Type of Financial Fraud
One of the most comprehensive ways of valuing a company is through a stock exchange. Here, investors assess the company based on intensive research, with the view of determining whether or not to invest in the specific company. It is for this reason that financial particulars of any publicly traded company must be available for scrutiny all the time. If these records show that the company is failing, investors will dump their stock in the company with adverse consequences. HealthSouth Corporation, a company publicly traded under the name HLS at the New York Stock Exchange loathed negative publicity because of the aforementioned repercussions on its stocks (Weld et al, 2004). Its founder Richard Marin Scrushy, therefore, instructed the accounting department to create fictitious accounts that showed the company to be financially healthy when it was not. This was done through creating fictitious sales and revenue streams which in many cases would be up to 4700% of actual earnings. Indeed, there were times when the company would owe more federal taxes than the company’s actual earnings, due to the fictitious entries. Based on the false information, investors continued placing their money in HealthSouth believing it to be secure when the company was on the verge of failure.
Red Flags
HealthSouth’s books were being handled by Ernst & Young, one of the most reputable auditors in the world. The relationship between the two organizations was placed under intense scrutiny for a considerable duration of time. This scrutiny was undertaken by formal regulators during a formal inquiry inter alia by the Securities and Exchange Commission. It was also the subject of investigations by federal and state law enforcement authorities during the several criminal investigations and trials that HealthSouth management, including its founder, were put through. Finally, the investigation was also the subject of resilient litigators during a successful case against the founder Richard Scrushy (Armstrong & Balch, 2015). In spite of all these investigations, there has never been found any susceptible red flags that the company’s accountants, as well as the investment community at large, would have detected. This creates a suggestion that Scrushy managed a very secretively run organization who effected the fraud very efficiently. However, in 1989, one of the company’s internal auditor had his services terminated and claimed that this was done because he correctly called out the company’s financial situation. This has raised the contention that the signs may have been there but no one looked closely enough.
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How the Scheme Came to Light
Euphemistically, hiding the true financial health of a company is like damming a river. Unless the river is eventually stopped from flowing into the dam, the walls will at one point fail. Stopping the river, in this case, would have meant getting HealthSouth back to profitable ways and this never happened. In 2002, it became clear that the dam will eventually fail and the company must report massive losses (Armstrong & Balch, 2015). This eventuality may not have triggered any investigation had the founder Scrushy not offloaded stocks worth US$75 billion just before the losses were reported. This raised several red flags amongst investors, investment regulators and law enforcement. The investigation that followed triggered the realization of the massive fraud. Secondly, the large share offloading just before revelations of losses came in 2002 when many companies had been found to have committed statement fraud. This factor also contributed towards the decision to investigate HealthSouth and, therefore, reveal the fraud (Armstrong & Balch, 2015). It is, however, worthy of notice that before the massive offloading and loss report, HealthSouth had never even come under suspicion for the fraud it had been perpetrating for years.
Steps to Prevent the Kind of Fraud
One of the greatest lessons that came to the investment community in the aftermath of the 2008 financial crisis is how dangerous trust can be. Indeed, trusting corporations to act ethically was found to be a dangerous trend, hence the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Abid & Ahmed, 2014). The first step, therefore, is to eliminate any element of trust and consistently test anything that looks suspicious. If there are any inordinate particulars within the statement of accounts, the same should attract further scrutiny. Most importantly, if the statement of accounts is always pristine, but only barely, the same must also attract further scrutiny (Weld et al, 2004). Secondly, a business operates in a manner that closely resembles Newton’s third law of motions with a slight twist to reflect that action and reaction are congruent and opposite. For any expenditure, there must be a congruent income or explanation for the lack of it and for any massive income, there must have been a massive expenditure heretofore. Relentlessly investigating any of these trends will definitely enable the realization of a statement fraud as it can never be perfectly camouflaged.
How the Case Differs From Others
The fundamental aspects of the instant HealthSouth case involve investors losing money because of the misconduct of company executives. Two other cases in 2002, the same time HealthSouth was discovered show a great congruency to the instant case albeit with some divergences. The first is the Tyco International PLC where investors lost billions of shillings due to the financial impropriety of the executives (Dyck et al, 2013). Indeed, two of the said executives; CEO Dennis Kozlowski and Mark H. Swartz got extensive prison sentences for the same. The main difference between this case and HealthSouth was that these executives actually took monies directly from the company to the tune of over US$150 million. The other massive scandal at the time was the WorldCom scandal that involved an overvaluation of over US$ 10 billion using the same tactics used by HealthSouth (Dyck et al, 2013). The main difference herein was that internal auditors at WorldCom were able to discover and expose the fraud, thus extenuating the situation.
References
Abid, G., & Ahmed, A. (2014). Failing in corporate governance and warning signs of a corporate collapse. Pakistan Journal of Commerce and Social Sciences . 8(3), 846-866
Armstrong, R. W., & Balch, D. R. (2015). The Tale of Two Cfos : The Banality of Wrongdoing at HealthSouth Corporation. Journal of Legal, Ethical and Regulatory Issues , 18 (2), 71-85
Dyck, I. J., Morse, A., & Zingales, L. (2013). How pervasive is corporate fraud? Rotman School of Management Working Paper No. 2222608. 1-56
Weld, L. G., Bergevin, P. M., & Magrath, L. (2004). Anatomy of a financial fraud. The CPA Journal , 74 (10) 44-49.
