I was a normal kid. I loved riding my bike and being with friends. I never got into any real trouble. My thoughts on December 6 moved forward to college. I made good grades and was extremely involved in extracurricular activities. Lying in bed, my thoughts drifted forward. When I graduated from college, had a job waiting at Ernst & Young. Passed the CPA exam, and for the next five years served as an auditor and specialized in the healthcare industry. I was surrounded by a lot of smart, hardworking people. As is so common with staff within CPA firms, with five years’ experience, my phone began ringing with various job offers.
Then one day, a former colleague called and wanted to have lunch. An opportunity had opened at a small startup company named Healthiness Rehabilitation Corporation. The next day, interviewed with Healthiness’s CEO and Founder, Richard Crush. He was extremely engaging and had a strong vision for the growth of the company. He also talked a lot about making money. I believed it was a great opportunity and accepted the position. The years rolled by and the company became enormously successful. During those years, Healthiness grew from a dozen locations to over two thousand, located in all 50 states and five countries. D risen from a middle-management position to become the company’s CUFF. With a large salary, bonuses, and stock options, I had become financially successful. From the outside looking in, it was a dream come true. But why was I thinking about all of this on December 6? Let me tell you where was. I was not at home in my comfortable bed that night. I was on the top rack of a bunk bed in a federal prison camp, looking at spending the next two years of my life there. All because I had become involved in a $3 billion accounting fraud at Healthiness. Never in a million years would I have imagined being in prison.
After all, I had always done all the “right things. ” How on earth had I become a convicted felon? Simple. I crossed the line. In business and in our personal lives, we are constantly faced with situations of crossing the line. I am not writing about $3 billion frauds, I am talking about everyday life?the small temptations to cross the line are always there. Therein lies the danger. Facing a new line will create trepidation, but may be answered with the simple rationalizations, “It’s not that big of a deal,” “Everyone does it,” “It is Weston L. Smith is the President of Chalklike Solutions, Inc. Blushed Online: June 201 3 901 Smith 902 just this one time,” “l want to get along,” “l want to be a team player. ” The rationalizations may not be clearly defined, but they are there. The biggest problem in crossing a line the first time is that it is so much easier to go back again, or a third, or fourth time. It is like a chalk line on a field. The first time someone crosses it, they are careful not to drag their foot. They go across and then carefully step back to safety. The second time, they may not be as careful and their toe may drag across the chalk.
The third time, it may be worse. That is where I put myself. And over time, I wound up in right field, with no line in sight, wondering how or why I had ever taken that path to begin With. CRITICAL LESSONS Let me be perfectly clear. I am guilty of being involved in a massive fraud. Make no excuses for my poor decisions and choices. Do not blame anyone else for what did, or for the consequences of my actions. I am so sorry to the victims of this fraud, from people whose jobs were lost to investors, and to the families of those who were impacted. My actions were reckless and greedy.
I can never right those wrongs, but hopefully can make this debacle a learning experience for others. What are the critical lessons? Ethics must be internalized. We must take ownership of its principles. There is no such thing as “business ethics. ” Ethics is ethics. The same decisions we make in our personal lives affect our business decisions, and vice versa. Unethical behavior must be recognized at its root level. Facing ethics only at a time of crisis is too late. “Tone at the Top” is crucial to corporate culture. The Tone is actions, not just words.
The consequences of unethical and illegal behavior are real, both for the perpetrator and the innocent. How does a $3 billion accounting fraud occur? How does it start? Why does it start? I promise you that did not just walk into the office one day and say “Ere, let’s commit securities fraud; imagine the fun we will have lying to the SEC. ” I would argue that there are two key elements to most corporate frauds: 1 . Publicly traded companies are not owned by their CEO or management. They are owned by investors, from large institutional holders to someone trading at home on their PC.
Hence, public companies’ management and boards of directors ultimately report to the shareholders. Why do shareholders invest in companies? Typically, not because they are in love with he product, service, or management, but because they are looking for growth or return on their investment. This growth or return will only occur if the company meets Wall Street expectations. Therein lies a key element of many corporate frauds, the incentive to do ‘Achiever it takes” to meet Wall Street expectations. The consequences of satisfying Wall Street are enormous.
Typically, a company that meets expectations will enjoy growth in its stock price, and management will enjoy the fruits of their work. On the other hand, Wall Street demands results. Period. Repeatedly, we see the stock rice plummet for companies that may be profitable, but do not reach Wall Street expectations. The CUFF position has the greatest level of turnover within executive management. 2. An expression we hear frequently is that of “tone at the top. ” Truly, the tone at the top sets the culture of the company. It is important to look at the word tone.
The tone of a company is set by its actions, not by its written policies and procedures. The tone of the company may be normalized through policies and procedures, both written and spoken, but nothing sets the tone more than the everyday actions of the leadership. The tone can shape the mindset Of Issues in Accounting Education Volume 28, No. 4, 2013 Lessons of the Healthiness Fraud: An Insiders View 903 individuals through layers of an organization. Proper and improper tone at the top can be used to inspire, motivate, and invigorate ethical and unethical behavior, respectively.
The real tragedy, however, is not the consequences of unethical behavior upon its participants, but its toll on the innocent. ROOTS OF FRAUD At Healthiness, the fraud began with small numbers and rationalizations. Healthiness was a public company with Wall Street expectations. The first mime that can recall the company cooking the books was over a shortfall of only $40,000 from earnings per share (PEPS) expectations (what I will refer to hereafter as “The Number”). For most public companies, this is nothing more than a rounding amount.
Yet for us, at the time, it was the difference between satisfying or disappointing Wall Street. Healthiness’s CEO, Richard Crush, had no tolerance whatsoever for disappointing the Street. His comments were ‘We are a startup company. We cannot let the Street down. They believe in us. We will catch it up next quarter. ” So the rationalizations began. I did not even work in the accounting department at the time, but worked in a financial area where the work product was heavily relied upon in the preparation of the financial statements. I let the rationalizations affect my work.
Adjustments were made to accounts receivable reserves to make up the shortfall. Was this fraudulent in itself? Maybe, maybe not. Reserves are not black and white. Just like various judgment areas inherent to financial statements of any company in the world, these numbers were estimates. However, whether these entries would be considered fraudulent or not, they set in motion a very dangerous precedent. The company began to “manage” its earnings to meet Wall Street expectations. Yet, even more dangerous for me was the fact that had rationalized why it was okay to begin playing this game.
This was the first step over the chalk line. The early rationalizations were “it is temporary’ and ‘We will catch it up next quarter. ” Yet, we did not catch it up. The company grew and, accordingly, The Number grew. The variance between The Number and our actual earnings grew, as well. Worse yet, my own rationalizations grew. Over the years, we acquired dozens of other companies that ranged in size from less than $1 million to over $1 billion. As part of the acquisition work, we conducted due diligence on these companies. The number of companies who were cooking their own books was staggering.
Since we were playing with our own numbers, we were somewhat capable of finding others’ games. In internal discussions on the deals, we would frequently discuss “what their game” was. Despite whatever we found, 95 percent of the time we would make the acquisition. Crush said many times, “I do not care what you find. If we do not do the deal, someone else will, and then we will have to compete against them. ” More than once, we were pulled off of due diligence, despite adverse findings, because Crush wanted to hurry up and close the deal.
As far as our own fraud was concerned, the darker rationalization I developed through acquisitions was that “everyone does it. ” Indeed, it did seem that “everyone did it,” and by my estimate, over 75 percent of the companies that we acquired had accounting games of their own. With only one exception, the scale of the other companies’ tricks was not as material to their statements as ours, but in hindsight, it was a disturbing testament to the way business was being run. Some of these companies were engaging in “aggressive” accounting versus fraudulent accounting. But is there really a difference?
Our fraud began as aggressive accounting. Businesses can operate aggressively, yet ethically. But is it the job of the accounting department to operate aggressively? Is not it our profession to be the gatekeeper? Whether one calls it aggressive accounting, bad accounting, or fraud, the differences are too fine a line for us to encroach. And the effects can be equally damaging. In my 16 years with Healthiness, We only walked away from One large acquisition due to their accounting improprieties. It was a national company whose revenue as drawn from membership revenue.
To cover up their revenue shortfalls, they consumed their deferred revenue into member Issues in Accounting volume 28, No. 4, 2013 904 revenue like a drunken sailor. In later years, the ruse was uncovered by the Securities and Exchange Commission (SEC), resulting in multi-million dollar penalties (but no criminal convictions). What were the other rationalizations? We frequently talk about the selfishness and greed of fraudsters. Yes, I was selfish and greedy. I understood, from a financial point of view, the rewards that would come along from being part of a “successful” company. Doorstop very well the relationship between meeting The Number and bonuses and the value of stock options. I kept an Excel spreadsheet with the details of my stock options, and I knew at the close of every day what my paper worth was. Had greed become a motivating factor in my life? Yes. However, another rationalization developed that we do not read about very often. It is called the fear of getting caught. Over the years, the fraud grew from a $40,000 shortfall to tens of millions of dollars every quarter. The greed and rationalizations were all there, as the variance grew between The
Number and our actual earnings. Quarter after quarter, we continued to cook the books, thinking and working toward bridging the earnings gap. For over ten years, Richard Crush proudly proclaimed the number of quarters that we had met or exceeded Wall Street expectations. It is easy to say that we put a lot of time into the fraud, but many times more hours were spent trying to figure out how to get out of the hole that we had dug ourselves into?how to fix the operations of the company. But what would happen if we walked into the office one day and decided that we would report actual earnings? We would go to jail.
Simply put, we began operating out of fear. The fear of getting caught. Ending the fraud would expose the very fraud that we were hiding. All types of rationalizations were used to create the fraud, but the fear of getting caught would keep it going for several more years. Can I put a timeline on when went from rationalization to fear? No. My mistake was getting on the slippery slope to begin with. Recently, was on The Crash Davis Show on KLAN in Omaha, Nebraska. Walked Mr.. Davis from the beginning of the fraud through the years, with the line between The Number and actual earnings resembling a ski jump.
A ski jump off of a cliff. He finally said, “Weston, when the number got so big . That when the real greed started? ” I had never been asked that question before. No. The greed began at $40,000, not $40 million or $400 million. The greed began when the numbers were small, and it was our own idiotic rationalizations that led us to believe that it was okay to cross the line. The latter years were absolute fear and reckless living. Living a lie can shatter a life, and that is exactly where had let this debacle lead me. MECHANICS OF THE FRAUD What exactly was the Healthiness fraud? When did it begin?
How was detection by the auditors avoided? Contrary to government and media reports, the fraud did not begin in 1996. That date was only used because of the application of the statute of limitations in the subsequent criminal trial of Richard Crush. I saw the early stages of fraud within weeks of my employment in 1987. Was I personally making entries? No. But I was one of the guys; my fingerprints were not on anything; after all, it was temporary?right? Wanted the company, and Weston Smith, to be successful; I was going to be a team player. Describe the accounting fraud at Healthiness in four stages: 1 . 3. 4. Accounts Receivable Reserves Capitalizations and Acquisition Accounting Mergers and Charges Rabbits pulled Out Of Hats It is important to note that the first three stages above stem from proper accounting principles. The use of accounts receivable reserves, capitalizations, accounting for acquisitions, mergers, and their accompanying charges are all normal business activities with their own sets of rules. Rabbits Issues in Accounting Education 905 being pulled out of hats should stay at the circus. The takeaway is that legitimate accounting policies were abused to perpetuate the fraud. 1 .
Every industry has areas requiring significant judgment in the preparation of financial statements. The use of judgment and estimates in financial statements is a necessary and proper activity. It is such a common practice that the use of estimates is a required disclosure in audited financial statements. In the insurance industry, actuarial estimates Of future losses are a critical area in the establishment of reserves. In construction, the percentage of completion estimate is crucial in the recognition of income. In banking, the valuations of loan portfolios can mean the difference in reporting net income or net loss.
In healthcare, valuation of accounts receivable is a tremendous area of judgment. Imagine going to the doctor’s office and the following week receiving a bill for $450. You may make a $40 copy, and then a month later, your insurance may pay $180. Or they may pay a different amount based on what they see in the chart. The net unpaid amount of $230 is then written off by the doctor. This is a contractual amount, which is initially reserved for as a contractual allowance. Now multiply this transaction times 100,000 similar transactions per week. You get the picture?in healthcare, this is a material amount subject to judgment.
This is the first area that was gamed in making The Number. It was not black and white and was subject to significant judgment. 2. Capitalizations and Acquisition Accounting: Expenditures such as startup costs, which have a future benefit, may be capitalized and amortized, as opposed to being absorbed as an expense at the time of the outlay. This is an important area to understand, as many company frauds have occurred through abuse of this rule. For example, World capitalized $38 billion in normal operating costs in just over one year. The capitalization flowed directly to the income statement in overstated net income.
Accounting guidance allows certain costs to be capitalized since they have value in the future. One of the tenets of accounting is that revenues and expenses be properly matched. With proper capitalization, the value of certain expenditures may be matched with future periods’ corresponding revenues. We began extremely aggressive capitalizations to improve our net income. For example, let us say we had three existing facilities in SST. Louis and opened two more. Certain costs of the two new facilities would legitimately qualify for capitalization.
We would throw the kitchen sink at it. We capitalized all costs of the new facilities for six months. Further, we would capitalize many of the costs of the originally existing sites under the premise that they were providing startup services to the new sites. At the corporate office, a massive percentage of our ongoing expenses were capitalized under the same development premise. Even more egregious, however, were our opening entries for new facilities and companies. Basics of accounting explain that in an acquisition, total purchase consideration less net assets equals goodwill.
Our acquisitions were booked very conservatively. Wait, is that not a good thing? Are we not supposed to be conservative as accountants? Our charade was to overstate opening liabilities, and understate opening net assets. The immediate effect was to overstate goodwill. So what is the problem? That does not overstate net income. Actually, it did, in that the “conservative” balance sheets were subsequently used as socks for subsequent earnings overstatements. Net income overstatements Were credited to the income statement, and corresponding debits then had a “sock” to go to on the balance sheet.
The Financial Accounting Standards Board (FAST) requires that if goodwill allocations are to correct, then the error must be corrected in the goodwill entry if discovered within 12 months, or if discovered later, should become adjusted through retained earnings. Obviously, we did neither, as the balance sheet valuations were only used as a place to park the debit side of fraudulent earnings overstatements. Just how significant was this? Refer to a 1 998 1 0-K for Issues in Accounting Education volume 28, NO. 4, 2013 906 the company.
It is clearly disclosed that in the year we made acquisitions totaling $766 million, Goodwill was recorded totaling $751 million, representing 98 percent of the total consideration. Would this seem to be a reasonable amount for a web provider or company comprised primarily of intellectual property? Perhaps. But for a bricks and mortar company? 3. Mergers and Charges: As the company continued to grow, the fraud climbed, as well. Further, in this next stage, the fraud was not only being used to overstate net income, but it was now being used to begin covering up years of accumulated fraud on the financial statements.
Analysts frequently set earnings expectations based on prior year performance, industry trends, and discussions with management regarding the opportunities and challenges of their company. Once several analysts set their range of estimates, a consensus PEPS estimate is formed. In a perfect world, it is a difficult dance, because analysts want PEPS as high as possible (for stock growth), and companies must attempt some sort of restraint in order to make their numbers achievable. The resulting guidance will factor heavily in analysts’ buy or sell ratings on a company’s stock.
More than once, heard Crush ask analysts what the PEPS estimate needed to be “to keep a strong buy on the stock. ” Thus, the projections were set in the wrong order. Rather than us projecting future PEPS based on our own operations, the PEPS was set on what loud keep the price of the stock high. It was a brazen example of putting the cart before the horse. Our own fraud led to a new set of issues in due diligence, particularly in transactions where we issued our own stock as consideration.
When a company is being purchased with the acquiring company’s stock, the acquired company must be satisfied that the stock that the acquirer is issuing is worth the paper it is printed on. Therefore, in many ways, the due diligence of a company being acquired is as important as the due diligence of the company doing the acquiring. This led to a weakness in our due diligence activities. We could not ask questions that We could not answer ourselves, for fear that our own fraud may be exposed. Of course, this led to weaker due diligence and surprises after we had acquired companies. . Depending on the type of transaction, most merged companies issue guidance to Wall Street of their new pro formal earnings. The pro formal PEPS will take into consideration not just the combined operations of the companies, but synergies developed from the elimination of duplicative costs. Our CEO, desiring growth in our stock price, would continue to promote PEPS that would satisfy analysts and investors. Our pro formal PEPS guidance became a perfect-world scenario of 100 percent delivery in every assumption that was made, from growth models, to expense reductions, to market share. Ender this scenario, our new pro formal PEPS estimates simply were not obtainable. Instead of improving our situation, the acquisitions made it worse. Companies frequently disclose “one-time charges. ” These are intended to be non-recurring in nature and be separate from normal ongoing business operations. Healthiness had frequent onetime charges, and the basis for these was typically valid. For example, with any merger, there are costs of the al itself, frequent costs of terminating duplicative set-vices, or lease termination costs for the scuttling of unneeded locations. These are all legitimate “one-time charges. Typically, analysts and investors look at the PEPS of the company before these charges, as it is a fairer presentation of results from ongoing operations. In the Healthiness fraud, the balance sheet?the recipient of fictitious debits?became grossly overstated. The “one-time charges” were used as a way to clean up the balance sheet. Otherwise legitimate one-time charges were used as cover to write off the accumulated redundant entries residing on the balance sheet. For example, bogus fixed assets could be written off via impairment charges of other legitimate activities.
Issues in Accounting Education Lessons of the Healthiness Fraud: An Insider’s View 907 5. Rabbits Pulled Out of Hats: Many of the exercises to prop up earnings had run their course, and we were no longer a high-growth company. Yet, the gap between The Number and reality was greater than ever. Simply stopping the fraud would have exposed it. With the same vision as a nearsighted goat, the methods used to mask the fraud grew. Another problem became obvious. First of all, the gap between The Number and actual was as wide as the Grand Canyon.
But further, the fraud itself was causing the gap to widen. If we were putting bogus fixed assets on the books, was there a subsequent expense consequence? Of course?depreciation expense. In addition to depreciation, we had amortization costs, property taxes, and income taxes on bogus earnings. Many of the mechanics of the fraud involved an explosion of entries from Excel to the Peoples accounting system. At the end of each quarter, we would run a consolidated income statement, from which we saw the earnings shortfall, referred to as “The Hole.
We would then make decisions of which operating divisions, and which lines on the income statement, to which fraudulent earnings would be posted. Fraudulent entries were referred to as “Dirt. ” Much is made in auditing classes of analytical reviews. Auditors are taught to look for trends or unusual changes. We knew that, so as a result, we would run all types of analytical reviews on ourselves to determine where we could “safely’ book bogus earnings. We would then isolate about two dozen numbers? the major categories on the income statement to which fraudulent entries would be made, and by operating division.