Missing the Red Flags

When the Securities & Exchange Commission on Mar. 19 charged HealthSouth Corp. (HRC ) with faking $1.4 billion in profits since 1999, the question was obvious: Where were the auditors? In a post-Arthur Andersen world, it's surprising that Ernst&Young, the largest audit firm in the country, could have missed one this big. Even Richard P. Wessel, head of the SEC's Atlanta office, seems amazed. "It is shocking that you could have a misstatement of income and revenues of this extent just since 1999," he says. And it may be even worse: The SEC alleges that HealthSouth began inflating its numbers from its start in 1986.

Outside experts say that, in hindsight, there were red flags auditors should have seen. From 1999 to 2001, net income rose nearly 500% even though revenue grew just 5%. And while the WorldCom Inc. and Enron Corp. frauds occurred over a couple of years, Ernst&Young failed to detect this one for about 17 years. "Given the amounts, and how long it went on, it seems the auditors should have uncovered problems with internal controls that would have helped them detect this," says Charles W. Mulford, an accounting professor at the Georgia Institute of Technology.

HealthSouth probably knew how to game the annual audit, analysts note, since then-CEO Richard M. Scrushy had hired a number of senior auditors from Ernst&Young's Birmingham (Ala.) office, including Weston Smith, a former CFO, and the only ex-E&Y employee to be charged. Similar revolving doors between audit firm and client existed at both Waste Management Inc. and Enron. Former SEC chief accountant Lynn E. Turner says that part of HealthSouth's fraud included inflating its cash balances, a maneuver less likely to be detected since many auditors assign younger staffers to check those accounts.

For its part, Ernst&Young officials insist that it's difficult to detect fraud when -- as appears to be the case with HealthSouth -- "it is conducted by a broad swath of management who are using calculated manipulation and falsification of documents to deceive the auditors," argues Beth A. Brooke, global vice-chair. Unlike Arthur Andersen at Enron, Ernst&Young, which was fired by the HealthSouth board on Mar. 31, was not also working as a consultant or getting a premium price on its HealthSouth audits. And so far, there's no sign of document shredding.

By Dean Foust in Atlanta

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