<<

. 3
( 21)



>>

Medical Bene¬ts, published semimonthly by Kelly Communications, Inc., Charlottes-
ville, VA.
Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

Other references pertaining to this chapter include
Blair, J. D., G. T. Savage, and C. J. Whitehead. 1989. “A Strategic Approach for
Negotiating with Hospital Stakeholders.” Health Care Management Review
(Winter): 13“23.
Brock, T. H. 2003. “CMS Investigates Outlier Payments.” Healthcare Financial
Management (February): 70“74.
Clement, J. P., D. G. Smith, and J. R. C. Wheeler. 1994. “What Do We Want and
What Do We Get from Not-for-Pro¬t Hospitals?” Hospital & Health Services
Administration (Summer): 159“178.
Coddington, D. C., D. J. Keene, K. D. Moore, and R. L. Clarke. 1991. “Factors
Driving Costs Must Figure into Reform.” Healthcare Financial Management
(July): 44“62.
Fallon, R. P. 1991. “Not-For-Pro¬t = No Pro¬t: Pro¬tability Planning in Not-For-
Pro¬t Organizations.” Health Care Management Review (Summer): 47“59.
Fottler, M. D., J. D. Blair, C. J. Whitehead, M. D. Laus, and G. T. Savage. 1989.
“Assessing Key Stakeholders: Who Matters to Hospitals and Why?” Hospital
& Health Services Administration (Winter): 525“546.
Healthcare Financial Management. The July 1997 issue has several articles related to
the tax sanctions imposed on not-for-pro¬t corporations when excess bene¬ts
accrue to individuals.
50 Healthcare Finance



Herzlinger, R. E., and W. S. Krasker. 1987. “Who Pro¬ts From Nonpro¬ts?” Harvard
Business Review (January“February): 93“105.
Hill, J. F. 1986. “Third Party Payment Strategies.” Topics in Health Care Financing
(Winter): 1“88.
Keough, C. L. 2003. “Hospitals Await Final Outlier Rule.” Healthcare Financial
Management (June): 30“34.
Lamm, R. D. 1990. “High-Tech Health Care and Society™s Ability to Pay.” Healthcare
Financial Management (September): 20“30.
McLean, R. A. 1989. “Agency Costs and Complex Contracts in Health Care Organi-
zations.” Health Care Management Review (Winter): 65“71.
Nauert, R. C., A. B. Sanborn, II, C. F. MacKelvie, and J. L. Harvitt 1988. “Hospitals
Face Loss of Federal Tax-Exempt Status.” Healthcare Financial Management
(September): 48“60.
Pink, G. H., and P. Leatt. 1991. “Are Managers Compensated for Hospital Financial
Performance?” Health Care Management Review (Summer): 37“45.
Quinn, K. 2004. “Dividing a Trillion-Dollar Pie.” Healthcare Financial Management
(April): 60“68.
Umbdenstock, R. J., W. M. Hageman, and B. Amundson. 1990. “The Five Criti-
cal Areas for Effective Governance of Not-for-Pro¬t Hospitals.” Hospital &
Health Services Administration (Winter): 481“492.
Unland, J. J., and J. J. Baker. 2002. “Prospective Payment.” Journal of Healthcare
Finance (Spring): 1“119.
Walker, C. L., and L. W. Humphreys. 1993. “Hospital Control and Decision Making:
A Financial Perspective.” Healthcare Financial Management (June): 90“96.
Wolfson, J., and S. L. Hopes. 1994. “What Makes Tax-Exempt Hospitals Special?”
Healthcare Financial Management (July): 57“60.
PAR T



II
Financial Accounting
This page intentionally left blank
CHAP TER



3
FINANCIAL ACCOUNTING BASICS
AND THE INCOME STATEMENT

Learning Objectives
After studying this chapter, readers will be able to:

• Explain why ¬nancial statements are so important both to managers
and to outside parties.
• Describe the standard setting process, under which ¬nancial
accounting information is created and reported, as well as the
underlying principles applied.
• Describe the components of the income statement”revenues,
expenses, and net income”and the relationships within and
between these components.
• Explain the difference between net income and cash ¬‚ow.


Introduction
Financial accounting involves identifying, measuring, recording, and commu-
nicating in dollar terms the economic events and status of an organization.
This information is summarized and presented in ¬nancial statements ”the
three most important being the income statement, the balance sheet, and
the statement of cash ¬‚ows. Because these statements communicate ¬nancial
information about an organization, ¬nancial accounting is often called “the
language of business.” Managers of health services organizations must under-
stand the basics of ¬nancial accounting because ¬nancial statements are the
best way to summarize a business™s ¬nancial status and performance.
Our coverage of ¬nancial accounting extends over several chapters.
This chapter begins with an introduction to basic ¬nancial accounting
concepts and then explains how organizations report ¬nancial performance,
speci¬cally revenues, costs, and pro¬ts. In Chapter 4, the discussion is ex-
tended to the reporting of ¬nancial status, which includes assets, liabilities,
and equity. In addition, Chapter 4 covers the reporting of cash ¬‚ows. Finally,
Chapter 17 again discusses ¬nancial statements, but here the focus is on how
interested parties use ¬nancial statements to assess the ¬nancial condition of
an organization. That chapter has purposely been placed at the end of the
book because the nuances of ¬nancial statement analysis can be better under-
53
stood after learning more about the ¬nancial workings of a business. These
54 Healthcare Finance



three chapters will provide you with a basic understanding of how ¬nancial
statements are created and used to make judgments regarding the ¬nancial
condition of a health services organization.



Historical Foundations of Financial Accounting
It is all too easy to think of ¬nancial statements merely as pieces of paper
with numbers written on them, rather than in terms of the economic events
and physical assets ”such as land, buildings, and equipment”that underlie
the numbers. However, if readers of ¬nancial statements understand how and
why ¬nancial accounting began, and how ¬nancial statements are used, they
can better visualize what is happening within a business and why ¬nancial
accounting information is so important.
Thousands of years ago, individuals or families were self-contained in
the sense that they gathered their own food, made their own clothes, and built
their own shelters. When specialization began, some individuals or families
became good at hunting, others at making arrowheads, others at making
clothing, and so on. With specialization came trade, initially by bartering one
type of goods for another. At ¬rst, each producer worked alone, and trade was
strictly local. Over time, some people set up production shops that employed
workers, simple forms of money were used, and trade expanded beyond the
local area. As these simple economies expanded, more formal forms of money
developed and a primitive form of banking began, with wealthy merchants
lending pro¬ts from past dealings to enterprising shop owners and traders
who needed money to expand their operations.
When the ¬rst loans were made, lenders could physically inspect bor-
rowers™ assets and judge the likelihood of repayment. Eventually, though,
lending became much more complex. Industrial borrowers were developing
large factories, merchants were acquiring ¬‚eets of ships and wagons, and loans
were being made to ¬nance business activities at distant locations. At that
point, lenders could no longer easily inspect the assets that backed their loans,
and they needed a practical way of summarizing the value of those assets. Also,
certain loans were made on the basis of a share of the pro¬ts of the business,
so a uniform, widely accepted method for expressing income was required.
In addition, owners required reports to see how effectively their own enter-
prises were being operated, and governments needed information for use in
assessing taxes. For all these reasons, a need arose for ¬nancial statements, for
accountants to prepare the statements, and for auditors to verify the accuracy
of the accountants™ work.
The economic systems of the industrialized countries have grown enor-
mously since the beginning, and ¬nancial accounting has become much more
complex. However, the original reasons for accounting statements still apply:
Bankers and other investors need accounting information to make intelligent
55
Chapter 3: Financial Accounting Basics



investment decisions; managers need it to operate their organizations ef¬-
ciently; and taxing authorities need it to assess taxes in an equitable manner.
It should be no surprise that problems can arise when translating phys-
ical assets and economic events into accounting numbers. Nevertheless, that
is what accountants must do when they construct ¬nancial statements. To
illustrate the translation problem, the numbers shown on the balance sheet
to re¬‚ect a business™s assets and liabilities generally re¬‚ect historical costs and
prices. However, inventories may be spoiled, obsolete, or even missing; land,
buildings, and equipment may have current values that are much higher or
lower than their historical costs; and money owned to the business may be
uncollectible. Also, some liabilities, such as obligations to make lease pay-
ments, may not even show up in the numbers. Similarly, costs reported on an
income statement may be understated or overstated, and some costs, such as
depreciation, do not even represent current cash expenses. When examining
a set of ¬nancial statements, it is best to keep in mind the physical reality that
underlies the numbers and also to recognize that many problems occur in the
translation process.


Self-Test
1. What are the historical foundations of ¬nancial accounting statements?
Questions
2. Do any problems arise when translating physical assets and economic
events into monetary units? Give one or two illustrations to support
your answer.


The Users of Financial Accounting Information
The predominant users of ¬nancial accounting information are those parties
who have a ¬nancial interest in the organization and hence are concerned
with its economic status. All organizations, whether not-for-pro¬t or investor
owned, have stakeholders who have an interest in the business. In a not-for-
pro¬t organization, such as a community hospital, the stakeholders include
managers, staff physicians, employees, suppliers, creditors, patients, and even
the community at large. Investor-owned organizations have essentially the
same set of stakeholders, plus owners. Because all stakeholders, by de¬nition,
have an interest in the organization, all stakeholders have an interest in its
¬nancial condition.
Of all the outside stakeholders, investors, who supply the capital (funds)
needed by businesses, typically have the greatest ¬nancial interest in health
services organizations. Investors fall into two categories: (1) owners (often
stockholders ) who supply equity capital to investor-owned businesses, and
(2) creditors (or lenders) who supply debt capital to both investor-owned and
not-for-pro¬t businesses. In general, there is only one category of owners.
However, creditors constitute a diverse group of investors including banks,
suppliers granting trade credit, and bondholders. Because of their direct
56 Healthcare Finance



¬nancial interest in healthcare businesses, investors are the primary outside
users of ¬nancial accounting information. They use the information to make
judgments pertaining to whether or not to make a particular investment, as
well as to set the return required on the investment. (Investor-supplied capital
is covered in greater detail in Chapters 11, 12, and 13.)
Although ¬nancial accounting developed primarily to meet the infor-
mation needs of outside parties, the managers of an organization, including its
board of directors (trustees), also are important users of the information. After
all, managers are charged with ensuring that the organization has the ¬nancial
strength to accomplish its mission, whether that mission is to maximize the
wealth of its owners or to provide healthcare services to the community at
large. Thus, an organization™s managers are not only involved with creating
¬nancial statements, but they are also important users of the statements, both
to assess current ¬nancial condition and to formulate plans to ensure that the
future ¬nancial condition of the organization will support its goals.
In summary, investors and managers are the predominant users of ¬-
nancial accounting information as a result of their direct ¬nancial interest in
the organization. Furthermore, investors are not merely passive users of ¬-
nancial accounting information; they do more than just read and interpret the
statements. Often, they create ¬nancial targets based on the numbers reported
in ¬nancial statements that managers must attain or suffer some undesirable
consequence. For example, many debt agreements require borrowers to main-
tain stated ¬nancial standards, such as a minimum earnings level, to keep the
debt in force. If the standards are not met, the lender can demand that the
business immediately repay the full amount of the loan. If the business fails to
do so, it may be forced into bankruptcy.


Self-Test 1. Who are the primary users of ¬nancial accounting information?
Questions 2. Are investors passive users of this information?


Regulation and Standards in Financial Accounting
As a consequence of the Great Depression of the 1930s, which caused many
businesses to fail and almost brought down the entire securities industry, the
federal government began regulating the form and disclosure of information
related to publicly traded securities. The regulation is based on the theory that
¬nancial information constructed and presented according to standardized
rules allows investors to make the best-informed decisions. The newly formed
Securities and Exchange Commission (SEC), an independent regulatory agency
of the U.S. government, was given the authority to establish and enforce the
form and content of ¬nancial statements. Nonconforming companies are pro-
hibited from selling securities to the public, so many businesses comply to
gain access to large amounts of capital. In addition, not-for-pro¬t corpora-
57
Chapter 3: Financial Accounting Basics



tions must ¬le ¬nancial statements with state authorities that conform to SEC
standards. Finally, most for-pro¬t businesses that do not sell securities to the
public are willing to follow the SEC-established guidelines to ensure unifor-
mity of presentation of ¬nancial data. The end result is that all businesses,
except for the very smallest, create SEC-conforming ¬nancial statements.
Rather than directly manage the process, the SEC designates other or-
ganizations to create and implement the standard system. For the most part,
the SEC has delegated the responsibility for establishing standards to the Fi-
nancial Accounting Standards Board (FASB)”a private organization whose
mission is to establish and improve standards of ¬nancial accounting and re-
porting for private businesses. Typically, the guidance issued by the FASB,
which is promulgated by numbered statements, applies across a wide range of
industries and, by design, is somewhat general in nature.1 More speci¬c imple-
mentation guidance, especially when industry-unique circumstances must be
addressed, is provided by Industry Committees established by the American
Institute of Certi¬ed Public Accountants (AICPA)”the professional associ-
ation of public (¬nancial) accountants. For example, ¬nancial statements in
the health services industry are based on the AICPA Audit and Accounting
Guide titled Health Care Organizations, which was published most recently
on January 1, 2003.
When even more speci¬c guidance is required, other professional orga-
nizations may participate in the standard-setting process, although such work
does not have the same degree of in¬‚uence as the FASB or the AICPA. For
example, the Healthcare Financial Management Association (HFMA) has es-
tablished a Principles and Practices Board, which develops position statements
on issues that require further guidance. For example, its August 11, 2000
statement regarding the handling of mergers, acquisitions, and collaborations
within health services organizations.
When taken together, all the guidance issued by FASB and the other
organizations constitute a set of guidelines called generally accepted accounting
principles (GAAP). GAAP can be thought of as a set of objectives, conven-
tions, and principles that have evolved through the years to guide the prepara-
tion and presentation of ¬nancial statements. In essence, GAAP set the rules
for the ¬nancial statement preparation game. Note, however, that GAAP ap-
ply only to the area of ¬nancial accounting, as distinct from other areas of
accounting, such as managerial accounting (discussed in later chapters) and
tax accounting.
For large organizations, the ¬nal link in the ¬nancial statement quality
assurance process is the external audit, which is performed by an independent
(outside) auditor”usually one of the major accounting ¬rms. The results
of the external audit are reported in the auditor™s opinion, which is a letter
attached to the ¬nancial statements stating whether or not the statements
are a fair presentation of the business™s operations, cash ¬‚ows, and ¬nancial
position as speci¬ed by GAAP.
58 Healthcare Finance



There are several categories of opinions given by auditors. The most
favorable, which is essentially a “clean bill of health,” is called an unquali¬ed
opinion. Such an opinion means that, in the auditor™s opinion, the ¬nancial
statements conform to GAAP, are presented fairly and consistently, and con-
tain all necessary disclosures. A quali¬ed opinion means that the auditor has
some reservations about the statements, while an adverse opinion means that
the auditor believes that the statements do not present a fair picture of the ¬-
nancial status of the business. The entire audit process, which is performed
both by the organization™s internal auditors and the external auditor, is a
means of verifying and validating the organization™s ¬nancial statements.2 Of
course, an unquali¬ed opinion gives users, especially those external to the or-
ganization, more con¬dence that the statements truly represent the business™s
current ¬nancial condition.
Although one would think that the guidance given under GAAP, along
with auditing rules, would be suf¬cient to prevent fraudulent ¬nancial state-
ments, in the early 2000s several large companies, including HEALTHSOUTH,
were found to be “cooking the books.” Because our ¬nancial system is so de-
pendent on the reliability of ¬nancial statements, on July 30, 2002, President
Bush signed the Sarbanes-Oxley Act, which mandated many changes to the
¬nancial statement management and auditing process. Here are some of the
more important provisions of the Act:

• An independent Public Accounting Oversight Board was created to
oversee the entire audit process.
• Auditors can no longer provide nonaudit (consulting) services to
the companies that they audit.
• The lead partners of the audit team for any company must rotate
off the team every ¬ve years (or more often).
• Senior managers involved in the audits of their companies cannot
have been employed by the auditing ¬rm during the one-year
period preceding the audit.
• Each member of the audit committee shall be a member of the
company™s board of directors and shall otherwise be independent of
the audit function.
• The chief executive of¬cer (CEO) and chief ¬nancial of¬cer (CFO)
shall personally certify the “appropriateness and fairness” of the
¬nancial statements.

It is hoped that these provisions, along with others in the Act, will deter future
fraudulent behavior by managers and auditors. So far, so good.
It should be of no surprise that the ¬eld of ¬nancial accounting is
typically classi¬ed as a social science rather than a physical science. Financial
accounting is as much an art as a science, and the end result represents
negotiation, compromise, and interpretation. The organizations involved in
59
Chapter 3: Financial Accounting Basics



setting standards are continuously reviewing and revising the GAAP to ensure
the best possible development and presentation of ¬nancial data. This task,
which is essential to economic prosperity, is motivated by the fact that the U.S.
economy is constantly evolving, with new types of business arrangements and
securities being created almost daily.3


Self-Test
1. Why are widely accepted principles important for the measurement and
Questions
recording of economic events?
2. What entities are involved in regulating the development and presenta-
tion of ¬nancial statements?
3. What does GAAP stand for, and what is its primary purpose?
4. What is the purpose of the auditor™s opinion?


Basic Concepts of Financial Accounting
Because the actual preparation of ¬nancial statements is done by accountants, a
detailed presentation of accounting theory is not required in this book. How-
ever, to better understand the content of ¬nancial statements, it is useful to
discuss some of the basic concepts that accountants apply when they develop
¬nancial accounting data and prepare an organization™s ¬nancial statements.

Accounting Entity
The ¬rst step in the preparation of ¬nancial statements is to de¬ne the ac-
counting entity. This step is important for two reasons. First, for investor-
owned businesses, ¬nancial accounting data must be pertinent to the business
activity as opposed to the personal affairs of the owners. Second, within any
business, the accounting entity de¬nes the speci¬c areas of the business to
be included in the statements. For example, a healthcare system may create
one set of ¬nancial statements for the system as a whole as well as separate
statements for its subsidiary hospitals. In effect, the accounting-entity speci¬-
cation establishes boundaries that tell accountants what data must be included
as well as inform readers what business (or businesses) is being reported.

Going Concern
It is assumed that the accounting entity will operate as a going concern and
will have an inde¬nite life. This means that most assets should be valued on
the basis of their value to the ongoing business as opposed to their current
market (liquidation) value. For example, the land, buildings, and equipment
of a hospital may have a value of $50 million when used to provide patient
services, but if sold to an outside party for other purposes, the value of these
assets might only be $20 million. Furthermore, short-term events should not
be allowed to unduly in¬‚uence the data presented in ¬nancial statements. The
going concern assumption, coupled with the fact that ¬nancial statements
60 Healthcare Finance



must be prepared for relatively short periods (as explained next), means that
¬nancial accounting data are not exact but represent logical and systematic
approaches applied to complex measurement problems.

Accounting Period
Because it is assumed that accounting entities have an inde¬nite life, but users
of ¬nancial statements require the information that they convey on a frequent
basis, it is common to report ¬nancial results on a regular basis. The period
covered by such statements, which is called an accounting period, can be any
length of time over which an organization™s managers, or outside parties, want
to evaluate operational results. Most health services organizations use calendar
periods”months, quarters, and years”as their accounting periods. However,
occasionally an organization will use a ¬scal year (¬nancial year) that does not
coincide with the calendar year. For example, Access Health, a provider of
management services for health maintenance organizations, has a ¬scal year
that runs from October 1 to September 30. In this book, an annual accounting
period is used in the illustrations. However, ¬nancial statement information
typically is also prepared for periods shorter than one year.4

Objectivity and Reliability
The conversion of economic events to ¬nancial accounting data is not an
easy task. One of the cornerstones of measurement is objectivity; that is, the
information reported in ¬nancial statements must, to the extent possible, be
based on objective, veri¬able supporting data. Thus, rather than pull data
“out of the air,” ¬nancial statement preparers should base their data on event
documentation such as invoices and contracts.
In addition, ¬nancial accounting information should be reliable, which
means that users can depend on it to be reasonably free of error and bias and
hence can assume that the information fairly represents the economic events
being portrayed. In general, reliability is ensured when independent measurers
(auditors), following identical guidelines, reach the same conclusions regard-
ing the values in the ¬nancial statements as do the in-house preparers.

Monetary Unit
The monetary unit provides the common basis by which economic events are
measured. In the United States, this unit is the dollar. Thus, all transactions
and events must be expressed in dollar terms. Although this concept is simple
enough, a major problem arises in implementation. In essence, the assumption
is made that the monetary unit has constant purchasing power over time. In
other words, ¬nancial statements ignore in¬‚ation. Thus, a dollar of revenue
today is treated the same as a dollar of revenue earned ten years ago, although
today™s dollar is worth less (has less purchasing power) than the dollar received
years ago. Similarly, a clinic today that could be built for $10 million might
have been built for $5 million ten years ago. The accounting profession has
61
Chapter 3: Financial Accounting Basics



grappled with the in¬‚ation impact problem for years but has not yet developed
a feasible solution.

Relevance
Financial statements must be relevant to their users, which means that the
information must make a difference in decisions that are being made. Thus,
¬nancial statements must include suf¬cient information upon which to base
decisions but not so much information that decision making becomes bogged
down by nonessential detail. In general, information that is not relevant makes
decision making harder rather than easier. However, the concept of relevance
is complicated by the fact that different information often is relevant to dif-
ferent users and when different decisions are being made by the same user.
Thus, ¬nancial accountants typically err on the side of providing too much
information rather than too little.

Full Disclosure
Financial statements must contain a complete picture of the economic events
of the business. Anything less would be misleading by omission. Furthermore,
because ¬nancial statements must be relevant to a diversity of users, full dis-
closure, like relevance, pushes ¬nancial accountants to include more, rather
than less, information in ¬nancial statements.

Materiality
If ¬nancial statements were created that contained all possible information,
they would be so long and detailed that making inferences about the organiza-
tion™s economic status would be very dif¬cult without a great deal of analysis.
Thus, to keep the statements manageable, only entries that are material to
the ¬nancial condition of an organization need to be separately categorized.
In general, the materiality principle affects the presentation of the ¬-
nancial statements rather than their aggregate ¬nancial content (i.e., the ¬nal
numbers). For example, medical equipment manufacturers carry large inven-
tories of materials that are both substantial in dollar value relative to other
assets and instrumental to their core business, so such businesses report in-
ventories as a separate asset item on the balance sheet. Hospitals, on the other
hand, carry a relatively small amount of inventories. Thus, many hospitals, and
other healthcare providers, do not report inventories separately but combine
them with other assets. Clearly, leeway exists for interpretation as to what is
and is not material, so some differences are likely to occur.

Conservatism
Although ¬nancial accountants try their best to paint a fair picture of a busi-
ness™s ¬nancial status, if uncertainty in the data or GAAP permit alternative
interpretations, the conservatism concept says to choose the approach that is
least likely to overstate the business™s ¬nancial condition. This does not mean
62 Healthcare Finance



that ¬nancial statements should deliberately understate a business™s position,
but, when in doubt, choose the path that will least likely overstate the position.

Consistency and Comparability
Consistency involves the application of like guidelines to a single accounting
entity over time. When a business™s ¬nancial statements are compared over
extended periods”say, annual statements for the past ten years”users must
feel con¬dent that they are comparing “apples to apples” and not “apples to
oranges.” Consistency does not mean that a business, when there is a choice,
must stick with the convention chosen forever. However, any change that
would create inconsistent data must be disclosed along with the impact of
that change.
Comparability is similar to consistency, except that the concept applies
across businesses and to different accounting periods. When users look at
quarterly and annual ¬nancial statements of the same business, they must feel
con¬dent that the data are comparable. Furthermore, when the statements
of one business are compared with the statements of another, but similar,
business”say, two hospitals”the data must be comparable.


Self-Test 1. Brie¬‚y explain the following basic concepts as they apply to the prepara-
Question tion of ¬nancial statements:
• Accounting entity
• Going concern
• Accounting period
• Objectivity and reliability
• Monetary unit
• Relevance
• Full disclosure
• Materiality
• Conservatism
• Consistency and comparability


Accounting Methods: Cash Versus Accrual
In the implementation of the accounting concepts discussed in the previous
section, two different methods have been applied: cash accounting and accrual
accounting. Although, as we discuss below, each method has its own set of
advantages and disadvantages, GAAP specify that only the accrual method
can receive an unquali¬ed auditor™s opinion, so accrual accounting dominates
the preparation of ¬nancial statements. Still, many small businesses that do
not require audited ¬nancial statements use the cash method, and knowledge
of the cash method helps our understanding of the accrual method, so we will
discuss both methods here.
63
Chapter 3: Financial Accounting Basics



Cash Accounting
Under cash accounting, often called cash basis accounting, economic events
are recognized when the ¬nancial transaction occurs. For example, suppose
Sunnyvale Clinic, a large multispecialty group practice, provided services to
a patient in December 2004. At that time, the clinic billed the insurer, Blue
Cross/Blue Shield of Florida, the full amount that the insurer is obligated to
pay”$700. However, Sunnyvale did not receive payment from the insurer
until February 2005. If it used cash accounting, the $700 obligation on the
part of the insurer would not appear in Sunnyvale™s 2004 income statement.
Rather, the revenue would not be recognized until the cash was actually
received in February 2005. The core argument in favor of cash accounting is
that the most important event to record is the receipt of cash, not the provision
of the service (i.e., the obligation to pay). Similarly, Sunnyvale™s expenditures
would be recognized as the cash is physically paid out: inventory costs would
be recognized as supplies are purchased, labor costs would be recognized
when employees are paid, new equipment purchases would be recognized
when the invoices are paid, and so on. To put it simply, cash accounting
records the actual ¬‚ow of money into and out of a business.
There are two advantages to cash accounting. First, it is simple and easy
to understand. No complex accounting rules are required for the preparation
of ¬nancial statements. Second, cash accounting is closely aligned to account-
ing for tax purposes, and hence it is very easy to translate cash accounting
statements into tax data. Because of these advantages, about 80 percent of all
medical practices, typically the smaller ones, use cash accounting. However,
cash accounting has its disadvantages, primarily the fact that in its pure form
it does not present information on revenues owed to a business by payers or
the business™s existing payment obligations.
Before closing our discussion of cash accounting, we should note that
most businesses that use cash accounting do not use the “pure” method
described above but use a modi¬ed method. These modi¬ed statements com-
bine some features of cash accounting, usually to report revenues and ex-
penses, with some features of accrual accounting, usually to report assets and
liabilities. Still, the cash method presents an incomplete picture of the ¬nancial
status of a business and hence the preference by GAAP for accrual accounting.

Accrual Accounting
Under accrual accounting, often called accrual basis accounting, the economic
event that creates the ¬nancial transaction provides the basis for the account-
ing entry rather than the transaction itself. When applied to revenues, the ac-
crual concept implies that revenue earned does not necessarily correspond to
the receipt of cash. Why? Earned revenue is recognized in ¬nancial statements
when a service has been provided that creates a payment obligation on the
part of the purchaser, rather than when the payment is actually received. For
64 Healthcare Finance



healthcare providers, the payment obligation typically falls on the patient, a
third-party payer, or both. If the obligation is satis¬ed immediately, such as
when a patient makes full payment at the time the service is rendered, the
revenue is in the form of cash. Thus, the revenue is recorded for ¬nancial
accounting purposes whether cash or accrual accounting is used.
However, in most cases, the bulk of the payment for services is not
received until later, perhaps several months after the service is provided. In
this situation, the revenue created by the service does not create an immediate
cash payment. If the payment is received within an accounting period”one
year for our purposes”the conversion of revenues to cash will be completed,
and, as far as the ¬nancial statements are concerned, the reported revenue
is cash. However, when the revenue is recorded (i.e., services are provided)
in one accounting period and payment does not occur until the next period,
the revenue reported has not yet been collected, and hence no cash has been
received.
Consider the Sunnyvale Clinic example discussed earlier. Although the
services were provided in December 2004, the clinic did not receive its $700
payment until February 2005. Because Sunnyvale™s accounting year ended
on December 31, and the clinic actually uses accrual accounting, the clinic™s
books were closed after the revenue had been recorded but before the cash was
received. Thus, Sunnyvale reported this $700 of revenue on its 2004 income
statement, even though no cash was collected. When accrual accounting is
used, the amount of revenues not collected is noted in another ¬nancial state-
ment (the balance sheet), which shows users that not all revenues represent
cash receipts.
The accrual accounting concept also applies to expenses. To illustrate,
assume that Sunnyvale had payroll obligations of $2 million for employees™
work during the last week of 2004 that would not be paid until the ¬rst payday
in 2005. Because the employees actually performed the work, the obligation
to pay the salaries was created in 2004. However, because the payment will
not be made until the next accounting period, an expense will be recorded,
even though no cash payment was made. (Under the cash basis of accounting,
Sunnyvale would not recognize the expense until it was paid, in this case in
2005.) Under accrual accounting, the $2 million will be shown as an expense
on the income statement in 2004, and, at the same time, the balance sheet
will indicate that a $2 million liability, or obligation to pay employees, exists.

The Matching Principle
The matching principle, which is central to accrual accounting, has two com-
ponents. First, it requires that the revenues of a business be “matched” with
the accounting period during which they are earned. Although this terminol-
ogy was not introduced in the last section, the matching principle underlies the
preference that accountants have for accrual accounting over cash accounting.
Second, the matching principle requires that an organization™s expenses be
65
Chapter 3: Financial Accounting Basics



matched, to the extent possible, with the revenues to which they are related.
In essence, after the revenues have been allocated to a particular account-
ing period, all expenses associated with producing those revenues should be
matched to the same period.
Although the concept is straightforward, implementation of the match-
ing principle creates many problems. One such problem occurs with long-lived
assets such as buildings and equipment. Because such assets”for example, a
hospital ward”provide revenues for many years, the matching principle dic-
tates that its costs should be spread over those same years. However, there
are many alternative ways to do this, and no single method is clearly best. For
another example of the matching principle, consider a clinic that is paid under
capitation. Its revenues are received up-front, while much of the expense asso-
ciated with providing services to the covered population occurs later, perhaps
much later. To adhere to the matching principle, the clinic must forecast the
costs associated with the revenues collected and record them in the same ac-
counting period that the revenues are reported. Obviously, this is no easy task.


Self-Test
1. Brie¬‚y explain the differences between cash and accrual accounting.
Questions
2. Why do GAAP favor accrual over cash accounting?
3. What is the matching principle?
4. Explain two problems that can occur when the matching principle is
implemented.


Recording and Compiling Accounting Data
The ultimate goal of a business™s ¬nancial accounting system is to produce
¬nancial statements. However, the road from the recording of basic account-
ing data to the completion of the ¬nancial statements is long and arduous,
especially for large, complex organizations. The starting point for the iden-
ti¬cation and recording of ¬nancial accounting information is a transaction,
which is de¬ned as an exchange of goods or services from one individual or
enterprise to another. To satisfy the objectivity concept, each transaction must
be supported by relevant documentation, which is retained for some required
length of time.
Once a transaction is identi¬ed, it must be recorded, or posted, to an
account, which is a record of transactions for one uniquely identi¬ed activity.
For example, under the general heading of cash, separate accounts might be
established for till cash, payroll checks, vendor checks, other checks, and the
like. A large business can easily have hundreds, or even thousands, of separate
primary accounts, which are combined to form the general ledger, plus sub-
sidiary accounts that support the primary accounts. The subsidiary accounts,
which pertain to very speci¬c assets or liabilities or to individual patients or
vendors, are aggregated to create data for a primary (general ledger) account.
66 Healthcare Finance



For example, individual patient charges, which are carried in subsidiary ac-
counts, are aggregated into one or more general ledger revenue accounts.
To help manage the large number of accounts, businesses have a docu-
ment called a chart of accounts, which assigns a unique numeric code to each
account. For example, the till cash account might have the code 1-1000-00
while the payroll checks account might have the code 1-1100-00. The ¬rst “1”
indicates that the account is an asset account; the second “1” indicates a cash
account; and the next digit, “0” or “1”, indicates the speci¬c cash account.
Further numbers are available should the organization decide to subdivide ei-
ther the till cash or payroll checks accounts into subsidiary accounts. Because
everyone who deals with the accounts is familiar with the business™s chart of
accounts, transactions can be easily sorted by account code to ensure that
transactions are posted to the correct account.
Within the system of primary and subsidiary accounts, accounts are
further classi¬ed as follows:

• Permanent accounts include items that must be carried from one
accounting period to another. Thus, permanent accounts remain
active until the items in the account are no longer “on the books”
of the business. For example, an account might be created, or
opened, to contain all transactions related to a ¬ve-year bank loan.
The account would remain open to record transactions relating to
the loan”say, annual interest payments”until the loan was paid off
in ¬ve years, at which time the account would be closed.
• Temporary accounts are for those items that will automatically be
closed at the end of each accounting period. For example, a
business™s revenue and expense accounts typically are closed at the
end of the accounting period and then new accounts are opened,
with a zero balance, at the beginning of the next period.
• Contra accounts are special accounts that convert the gross value of
some other account into a net value. As you will see in the next chap-
ter, there is a contra account associated with depreciation expense.

Each transaction is recorded in an account by a journal entry. The
system used in making journal entries is called the double entry system because
each transaction must be entered in two different accounts”once as a debit
and once as a credit. We will not de¬ne debits and credits here, as their
de¬nitions depend on the speci¬c account in which the entry is made. Because
accounts have both debit and credit entries, they traditionally have been set up
in a “T” format, and hence are called T accounts, with debits entered on the
left side of the vertical line and credits entered on the right side. To illustrate
the double entry system, assume that Sunnyvale Clinic receives $100 in cash
from a self-pay patient at the time of the visit. A debit entry would be made in
the cash account indicating a $100 receipt, while a credit entry would be made
67
Chapter 3: Financial Accounting Basics



in the equity account indicating that the business™s value has increased by the
amount of the cash revenue. The double entry system ensures consistency
among the ¬nancial statements.
Ultimately, after the journal entries are veri¬ed, consolidated, and rec-
onciled, they are formatted into the business™s ¬nancial statements, which
include the income statement, the balance sheet, and the statement of cash
¬‚ows.5 Often, the primary means for disseminating this information to out-
siders is the business™s annual report. It typically begins with a verbal section
that discusses in general terms the organization™s operating results over the
past year as well as developments that are expected to affect future operations.
The verbal section is followed by the business™s ¬nancial statements.
Because the ¬nancial statements cannot possibly contain all relevant
information, additional information is provided in footnotes. For health ser-
vices organizations, these notes contain information on such topics as inven-
tory accounting practices, the composition of long-term debt, pension plan
status, amount of charity care provided, and the cost of malpractice insur-
ance. Because the footnotes contain a great deal of information essential to
a good understanding of the ¬nancial statements, a thorough examination
always considers the footnotes.
This chapter provides a detailed discussion of the contents and logic
behind the income statement. In Chapter 4, the remaining two statements”
the balance sheet and the statement of cash ¬‚ows”are discussed.


Self-Test
1. Brie¬‚y explain the following terms used in the recording and compiling
Questions
of accounting data:
• Transaction
• Account
• Posting
• Chart of accounts
• General ledger
• T account
• Double entry system
2. What are the three primary ¬nancial statements?
3. Why are the footnotes to the ¬nancial statements important?


Income Statement Basics
The overall purpose of our ¬nancial accounting coverage is to provide readers
with a basic understanding of the preparation, content, and interpretation of
a business™s ¬nancial statements. Unfortunately, the ¬nancial statements of
large organizations can be long and complex, and there is signi¬cant leeway
regarding the format used, even within health services organizations. Thus, in
our discussion of the statements, we will use simpli¬ed illustrations and focus
68 Healthcare Finance



on the key issues. This is the best way to learn the basics; the nuances must be
left to other books that focus exclusively on accounting issues.
Perhaps the most frequently asked, and the most important, question
about a business is this: Is the business making money? The income statement
summarizes the operations (i.e., the activities) of an organization with a focus
on its revenues, expenses, and pro¬tability. Thus, the income statement is also
called the statement of operations or the statement of activities.
The income statements of Sunnyvale Clinic are presented in Table 3.1.
Most ¬nancial statements contain two years of data, with the most recent
year presented ¬rst. The title section tells us that these are annual income
statements, ending on December 31, for the years 2004 and 2003. Whereas
the balance sheet, which is covered in Chapter 4, reports a business™s ¬nancial
position at a single point in time, the income statement contains operational
results over a speci¬ed period of time. Because these income statements are
part of Sunnyvale™s annual report, the time period is one year. Also, the dollar
amounts reported are listed in thousands of dollars, so the $169,013 reported
as net patient service revenue for 2004 is actually $169,013,000.
The core components of the income statement are straightforward:
revenues, expenses, and pro¬tability (i.e., net income). Revenues, as discussed
previously in the section on cash versus accrual accounting, represent both
cash received to date and the obligations of payers for services provided
during the period. For healthcare providers, the revenues result mostly from
the provision of patient services. To produce revenues, organizations must
incur costs, or expenses, which are classi¬ed as operating or capital (¬nancial ).
Although not separately broken out on the income statement, operating costs
consist of salaries, supplies, insurance, and other costs directly related with
providing services. Capital costs are the costs associated with the buildings and
equipment used by the organization, such as depreciation, lease, and interest
expenses. Expenses decrease the pro¬tability of a business, so expenses are
subtracted from revenues to determine an organization™s pro¬tability:

Revenues ’ Expenses = Net income.
Note that net income may be positive or negative. When revenues exceed
expenses, the result is called net income. When expenses exceed revenues, a
net loss (negative net income) results.
Net income is an important measure of a business™s pro¬tability. (Sev-
eral other measures of pro¬tability are discussed in later chapters.) The greater
the net income, the greater the accounting pro¬tability of the business and,
with all else the same, the better its ¬nancial position.
The income statement, then, summarizes the ability of an organization
to generate pro¬ts. Basically, it lists the organization™s income (revenues),
the costs that must be incurred to produce the income (expenses), and the
69
Chapter 3: Financial Accounting Basics


TABLE 3.1
2004 2003
Sunnyvale
Clinic: Income
Revenues: Statements
Net patient service revenue $ 169,013 $ 140,896
Years Ended
Other revenue 7,079 5,704
December 31,
Total revenues $ 176,092 $ 146,600
2004 and 2003
Expenses: (in thousands)
Salaries and bene¬ts $ 126,223 $ 102,334
Supplies 20,568 18,673
Insurance 4,518 3,710
Lease 3,189 2,603
Depreciation 6,405 5,798
Provision for bad debts 2,000 1,800
Interest 5,329 3,476
Total expenses $ 168,232 $ 138,394
Net income $ 7,860 $ 8,206




difference between the two (net income). In the following sections, the major
components of the income statement are discussed in detail.


Self-Test
1. What is the primary purpose of the income statement?
Questions
2. In regards to time, how do the income statement and balance sheet
differ?
3. What are the major components of the income statement?


Revenues
Revenues can be shown on the income statement in several different formats.
In fact, there is more latitude in the construction of the income statement than
there is in the balance sheet, so the income statements for different types of
healthcare providers tend to differ more in presentation than do their balance
sheets. (See Problems 3.2 and 3.3, as well Table 17.1, for examples of income
statements of other types of providers.)
Sunnyvale reported net patient service revenue of $169,013,000 for
2004. The key terms here are net and patient service. This line contains
revenues that stem solely from patient services, as opposed to revenues that
stem from other sources such as charitable contributions or interest earned on
securities investments. However, patient service can be rather broadly de¬ned,
so revenues associated with such activities as parking garages and visitor food
services often are categorized as patient service revenue.
70 Healthcare Finance



The term net signi¬es that the amount shown is less than the clinic™s
gross charges for the services provided. Sunnyvale, like all healthcare provid-
ers, has a charge description master ¬le, or charge master, that contains the
charge code and gross price for each service that it provides. However, the
charge master price does not always represent the amount the clinic expects
to be paid for a particular service. For example, the price for a particular
service might be $80, while the contract with a particular payer might specify
a reimbursement amount of $50. This agreed-upon payment, which is less
than the charge master price, results in a discount from charges. For services
provided at a discount, the clinic expects to be paid less than the amount
shown on the charge master, so the amount to be paid is the listed charge less
the negotiated discount. Such discounts are incorporated before the revenue
is recorded on the net patient service revenue line, so the patient service
revenue amounts shown on the income statement are net of discounts. In this
example, the amount of net patient service revenue reported would be $50.
Furthermore, some services have been provided as charity care to in-
digent patients. (Indigent patients are those who presumably are willing to
pay for services provided but do not have the ability to pay.) Sunnyvale has
no expectation of ever collecting for these services, so, like discounts, charges
for charity care services are not re¬‚ected in the $169,013,000 net patient
service revenue reported for 2004. Finally, some revenues that are expected
to be collected, and hence reported, will never be realized and ultimately will
become bad debt losses. To recognize that Sunnyvale does not really expect
to collect the entire $169,013,000 net patient service revenue reported, the
clinic lists as an expense for 2004 a $2,000,000 provision for bad debts. (This
expense item is discussed in more detail in the next section.)
Note the distinction between charity care and bad debt losses. Charity
care represents services that are provided to patients that do not have the
capacity to pay. Bad debt losses result from the failure to collect for services
provided to patients or third-party payers that do have the capacity to pay.
A description of policies regarding discounts and charity care will often
appear in the footnotes to the ¬nancial statements. To illustrate, Sunnyvale™s
¬nancial statements include the following two footnotes:

Revenues. Sunnyvale has entered into agreements with third-party
payers, including government programs and managed care plans,
under which it is paid for services on the basis of established charges,
the cost of providing services, predetermined rates per diagnosis,
or discounts from established charges. Revenues are recorded at
estimated amounts due from patients and third-party payers for the
services provided. Settlements under reimbursement agreements
with third-party payers are estimated and recorded in the period
the related services are rendered and are adjusted in future periods,
as ¬nal settlements are determined. The adjustments to estimated
71
Chapter 3: Financial Accounting Basics



settlements for prior years are not considered material and thus are
not shown in the ¬nancial statements or footnotes.

Charity care. Sunnyvale has a policy of providing charity care to
indigent patients in emergency situations. These services, which are
subtracted from gross revenues, amounted to $67,541 in 2004 and
$51,344 in 2003.

Even though Sunnyvale ultimately expects to collect all of its reported
net patient service revenue not yet received, less realized bad debt losses,
the clinic did not actually receive $169,013,000 in cash payments in 2004.
Rather, some of the revenue has not yet been collected. As readers will learn in
Chapter 4, the yet-to-be-collected portion of the net patient service revenue,
$28,509,000, appears on the balance sheet (Table 4.1) as net patient accounts
receivable.
In a fee-for-service environment, providers offer healthcare services
that are paid for on the basis of utilization (i.e., the volume of services pro-
vided); that is, revenues stem from reimbursement made on a per diem, per
test, per visit, per procedure, or per ancillary service basis, and so on, so rev-
enues are tied to the amount of services provided. Sunnyvale operates primar-
ily as a fee-for-service provider, so its patient service revenue is reported as
shown in Table 3.1.
Revenue associated with capitation contracts is often called premium
revenue when reported on the income statement. If the provider has almost
all capitated revenue, it may replace the patient service revenue category as re-
ported by Sunnyvale by the premium revenue category. Other providers, with
signi¬cant amounts of both fee-for-service and capitation revenue may report
both patient service revenue and premium revenue on the income statement.
The key difference is that patient service revenue is reported when services
are provided, but premium revenue is reported at the start of each contract
payment period”typically the beginning of each month. Thus, premium rev-
enue implies an obligation on the part of the reporting organization to provide
future services, while patient service revenue represents an obligation on the
part of payers to pay the reporting organization for services already provided.
Also, different types of providers may use different terminology for revenues;
for example, some nursing homes report resident service revenue.
Most health services organizations have revenue besides that arising
from patient services, and Sunnyvale is no exception. In 2004, Sunnyvale
reported other revenue of $7,079,000. One major source of other revenue
is interest earned on securities investments. Although not shown directly on
the income statement, the footnotes to the ¬nancial statements indicated that
the clinic earned $3,543,000 in interest income during 2004.
Charitable contributions represent the second major component of the
other revenue category. Some not-for-pro¬t organizations, especially those
72 Healthcare Finance



with large, well-endowed foundations, rely heavily on charitable contribu-
tions, as well as earnings on securities investments, as a revenue source. How-
ever, health services managers must recognize that such revenue is not central
to the core business, which is providing healthcare services. Over-reliance on
other revenues could mask serious operational inef¬ciencies that, if not cor-
rected, could lead to future ¬nancial problems.
Additional sources of other revenues include revenue from such activ-
ities as consulting services, renting of space, educational activities, and sales
of pharmaceuticals to employees, staff, and visitors. A unique problem facing
not-for-pro¬t providers is that a large amount of revenues associated with
tangential activities, which is good ¬nancially, may be perceived by others,
especially tax authorities, as evidence that the provider has strayed from its
charitable purpose. This could lead to either explicit or implicit taxation. An
interesting example of this problem involved a not-for-pro¬t hospital in Buf-
falo, New York, that generated substantial revenue from a yacht cruise business
on Lake Erie. The IRS, which does not take such activities lightly, revoked the
hospital™s not-for-pro¬t status. In hindsight, the hospital would have been
much better off had it created a for-pro¬t subsidiary for the cruise business
and paid taxes on these revenues like any other cruise operator. By doing so,
it would have protected the tax-exempt status for its patient service revenue.
At this point, it is worthwhile to spend some time on historical perspec-
tive. Until 1996, healthcare providers reported gross patient service revenue
based on the charge master, deductions for contractual allowances and charity
care, and net patient service revenue directly on the income statement. This
made the income statements of healthcare providers different from businesses
in virtually every other industry. For example, airlines have a set of full fares
such as $1,500 for a round-trip coach ticket from New York to Chicago. Most
travelers in coach do not pay this fare, however. Rather, they pay restricted
excursion fares that could be as low as $400, or even less. When an airline
prepares its income statement, it does not list revenues at full fares and then
subtract an allowance for discount fares. What it shows on the income state-
ment are those revenues that it actually expects to collect. Thus, the “rest of
the world” reports only those revenues that businesses truly expect to receive,
except for bad debt losses, which are accounted for by other means. Thus,
healthcare providers were forced to report revenues the same way as everyone
else”net of allowances (discounts).
Under the old guidance, the charity care given by a healthcare provider
was reported as a deduction to gross patient service revenue directly on the
income statement; that is, if $500 worth of charity services were provided, the
income statement included this $500 in gross patient service revenue, then
deducted the $500 as charity care, resulting in $0 net patient service revenue
for those services. This accounting treatment allowed providers, particularly
those with not-for-pro¬t status, to highlight the amount of charity care pro-
vided. However, it also created measurement problems because there is no
73
Chapter 3: Financial Accounting Basics



widely accepted methodology for setting the value of charity care that should
be reported as revenue. Is it the charge on the provider™s charge master, the
charge less some discount, the provider™s cost of providing the service, the
societal value for the service, or some other amount? Because of the measure-
ment problem, reporting charity care directly on the income statement made
it more dif¬cult to compare one provider™s income statement to another. Now,
a broad description of the organization™s charity care policy, and perhaps an
estimate of the value of such care provided, is contained in the footnotes to
the ¬nancial statements.


Self-Test
1. What categories of revenue are reported on the income statement?
Questions
2. Brie¬‚y, what is the difference between gross patient service revenue and
net patient service revenue?
3. Describe how the following types of revenue are reported on the
income statement:
• Discounts from charges
• Charity care
• Bad debt losses


Expenses
Expenses are the costs of doing business. As shown in Table 3.1, Sunnyvale
reports its expenses in categories such as salaries and bene¬ts, medical sup-
plies, insurance, and so on. According to GAAP, expenses may be reported
using either a natural classi¬cation, which classi¬es expenses by the nature of
the expense, as Sunnyvale does, or a functional classi¬cation, which classi¬es
expenses by purpose, such as inpatient services, outpatient services, and ad-
ministrative. The number and nature of expense items reported on the income
statement, which depends on the nature and complexity of the organization,
can vary widely. For example, some businesses, typically smaller ones, may
report only two categories of expenses: health services and administrative.
Others may report a whole host of categories. Sunnyvale takes a middle-of-
the-road approach to the number of expense categories. Most users of ¬nancial
statements would prefer more, as well as a mixing of classi¬cations, rather than
less because more insights can be gleaned if an organization reports revenues
and expenses both by service breakdown (e.g., inpatient versus outpatient)
and by type (e.g., salaries versus supplies).
Sunnyvale is typical of most healthcare providers in that the dominant
portion of its cost structure is related to labor. The clinic reported salaries
and bene¬ts of $126,223,000 for 2004. The detail of how these costs are
broken down by department or contract, or the relationship of these expenses
to volume, is not part of the ¬nancial accounting information system. How-
ever, such information, which is very important to managers, is provided by
74 Healthcare Finance



Sunnyvale™s managerial accounting system. Chapters 5 through 8 focus on
managerial accounting matters.
The expense item titled supplies represents the cost of supplies (primar-
ily medical) used in providing patient services. Sunnyvale does not order and
pay for supplies when a particular patient service requires them. Rather, the
clinic™s managers estimate the usage of individual supply items, orders them
beforehand, and then maintains a medical supplies inventory. As readers will
see in Chapter 4, the amount of supplies on hand is reported on the balance
sheet. The income statement expense reported by Sunnyvale represents the
cost of the supplies actually consumed in providing patient services. Thus,
the expense reported for supplies does not re¬‚ect the actual cash spent by
Sunnyvale on supplies purchases. In theory, Sunnyvale could have several years
worth of supplies in its inventories at the beginning of 2004, could have used
some of these supplies without replenishing the stocks, and hence might not
have actually spent one dime of cash on supplies during that year.
Sunnyvale uses commercial insurance to protect against many risks,
including both property risks, such as ¬re and damaging weather, and liability
risks, such as managerial malfeasance and professional (medical) liability. The
cost of this protection is reported on the income statement as insurance
expense.
Sunnyvale owns all of its property (i.e., land and buildings) but
leases (rents) much of its diagnostic equipment. The total amount of lease
payments, $3,189,000 for 2004, is reported as an expense on the income
statement.
The next expense category, depreciation, requires closer examination.
Businesses require ¬xed assets (i.e., long-term assets such as buildings and
equipment) to provide goods and services. Although some of its assets are
leased, Sunnyvale owns most of the ¬xed assets necessary to support its mis-
sion. When the ¬xed assets were initially purchased, Sunnyvale did not report
their purchase price as an expense on the income statement, but the ¬xed
assets were listed on the balance sheet as property owned by the clinic. The
logic of not reporting the cost of such assets when purchased is that it would
be improper to allocate ¬xed asset acquisition costs to a single accounting
period because these assets are used to produce revenues over a much longer
period of time. A more pragmatic reason for not reporting the costs of ¬xed
assets when they are acquired is that such outlays would have a severe impact
on reported pro¬tability in years when large amounts are purchased. Further-
more, reported earnings would ¬‚uctuate widely from year to year on the basis
of the amount of ¬xed assets acquired.
To match the cost of ¬xed assets to the revenues produced by such
long-lived assets, accountants use the concept of depreciation expense, which
spreads the cost of a ¬xed asset over many years. Note that most people use the
terms “cost” and “expense” interchangeably. To accountants, however, the
terms can have different meanings. Depreciation expense is a good example.
75
Chapter 3: Financial Accounting Basics



Here, the term “cost” is applied to the actual cash outlay for a ¬xed asset,
while the term “expense” is used to describe the allocation of that cost over
time. The calculation of depreciation expense is somewhat arbitrary, so the
amount of depreciation expense applied to a ¬xed asset in any year generally
is not closely related to the actual usage of the asset or its loss in market value.
To illustrate, Sunnyvale owns a piece of diagnostic equipment that it uses
infrequently. In 2003 it was used 23 times, while in 2004 it was used only nine
times. Still, the depreciation expense associated with this equipment was the
same $7,725 in both years. Also, the clinic owns another piece of equipment
that could be sold today for about the same price that Sunnyvale paid for it
four years ago, yet each year the clinic reports a depreciation expense for that
equipment, which implies loss of value.
Depreciation expense, like all other ¬nancial statement entries, is calcu-
lated in accordance with GAAP.6 The calculation typically uses the straight-line
method”that is, the depreciation expense is obtained by dividing the histor-
ical cost of the asset, less its estimated salvage value, by the number of years
of its estimated useful life. (Salvage value is the amount, if any, expected to
be received when ¬nal disposition occurs at the end of an asset™s useful life.)
The result is the asset™s annual depreciation expense, which is the charge that
is re¬‚ected in each year™s income statement over the estimated life of the as-
set and, as readers will discover in Chapter 4, accumulated over time on the
organization™s balance sheet. (The term straight-line stems from the fact that
the depreciation expense is constant in each year, and hence the implied value
of the asset declines evenly”like a straight line”over time.)
The next expense category on Sunnyvale™s income statement is provi-
sion for bad debts. As discussed previously, the clinic reports as revenue in each
year the charges for services provided minus discounts and charity care. Thus,
it either collected, or expects to collect, a total of $169,013,000 for patient
services provided in 2004. However, past experience indicates that the clinic
will not collect every dollar that it expects to collect, even though the pay-
ers are assumed to have the ability to pay. Of the reported $169,013,000 in
net patient service revenue, Sunnyvale expects that $2,000,000 will never be
collected. Thus, the clinic either has already collected, or expects to collect,
$167,013,000 for patient services provided in 2004. With bad debt losses run-
ning at about $2,000 / $169,013 = 0.012 = 1.2% of patient service revenue,
Sunnyvale is not losing a high percentage to deadbeat payers. Still, $2,000,000
is a great deal of money, and managers should review the clinic™s collection
policy to ensure that its collection efforts are effective. Finally, accountants
must reconcile actual realized bad debt losses (which will not be known for
some time) with past estimates.
The ¬nal expense line reports interest expense. Sunnyvale owes or paid
its lenders $5,329,000 in interest expense for debt capital supplied during
2004. Not all of the interest expense reported has been paid because Sun-
nyvale typically pays interest monthly or semiannually, and hence interest has
76 Healthcare Finance



accrued on some loans that will not be paid until 2005. The amount of interest
expense reported by an organization is in¬‚uenced primarily by its capital struc-
ture, which re¬‚ects the amount of debt that it uses. Also, interest expense is
affected by the borrower™s creditworthiness, its mix of long-term versus short-
term debt, and the general level of interest rates. (These factors are discussed
in detail at different points in later chapters.)
In closing our discussion of expenses, note that many income state-
ments contain a catchall category labeled “other.” Listed here are general and
administrative expenses that individually are too small to list separately, includ-
ing items such as marketing expenses and external auditor™s fees. Although
organizations cannot possibly report every expense item separately, it is frus-
trating for users of ¬nancial statement information to come across a large,
unexplained expense item. Thus, income statements that include the “other”
category often add a footnote that provides additional detail regarding these
expenses.


Self-Test 1. What is an expense?
Questions 2. Brie¬‚y, what are some of the commonly reported expense categories?
3. What is the logic behind depreciation expense?
4. What is the logic behind the provision for bad losses?


Net Income
Although the reporting of revenues and expenses is clearly important, the
most important single piece of information on the income statement is prof-
itability, as captured in Table 3.1 by the line titled net income. As discussed
earlier, net income is merely the difference between total revenues and to-
tal expenses. To illustrate, Sunnyvale reported net income of $7,860,000 for
2004: $176,092,000 ’ $168,232,000 = $7,860,000.
Because of its location on the income statement and its importance,
net income is referred to as the bottom line. The income statements of not-
for-pro¬t organizations often call the pro¬t line revenues over expenses, excess
of revenues over expenses, change in net assets, or something else. Regardless of
the terminology used, not-for-pro¬t organizations are required by GAAP to
include a performance indicator on their income statements that reports the
¬nancial results (pro¬tability) of the organization. Throughout this book, we
will refer to this performance indicator as net income because this terminology,
which is used on for-pro¬t income statements, has universal recognition.
In spite of the fact that Sunnyvale is a not-for-pro¬t organization, it still
must make a pro¬t. If the clinic is to offer new services in the future, it must
earn a pro¬t today to produce the funds needed for new assets. Because of
in¬‚ation, the clinic could not even replace its current ¬xed asset base as needed
77
Chapter 3: Financial Accounting Basics



without the funds generated by pro¬table operations. Thus, turning a pro¬t
is essential for all businesses, including those having not-for-pro¬t status. The
logic behind this statement is examined in more detail in the next section.
What happens to an organization™s net income? For the most part, it
is reinvested in the organization. Not-for-pro¬t businesses must reinvest all
earnings in the business. An investor-owned business, on the other hand, may
return a portion or all of its net income to owners in the form of dividend
payments. The amount of pro¬ts reinvested in an investor-owned business,
therefore, is net income minus the amount paid out as dividends.
The proportion of net income paid out to owners is called the pay-
out ratio, while the proportion retained within the business is called the re-
tention ratio. Thus, if Sunnyvale were an investor-owned clinic, and if it
paid $2,000,000 in dividends in 2004, its payout ratio would be $2,000 /
$7,860 = 0.254 = 25.4% and its retention ratio would be ($7,860 ’ $2,000)
/ $7,860 = $5,860 / $7,860 = 0.746 = 74.6%. Note that net income only
has two places to go”to owners as dividends or to the business as retained
earnings”so Retention ratio = 1 ’ Payout ratio and Payout ratio = 1 ’
Retention ratio.
Net income measures pro¬tability as de¬ned by GAAP. In establish-
ing GAAP, accountants have created guidelines that attempt to measure the
economic income of a business, which, in all honesty, is a very dif¬cult task be-
cause economic gains and losses often are not tied to easily identi¬able events.
Furthermore, because of accrual accounting and the matching principle, the
fact that Sunnyvale reported net income of $7,860,000 for 2004 does not
mean that the clinic, on net, experienced a cash in¬‚ow of that amount. This
point is discussed in greater detail in the next section.
Before moving on, note that some not-for-pro¬t income statements
contain a section below the net income entry that reconciles the reported
net income with the net assets (i.e., equity) reported on the balance sheet.
In essence, the entire amount of net income of not-for-pro¬t organizations
must be reinvested in the business, so the amount of net assets reported on
the balance sheet, after various adjustments, must increase over the year by
the amount of net income. The important relationships between the income
statement and the balance sheet are considered in more depth in Chapter 4.


Self-Test
1. How is net income calculated?
Questions
2. Why is net income called the bottom line?
3. What happens to net income?
4. What is the payout ratio?
5. What is the retention ratio?
6. What are the payout and retention ratios of a not-for-pro¬t organization?
78 Healthcare Finance




Net Income Versus Cash Flow
As stated previously, the income statement reports pro¬tability as net income,
which is determined in accordance with GAAP. Although net income is an
important measure of pro¬tability, an organization™s ¬nancial condition, at
least in the short run, depends more on the actual cash that ¬‚ows into and
out of the business than it does on reported net income. Thus, occasionally
a business will go bankrupt even though its net income has historically been
positive. More commonly, many businesses that have reported negative net
incomes (i.e., net losses) have survived with little or no ¬nancial damage. How
can these things happen?
The problem is that the income statement is like a mixture of ap-
ples and oranges. Consider Table 3.1. Sunnyvale reported total revenues of
$176,092,000 for 2004. Yet, even if we assume no bad debt losses, this is
not the amount of cash that was actually collected during the year, because
some of these revenues will not be collected until 2005. Furthermore, some
revenues reported for 2003 were actually collected in 2004, but these don™t
appear on the 2004 income statement. Thus, because of accrual accounting,
reported revenue is not the same as cash revenue. The same logic applies to
expenses; few of the values reported as expenses on the income statement
are the same as the actual cash out¬‚ows. To make matters even worse, not
one cent of depreciation expense was paid out as cash. Depreciation expense
is an accounting re¬‚ection of the cost of ¬xed assets, but Sunnyvale did not
actually pay out $6,405,000 in cash to someone called the “collector of depre-
ciation.” According to the balance sheet (Table 4.1), Sunnyvale actually paid
out $88,549,000 sometime in the past to purchase the clinic™s total ¬xed as-
sets, of which $6,405,000 was recognized in 2004 as a cost of doing business,
just as salaries and fringe bene¬ts are a cost of doing business.
Can net income be converted to cash ¬‚ow”the actual amount of cash
generated during the year? As a rough estimate, cash ¬‚ow can be thought of as
net income plus noncash expenses. Thus, the cash ¬‚ow generated by Sunnyvale
in 2004 is not merely the $7,860,000 reported net income, but this amount
plus the $6,405,000 shown for depreciation, for a total of $14,265,000.
Depreciation expense must be added back to net income to get cash ¬‚ow
because it initially was subtracted from revenues to obtain net income even
though there was no associated cash outlay.
Here is another way of looking at cash ¬‚ow versus accounting income:
If Sunnyvale showed no net income for 2004, it would still be generating
cash of $6,405,000 because that amount was listed as an expense but not
actually paid out in cash. The idea behind the income statement treatment is
that Sunnyvale would be able to set aside the depreciation amount, which
is above and beyond its operating expenses, this year and in future years.
Eventually, the accumulated total of depreciation cash ¬‚ow would be used by
79
Chapter 3: Financial Accounting Basics



Sunnyvale to replace its ¬xed assets as they wear out or become obsolete.
Thus, the incorporation of depreciation expense into the cost, and ultimately
the price structure, of services provided is designed to ensure the ability of
an organization to replace its ¬xed assets as needed, assuming that the assets
could be purchased at their historical cost. To be more realistic, businesses
must plan to generate net income, in addition to the accumulated depreciation
funds, suf¬cient to replace existing ¬xed assets in the future at in¬‚ated costs
or even to expand the asset base. It appears that Sunnyvale does have such
capabilities as re¬‚ected in its $7,860,000 net income and $14,265,000 cash
¬‚ow for 2004.
It is important to understand that because of accrual accounting the
$14,265,000 cash ¬‚ow calculated here is only an estimate of actual cash ¬‚ow
for 2004, because almost every item of revenues and expenses listed on the
income statement does not equal its cash ¬‚ow counterpart. The greater the
difference between the reported values and cash values, the less reliable is the
rough estimate of cash ¬‚ow de¬ned here. The value of knowing the precise
amount of cash generated or lost has not gone unnoticed by accountants. In
Chapter 4, readers will learn about the statement of cash ¬‚ows, which can be
thought of as an income statement that is recast to focus on cash ¬‚ow.



Self-Test
1. What is the difference between net income and cash ¬‚ow?
Questions
2. How can income statement data be used to estimate cash ¬‚ow?
3. Why do not-for-pro¬t businesses need to make pro¬ts?



Income Statements of Investor-Owned Firms
Our income statement discussion focused on a not-for-pro¬t organization:
Sunnyvale Clinic. What do the income statements for investor-owned ¬rms
such as HCA and Beverly Enterprises look like? The ¬nancial statements of
investor-owned ¬rms and not-for-pro¬t businesses are generally similar except
for transactions, such as tax payments, that are applicable only to one form
of ownership. Because the transactions of all health services organizations in
the same core business are similar, ownership plays only a minor role in the
presentation of ¬nancial statement data. In reality, more differences exist in
¬nancial statements because of lines of business (e.g., hospitals versus nursing
homes versus managed care plans) than differences because of ownership.



Self-Test
1. Are there appreciable differences in the income statements of not-for-
Question
pro¬t businesses and investor-owned businesses?
80 Healthcare Finance



A Look Ahead: Using Income Statement
Data in Financial Statement Analysis
Chapter 17 discusses in some detail the techniques used to analyze ¬nancial
statements. The purpose of such an analysis is to gain insights into a business™s
¬nancial condition. At this point, however, it would be worthwhile to intro-
duce ratio analysis ”one of the techniques used in ¬nancial statement analysis.
In ratio analysis, values found on the ¬nancial statements are combined to
form ratios that have economic meaning and hence that help managers and
investors interpret the numbers.
To illustrate, total pro¬t margin, usually just called total margin, is
de¬ned as net income divided by total revenues. For Sunnyvale Clinic, the
total margin for 2004 was $7,860,000 / $176,092,000 = 0.045 = 4.5%.
Thus, each dollar of revenues generated by the clinic produced 4.5 cents of
pro¬t (i.e., net income). By implication, each dollar of revenues required 95.5
cents of expenses. The total margin is a measure of expense control; for a

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