Sick Case of HealthSouths Accounting Fraud Case Study

Sick Case of HealthSouths Accounting Fraud Case Study
Read the “Sick Case of HealthSouth’s Accounting Fraud” attached No.1. Please perform a case
analysis that answers the following questions:
1. Which one from the five main categories financial fraud schemes were employed? How were
they employed? (The five main categories of financial statement fraud schemes: (1) fictitious
revenues, (2) timing differences, (3) concealed liabilities and expenses, (4) improper
disclosures, and (5) improper asset valuations.)
2. Look at the financial statements and perform a financial statement analysis (vertical,
horizontal, and ratio analysis). Include these calculations in your paper. Please comment on
the items that raise red flags and should have been investigated in detail.
3. Please explain the improper accounting management employed to commit the financial
statement fraud. What were the fraudulent entries? What entries should have been recorded?
Example:
Incorrect:
Cash
Correct:
$$
Bad Debt Expense
Bad Debt Expense
$$
$$
Allowance for Doubtful Accounts$$
4. What were the red flags of this fraud?
5. How the auditors could have uncovered the fraudulent behavior if proper procedures were
performed (What steps should the auditors have taken to be able to uncover these frauds? You
can find these steps in attached No.2
6. What were managements’ sanctions at the end of the case? Prison sentence? Fines? Both?
Concealed Liabilities and Expenses
X. CONCEALED LIABILITIES AND EXPENSES
Liabilities represent obligations a company has to outside creditors or other groups, such as employees.
In addition to debt, pensions promised to retired workers and stock options paid to current employees
are held on the books as liabilities. Readers of the financial statements tend to look unfavorably at
companies with liabilities that outweigh assets or overly burden the company’s future earnings.
Consequently, if a company had high amounts of debt, management might try to conceal the debt or
keep it off the books. Additionally, to increase net income, management might omit expenses from the
company’s income statement.
Management might decide to either fail to record liabilities or expenses, or find ways to conceal them
using accounting tricks.
When management conceals a liability or an expense, the company’s equity, net assets, or earnings are
fraudulently inflated. Fraud is perpetrated both by wrongly recording expenses and liabilities, and by
omitting disclosures of potential liabilities that are not yet required to be recorded.
The following are schemes management may use to omit or conceal liabilities and expenses:
• Failure to record liabilities or expenses
• Omission of contingent liabilities for warranties, products, or environmental costs
• Use of off-balance sheet entities to conceal liabilities or expenses
Video
In the video titled “Chapter X: Concealed Liabilities,” anti-fraud expert Gerry Zack, CFE, CPA,
CIA, describes common categories into which concealed liability schemes fall. Mr. Zack is a
managing director in the Global Forensics practice of BDO Consulting. (Go to
www.acfe.com/DetectAndPreventFSF to view the video.)
Failure to Record Liabilities or Expenses
Management commits fraud when it purposefully fails to record liabilities, or amounts that the company
owes to others. Likewise, intentional omissions of expenses from the financial statements are also
fraudulent.
Liabilities can be fraudulently manipulated by either understating the total amount owed or omitting the
liability completely. By not reporting the full amount of liabilities, management makes the company
appear to be more solid, with a healthier debt-to-equity ratio on the balance sheet. Similarly,
How to Detect and Prevent Financial Statement Fraud
179
Concealed Liabilities and Expenses
management might omit or understate expenses so that net income is falsely overstated, further
affecting the overstatement of retained earnings.
Management conceals liabilities and expenses on its financial statements using various techniques. The
following are the most common methods employed in this scheme:
• Omitting liabilities or expenses
• Reporting revenue rather than a liability when cash is received
Omitting Liabilities or Expenses
Companies might do something as blatant as stuffing requests for payment into a desk drawer,
effectively failing to record the expenses. Most often, however, expense or liability omission relates to
disregarding accounting principles. For instance, when a service is performed or goods are received before
they are paid, the amount due should be accrued. The unpaid amount that is accrued at the end of the
accounting period is recorded as both an expense against the income for the period and a liability on the
balance sheet (e.g., accrued expenses or accounts payable). Companies that want to fraudulently increase
net income and equity may omit the accrued liability from their books.
EXAMPLE OF OMITTED EXPENSES
According to a March 2002 SEC litigation release, waste hauler Waste Management, Inc. reported
fraudulent earnings for the years 1992 through 1997. The company’s management engaged in various
schemes and activities. A primary source of what became a $1.8 billion scheme to increase earnings was
the practice of not recording current expenses, but netting the deferred expenses against one-time gains in
future periods.
First, the operating results were recorded by the company’s many operating units, known as “Groups,”
using one set of assumptions. Then, top management made after-period adjustments to the consolidated
numbers to match earnings targets set by the company CEO, CFO, and president. Many of what it
referred to as “top-level adjustments” occurred in the results of the subsidiary managed by the president,
which accounted for approximately 70% of the company’s reported earnings. To meet the stated goals,
managers failed to record expenses for decreases in the value of landfills as they were filled with waste, failed
to write off the costs of impaired and abandoned landfill development projects, and established inflated
environmental reserves in connection with acquisitions so that excess reserves could be used to avoid recording
unrelated environmental and other expenses.
Detecting Omitted Expenses and Liabilities

180
Search for unrecorded expenses and liabilities. A test that is traditionally used to detect liability
understatement, which invariably identifies expense understatement, is called a search for
How to Detect and Prevent Financial Statement Fraud
Concealed Liabilities and Expenses



unrecorded liabilities. The objective is to identify obligations that should have been recorded at the
balance sheet date, as well as their related expenses. This procedure is a cut-off test whereby
vendors’ invoices, receiving documents, and cash disbursements are examined to determine that the
liability and related expense are recorded in the proper period. The following are the steps
undertaken in the search for unrecorded liabilities:
‒ Examine the subsequent period’s cash disbursement detail and select items that have large dollar
amounts or are questionable (e.g., checks to related parties or round dollar amounts).
‒ Examine each item’s supporting documentation, usually consisting of the vendor’s invoice,
receiving reports, and check copy payable to the vendor, and determine when the liability was
incurred.
‒ Trace these items to the accounts payable subsidiary ledger on the balance sheet date. Those
items that are not on the ledger, but should be, are unrecorded liabilities. Unrecorded liabilities
usually mean unrecorded expenses. Do not forget that companies may also overstate liabilities
and expenses by recording items in the current period that should be recorded in the subsequent
period.
‒ Examine the open invoice file. This file comprises invoices that have not been paid. When
examining this file, the objective is to identify invoices that should be recorded as of the balance
sheet date, but that by error or intent have been omitted from the accounts payable detail. The
key question when examining invoices is: When were the goods or services received? The
invoice date, as well as the due date, may be January 20X2; however, if the goods were received
in December 20X1, as indicated by the receiving date, then the expense and payable should be
recorded in December 20X1.
Examine subsequent disbursements. Companies with cash flow problems often hold checks issued
against their accounts payable. By doing so, they remove the liability from their books; however, the
liability is not actually extinguished as long as the company still has custody of the check. This
scheme is detected by examining the checks clearing subsequent to year-end. For example, a check
with an early December 20X1 date that clears the bank in February 20X2 might indicate check
holding. If check holding is suspected, question personnel in charge of cash management.
Confirm liabilities with vendors. Confirmations are sent to vendors with whom the company has
done a relatively large amount of business. The fraud examiner is concerned with what should be
recorded rather than what is recorded. Therefore, confirmations are sent to vendors who do the
most business with the company, regardless of whether they have large balances, or zero or small
balances.
Examine minutes. Examine minutes of the board of directors meetings, contracts, loan and lease
agreements, etc., to detect unrecorded liabilities. Verify that the liabilities indicated in the minutes
and other documents are properly recorded on the books. Reading the minutes of the board of
directors meetings might help a fraud examiner to detect an unrecorded dividend payable.
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Concealed Liabilities and Expenses




Identify related parties. Identify all related parties because liabilities may be hidden via hidden-party
transactions or moved to related parties’ books.
Examine vendor complaints. Determine if there is a vendor complaint file in the purchasing or
procurement department, and check to see if vendors have been complaining about not being paid
on a timely basis. This may indicate failure to record amounts owed to vendors in the company’s
accounting system, resulting in late payments.
Calculate the current ratio. Calculate the current ratio (current assets/current liabilities) and compare
it to those of other accounting periods and to the industry average. An unreasonably high current
ratio might indicate the concealment of current liabilities.
Examine SOX Section 404 documentation. Review controls for points of weakness, especially those
where management could have overridden existing controls. Check to see whether any requests that
depart from company policies and controls have been made of division managers. In the case of
Waste Management, for instance, the changes made to division accounts after the books were closed
involved management override of company policies that were designed to comply with accounting
regulations.
Reporting Revenue Rather Than a Liability When Cash Is Received
As discussed in the section describing premature revenue recognition, some sales transactions occur
over an extended period of time. When a customer pays cash for goods or services that have not been
performed by the seller, the seller should record a liability. This liability is called deferred revenues, or
unearned revenues. Unearned revenues are expected to become revenues upon completion of the sale of
the goods or performance of the services. Companies that record revenues upon receipt of cash for
goods that have not been transferred or services that have not been performed fraudulently conceal
their liabilities and overstate their revenues. In the example of NetEase from the revenue recognition
chapter, had the company recorded the payments received for the second portion of the advertising
contracts as liabilities, the actions would have complied with accounting principles.
Detecting Unearned Revenues Recorded as Sales

182
Examine cash receipts. Select large cash receipts, especially those near year-end, and determine when
the sale was consummated. A copy of the customer’s check is usually attached to its sales invoice
and shipping documentation (the invoice package). Examine the invoice package to identify the date
the sale was completed and the date of the check. Note that check dates usually are not the date that
the seller received the check. The fraud examiner should, therefore, review the deposit slip to
determine when the seller received the cash. Checks are often deposited the day they are received.
For example, if a check is dated December 25, 20X1, the deposit slip is dated December 29, 20X1,
and the shipping document is dated January 2, 20X2, then a liability should be recorded at year-end.
How to Detect and Prevent Financial Statement Fraud
Concealed Liabilities and Expenses

Review invoices for terms of sales. Clues to fraud in which unearned revenue is not recorded as a
liability can be found on the invoices. If the terms do not comply with accounting principles for the
type of sale, check to see that the payment not yet earned is recorded as a liability.
Omission of Contingent Liabilities for Warranties, Products, or Environmental Impacts
Fraudulent accounting for contingent liabilities generally takes one of the following forms:
• Failure to record contingencies
• Omission of warranty liabilities
• Omission of product liabilities
• Omission of environmental liabilities
Failure to Record Contingencies
Companies often like to downplay the significance of contingent liabilities that might have a decisive
influence on the company’s value. For example, if a company is facing a large class action suit or an
environmental hazard suit, the company’s entire net worth might be at risk. For this reason, companies
may attempt to conceal contingencies.
A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to a
possible gain or loss to an enterprise that will ultimately be resolved when one or more future events
occur or fail to occur. An estimated loss from a loss contingency is charged to income, and a liability is
incurred if:
• It is probable that an asset has been impaired or a liability has been incurred at the date of the
financial statements.
• The amount of the loss can be reasonably estimated.
If both of these conditions are met, the organization must deduct the amount of the estimated loss from
income and record the amount as a liability. When a contingency is probable, an estimate of the loss is
within a range of amounts, and no amount in that range appears to be a better estimate than any other
amount, then the minimum amount in the range is accrued and the estimated range of potential loss is
disclosed in the notes to the financial statements. If no accrual is made for a loss contingency due to one
or both of the previously mentioned conditions not being met, but it is reasonably possible that the loss
may occur, then disclosure is required. The nature of the contingency and an estimate of the loss or
range of loss are required.
The most common types of contingent liabilities disclosed in the financial statements are related to
litigation and guarantees. A company sometimes guarantees a loan for another company, a supplier, or
an affiliate. These guarantees create an obligation for the company to pay the loan in case the borrower
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Concealed Liabilities and Expenses
defaults. The fraud occurs when the company fails to disclose the contingency, thus understating its
liabilities. For instance, assume that it is probable that the company is about to lose a lawsuit and will
have to pay $500,000. Since both of the conditions to accrue a contingency loss are present, the
following entry should be made:
Date
Description
Ref. Debit Credit
800 $500,000
12/31/X1 Loss from Litigation
Estimated Litigation Liability 450
$500,000
To accrue loss from litigation
If the company fails to make the proper entry to record the contingency, then the liabilities will be
understated and the income overstated.
Detecting Unrecorded Contingencies


Question management. Ask management about any contingencies, either recorded or unrecorded.
Inquiries should be followed by a review of the minutes of board meetings to discover if the
company has guaranteed the indebtedness of others. Regarding litigation, ask management whether
there have been any lawsuits filed against the company. Follow up by inquiring of the company’s
legal counsel if litigation exists. If litigation does exist, then the auditor should have the lawyer
evaluate the outcome of the identified litigation and offer an estimate of the contingent loss or the
range of loss. This contingent loss should be disclosed in the financial statements. Also, ask the
lawyer to identify the dollar amount of services rendered to the company that have not been paid.
Once determined, verify that the liability is recorded.
Examine the legal expense account. Examine the general ledger detail of the legal and professional
expense account. If there are numerous or large legal expenses, this could be a sign of litigation. Ask
management and the company’s legal counsel for the details of these transactions.
Omission of Warranty Liabilities
Companies often grant their customers a warranty on a product, such as a warranty on an automobile.
Estimated warranty costs should be recognized at the same time the revenue is recorded. When the
warranty expense is recorded, the corresponding warranty liability should also be recorded. For example,
if a company offers a five-year warranty on a car’s transmission, then the company is liable for repairing
a defective transmission for five years. After the five-year term is exhausted, if no expense related to that
customer’s transmission has been incurred, the liability can be removed from the books. If a company
does not record a warranty liability, it is understating its liabilities and overstating its net income.
184
How to Detect and Prevent Financial Statement Fraud
Concealed Liabilities and Expenses
EXAMPLE OF WARRANTY LIABILITY CONCEALMENT
Sunbeam Corp.’s “Other Current Liabilities” account mysteriously dropped by $18.1 million in 1997.
According to individuals close to the company, various reserves for product warranties and other items set
aside in 1996 were conveniently drained down in 1997, resulting in an additional $25 million or so in
net income for the year.
Omission of Product Liabilities
A product liability is a liability that results from selling defective products to customers. If a company is
cognizant of the fact that one of its products is defective, a product liability should be established.
Failure to do so not only keeps essential information away from the company’s financial statement
readers, but also fraudulently misrepresents net income and equity by understating the liability and
expense. Companies are aware that reporting a product liability is an automatic red flag to both
consumers and investors. Through concealment of a product liability, a company, for the time being,
can avoid potential financial disaster and lawsuits. In the long run, however, companies may face
product liabilities so great that they are forced into bankruptcy due to their insolvency caused by the
publicity of the product liability.
EXAMPLE OF OMITTED PRODUCT LIABILITY
Pfizer, Inc., a research-based company dealing in pharmaceuticals, medical devices, and surgical equipment,
reportedly knew that its Shiley heart valve was troublesome; therefore, Pfizer took the product off the
market. Unfortunately, 60,000 valves had already been implanted. By the time a class action lawsuit …
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