ACTIVITIES AND COMPLEMENTARY READINGS No.

CASE No. 1
A “Clean Audit” for HealthSouth
What is an assurance service? What is an audit-related service?
Ernst & Young (E&Y) were the independent auditors of HealthSouth between 2000
and 2002. They also conducted janitorial inspections of the company’s facilities.
These inspections were called “pristine audits.” E&Y advised HealthSouth to classify
the payments for “pristine audits” as “audit-related fees.”
HealthSouth, headquartered in Birmingham, Alabama, USA, is the largest provider
of outpatient surgery, diagnostic and rehabilitative healthcare services in the USA
with approximately 1,800 worldwide facilities in the USA, Australia, Puerto Rico, and
the UK. Its former CEO, Richard M. Scrushy, is under an 85-count federal indictment,
accused of conspiracy, securities fraud, mail and wire fraud, and money laundering.
(SEC 2003) A US government indictment charged that between 1996 and 2002
HealthSouth managers, at the insistence of Scrushy, inflated profits by $2.74 billion.
Scrushy certified the HealthSouth financial statements when he knew that they were
materially false and misleading.
On November 4, 2003, he became the first CEO of a major company to be indicted
for violating the Sarbanes-Oxley Act, which holds executives personally accountable
for their companies’ financial reporting. (Business Week 2003).
Six months elapsed from the start of the SEC’s investigation to the filing of its fraud
suit against Scrushy in March 2003. It took just seven weeks, from March 19 to May
5, for the US Justice Department to accumulate 11 guilty pleas from Scrushy aides.
All five CFOs in the company’s history have admitted to cooking the books. (Helyar
2003) Pristine Audits Scrushy devised a facilities inspection program called “Pristine
Audits” and hired E&Y to do the work. The primary purpose of the inspections was
to check the cleanliness and physical appearance of HealthSouth’s surgical and
rehabilitation facilities. Under the program, E&Y made unannounced visits to each
facility once a year, using dozens of junior-level accountants who were trained for
the inspections at HealthSouth’s headquarters. For the most part E&Y used audit
personnel who were not members of the HealthSouth auditengagement team to
conduct the pristine audits.
The accountants carried out the reviews using as criteria a 50-point checklist
designed by Mr. Scrushy. The checklist included procedures such as seeing if
magazines in waiting rooms were orderly, the toilets and ceilings were free of stains,
and the trash receptacles all had liners. Other items on the checklist included: check
the walls, furniture, floors and whirlpool areas for stains; check that the heating and
cooling vents “are free of dust accumulation;” that the “floors are free of trash;” and
that the “overall appearance is sanitary.” A small portion of the checklist pertained to
money matters, though none of it pertained to accounting. Assignments included
checking if petty-cash drawers were secure and company equipment was properly
tagged. The checklists did not cover insurancebilling procedures or the quality of the
medical treatment. (Weil 2003a) In 2002 E&Y ended their relationship with
HealthSouth, and HealthSouth discontinued the pristine audits.

Describing the pristine audits, Mr. Scrushy told an investor group: “We believe one
of the reasons that we have done so well has to do with the fact that we do audit all
of our facilities, 100 percent, annually. And we use an outside audit firm, our auditors,
Ernst & Young. They visit all our facilities, 100 percent.” On its website, HealthSouth
said the pristine audit, “administered independently by Ernst & Young LLP ... ensures
that all of our patients enjoy a truly pristine experience during their time at
HealthSouth. The average score was 98 percent, with more than half of our facilities
scoring a perfect 100 percent.”
E&Y Fees Charged HealthSouth HealthSouth’s April 2001 proxy (form DEF14A),
filed with the SEC, said the company paid E&Y $1.03 million to audit its 2000
financial statements and $2.65 million of “all other fees.”
The proxy said the other fees included $2.58 million of “audit-related fees,” and
$66,107 of “non-audit-related fees.” In its April 2002 proxy, HealthSouth said it paid
E&Y $1.16 million for its 2001 audit and $2.51 million for “all other fees.” The proxy
said the other fees included $2.39 million for “audit-related fees” and $121,580 for
“non-audit-related fees.”
Neither proxy described in any detail the audit-related or non-audit-related services
for which E&Y was paid. Andrew Brimmer, a HealthSouth spokesman, was quoted
as saying the “audit-related-fee” figures for each year included about $1.3 million for
the pristine audits. Mr. Brimmer said HealthSouth paid E&Y $5.4 million for 2002,
including $1.1 million for financial-statement audit services and $1.4 million for the
pristine audits.
(Weil 2003a) Pristine Audits as “Audit-Related Fees”
A March 2002 E&Y report to HealthSouth’s Board of Directors included an
attachment that summarized E&Y’s fees and provided a suggested “Proxy
Disclosure Format.” The attachment classified the pristine audits as “audit-related
services” and the fees for them as“audit-related fees.”
(Weil 2003a) David Howarth, a spokesman for E&Y is quoted as saying: “The audit-
related category is not limited to services related to the financial statement audit per
se. At the time of
HealthSouth’s disclosures, there were no SEC rules that defined audit-related
services.
Describing operational audit procedures as audit-related services was reasonable.”
Howarth claimed that SEC ruled that audit-related fees would include assurance
services traditionally performed by the independent auditor, including “internal-
control reviews.” He maintained the pristine audit was an internal control review.
“Under the new SEC rules adopted in response to the Sarbanes-Oxley Act, these
(internal control review) fees are specifically mentioned as ones that should be
included in audit-related fees.”
(Weil 2003b) After the Weil 2003b article appeared, Scott A. Taub, the Deputy Chief
Accountant of the SEC wrote a letter to E&Y partner Ed Caulson. Taub wrote: “The
Commission’s current rules state that registrants are to “disclose, under the caption
Audit-Related Fees, the aggregate fees billed in each of the last two fiscal years for
assurance and related services by the principal accountant that are reasonably
related to the performance of the audit or review of the registrant’s financial
statements.” (emphasis added) It is clear from a reading of the release text and
related rules that the Commission’s intent is that only fees for services that are
reasonably related to the performance of an audit or review of the financial
statements and that traditionally have been performed by the independent
accountant should be classified as audit-related.”(Taub 2003)

What criteria would the pristine audits have to meet to be considered an audit
engagement?
■ What criteria would the pristine audits have to meet to be considered “audit-
related”?
■ Can the pristine audits be considered an assurance service? How does the pristine
audit meet the five criteria required to qualify an engagement as an assurance
service?

References

Business Week, 2003, “Sarbanes-Oxley’s First,” p. 52, November 17.

Helyar, J., 2003, “The Insatiable King Richard; He started as a nobody. He became
a hotshot CEO. He
tried to be a country star. Then it all came crashing down. The bizarre rise and fall
of HealthSouth’s
Richard Scrushy,” Fortune, p. 76. July 7.
SEC, 2003, Litigation Release 18044, “SEC charges HealthSouth Corp., CEO
Richard Scrushy with $1.4
Billion Accounting Fraud,” US Security and Exchange Commission, March 20.
Taub, S., 2003, Letter to Ed Coulson, Partner Ernst & Young, Office of Chief
Accountant, US Security
and Exchange Commission, July 8.
Weil, J., 2003a, “What Ernst Did for HealthSouth – Proxy Document Says Company
Performed
Janitorial Inspections Misclassified as Audit-Related,” Wall Street Journal, June 11.
Weil, J., 2003b, “HealthSouth and Ernst Renew Flap Over Fee Disclosures,” Wall
Street Journal, July 1.