model
HealthSouth's revenue came from various payors such as Commercial Insurance and other managed care plans; Medicare; worker's compensation; and payments from individual patients. At 40.3%, the largest source of HealthSouth's revenue was commercial insurance and managed care plans. Medicare was the second highest source of revenue for HealthSouth in 1999, accounting for 33% of revenue.
There are four tenets to HealthSouth's business Model, which include the integration of services; marketing to managed care organizations and other payors; cost-effective services; and expansion of the national network (Annual Report, 1999).
Integration of Services: HealthSouth tries to integrate its five business segments for its payors by offering all or most of its services in the same city. This integrated system is convenient for large payors, such as insurance companies and Medicare, as they do not have to deal with multiple companies to provide different forms of healthcare coverage for their participants. This system also allows for increased revenue for the company by means of patient cross-referrals between the different HealthSouth facilities in the same city (Annual Report, 1999).
Marketing to Individual Patients and Large Payors: Another important element of HealthSouth's business model is a strong marketing effort geared towards individual patients and large payors. HealthSouth understands the value of marketing to patients, regardless of whether they have healthcare coverage or not. The marketing plan for each individual facility is designed with the key factors such as the area's disability statistics and population characteristics in mind. As important as the marketing campaign for each facility is, HealthSouth primarily focuses on developing and maintaining contractual relationships and national agreements with large insurance companies, employers, and managed care organizations. (Annual Report, 1999)
Services provided at a Lower Cost: Offering services at lower costs is essential for retaining large payors who are often seeking the most cost-effective healthcare provider. With its strong marketing effort, HealthSouth charges less for its various services than the competition, and still prospers as it receives a large number of patients. The company's Outpatient surgery facilities in particular are renowned for providing cost savings (Annual Report, 1999).
Expansion of HealthSouth's National Network: A continuous expansion of HealthSouth's network of healthcare facilities is also an important part of the company's business model. Internal growth and acquisition have made this expansion possible. The company has become the largest provider of healthcare services in the United States, and this position has allowed the company to realize economies of scale and successfully compete for contracts with large national payors. As a result, the company is able to utilize greater buying power through centralized purchasing, resulting in substantial cost savings (Annual Report, 1999).
HealthSouth's Critical Success Factors
Some of the critical success factors for HealthSouth are:
Meeting revenue targets and maintaining the company stock price ( Wall Street expectations)
Providing high-quality, cost-effective health care services
Effectively marketing services to large payors and patients
Expansion of HealthSouth's National Network
Attracting and retaining high-quality personnel
Improving patient rehabilitation time
HealthSouth Fiasco: Brief Overview
At the end of 2002, after the Enron crisis, HealthSouth became a target of the security exchange commission. The creative approach detracted attention from external auditors, government and shareholders. HealthSouth's deception was comparable to the fraud committed by Enron and Worldcom. HealthSouth's employees manipulated auditing tracks by altering and adjusted entries, invoices. They also cautiously forged all supporting documents.
Like other infamous accounting scandals, the fraud in HealthSouth was discovered by the SEC in 2002 when the CEO sold $75 million in his stock options just days before the company announced significant losses. Within days, the Board of Directors immediately hired an outside consultant to examine the company's accounting records to investigate these large losses. After several failed attempts to link HealthSouth CEO's share dumping to the company's sudden financial loss, on March 18, 2003, FBI agents executed search warrants at the company's headquarters in Alabama (Chaubey, 2006). With records collected, on March 19, 2003, the SEC filed a civil complaint against HealthSouth for significant accounting deception (SEC Litigation, 2003). The trading of HealthSouth's stock in NYSC was immediately suspended pending investigation (Laurence& Voreaco, 2006).
Evidence of HealthSouth's deceptive accounting astonished the jury, unsuspecting Board of Directors and shareholders. Firstly, HealthSouth reported net revenue by reducing its contra-revenue balance, a reserve account that represents the estimated difference between the amount billed to patients and the expected insurance reimbursements. Contra-revenue accounting is allowed in the healthcare industry but it is subject to a lot of managerial discretion. HealthSouth's wrongful reduction of its contra-revenue account meant that the company expected to collect all amounts billed to patients. In doing so, the company concealed the impact of claims that would not be reimbursed by the insurance provider. Secondly, to balance these fraudulent adjustments to the contra-revenue account, corresponding entries were made to non-existence fixed asset "property, plant, and equipment" balance. Thirdly, the adjusting entries did not exceed $4999 as executives knew that auditors only questioned entries that exceeded that amount. This discretionary accounting took place in 2000 HealthSouth facilities across the United States. This cumulatively resulted in about $800 million overstatement in the plant and property asset balance by Quarter 2, 2002. Since that large overstatement was done in multiple facilities it was very difficult to detect.
The key players in the HealthSouth fraud included five former CFOs (Weston L. Smith, Tadd McVay, Aaron Beam, Michael Martin, and William Owens) and fifteen executives. Ex-CFOs and top executives all pleaded guilty to knowingly participating in the misinterpretation of the company's financial statements and argued that the former CEO, Richard Scrushy, pushed them exaggerate earnings in order to meet Wall Street and stockholders expectation. However, Scrushy has continued to deny any wrong-doing despite being sentenced to prison for six years on June 28, 2007.
The fiasco in HealthSouth was made possible by a failed management control system based on loose cultural controls and result controls that had undesirable outcomes. To keep auditors' communication in check, top management limited the auditors' internal communication with senior management and staff to just two managers (Congressional Hearing, 2002). Auditors (Ernest and Young) were not totally independent as they provided other consulting services to HealthSouth, and some board members had close relationship with the CEO. From 1996 to 2003, HealthSouth had inflated about $2.7 billion of overstated assets and fictitious profits. (United States Court File, 2004). Exhibit 1 shows a detailed time-line of HealthSouth's accounting fraud.
Management Control System
According to Jay Grinney, current CEO of HealthSouth, Health South had extremely weak checks and balances before the fraud occurred (Whitmire, 2009). Grinney argued that the company operated under a system that did not recognize the importance of instilling a good management control system. Nevertheless, like most organizations, HealthSouth did have a basic management control system in place before the fiasco. The company had an established internal auditing group that examined journal entries and its supporting documents, and ensured that journals were properly signed by appropriate personnel. HealthSouth also had reputable external auditors (Ernest & Young) who claimed that they followed due diligence in reporting the company's financial statements.
HealthSouth's Organizational Culture before the fraud
HealthSouth had a strong organizational structure where decisions were made from the top down. The company's CEO was a charismatic leader. Employees who testified at HealthSouth's congressional hearing called Scrushy's routine review meetings a "Monday-morning beatings" process. Employees explained that Scrushy, who chaired the meetings, would publicly ridicule employees that failed to meet his unrealistic expectations (Abelson & Freudenhim, 2003).
In his book, "HealthSouth, The Wagon to Disaster", Aaron Beam, HealthSouth's former CFO, explained that Scrushy instilled fear in all of his employees including key analysts, internal auditors, and CFOs. He even instilled fear in the board of directors. Beam explained that open communication was impossible in HealthSouth. Analysts presented their reports to Scrushy and waited in fear for his judgment. The employee who testified against HealthSouth explained that analysts had little chance to interpret their findings before they were stopped by Scrushy's infamous phrase, 'That was the stupidest thing I ever heard" (Abelson & Freudenhim, 2003). Beam explained that Scrushy constantly reminded everybody that HealthSouth was his company and that things needed to be done his way.
Senior management was closely involved in the day to day operations of the company. Helyar (2003) explained that Scrushy most often visited rehab centers randomly for inspection without any notices. "Like a drill sergeant, he would run a finger along the tops of a picture frame, and then wipe it on the blazer of the center's administrator. Any visible mark meant points deducted - and possible dismissal." (Haddad, Weintraub, & Grow, 2003). Scrushy cultured a group of fearful subordinators with excessive obedience and flattery (Abelson & Freudenheim 2003).
Result Control: Performance Measurement
HealthSouth executive compensation during 1996 to 2002 included significant cash bonuses as long as key performance criteria were met. The performance measurement was based on annual quantitative targets. The bonus pool for the executives and management was calculated as the lesser of the amount of annual net income exceeding targeted net income set by the Board of Directors and 10% of the actual net income achieved. No bonus was awarded if the annual net income does not meet the budgeted income.
Individual bonuses were assigned on a case by case basis instead of a formula. There was no predetermined relationship between any specific performance index and amount of bonus. The Incentive program was the primary element of the executive compensation and Committee believed that it could stimulate executives to achieve aggressive goals set by board (Reuters, 2003).
Fiasco in Health South: Behavioural Causes
Organizational Culture: Culture is an important environmental factor influencing accounting practices and management control systems (Chan, Hung, Lin & Mo, 2003 ). Senior management set bad examples themselves through inappropriate conduct, which was seen as acceptable part of the organization culture. HealthSouth culture of working together as a family instilled a strong sense of co-operation among employees. Because employees viewed each other as brothers and sisters corrupt practices were easily swept under the table. During HealthSouth's congressional hearing senior management was described as being a Mafia family that did anything to protect its family members. A 1998 voice mail left by former CFO, Mike Martin, reminded employees completing the company's year-end financial reporting of the rules and regulation of family. According to the transcripts Martin told the assistant CFO, Emery Harri, that "there were a lot of people counting on you to make things happen this quarter. Were expecting big things, you know. If you don t lay down for the family, you'll get whacked". The employee who testified explained that accounting staff would meet regularly to discuss ways to artificially inflate HealthSouth's earnings. He described these meetings as "family" meetings, and the attendees were known as the "family" (Hamilton, 2008).
Employee selection and Placement: HealthSouth was very strategic in selecting its employees in the accounting and finance department. HealthSouth recruited employees with extensive education, accounting experience and past success. For instance, CFO, William Owens, was previously employed by Ernst and Young. These employees were a good fit for the company's family based culture and were knowledgeable about what auditors would look for during the audits.
Weak Board of Directors: The close relationships that existed between some board members and HealthSouth was also seen by many as the reason why the board members failed to conduct inquiries of Scrushy or any of his decisions. A great number of critics stated that Scrushy's allies dominated most of HealthSouth's board and that this lack of truly independent directors contributed to the financial fraud. For example, a longtime director, Dr. Phillip C. Watkins, co-owned a Florida based vacation home with Scrushy (New York Times, 2002). In other words, HealthSouth's Board of Directors had the ability, but failed to control the conduct that ultimately led to the fraud at HealthSouth.
In addition, several board members were investors in companies that HealthSouth acquired or did business with. For instance, C. Givens had been a member of the auditing committee on the HealthSouth board since 1985. In 1995, Givens founded her own company, Acacia Venture Partners, and HealthSouth was one of the first to invest in it. HealthSouth made an initial investment of $3.5 million in Acacia Venture Partners (New York Times, 2003). The appropriateness of these types of financial relationships has been questioned, particularly whether they look after their own interests or shareholders' benefits.
Auditors' understandbility of responsibility: During the trial of HealthSouth, Ernst and Young argued that they had followed due diligence in auditing. The auditors argued that they met the satisfactory requirements of a series of generally accepted steps in examining HealthSouth financial results, but did not analyze beyond stated steps. Regardless of red flags indicating fraudulent accounting practices, Ernest & Young failed to notify the board of directors as they were more focused on completing the satisfactory auditing steps, ignoring the detailed procedure. For example, it was unlikely that a company like HealthSouth whose revenue depended on its account receivable collection, did not account for bad debt expenses. Bad debt expenses are unavoidable in health care services. The auditors' inability to understand the simple relationship between bad debt expense and the health care industry allowed for the fraud to continue for a long period of time. Although Ernst &Young's chairman, James Turley, continued to argue that "even the best audit may not detect a collusive effort designed to hide things from the auditors," the auditors inability to understand the detailed procedure of examining other documents allowed for unsatisfactory behaviour even though the complete accounting procedure was performed (Schneider, 2003).
Fiasco in Health South: Result focused Causes
Shareholders Emphasis on Revenue: According to Jared Harris, and Philip Bromley, "companies that turn in a very good year have a propensity for faking numbers the next yearâ€¦" (Uco, 2005) and HealthSouth investors fell into this trap. HealthSouth shareholders comprised of investors' whose primary interest was the company's revenue projections rather than its overall performance as a company. When HealthSouth went public in 1986 the company's revenue was one of the highest in the health/rehabilitation industry and this attracted a large number of investors. To increase their return, investors continually expected high revenues and management felt obliged to meet expectations.
Management Compensation: Like many corporate scandal in the United States, management bonuses and compensation is a driving force behind the manipulation of financial records. During congressional hearings, employees of HealthSouth described Richard Scrushy is as an American CEO that believed he would be the highest paid CEO in United States history. Scrushy received a total compensation package of $11Million despite the charges placed on the company's management (Chaubey, 2006). In 2001, Scrushy collected $3.96M in salary entitlement, $6.5M for reaching agreed sales targets and $1.2M in stock options (see table 1 for breakdown). The lack of control around management incentives at HealthSouth allowed for dubious behaviour and the board of directors failed in establishing a mechanism that prevented fraud (NewYork Times, 2005). According to Borden (2003), when the board of directors linked large management incentives with ambitious revenue goals, they were asking for trouble.
Table 1- Scrushy's Remuneration From 1996-2002
Auditors' Conflict of Interest: The failure of Ernst & Young to deliver truly unbiased report to HealthSouth investors was a primary driver to HealthSouth management fiasco. Ernst & Young overlooked HealthSouth's management incentives to achieve short-term financial returns because of the other profitable business it had with HealthSouth. Ernst & Young were not only HealthSouth auditors, but also provided non-auditing related services to HealthSouth. Between 2000 and 2001, E&Y provided janitorial, cleanliness and physical appearance inspection for all HealthSouth locations in the United States. To protect their business interest in Ernest and Young, researchers argue that the auditors were in a dilemma and compromised on their independent financial monitoring obligation. Ernst &Young provided a clean bill of health to HealthSouth, which HealthSouth executives used in defending their large compensation packages and investors confidence (Chaubey, 2006). Table 2 shows the overstatement of HealthSouth's earnings, approved by Ernst & Young.
Table 2- Overstated Earnings
Income (Loss) before Income Taxes and Minority Interests (in $ millions)
For 6 Months ended June 30, 2002
Source: COMSATS INSTITUTEOF INFORMATIONTECHNOLOGY
Power of Wall Street's voice: Aaron Beam, in his book argued that the fraud was encouraged because Wall-Street's voice was so strong that it was impossible for Scrushy to disappoint analysts. According to Beam, lenders and investment bankers would constantly call the company asking for revenue projections and stressing the importance of not failing to meet expected projections. This pushed management to make unrealistic projections to secure loans and cash from share sales. This was particularly important to secure loans for planned mergers, acquisitions and facility expansions.
Evaluation of HealthSouth's MCS
What Was Desired? In order to effectively evaluate HealthSouth's management control systems, it is important to understand what management desired. In HealthSouth's case, management was focused on meeting revenue targets and increasing the company's stock price.
Key Actions to Achieve Desired Results
To achieve success, the desired actions should have involved key strategies such as providing high-quality, cost-effective health care services; effectively marketing services to large payors and patients; expansion of HealthSouth's National Network; and attracting and retaining high-quality personnel. However, because of the CEO's desire to achieve revenue targets through illegitimate means, HealthSouth focused on manipulating the numbers and forging supporting documents to manage the auditing trail.
Results Controls Evaluation
Pay For Performance
Result controls in the form of large executive compensation made it extremely lucrative for the executives to meet net income targets. The 1990's was a time of economic prosperity in the US and investors were quite careless in what factors they looked at when investing in companies. As long as HealthSouth could achieve these net income targets they could continue to raise capital to expand their operations.
Lack of congruence between Results Controls and Strategic Objectives
Implementation of results controls has four steps: defining performance dimensions, measuring performance, setting performance targets, and providing rewards for meeting those performance targets. In the case of HealthSouth, the most relevant element to consider is the performance dimensions for the executives. The Compensation Committee provided huge cash bonuses to executives who contributed to the performance dimension by meeting investors' expectations for revenue growth (1). Meanwhile, the company's 1999 annual report stated that the primary elements of the company's strategy were to implement their integrated service model in appropriate markets; successful marketing to managed care organizations and other payors; provision of high-quality; cost-effective healthcare services; and expansion of national network (2). Therefore this key performance dimension of meeting investors' revenue expectations was clearly not in congruence with the overall strategic objectives of the organization and when this happens, the people who work within these dimensions are encouraged to do wrong things. This resulted in what's known as behavioural displacement and in HealthSouth's case it resulted in huge indirect costs once the scandal was discovered. Behavioural displacement happens when the MCS encourages unwanted behaviour that is not in line with the organizations strategy and objectives. Behavioural displacement occurs typically occurs because of either management's poor understanding of desired results or tendency to focus on concrete and quantifiable results (3). In this case it was because management had a poor understanding of desired results. Management was too focused on meeting "Wall Street" expectations when they should have worked towards improving more important success factors such as liquidity, return on assets, quality of service, reducing operating costs, strengthening brand recognition, etc.
Tone at the Top Encouraged Accounting Fraud
HealthSouth's culture was primarily shaped by the type of cultural control known as Tone at the Top. This strong cultural control established by the charismatic CEO, Richard Scrushy, instilled fear and intimidation in senior executives and board of directors. Employees were told what to do, when to do it, and how it should be done. This prevented other employees from questioning the decisions of the executives. Intimidation and fear were shared norms that were part of the MCS at HealthSouth and these conditions created an environment that was conducive to committing fraud.
Group Rewards Encouraged Misconduct
Group rewards were a form of cultural control that existed at HealthSouth. The group rewards were the bonuses that were paid if the departments met Scrushy's suggested profit targets. Motivation to achieve these rewards was not the main force that was affected by this cultural control. Mutual monitoring and communication of expectations were the forces that were positively affected the most by this cultural control. This is normally a desirable and positive effect, but in the case of HealthSouth, the bonuses only ensured that employees and management monitored each other so that the company could fool shareholders and the general public.
Action Accountability Ensured Accounting Fraud was Conducted with Precision
HealthSouth's management executed action accountability controls flawlessly. They defined, communicated, and tracked the actions that employees took with respect to fraudulently adjusting entries, invoices, and support documents.
HealthSouth has to re-evaluate its current business processes and conduct. The redesigned management control system should be designed to align management and employee actions to the organizations strategies to attain desired results as well as ensure that the company personnel are acting in the best interests of its shareholders. See exhibit 2 for actions taken by the company after the scandal in comparison to our recommendations.
Reinforce Code of Conduct
HealthSouth should revamp its code of conduct and create a set of best practices that would guide employees to properly perform their duties. Employees must properly understand the importance of following the code of conduct and applying it to their daily responsibilities. This business code of conduct should be framed and placed around offices, and facilities where customer and employees can see it, understand it, and use it. Furthermore employees should have to sign a statement stating that they have read and understood the code of conduct.
HealthSouth should help employees understand new values and ethical business conduct by offering seminars, online courses related to ethics, town hall meetings organized by executives, and a manual on whistle blowing.
Implement Balanced Scorecard
Introduce Kaplan and Norton`s balanced scorecard that will include a combination of performance measures that will allow management to focus on both financial and non-financial targets (Pg 473). From a financial perspective HealthSouth`s results controls should be redesigned to stop focusing on Wall Street`s net income expectations and focus more on improving operating income and ROE. From a customer perspective a results controls should be designed to help HealthSouth`s management focus on improving the rehabilitation time of customers and increasing overall patient satisfaction. From an internal, innovation and learning perspective, results controls should also be designed so that management focuses on improving operating efficiency with respect to the care services HealthSouth provides. Bonuses should be awarded based on all of these performance measures in order to align management`s actions and motives with that of the shareholder and overall well-being of the company.
Changing Board of Directors
Board of directors that had vested interests in the company and or were affiliated with HealthSouth personnel should be removed and replaced. This should allow for more transparency and will help towards building investor confidence.
Application of GAAP
HealthSouth also needs to examine and review the company's current accounting practices and properly apply GAAP where it was not applied before.
Giving More Independence to Auditors
There were specific communication processes between employees and external auditors during the scandal. Any concerns from the auditors had to be addressed by two specific managers. External auditors should be allowed to speak with anybody that they need to speak with to ensure a proper audit. Internal auditors should also be independent and should not have to report to the CEO.
Table 3 - Group Recommendation VS. Company's Actual Actions
Source: Grant Thornton LLP
Health South's Actual Actions
Reinforce Code of Conduct
Modified its corporate governance guidelines and charters in order to conform
Implement Balanced Scorecard
Research shows no evidence of the implementation of balance scorecard
Changing Board of Directors
Removed a number of Board of Directors that had business dealings with the CEO and company
Application of GAAP
Conducted review of GAAP's applicability and implemented missing principles
Giving More Independence to Auditors
Company switched to KPMG and gave more independence to them as well as internal auditors
Management controls is an extremely important area in a company that can often be overlooked. Most financial frauds that have happened in history are a result of failed management control systems. HealthSouth is an example of a company that had a flawed internal control system. Due to the failure of HealthSouth's internal control system, senior management was able to enrich themselves at the expense of shareholders.
The CEO created a culture of fear in the organization which encouraged employees to collaborate with each other to commit fraud. The company emphasized the importance of meeting Wall Street's financial expectations to maximize management bonuses and meet debt covenants. This failed management control system lasted for almost a decade. This was made possible because auditors failed to fulfill their fiduciary duties; the board of directors created strong alliances with the CEO; management compensation was tied to net income; and the market emphasized unrealistic revenue expectations.
HealthSouth survived this scandal but to prevent a similar incident from occurring, the company needs to reinforce a new code of conduct that enforces a strong ethical tone from the top and creates a set of best practices that would guide employees to properly perform their duties. Management should create and implement a balance scorecard that emphasizes aspects of the business other than just the financial perspective. All Board of directors must be independent with no formal ties to the CEO or the company. Accountants must be trained to understand GAAP and all of its fundamental principles.
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