An Accountant Tried in Vain
To Expose HealthSouth Fraud

At 10:06 a.m. on Feb. 13, someone made a sensational claim on the Yahoo bulletin board devoted to discussion of HealthSouth Corp.

"What I know about the accounting at HRC will be the blow that will bring HRC to its knees," wrote the individual, alluding to the company's stock symbol and using the alias Junior followed by eight numbers. A few minutes later, he added, "what is going on at HRC ... if discovered by the right people will bring change to the accounting department at HRC if not the entire company."

"Junior" was Michael Vines, a former bookkeeper in HealthSouth's accounting department. Since leaving the company in May 2002, Mr. Vines tried to spread the word about alleged questionable practices in the department -- but at every turn his disclosures came to nothing. He sent an e-mail to HealthSouth's auditor, Ernst & Young LLP, flagging one small area of alleged fraud, but Ernst concluded that the accounting was legitimate. Later, he tried to make his case online, where readers of the Yahoo forum dismissed his claims as typical Internet blather.

But his warnings were on target -- and today they offer a lesson in how hard it can be to sound the alarm against corporate wrongdoing. On March 19, the Securities and Exchange Commission filed a civil lawsuit claiming that HealthSouth and its chairman, Richard M. Scrushy, had committed "massive accounting fraud" to overstate earnings by a total of $1.4 billion since 1999. Within seven weeks, the Justice Department had reached plea agreements in its criminal investigation with all five of the chief financial officers who have worked at HealthSouth, as well as six lower-level former executives, one of whom detailed an additional $1.1 billion of allegedly fraudulent accounting.

The company, the largest operator of outpatient surgery and rehabilitation facilities in the nation, is now under the temporary control of a corporate turnaround specialist, and company officials are fighting to keep the Birmingham, Ala., company out of Chapter 11 bankruptcy proceedings. Mr. Scrushy has denied wrongdoing through his attorneys.

Mr. Vines, a 31-year-old who made about $39,000 a year at HealthSouth, lives at the end of a gravel driveway off a two-lane road 30 miles from downtown Birmingham. Mr. Vines and others familiar with the investigation confirm that he is "Junior." Mr. Vines is cooperating with the federal investigation, and testified at an April federal court hearing.

A native of Birmingham, Mr. Vines learned accounting by taking classes over several years at three Alabama colleges but hasn't completed a degree. "I just like working with numbers and making sure everything balances at the end of the day," he says.

He began work in HealthSouth's asset-management division in 1997, one of three employees overseeing expenses and the purchase of equipment at the company's 1,800 facilities. By late 2001, he had become uncomfortable with how the accounting department operated.

Over the course of that year, according to his testimony at the April federal court hearing, he came to believe that people in the department were falsifying assets on the balance sheet. The accountants, he testified, would move expenses from the company's income statement -- where the expenses would have to be deducted from profits immediately -- to its balance sheet, where they wouldn't have to be deducted all at one time. Thus, the company's expenses looked lower than they were, which helped artificially boost net income.

The individual expenses were relatively small -- between $500 and $4,999 apiece, according to Mr. Vines's testimony -- because the auditor, Ernst & Young, examined expenses over $5,000. Overall, according to the SEC complaint, about $1 billion in fixed assets were falsely entered. In his testimony, Mr. Vines identified about $1 million in entries he believed were fraudulent.

Mr. Vines told his immediate superior, Cathy C. Edwards, a vice president in the accounting department, that he wouldn't make such entries unless she first initialed them. "I wanted her signature on it," Mr. Vines testified.

Ms. Edwards, according to Mr. Vines's testimony, signed off on the entries, and he logged them. Mr. Vines also testified that he saw Ms. Edwards falsifying an invoice, which according to his testimony was a way to cover up the larger fraud involving the accounts. In December 2001, Mr. Vines said on the stand, Ernst was conducting a routine review of how HealthSouth depreciated its assets. As part of the review, Ernst asked about an asset on the company's balance sheet.

The problem: There was no invoice showing that the asset, for a facility in Kansas, had been purchased. (The court papers don't specify what the asset actually was.) So, Mr. Vines testified, Ms. Edwards ordered Mr. Vines to pull an invoice for a different purchase, for a facility in Braintree, Mass., that roughly matched the asset's price. She then scanned the invoice into her computer and altered the shipping cost and other information to make it fit the asset that Ernst was asking about, according to Mr. Vines's testimony.

On April 3, Ms. Edwards pleaded guilty to conspiracy to commit wire and securities fraud. As part of the plea, she admitted to falsifying records, although the plea doesn't mention specific incidents. Ms. Edwards's attorney didn't return calls seeking comment.

In May 2002, Mr. Vines grew more concerned about the accounting practices, particularly in light of the scandal that had recently erupted at Enron Corp. He quit his job and moved to the accounting office of a Birmingham country club. HealthSouth's current management says that Mr. Vines left the company voluntarily.

Not long afterward, he sent the e-mail to Ernst, alleging fraudulent transactions between the company's accounts and identifying three account numbers that Ernst should investigate. The accounts covered expenses for "minor equipment," "repairs and maintenance" and "public information," which included costs for temporary workers and advertising job openings, he said in an interview and in court testimony.

When asked about the e-mail by a reporter last month, Mr. Vines denied writing it, but now confirms he did. In an interview, Mr. Vines says he didn't send the information to a regulatory agency because he assumed Ernst "would in turn get with the SEC and say, 'We have a problem here.' Of course, that never happened."

Mr. Vines's e-mail was passed on to James Lamphron, a partner in Ernst's Birmingham office. Mr. Lamphron testified at the April federal court hearing that he contacted William T. Owens, who was then president and chief operating officer at HealthSouth, and George Strong, who served as chairman of the audit committee of HealthSouth's board. A HealthSouth spokesman says Mr. Strong, who hasn't been named in the civil or criminal proceedings, felt the matter was being resolved.

According to Mr. Lamphron's testimony, Mr. Owens defended the company's accounting practices. He acknowledged that the company had moved expenses from one category to another, but he argued that the company had done it for several years and that it was an acceptable practice. Mr. Lamphron testified that Mr. Owens called Mr. Vines a "disgruntled employee."

On March 26, Mr. Owens pleaded guilty to wire and securities fraud and certifying a false financial report to the SEC. Mr. Owens's attorney, Frederick Helmsing, declines to comment on Mr. Lamphron's testimony.

Then, Mr. Lamphron testified, Ernst conducted "audit-related procedures" with the accounts Mr. Vines pointed out. The result: Ernst "reached a point where we were satisfied with the explanation that the company had provided to us ... We then closed the process."

What happened? According to Mr. Lamphron's testimony, Mr. Vines never specified that invoices were being falsified -- only that there was a problem with the three accounts he mentioned. So Ernst never investigated the falsified invoices and didn't find any evidence of fraud.

Meanwhile, Mr. Owens's attorney, Mr. Helmsing, says that while his client admits to fraud, the accounts that Mr. Vines pointed out to Ernst actually involved legitimate accounting maneuvers different from the fraudulent schemes.

Mr. Vines acknowledges that he didn't mention the falsification of invoices. But he argues that the three accounts he pointed out raise plenty of serious questions by themselves -- and an accounting expert agrees.

For example, court documents show that one of the expenses that was shifted to the balance sheet was the sponsorship of the Erie Otters junior-league hockey team in Pennsylvania -- which was listed as a Dec. 31, 2001, Internet cost. Charles Mulford, director of the DuPree Financial Reporting and Analysis Lab at the Georgia Institute of Technology, acknowledges there's a gray area in accounting for assets. But he argues that assets such as the hockey sponsorship and others, such as newspaper advertisements, clearly should be expensed immediately and don't belong on the balance sheet, where things such as land, buildings and equipment reside.

A spokesman for Ernst declines to comment on Mr. Vines's e-mail and the firm's handling of it. In prior statements, the firm emphasized the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. Ernst hasn't been named or charged as a defendant in the government cases, and the firm says it is cooperating with investigators.

After the review, Mr. Lamphron testified, he attempted to reach Mr. Vines to tell him that Ernst "found nothing that was inappropriate," but he was never able to reach Mr. Vines by phone.

Mr. Vines confirms he never heard from Ernst. He did nothing more to try to bring to light HealthSouth's accounting practices during 2002.

He had become a regular reader of the Yahoo bulletin board devoted to his former employer, one of many company message boards that Yahoo maintains. Late in January 2003, he began posting warnings as Junior "to get the truth out there," he says in an interview. He wrote, among other things, that HealthSouth's ledger contained "bogus accounts" and that management needed to go, starting with the accounting department.

In early February, local media reported that the FBI had begun interviewing HealthSouth employees about insider-trading allegations. The Yahoo board lit up with messages, including one from Mr. Vines: "The FBI needs to look into the accounting department."

In response to doubters on the Web site, Mr. Vines fired off a flurry of postings on Feb. 13, describing the alleged irregularities. "OK. What about moving telephone expense to a capital account calling it 'cap internet expense.' Or moving repairs and maintenance out to a capital account and calling it the same thing."

That afternoon, skeptics pummeled him on Yahoo: "Sounds like jr. may have been one of the many people churned through hrc's accounting dept. and now has an axe to grind." Another derided Mr. Vines's postings as "water cooler talk."

James Goodreau, HealthSouth's former security chief, who was laid off last week, testified during the April federal court hearing that on the day Mr. Vines posted the messages describing the alleged fraud, Mr. Owens and other executives told him to determine the identity of "Junior."

Mr. Goodreau testified that he asked Ms. Edwards, Mr. Vines's former supervisor, for the names of the current and former employees who might have posted the message on the board. Mr. Goodreau, who hasn't been named in the civil or criminal complaints, testified that he didn't know the posting was describing real potential wrongdoing at the company.

Ms. Edwards wrote 10 names on yellow note paper, and pointed out that Mr. Vines and one other employee on the list no longer worked for HealthSouth. Mr. Goodreau pulled those two workers' personnel files and noticed that some digits of Mr. Vines's Social Security number matched some digits in the Yahoo pseudonym of Junior. He reported that Junior was Mr. Vines, but took no further action. What Mr. Owens planned to do with the knowledge of Junior's identity isn't clear. Mr. Owens's attorney, Mr. Helmsing, declines to comment on the Yahoo episode.

On Feb. 21, Mr. Vines was back on Yahoo: "I know for a fact that HRC has assets on the books that are made up to trick the auditors." A naysayer replied: "If you really had information, you would have shorted the stock and given your info to the appropriate people. You wouldn't be babbling about it here. You'd be too busy picking out your new trailer." Mr. Vines says he owns few shares of HealthSouth and never shorted the stock, a strategy in which traders sell borrowed shares in hopes of buying them back later at a lower price.

Mr. Vines was finally able to crow on March 20 -- the day after a former HealthSouth chief financial officer pleaded guilty to fraud in the criminal investigation and the SEC filed its civil complaint in U.S. District Court in Birmingham.

"Everyone sees what I have been talking about," he wrote on the Yahoo board.

Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com⁴

Updated May 20, 2003