. 4
( 21)


given amount of revenues, the higher the net income, and hence total margin,
the lower the expenses. If the total margin for other clinics were known,
judgments about how well Sunnyvale is doing in the area of expense control,
relative to its peers, could be made.
Sunnyvale™s total margin for 2003 was $8,206,000 / $146,600,000 =
0.060 = 6.0%, so the clinic™s total margin slipped from 2003 to 2004. This
¬nding should alert managers to examine carefully the increase in expenses in
2004. In effect, Sunnyvale™s expenses increased faster than its revenues, which
resulted in falling pro¬tability as measured by the total margin. If this trend
continues, it would not take long for the clinic to be operating in the red (i.e.,
losing money).
A complete discussion of ratio analysis can be found in Chapter 17.
The discussion here, along with a brief visit in Chapter 4, is merely intended
to give readers a preview of how ¬nancial statement data can be used to make
judgments about a business™s ¬nancial condition.

Self-Test 1. Explain how ratio analysis can be used to help interpret income state-
Questions ment data.
2. What is the total pro¬t margin, and what does it measure?

Key Concepts

Financial accounting information is the result of a process of identifying,
measuring, recording, and communicating the economic events and status
of an organization to interested parties. This information is summarized and
Chapter 3: Financial Accounting Basics

presented in three primary ¬nancial statements: the income statement, the
balance sheet, and the statement of cash ¬‚ows. The key concepts of this
chapter are:
• The predominant users of ¬nancial accounting information are parties who
have a direct ¬nancial interest in the economic status of a
business”primarily its managers and investors.
• Generally accepted accounting principles (GAAP ) establish the standards
for ¬nancial accounting measurement and reporting. These principles have
been sanctioned by the Securities and Exchange Commission (SEC ),
developed by the Financial Accounting Standards Board (FASB), and
re¬ned by the American Institute of Certi¬ed Public Accountants
(AICPA) and other organizations.
• The preparation and presentation of ¬nancial accounting data is based on
a set of principles, the most important of which are: (1) accounting entity,
(2) going concern, (3) accounting period, (4) objectivity, (5) reliability,
(6) monetary unit, (7) relevance, (8) full disclosure, (9) materiality,
(10) conservatism, (11) consistency, and (12) comparability.
• Under cash accounting, economic events are recognized when the ¬nancial
transaction occurs. Under accrual accounting, economic events are
recognized when the obligation to make payment occurs. Because of the
matching principle, GAAP require that businesses use accrual accounting.
• The collection and recording of ¬nancial accounting data uses the
following concepts: (1) transaction, (2) posting, (3) chart of accounts,
(4) general ledger, (5) double entry, and (6) T account.
• The income statement reports on an organization™s operations over a
period of time. Its basic structure consists of revenues, expenses, and pro¬t
(i.e., net income), which equals revenues minus expenses.
• Revenues are monies collected or expected to be collected by the business.
Revenues are broken down into categories such as net patient service
revenue, premium revenue, and other revenue.
• Expenses are the economic costs associated with the provision of services.
• Net income represents the economic pro¬tability of a business as de¬ned
by GAAP.
• Because the income statement is constructed using accrual accounting, net
income does not represent the actual amount of cash that has been earned
or lost during the reporting period. To estimate cash ¬‚ow, noncash
expenses (primarily depreciation) must be added back to net income.
• The income statements of investor-owned and not-for-pro¬t businesses
tend to look very much alike. However, the income statements of health
services organizations in different lines of business can vary. The good
news is that all income statements have essentially the same economic
• Ratio analysis, which combines values that are found in the ¬nancial
82 Healthcare Finance

statements, helps managers and investors interpret the data with the goal
of making judgments about the ¬nancial condition of the business.

In this chapter, we focused on ¬nancial accounting basics and the income
statement. In Chapter 4, the discussion of ¬nancial accounting continues with
the remaining two statements: the balance sheet and statement of cash ¬‚ows.

3.1 a. What is a stakeholder?
b. What stakeholders are most interested in the ¬nancial condition of a
healthcare provider?
3.2 a. What are generally acceptable accounting principles (GAAP)?
b. What is the purpose of GAAP?
c. What organizations are involved in establishing GAAP?
3.3 Brie¬‚y describe the following concepts as they apply to the preparation
of ¬nancial statements:
a. Accounting entity
b. Going concern
c. Accounting period
d. Objectivity and reliability
e. Monetary unit
f. Relevance
g. Full disclosure
h. Materiality
i. Conservatism
j. Consistency and comparability
3.4 Explain the difference between cash and accrual accounting. Be sure to
include a discussion of the matching principle.
3.5 Brie¬‚y describe the format of the income statement.
3.6 a. What is the difference between gross revenues and net revenues?
(Hint: Think about discounts and charity care.)
b. What is the difference between patient service revenue and other
c. What is the difference between charity care and bad debt losses? How
is each handled on the income statement?
3.7 a. What is meant by the term expense?
b. What is depreciation expense, and what is its purpose?
c. What are some other categories of expenses?
3.8 a. What is net income?
b. Why is net income called the bottom line?
c. What is the difference between net income and cash ¬‚ow?
d. Is ¬nancial condition more closely related to net income or to cash
Chapter 3: Financial Accounting Basics

3.1 Entries for the Warren Clinic 2004 income statement are listed below in
alphabetical order. Reorder the data in proper format.

Bad debt expense $ 40,000
Depreciation expense 90,000
General/administrative expenses 70,000
Interest expense 20,000
Interest income 40,000
Net income 30,000
Other revenue 10,000
Patient service revenue 440,000
Purchased clinic services 90,000
Salaries and bene¬ts 150,000
Total revenues 490,000
Total expenses 460,000

3.2 Consider the following income statement:

BestCare HMO
Statement of Operations
Year Ended June 30, 2004
(in thousands)

Premiums earned $26,682
Coinsurance 1,689
Interest and other income 242
Total revenues $28,613
Salaries and bene¬ts $15,154
Medical supplies and drugs 7,507
Insurance 3,963
Provision for bad debts 19
Depreciation 367
Interest 385
Total expenses $27,395

Net income $ 1,218

a. How does this income statement differ from the one presented in
Table 3.1?
b. Did BestCare spend $367,000 on new ¬xed assets during ¬scal year
2004? If not, what is the economic rationale behind its reported
depreciation expense?
84 Healthcare Finance

c. Explain the provision for bad debts entry.
d. What is BestCare™s total pro¬t margin? How can it be interpreted?

3.3 Consider this income statement:

Green Valley Nursing Home, Inc.
Statement of Income
Year Ended December 31, 2004

Net patient service revenue $3,163,258
Other revenue 106,146
Total revenues $3,269,404
Salaries and bene¬ts $1,515,438
Medical supplies and drugs 966,781
Insurance and other 296,357
Provision for bad debts 110,000
Depreciation 85,000
Interest 206,780
Total expenses $3,180,356
Operating income $ 89,048
Provision for income taxes 31,167

Net income $ 57,881

a. How does this income statement differ from the ones presented in
Table 3.1 and Problem 3.2?
b. Why does Green Valley show a provision for income taxes while the
other two income statements did not?
c. What is Green Valley™s total pro¬t margin? How does this value
compare with the values for Sunnyvale Clinic and BestCare?
d. The before-tax pro¬t margin for Green Valley is operating income
divided by total revenues. Calculate Green Valley™s before-tax pro¬t
margin. Why may this be a better measure of expense control when
comparing an investor-owned business with a not-for-pro¬t business?

3.4 Great Forks Hospital reported net income for 2004 of $2.4 million on
total revenues of $30 million. Depreciation expense totaled $1 million.
a. What were total expenses for 2004?
b. What were total cash expenses for 2004? (Hint: Assume that all
expenses, except depreciation, were cash expenses.)
c. What was the hospital™s 2004 cash ¬‚ow?
3.5 Brandywine Homecare, a not-for-pro¬t business, had revenues of $12
Chapter 3: Financial Accounting Basics

million in 2004. Expenses other than depreciation totaled 75 percent of
revenues, and depreciation expense was $1.5 million. All revenues were
collected in cash during the year and all expenses other than depreciation
were paid in cash.
a. Construct Brandywine™s 2004 income statement.
b. What were Brandywine™s net income, total pro¬t margin, and cash
c. Now, suppose the company changed its depreciation calculation
procedures (still within GAAP) such that its depreciation expense
doubled. How would this change affect Brandywine™s net income,
total pro¬t margin, and cash ¬‚ow?
d. Suppose the change had halved, rather than doubled, the ¬rm™s
depreciation expense. Now, what would be the impact on net income,
total pro¬t margin, and cash ¬‚ow?
3.6 Assume that Mainline Homecare, a for-pro¬t corporation, had exactly
the same situation as reported in Problem 3.5. However, Mainline must
pay taxes at a rate of 40 percent of pretax income. Assuming that the
same revenues and expenses reported for ¬nancial accounting purposes
would be reported for tax purposes, redo Problem 3.5 for Mainline.

1. The Government Accounting Standards Board (GASB) has the identical
responsibility for businesses that are partially or totally funded by a government
entity. Also, note that the predecessor organization to FASB was called the
Accounting Principles Board (APB), which provided guidance in the form of
2. Historically, external auditors were mostly concerned with the letter of the law.
Their work was relatively narrow in scope, primarily ensuring that ¬nancial
statements were prepared and presented in accordance with GAAP. However,
this approach seldom identi¬ed problems, especially fraud, which affected the
organization™s ¬nancial condition. After several large lawsuits found major
accounting ¬rms negligent in failing to identify problem areas, auditors are now
paying much more attention to the activities behind the numbers.
3. Each year, the FASB must deal with very dif¬cult and controversial matters. As
this edition is being written, the FASB is grappling with how to report new and
complex ¬nancial instruments that have characteristics of both debt and equity.
4. Investor-owned health services organizations with publicly traded securities are
required by the Securities and Exchange Commission (SEC) to ¬le both annual
and quarterly ¬nancial statements. Many of these statements are available for free
at various sites on the Internet. For example, see www.freeedgar.com.
5. Although there are four basic ¬nancial statements, this book covers only the
three statements that are most important. The fourth statement, titled the
statement of changes in net assets or the statement of changes in equity, focuses on
changes in the equity position from one year to the next. Because this statement
86 Healthcare Finance

is relatively short, not-for-pro¬t organizations have the option to include it at
the end of the income statement.
6. In addition to depreciation calculated for ¬nancial statement purposes, which
is called book deprecation, for-pro¬t businesses must calculate depreciation for
tax purposes. Tax depreciation is calculated in accordance with IRS regulations
as opposed to GAAP. Also, note that land is not depreciated for either ¬nancial
reporting or tax purposes.

AICPA. 2003. Audit and Accounting Guide. New York: American Institute of Certi-
¬ed Public Accountants.
. 2003. Checklists and Illustrative Financial Statements for Health Care Orga-
nizations. New York: American Institute of Certi¬ed Public Accountants.
Bitter, M. E., and J. Cassidy. 1992. “Perceptions of New AICPA Audit Guide.”
Healthcare Financial Management (November): 38“48.
CRAHCA. 1996. Medical Group Practice Chart of Accounts. Englewood, CO: Center
for Research in Ambulatory Health Care Administration.
Duis, T. E. 1993. “The Need for Consistency in Healthcare Reporting.” Healthcare
Financial Management (July): 40“44.
. 1994. “Unravelling the Confusion Caused by GASB, FASB Accounting
Rules.” Healthcare Financial Management (November): 66“69.
Maco, P. S., and S. J. Weinstein. 2000. “Accounting and Accountability: Observations
on the AHERF Settlements.” Healthcare Financial Management (October):
Peregrine, M. W., and J. R. Schwartz. 2002. “What CFOs Should Know”And Do”
About Corporate Responsibility.” Healthcare Financial Management (De-
cember): 60“63.
Robbins, W. A., and R. Turpin. 1993. “Accounting Practice Diversity in the Health-
care Industry.” Healthcare Financial Management (May): 111“114.
Seawell, L. V. 1999. Chart of Accounts for Hospitals. Chicago: Probus Publishing.


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

• Explain the purpose of the balance sheet.
• Describe the contents of the balance sheet and its interrelationship
with the income statement.
• Explain the purpose of the statement of cash ¬‚ows.
• Describe the contents of the statement of cash ¬‚ows and how it
differs from the income statement.
• Describe how a business™s transactions affect its income statement
and balance sheet.

Although the income statement, which was covered in Chapter 3, contains in-
formation about an organization™s operations, it does not provide information
about the resources needed to produce the revenues or how those resources
were ¬nanced. Another ¬nancial statement, the balance sheet, contains infor-
mation about an organization™s assets and the ¬nancing used to acquire those
In addition to the need to disclose resources and ¬nancing, accountants
and managers have, over time, become increasingly aware that net income is
not the only determinant of ¬nancial condition. Although net income, which
re¬‚ects an organization™s economic pro¬tability as de¬ned by GAAP, is an
important pro¬tability measure, ¬nancial condition, especially in the short-
run, is also related to the actual ¬‚ow of cash into and out of a business. The
second ¬nancial statement discussed in this chapter, the statement of cash ¬‚ows,
focuses on this important determinant of ¬nancial condition.
Although understanding the composition of the ¬nancial statements is
essential, it is also very important that managers understand the relationships
among the ¬nancial statements. Thus, emphasis is placed on the interrelation-
ships among the statements throughout the chapter. Finally, the end of the
chapter contains a brief introduction on how actual business transactions work
88 Healthcare Finance

their way into an organization™s ¬nancial statements. Our purpose here is to
provide readers with a feel for how ¬nancial statements are actually created.

Balance Sheet Basics
Whereas the income statement reports the results of operations over a period
of time, the balance sheet presents a snapshot of the ¬nancial position of an
organization at a given point in time. For this reason, the balance sheet is also
called the statement of ¬nancial position. The balance sheet changes every day
as a business increases or decreases its assets, or changes the composition of
its ¬nancing. The important point is that the balance sheet, unlike the income
statement, re¬‚ects a business™s ¬nancial position as of a given date, and the
data in it typically become invalid one day later, even when both dates are in
the same accounting period. Healthcare providers with seasonal demand, such
as a walk-in clinic in Fort Lauderdale, Florida, have especially large changes
in their balance sheets during the year. For such businesses, a balance sheet
constructed in February can look quite different from one prepared in August.
Also, businesses that are growing very rapidly will have signi¬cant changes in
their balance sheets over relatively short periods of time.
The balance sheet lists, as of the end of the reporting period, the
resources of an organization and the claims against those resources. In other
words, the balance sheet reports the assets of an organization and how those
assets were ¬nanced. The balance sheet has the following basic structure:

Assets Liabilities and Equity
Current assets Current liabilities
Long-term assets Long-term liabilities

Total assets Total liabilities and equity

The assets side (left side) of the balance sheet lists all the resources, or assets,
owned by the organization in dollar terms. In general, assets are broken down
into categories that distinguish short-lived assets from long-lived assets. The
liabilities and equity side (claims side or right side) lists the claims against
these resources, again in dollar terms. In essence, the right side reports the
sources of ¬nancing (capital) used to acquire the assets listed on the left side.
The sources of capital are divided into two broad categories: liabilities, which
are claims ¬xed by contract, and equity, which is a residual claim that depends
on asset values and the amount of liabilities. As with assets, liabilities are listed
by maturity (short-term versus long-term)
Perhaps the most important characteristic of the balance sheet is sim-
ply that it must balance”that is, the left side must equal the right side. This
Chapter 4: The Balance Sheet

relationship, which is called the accounting identity or basic accounting equa-
tion, is expressed in equation form as:

A = L + E,
where A = Total assets, L = Total liabilities, and E = Equity. Because creditor
claims are paid before equity claims if a healthcare organization is liquidated,
liabilities are shown before equity both on the balance sheet and in the basic
accounting equation.
Note that the accounting identity can be rearranged as follows:

E = A ’ L.
This format reinforces the concept that equity represents a residual claim
against the total assets of the business and the fact that equity can be negative.
If a business writes down (decreases) the value of its assets, its liabilities are
unaffected because these amounts are still owed to creditors and others. If
total assets are written down so much that their value drops below that of total
liabilities, then the equity reported on the balance sheet becomes a negative
Table 4.1 contains Sunnyvale™s balance sheet, which follows the basic
structure explained above. The title of the balance sheet reinforces the fact that
the data are presented for the entire clinic. The balance sheet is not going
to provide much information, if any, about the subparts of an organization
such as departments or service lines. Rather, the balance sheet will provide an
overview of the economic position of the organization as a whole. The timing
of the balance sheet is also apparent in the title. The data are reported for
2004 and 2003 as of December 31. Whereas Sunnyvale™s income statement
indicates the data were for the years ended on December 31, the balance
sheet merely indicates a closing date. This minor difference in terminology
reinforces the point that the income statement reports operational results over
a period of time, while the balance sheet reports ¬nancial position as of a single
point in time. Finally, the amounts reported on Sunnyvale™s balance sheet, just
as on its income statement, are expressed in thousands of dollars.
The format of the balance sheet emphasizes the basic accounting
equation. For example, as of December 31, 2004, Sunnyvale had a total of
$154,815,000 in assets that were ¬nanced by a total of $154,815,000 of li-
abilities and equity. Besides this obvious con¬rmation that the balance sheet
balances, this statement indicates that the total assets of Sunnyvale were val-
ued, according to GAAP, at $154,815,000. Liabilities and equity represent
claims against the assets of the business by various classes of creditors, other
claimants with ¬xed claims, and “owners.” Creditors and other claimants have
¬rst priority in claims for $100,747,000 and “owners” follow with a residual
claim of $54,068,000. The right side of the balance sheet (liabilities and eq-
uity, which are in the bottom section of Table 4.1) re¬‚ects the manner in
which Sunnyvale raised the capital needed to acquire its assets.
90 Healthcare Finance

ASSETS 2004 2003
Clinic: Balance
Current Assets:
Cash $ 12,102 $ 6,486
December 31,
Marketable securities 10,000 5,000
2004 and 2003 Net patient accounts receivable 28,509 25,927
(in thousands) Inventories 3,695 2,302
Total current assets $ 54,306 $ 39,715
Long-term investments $ 48,059 $ 25,837
Property and Equipment (Fixed Assets):
Land $ 2,954 $ 2,035
Buildings and equipment 85,595 77,208
Gross ¬xed assets $ 88,549 $ 79,243
Less: Accumulated depreciation 36,099 29,694
Net ¬xed assets $ 52,450 $ 49,549
Total assets $ 154,815 $ 115,101


Current Liabilities:
Notes payable 4,334 3,345
Accounts payable 5,022 6,933
Accrued expenses: 6,069 5,037

Total current liabilities $ 15,425 $ 15,315

Long-term debt $ 85,322 $ 53,578

Total liabilities $100,747 $ 68,893

Net assets (Equity) $ 54,068 $ 46,208

Total liabilities and equity $ 154,815 $ 115,101

Self-Test 1. What is the purpose of the balance sheet?
Questions 2. What are the three major sections of the balance sheet?
3. What is the accounting identity, and what information does it provide?

Assets either possess or create economic bene¬t for the organization. Ta-
ble 4.1 contains three major categories of assets: current assets, long-term
Chapter 4: The Balance Sheet

investments, and property and equipment (¬xed assets). The following sec-
tions describe each asset category in detail.

Current Assets
Current assets include cash and other assets that are expected to be converted
into cash within one accounting period, which in this example is one year.
For Sunnyvale, current assets total $54,306,000 at the end of 2004. Suppose
that the marketable securities on the books at that time were converted into
cash as they matured; the receivables were collected; and the inventories were
used, billed to patients, and collected; all at the values stated on the balance
sheet. With all else the same, Sunnyvale would have $54,306,000 in cash at
the end of 2005. Of course, all else will not be the same, so Sunnyvale™s 2005
reported cash balance will undoubtedly be different from $54,306,000. Still,
this little exercise reinforces the concept behind the current asset category:
the assumption that these assets will be converted into cash during the next
accounting period.
The conversion of current assets into cash is expected to provide all or
part of the funds that will be needed to pay off the $15,425,000 in current
liabilities outstanding at the end of 2004 as they become due in 2005. Thus,
current assets are one factor that makes up the liquidity of the organization.
A business is liquid if it has the cash available to pay its bills as they become
due. The difference between total current assets and total current liabilities
is called net working capital. Thus, at the end of 2004, Sunnyvale had net
working capital of $54,306,000 ’ $15,425,000 = $38,881,000. From a
pure liquidity standpoint, the greater an organization™s net working capital,
the better. However, as will be pointed out in this and subsequent chapters,
there are costs to carrying current assets, so health services organizations have
to balance the need for liquidity against the associated costs of maintaining
liquidity. Also, as we will discuss elsewhere, there are other factors, such as
expected cash in¬‚ows, that contribute to a business™s overall liquidity.
Within Sunnyvale™s current assets, there is $12,102,000 in cash”an
account that represents actual cash in hand plus money held in commercial
checking accounts (demand deposits). There is also $10,000,000 of short-
term marketable securities, which represent short-term investments in highly
liquid, low-risk securities such as bank savings accounts, money market mutual
funds, U.S. Treasury bills, or prime commercial paper.1 Organizations hold
marketable securities because cash and money held in commercial checking
accounts do not earn interest. Thus, businesses should hold only enough cash
and checking account balances to pay their recurring operating expenses”
any funds on hand in excess of immediate needs should be invested in safe,
short-term, highly liquid (but interest bearing) securities. Additionally, mar-
ketable securities are built up periodically to meet projected nonoperating cash
outlays such as tax payments, investments in property and equipment, and le-
gal judgments. Even though marketable securities pay relatively low interest,
92 Healthcare Finance

any return is better than none, so marketable securities are preferable to cash
Marketable securities normally are reported on the balance sheet at
cost, which is the amount initially paid for the securities. However, because of
changing interest rates and other factors, the marketable securities may actu-
ally be worth more or less than their purchase price. Still, because marketable
securities have maturities of less than one year, it is rare for their market values
to be substantially different from their costs. Furthermore, the current market
value of the securities is listed in the notes to the ¬nancial statements.
Net patient accounts receivable represents money owed to Sunnyvale for
services that the clinic has already provided. As discussed in Chapter 2, and
reiterated in Chapter 3, third-party payers make most payments for health-
care services, and these payments often take weeks or months to be billed,
processed, and ultimately paid. The patient accounts receivable amount of
$28,509,000 at the end of 2004 is listed on the balance sheet net of allowances
for discounts, charity care, and bad debt losses. Thus, the presentation on
the balance sheet is consistent with the Chapter 3 discussion concerning net
patient service revenue.
The $28,509,000 net receivable amount seen on the balance sheet is a
subset of the income statement™s net patient service revenue of $169,013,000
for 2004 (see Table 3.1 in Chapter 3). The logic is as follows. A total of
$169,013,000 was billed to patients and payers during 2004. This is a “net”
number as there is some higher gross amount of charges in Sunnyvale™s man-
agerial accounting system that re¬‚ects charges before deductions for discounts
and charity care. Of this $169,013,000 of patient service revenue, $2,000,000
is shown as a provision for bad debts on the income statement. This bad debt
expense represents Sunnyvale™s estimate, based on past experience, of the to-
tal dollar amount of net patient service revenue that will never be collected.
Thus, Sunnyvale actually expected to receive $169,013,000 ’ $2,000,000 =
$167,013,000 in cash revenues for services provided during 2004.
The fact that $28,509,000 of this net patient service revenue re-
mains to be collected suggests that the difference between $167,013,000 and
$28,509,000, which totals $138,504,000, was collected during 2004. Where
is this collected cash? It could be anywhere. Most of it went right out the door
to pay operating expenses. Some of the collected cash may have been used to
purchase assets (e.g., new equipment) and hence may be sitting in one of the
asset accounts on the balance sheet. If the clinic were to close its doors on the
last day of 2004, its patient accounts receivable balance of $28,509,000 would
fall to zero when the entire amount was collected (except for any errors in the
bad debt forecast). However, if Sunnyvale continues as an ongoing enterprise,
the receivables balance really never falls to zero because while Sunnyvale™s col-
lections are lowering it, new services are constantly being provided that create
new billings, and hence new receivables, that are added to it.
Chapter 4: The Balance Sheet

The ¬nal current asset on Table 4.1, inventories, primarily re¬‚ects Sun-
nyvale™s investment in medical supplies. The value of supplies on hand at the
end of 2004 was $3,695,000. As with the cash account, it is not in a business™s
best interest to maximize the amount of inventories that it holds. There is
a certain level of supplies necessary to meet medical needs and to maintain
a safety stock to guard against unexpected surges in usage. However, many
health services organizations are trying to drive their investment in inventories
toward zero through aggressive inventory management. One technique being
used is the just-in-time system, in which suppliers are expected to manage the
inventory and, as the term suggests, deliver the inventory to providers just
before it is needed.
Businesses that hold large amounts of inventories, such as medical
supply companies, typically include a footnote that discusses the speci¬c ac-
counting practices used to value those inventories. However, most healthcare
providers hold relatively small levels of inventories, and hence footnote in-
formation often is not provided. In fact, because of the materiality principle
discussed in Chapter 2, many providers do not break out inventories as a sep-
arate item on their balance sheets, but include the value of inventories in a
catchall account called other current assets.
It should be obvious that the primary purposes served by the current
asset accounts are to support the operations of the organization and to provide
liquidity. However, current assets do not generate high returns. For example,
cash earns no return, and marketable securities generally earn relatively low
returns. The receivables account does not earn interest income nor generate
new patient service revenue, and inventories represent dollar amounts invested
in items sitting on shelves, which earn no return until patients are billed
for their use. Because of the low (or zero) return earned on current assets,
businesses try to minimize these accounts yet ensure that the levels on hand
are suf¬cient to support operations and maintain liquidity. (Readers will learn
much more about current asset management in Chapter 16.)
Notice that the current assets section of the balance sheet is listed in
order of liquidity, or nearness to cash. Cash, as the most liquid asset, is listed
¬rst, while the least liquid of current assets, inventories, is listed last. Dollars
invested in inventories will ¬rst move into patient accounts receivable as the
patients are billed for the supplies utilized. Then, accounts receivable will
eventually be converted into cash when they are collected and, perhaps, shifted
to marketable securities if the cash is not needed to pay current bills.
The importance of converting current assets into marketable securi-
ties as quickly as possible, and ultimately converting zero-return assets into
some-return assets, cannot be overemphasized. Under most reimbursement
methods, providers must ¬rst build the current assets necessary to provide the
services, then actually do the work, and ¬nally, some time later (often 60 days
or more), get paid. Providers that operate under capitation have a signi¬cant
94 Healthcare Finance

liquidity advantage as compared to those that primarily receive fee-for-service
revenue. As discussed in Chapter 2, payment for capitated services occurs up-
front, before the services are actually provided. Thus, providers that work in a
predominantly capitated environment will have much smaller accounts receiv-
able balances and much larger cash and marketable securities balances than do
providers, such as Sunnyvale, that operate in a predominantly fee-for-service

Long-Term Investments
The second major asset category (after current assets) is long-term investments,
which is the money Sunnyvale has invested in various forms of long-term (ma-
turities that exceed one year) securities. This account represents investments in
long-term ¬nancial assets, as opposed to investments in long-term real assets,
which are listed next on the balance sheet as property and equipment (¬xed
assets). The $48,059,000 reported at the end of 2004 represent the amount
that the clinic has invested in stocks, bonds, and other investments that have
a longer maturity than marketable securities and that hopefully will provide
Sunnyvale with a higher return.
Long-term securities investments are reported on the balance sheet at
fair market value, rather than initial cost, so changes in market conditions over
time will cause the value of this account to change, even if the securities held
remain the same. Also, changes in market values of long-term investments
result in unrealized gains or losses on the investments, which must be incor-
porated into the income statement. A footnote will usually reveal the details
of the types of security investments held by the organization and the resulting
gains and losses. The income produced by the long-term investments, as well
as the income earned on marketable securities, is reported on the income state-
ment as other revenue. As discussed in Chapter 3, Sunnyvale reported other
revenue of $7,079,000 for 2004. According to the footnotes, this amount
included interest income of $3,543,000.
The discussion of current assets emphasized that businesses try to min-
imize the amounts held, maintaining only the amounts necessary to support
operations. One of the bene¬ts of prudent management of working capital
(current assets) is that more money can be moved into long-term investments,
both ¬nancial and real, which generate greater returns than those provided by
current assets. The ultimate rewards for minimizing an organization™s work-
ing capital are both the reduction in carrying costs (current assets costs money
because each dollar in assets has to be matched by a dollar of ¬nancing) and
the increased return available on long-term investments.
Sunnyvale is not in the ¬nancial services business; it is in the business of
providing healthcare services. Still, not-for-pro¬t organizations typically carry
large amounts of long-term securities investments, generally funded from
depreciation cash ¬‚ow and hence often called funded depreciation. Eventually,
the funds invested in long-term securities investments will be used to purchase
Chapter 4: The Balance Sheet

real assets that provide new or improved services to Sunnyvale™s patients. In
contrast, investor-owned businesses usually do not build up such reserves. Any
cash ¬‚ow above the amount needed for near-term reinvestment in the business
would likely be returned to the capital suppliers, either by debt repurchases
or, more typically, by dividends or stock repurchases. When additional capital
is needed for long-term asset investment, an investor-owned business simply
accesses the capital markets for additional ¬nancing.

Property and Equipment (Fixed Assets)
The third major asset category is property and equipment, often called ¬xed
assets. Fixed assets, as compared to current assets, and even compared to long-
term securities investments, are highly illiquid and are used over long periods
of time by the organization. Whereas current assets rise and fall spontaneously
with the organization™s level of operations, ¬xed assets (land, buildings, and
equipment) are normally maintained at a level suf¬cient to handle peak patient
Fixed assets are listed at historical cost (the purchase price) minus ac-
cumulated depreciation as of the date of the balance sheet. Accumulated de-
preciation represents the total dollars of depreciation that have been expensed
on the income statement against the historical cost of the organization™s ¬xed
assets. Numerically, the amounts of depreciation expense reported on the in-
come statement each year are accumulated over time to create the accumu-
lated depreciation account on the balance sheet.2 The accumulated deprecia-
tion account is an example of a contra-asset account because it is a negative
asset. The greater the value of this account, the smaller an organization™s total
assets. Contra accounts reduce the value of “parent” accounts; in this case,
the parent account is gross ¬xed assets.
For Sunnyvale, the net balance of property and equipment (net ¬xed
assets ) is $52,450,000 at the end of 2004. The historical cost of these assets
(gross ¬xed assets ) is $88,549,000. Some of the ¬xed assets were purchased
in 2004, some in 2003, some in 2002, and some in prior years, but the total
purchase price of all the ¬xed assets being used by Sunnyvale on December 31,
2004 is $88,549,000. The accumulated depreciation on these assets through
December 31, 2004 is $36,099,000, which accounts for that portion of the
value of the assets that was “spent” in producing income. The difference, or
net, of $52,450,000, re¬‚ects the remaining book value of the clinic™s ¬xed
assets. Often, a more detailed explanation of the ¬xed asset accounts will be
found in the footnotes.
As mentioned earlier, the connection of the balance sheet net ¬xed
assets account to the income statement is through depreciation expense. The
accumulated depreciation of $36,099,000 reported at the end of 2004 is
$6,405,000 greater than the 2003 amount of $29,694,000. This increase
in accumulated depreciation on the balance sheet re¬‚ects the $6,045,000 in
depreciation expense reported on the 2004 income statement.
96 Healthcare Finance

Depreciation, even though it typically does not re¬‚ect the true change
in value of a ¬xed asset over time, at least ensures an orderly recognition
of value loss. Occasionally, assets experience a sudden, unexpected loss of
value. One example is when changing technology instantly makes a piece of
diagnostic equipment obsolete and hence worthless. When this occurs, the
asset that has experienced the decline in value is written off, which means that
its value on the balance sheet is reduced (perhaps to zero) and the amount of
the reduction is taken as an expense on the income statement.3
In closing our discussion of assets, note that many providers will report
a fourth asset category: other assets. This is really a catchall category of miscel-
laneous long-term assets, which may or may not be very signi¬cant. Examples
include ¬xed assets not used in the provision of healthcare services and funds
that were used to support long-term debt sales that will be expensed over

Self-Test 1. What are the four major categories of asset accounts?
Questions 2. What is the primary difference between current assets and the remainder
of the asset side of the balance sheet?
3. What is accumulated depreciation, and how does it tie in to the income

Liabilities and equity, which comprise the right side of the balance sheet, are
shown in the lower section of Table 4.1. Together, they represent the capital
(the money) that has been raised by an organization to acquire the assets
shown on the left side. Again, by de¬nition, total capital (the sum of liabilities
and equity) must equal total assets.
Liabilities represent claims against the assets of an organization that
are ¬xed by contract. Some of the liability claims are by workers for unpaid
wages and salaries, some are by tax authorities for unpaid taxes, and some
are by vendors that grant credit when supplies are purchased. (Even not-for-
pro¬t organizations, which do not pay income taxes, typically have unpaid
payroll and withholding taxes on their employees.) However, the majority of
liability claims are by creditors (lenders) who have supplied debt capital to the
business. Most creditor™s claims are against the total assets of the organization
(unsecured), rather than tied to speci¬c assets that were used as collateral for
the loan. In the event of default (nonpayment of interest or principal) by the
borrower, creditors have the right to force the business into bankruptcy, with
liquidation as a possible consequence. If liquidation occurs, the law requires
that any proceeds be used ¬rst to satisfy liability claims before any funds can be
paid to owners or, in the case of not-for-pro¬ts, used for charitable purposes.
Furthermore, the dollar value of each liability claim is ¬xed by the amount
Chapter 4: The Balance Sheet

shown on the balance sheet, while the owners, including the community at
large for not-for-pro¬t organizations, have a claim to the residual proceeds of
the liquidation rather than to a ¬xed amount.
Like assets, the balance sheet presentation of liabilities follows a log-
ical format. Current liabilities, which are those liabilities that fall due (must
be paid) within one accounting period (one year in this example), are listed
¬rst. Long-term debt, distinguished from short-term debt by having matu-
rities greater than one accounting period, is listed second. As shown in Ta-
ble 4.1, Sunnyvale had total liabilities at the end of 2004 of $100,747,000,
which consisted of two parts: total current liabilities of $15,425,000 and total
long-term debt of $85,322,000. The following sections describe each liability
account in detail.

Current Liabilities
Current liabilities include liabilities that must be paid within one accounting
period. Many healthcare businesses use short-term debt”de¬ned as having a
maturity of less than one accounting period. Such debt, which often is in the
form of bank loans, generally is used to ¬nance seasonal or cyclical working
capital (current asset) needs. When listed on the balance sheet, short-term
debt typically is called notes payable. We see that Sunnyvale had $4,334,000
of short-term debt outstanding at the end of 2004.
Accounts payable, as well as accrued expenses, represent payment obli-
gations that have been incurred as of the balance sheet date but that have not
yet been paid. In particular, accounts payable represents amounts due to ven-
dors for supplies purchases. Often, suppliers offer their customers credit terms,
which allow payment sometime after the purchase is made. For example, one
of Sunnyvale™s suppliers offers credit terms of 2/10, net 30, which means that
if Sunnyvale pays the invoice in ten days, it will receive a 2 percent discount
off the list price; otherwise, the total amount of the invoice is due in 30 days.
In effect, by allowing Sunnyvale to pay either 10 or 30 days after the supplies
have been received, the supplier is acting as a creditor, and the credit being
offered is called trade credit. The balance sheet tells us that suppliers, at the
end of 2004, had extended Sunnyvale $5,022,000 worth of such credit.4
Wages and bene¬ts due to employees, interest due on debt ¬nancing,
accrued utilities expenses, and similar items are included on the balance sheet
as accrued expenses. Sunnyvale™s employees are used to illustrate the logic
behind accruals. Sunnyvale™s staff earns its wages and bene¬ts on a daily basis
as the work is performed. However, the clinic pays its workers every two
weeks. Therefore, other than on paydays (assuming no lag), the clinic owes its
staff some amount of salaries for work performed. Whenever the obligation
to pay wages extends into the next accounting period, an accrual is created
on the balance sheet. This obligation, as well as taxes due to government
authorities and interest due to lenders, appears on Sunnyvale™s balance sheet
as an accrual.5
98 Healthcare Finance

Long-Term Debt
The long-term debt section of the balance sheet represents debt ¬nancing to
the organization with maturities of more than one accounting period, and
hence repayment in this example is not required during the coming year. The
long-term debt section lists any debt owed to banks and other creditors such as
bondholders as well as obligations under certain types of lease arrangements.
Usually, detailed information relative to the speci¬c characteristics of the long-
term debt is disclosed in the footnotes to the ¬nancial statements.6
Sunnyvale had total liabilities, combined current liabilities and long-
term debt, of $100,747,000 at the end of 2004. As discussed in the next
section, Sunnyvale reported $54,068,000 in equity, for total ¬nancing (which
must equal total assets) of $154,815,000. Thus, based on the values recorded
on the balance sheet, or book values, Sunnyvale uses much more debt ¬nanc-
ing than equity ¬nancing. The choice between debt and equity ¬nancing is
discussed in Chapter 13. Also, Chapter 17 includes coverage of alternative
ways to measure the amount of debt ¬nancing that an organization uses and
its effect on the business™s ¬nancial condition.

Self-Test 1. What are liabilities?
Questions 2. What are some of the accounts that would be classi¬ed as current
3. Use an example to explain the logic behind accruals.
4. What is the difference between notes payable and long-term debt?

On the balance sheet, the equity (ownership) claim on an organization™s
assets is called net assets when the organization has not-for-pro¬t status. As
the term net implies, net assets represent the dollar value of assets remaining
when a business™s liabilities are stripped out. However, as readers learned in
Chapter 2, there are a wide variety of ownership types in the health services
industry, which results in an almost bewildering difference in terminology
used for the equity portion of the balance sheet. For example, depending
on the type of business organization, the equity section of the balance sheet
may be called stockholders™ equity, owner™s net worth, net worth, proprietor™s
worth, partners™ worth, or even something else. To keep things manageable
in this book, the term equity typically will be used, but the various terms all
indicate the same thing: the amount of total assets ¬nanced by nonliability
capital, or total assets minus total liabilities. To determine what belongs to
the owners, whether explicitly recognized in for-pro¬t businesses or implicitly
implied in not-for-pro¬t organizations, ¬xed claims (liabilities) are subtracted
from the value of the business™s assets. The remainder, the net assets (equity),
represents the residual value of the assets of the organization.
Chapter 4: The Balance Sheet

The equity section of the balance sheet is extremely important because
it, more than anything else in the ¬nancial statements, re¬‚ects the ownership
status of the organization. Because Table 4.1 lists the equity as net assets, Sun-
nyvale is a not-for-pro¬t corporation. Some of the equity capital could have
come from charitable contributions and some from government grants, but
the vast majority of Sunnyvale™s equity capital was obtained by reinvesting
earnings within the business. For a not-for-pro¬t organization such as Sunny-
vale, all earnings (net income) must be reinvested in the business.
Sunnyvale™s equity increased by $7,860,000 from 2003 to 2004, which
is the same amount that Sunnyvale reported as net income for 2004. It is
important to recognize that this connection between the bottom line of the
income statement and the equity section of the balance sheet is a mathematical
necessity. In the case of not-for-pro¬t businesses, there is simply nowhere else
for those earnings to go. This highlights a second connection between the
balance sheet and the income statement; the ¬rst was depreciation.
Sunnyvale™s balance sheet balances because the increase in equity of
$7,860,000 was matched by a like increase in assets, along with asset increases
that resulted from other ¬nancing. The assets increase might be in cash, receiv-
ables, ¬xed assets, or in some other account. The key point is that the equity
(net asset) balance is not a store of cash. As Sunnyvale earned pro¬ts over
the years that increased the equity account, these funds were invested in sup-
plies, property and equipment, and other assets to provide future services that
would likely generate even larger pro¬ts in the future. Sunnyvale™s total assets
grew by $154,815,000 ’ $115,101,000 = $39,714,000 in 2004, which was
supported by an increase in total liabilities of $100,747,000 ’ $68,893,000
= $31,854,000 and an increase in equity (net assets) of $54,068,000 ’
$46,208,000 = $7,860,000.
The net assets type of equity section shown in Table 4.1 is typical of not-
for-pro¬t organizations such as community or religious hospitals. However, a
relatively rare form of not-for-pro¬t organization can sell stock privately, and
such organizations may show a limited amount of stock outstanding. This
type of stock is not sold in the open market, though, and does not convey
ownership rights, as does the stock of investor-owned companies.
Thus far, the discussion of the balance sheet has focused on Sunnyvale,
a not-for-pro¬t corporation. In general, the asset and liability sections of the
balance sheet are much the same regardless of ownership status. The equity
section tends to differ in presentation for different types of ownership because
the types have different forms of equity. That is the bad news. The good news
is that the economic substance of the equity section remains the same.
Table 4.2 contains the equity section of the balance sheet assuming
that Sunnyvale, with a new name (Southeast Healthcare), were an investor-
owned (for-pro¬t) corporation. This is the type of presentation that would
be seen on the balance sheets of for-pro¬t health services businesses such
as HCA, Beverly Enterprises, and Paci¬Care. The ¬rst major difference is
100 Healthcare Finance

2004 2003
Stockholders™ Equity:
Balance Sheet
Common stock ($1 par value, $ 1,000 $ 1,000
Equity Section
1,500,000 shares authorized,
December 31, 1,000,000 shares outstanding)
2004 and 2003 Capital in excess of par 9,000 9,000
Retained earnings 44,068 36,208
(in thousands)

Total equity $ 54,068 $ 46,208

Total liabilities and equity $ 154,815 $ 115,101

the title of the section, “Stockholders™ Equity.” This title, or a similar title
such as “Shareholders™ Equity,” provides explicit recognition that there are
stockholders (shareholders) who own the business.
The stockholders™ equity section of the balance sheet consists of
two parts: contributed capital and accumulated earnings. Contributed capital,
which typically is not identi¬ed as such on the balance sheet, is the sum of the
common stock and capital in excess of par accounts. This amount represents
the dollars of capital contributed directly, or paid out-of-pocket, by stockhold-
ers of corporations or by proprietors or partners of unincorporated businesses.
The retained earnings account represents the accumulated earnings of the or-
ganization that have been reinvested in the business. Because not-for-pro¬t
organizations cannot pay dividends, all earnings must be retained in the busi-
ness. However, some portion (or all) of the earnings of for-pro¬t businesses
may be distributed to owners through dividend payments.
Southeast Healthcare was incorporated in 1975, with the bylaws autho-
rizing issuance of 1.5 million shares of common stock. At that time, 1 million
shares were sold at a price of $10 per share, so $10 million was collected.
However, the stock has a par value, which is a somewhat antiquated legal
concept that speci¬es the minimum liability of shareholders in the event of
bankruptcy, of $1. Today, par value has limited economic relevance, but ac-
countants continue to separate contributed capital into two separate accounts.
Because 1 million shares were sold at a par value of $1, the common stock ac-
count shows a balance of $1 million. Any proceeds collected from the sale of
common stock at a price above par value are listed in the capital in excess of par
account. Because Southeast Healthcare collected $10 per share, or $9 above
par value for each of the 1 million shares sold, this account shows a balance
of $9 million.
The retained earnings account represents the accumulation of earnings
over time that are reinvested in the business. Each year, the amount of net in-
Chapter 4: The Balance Sheet

come shown on the income statement, less the amount paid out to stockhold-
ers as dividends, is transferred from the income statement to the balance sheet.
Suppose that, as with Sunnyvale, Southeast Healthcare had actually earned
$7,860,000 in 2004. Because the ¬rm™s retained earnings account increased
by a like amount, no dividends were paid to stockholders during the year.
Retained earnings, like all equity accounts, represent a claim against
assets, and they are not available to buy new equipment, to pay dividends,
or for any other purpose. The ¬nancing represented by retained earnings has
already been used within the business to buy property and equipment; to buy
supplies; and, yes, to increase the cash, marketable securities, and long-term
investments accounts. Only the portion of retained earnings that is sitting in
the cash account is available to the business for immediate use.
Although Table 4.2 shows only the equity section, it is likely that there
would be signi¬cant differences in the values of other balance sheet accounts
between investor-owned and not-for-pro¬t businesses. For example, it is un-
likely that a for-pro¬t healthcare business would amass such a large amount
of long-term investments (securities), unless the funds were earmarked for
a particular use in the next few years. Southeast™s stockholders would ques-
tion why the company had over $42 million in long-term securities because
they would prefer to have all of the business™s capital invested in operating as-
sets, which, as indicated earlier, usually earn a higher return than do securities
investments. Thus, there would be stockholder pressure on management to
return this capital to owners (as dividends or stock repurchases) so that they
could, themselves, make the decision on how to invest these funds. Stockhold-
ers have invested in Southeast Healthcare because it is a healthcare provider;
if they had wanted to own a bank, they would have bought bank stock. If
and when Southeast requires more capital for asset acquisitions, it can always
obtain additional debt ¬nancing or sell more common stock.
Access to the capital markets is seen as a real economic advantage
that for-pro¬t providers”whether they are hospitals, medical practices, or
managed care plans”have over not-for-pro¬t providers. The ability to “open
the faucet” to acquire more capital has certain advantages in today™s highly
competitive health services industry, which is re¬‚ected in the number of not-
for-pro¬t organizations that have converted to for-pro¬t status.7

1. What is equity (net assets)?
2. What are the differences in the equity sections of not-for-pro¬t and
investor-owned providers?
3. What is the relationship between the retained earnings account on
the balance sheet and earnings (net income) reported on the income
102 Healthcare Finance

Fund Accounting
One unique feature of many not-for-pro¬t balance sheets is that they classify
certain asset and equity (net asset) accounts as being restricted. When a not-
for-pro¬t organization receives contributions that donors have indicated must
be used for a speci¬c purpose, the organization must create multiple funds
to account for its assets and equity (net assets). A fund is de¬ned as a self-
contained pool set up to account for a speci¬c activity or project. Each fund
typically has assets, liabilities, and an equity (net asset) balance. Because the
balance sheet of an organization that receives restricted contributions is sepa-
rated into restricted and unrestricted funds, this form of accounting is called
fund accounting. Only contributions to not-for-pro¬t organizations are tax
deductible to the donor, and hence few contributions are made to investor-
owned healthcare businesses. Thus, fund accounting is only applicable to not-
for-pro¬t organizations.
Restricted contributions and gifts impose legal and ¬duciary respon-
sibilities on health services organizations to carry out the written wishes of
donors. Thus, numerous rules are associated with fund accounting that go
well beyond the scope of this book. The good news is that GAAP encourage
organizations that use fund accounting to present balance sheets to outside
parties that have roughly the same look as shown in Table 4.1. Thus, with
the exception of further breakdown into unrestricted and restricted accounts,
such balance sheets have the same economic content as those prepared by
nonfund-account health services organizations.

Self-Test 1. What is fund accounting?
Questions 2. What type of a health services organization is most likely to use fund
3. Is there a signi¬cant difference in the economic content of balance
sheets created by investor-owned and not-for-pro¬t health services

The Statement of Cash Flows
The balance sheet and income statement are traditional ¬nancial statements
that have been required for many years. In contrast, the statement of cash ¬‚ows
has only been required since 1989 for for-pro¬t businesses and 1995 for not-
for-pro¬t businesses.8 This relatively new ¬nancial statement has been added
to the annual report in response to demands by users for better information
about a ¬rm™s cash in¬‚ows and out¬‚ows.
While the balance sheet reports the cash balance on hand at the end
of the period, it does not provide details on why the cash account is greater
or smaller than the previous year™s value nor does the income statement give
Chapter 4: The Balance Sheet

detailed information on cash ¬‚ows. In addition to the problems of accrual
accounting and noncash expenses discussed in Chapter 3, there may be cash
raised by means other than operations that does not even appear on the
income statement. For example, Sunnyvale may have raised cash during 2004
by taking on more debt or by selling some ¬xed assets. Such ¬‚ows, which are
not shown on the income statement, affect a ¬rm™s cash balance. Finally, the
cash coming into a business does not sit in the cash account forever. Most of
it goes to pay operating expenses or to purchase other assets, or for investor-
owned ¬rms, some may be paid out as dividends. Thus, the cash account does
not increase by the gross amount of cash generated, and it would be useful to
know how the difference was spent. The statement of cash ¬‚ows details where
cash resources come from and how they are used.
Two formats for the statement of cash ¬‚ows are allowed by GAAP. Un-
der the direct method, operating cash ¬‚ow is computed by focusing “directly”
on the cash account. Thus, the statement of cash ¬‚ows contains entries such as
“cash received from patients and third-party payers” and “interest received.”
Under the indirect method, the movement of cash into and out of the cash
account is imputed by examining both the data on the income statement and
changes in balance sheet accounts. Because the indirect method uses ¬nancial
statement data, while the direct method must pull data from the underlying
accounts, most businesses use the indirect method. However, to develop the
cash ¬‚ows for large organizations, many adjustments must be made to the
underlying income statement and balance sheet data. These adjustments are
often complicated, so it is necessary to be well versed in ¬nancial accounting
to prepare a complete statement of cash ¬‚ows.
Sunnyvale™s 2004 and 2003 statements are presented in Table 4.3 in
the indirect format. To simplify the discussion, the data in the statements have
been reduced; they are somewhat shorter and easier to comprehend than most
“real world” statements. Nevertheless, an understanding of the composition
and presentation of Table 4.3 will give readers an excellent appreciation of the
value of the statement of cash ¬‚ows.
The statement of cash ¬‚ows is formatted to make it easy to understand
why and how Sunnyvale™s cash position increased by $5,616,000 during 2004.
In other words, it tells us Sunnyvale™s sources of cash and how this cash is used.
The statement is divided into three major sections: cash ¬‚ows from operating
activities, cash ¬‚ows from investing activities, and cash ¬‚ows from ¬nancing

Cash Flows from Operating Activities
The ¬rst section, cash ¬‚ows from operating activities, focuses on the sources
and uses of cash tied directly to operations. Of course, the most important
source is net income, so its value for 2004, $7,860,000, is listed ¬rst. However,
net income does not equal cash ¬‚ow, so various adjustments must be made.
The ¬rst adjustment is to add back the noncash expenses that appear on the
104 Healthcare Finance

2004 2003
Cash Flows from Operating Activities:
Statements of
Net income $ 7,860 $ 8,206
Cash Flows
Years Ended Depreciation 6,405 5,798
December 31, Increase in net patient accounts receivable (2,582) (1,423)
Increase in inventories (1,393) (673)
2004 and 2003
Decrease in accounts payable (1,911) (966)
(in thousands)
Increase in accrued expenses 1,032 865
Net cash from operations $ 9,411 $ 11,807

Cash Flows from Investing Activities:
Capital expenditures ($ 9,306) ($ 1,953)

Cash Flows from Financing Activities:
Increase in marketable securities ($ 5,000) $ 0
Increase in notes payable 989 0
Increase in long-term investments (22,222) (20,667)
Increase in long-term debt 31,744 0
Net cash from ¬nancing $ 5,511 ($20,667)

Net increase (decrease) in cash $ 5,616 ($ 10,813)

Cash, beginning of year $ 6,486 $ 17,299

Cash, end of year $ 12,102 $ 6,486

income statement. As we explained in Chapter 3, as a ¬rst approximation, the
cash ¬‚ow of a business can be approximated as net income plus depreciation:
$7,860,000 + $6,405,000 = $14,265,000.
Adjustments are then made for changes in those current asset and li-
ability accounts that are directly affected by operations. For Sunnyvale, this
means the net patient accounts receivable, inventories, accounts payable, and
accrued expenses accounts. The theory for these adjustments is that these ac-
counts stem directly from operations; hence, any cash that either is generated
by, or is used for, these accounts should be included as part of operations. In
addition, using balance sheet data to calculate operating cash ¬‚ow recognizes
that under accrual accounting not every dollar of revenues or expenses listed
on the income statement represents a dollar of cash ¬‚ow.
Note that marketable securities and notes payable, although current
accounts, are ¬nancing accounts that are not directly tied to operations, and
hence these accounts will be handled in the third section of the statement of
cash ¬‚ows. Also, note that the entire statement focuses on the change in cash,
so that will be the output of the statement rather than one of its entries.
Chapter 4: The Balance Sheet

To illustrate the adjustments to operating cash ¬‚ow, Sunnyvale™s net
patient accounts receivable increased from $25,927,000 to $28,509,000, or
by $2,582,000, during 2004. Because this amount was included in 2004
revenues and hence reported in net income, but it was added to receivables
instead of collected, it is not available as cash ¬‚ow to Sunnyvale. Thus, it
appears as a deduction (negative adjustment) to operating cash ¬‚ow. To make
this point in another way, note than an increase in an asset account requires
that the business use cash, so the $2,582,000 increase in receivables reduces
the cash ¬‚ow for other purposes. For another illustration, note that accrued
expenses increased by $1,032,000 in 2004. Because an increase in accruals,
which is on the right side (liabilities and equity) of the balance sheet, creates
¬nancing for the clinic and hence represents a source of cash (as opposed to a
use), this change is shown as an addition to operating cash ¬‚ow.
When all the adjustments are made, Sunnyvale reported $9,411,000 in
net cash from operations for 2004. For a business, whether investor-owned
or not-for-pro¬t, to be ¬nancially sustainable, it must generate a positive
cash ¬‚ow from operations. Thus, at least for 2004 and 2003, Sunnyvale™s
operations are doing what they should be doing”generating cash. However,
the clinic™s cash ¬‚ow from operations has decreased from 2003 to 2004,
so its managers should be identifying why this happened and then taking
appropriate action. Unlike Sunnyvale™s situation, a consistent negative net cash
¬‚ow from operations would send a warning to managers and investors alike
that the business may not be economically sustainable.

Cash Flows from Investing Activities
The second major section on the statement of cash ¬‚ows is cash ¬‚ows from
investing activities. The terminology here can be misleading because the em-
phasis in this section is on capital investing, which is investment in ¬xed assets
as opposed to ¬nancial investing (investing in securities). Because depreciation
is accounted for in the cash ¬‚ows from operating activities section, we focus
here on the total (gross) investment in ¬xed assets. As evidenced by the 2003
to 2004 change in gross ¬xed assets derived from the balance sheets, Sunny-
vale spent $9,306,000 to acquire additional property and equipment. Thus,
almost all of the clinic™s operating cash ¬‚ow was spent on new ¬xed assets.
This fact should not be alarming, especially for a not-for-pro¬t business, as
long as the investments are prudent. (Chapters 14 and 15 contain a great
deal of insights into what makes a prudent capital investment, at least from a
¬nancial perspective.)

Cash Flows from Financing Activities
The ¬nal major section is cash ¬‚ows from ¬nancing activities, which focuses
on securities investments and ¬nancing. The changes in balance sheet ac-
counts from 2003 to 2004 indicate that the clinic invested $5,000,000 in
marketable securities (which requires a use of cash), increased its notes payable
106 Healthcare Finance

by $500,000 (which is a source of cash), invested $22,222,000 in long-term
securities (another use), and took on an additional $31,744,000 in long-term
debt (another source). On net, Sunnyvale generated a $5,511,000 cash in-
¬‚ow from ¬nancing activities. This section shows that Sunnyvale used the vast
majority of new debt to purchase securities. In general, new debt would be
used to acquire real assets rather than ¬nancial assets. However, Sunnyvale is
planning to acquire a large group practice in 2005, and the ¬nancing activities
undertaken in 2004 are in preparation for this purchase.

Net Increase (Decrease) in Cash and Reconciliation
The next line of the statement of cash ¬‚ows is the net increase (decrease) in cash.
It is merely the sum of the totals from the three major sections. For Sunnyvale,
there is a net increase in cash of $9,411,000 ’ $9,306,000 + $5,511,000 =
$5,616,000 in 2004. Unlike the “bottom line” of the income statement, the
change in cash line has limited value in assessing an organization™s ¬nancial
condition because it can be manipulated by ¬nancing activities. If an organi-
zation is losing cash on operations, but its managers want to report an increase
in the cash account, in most cases they simply can borrow the funds necessary
to show a net cash increase on the statement of cash ¬‚ows. Thus, the net cash
from operations line is a more important indicator of ¬nancial well-being than
is the net increase (decrease) in cash line.
The net increase (decrease) in cash line is used to verify the correctness
of the entries on the statement of cash ¬‚ows. As shown in Table 4.3, the
$5,616,000 increase in cash reported by Sunnyvale for 2004 is added to the
beginning of year cash balance, $6,486,000, to get an end of year total of
$12,102,000. A check of the end-of-2004 cash balance shown in Table 4.1
con¬rms the amount calculated on the statement of cash ¬‚ows.
In summary, the income statement focuses on accounting pro¬tability,
while the statement of cash ¬‚ows focuses on the movement of cash: Where
did the money come from and how did the organization use it? While the
major concern of the income statement is economic pro¬tability as de¬ned
by GAAP, the statement of cash ¬‚ows is concerned with cash viability. Is the
organization generating, and will it continue to generate, suf¬cient cash to
meet both short-term and long-term needs?

Self-Test 1. How does the statement of cash ¬‚ows differ from the income statement?
Questions 2. Brie¬‚y explain the three major categories shown on the statement.
3. In your view, what is the most important piece of information reported
on the statement?

As we discussed in the last chapter, the recording of transactions by accoun-
tants is the ¬rst step in the creation of a business™s ¬nancial statements. Under-
Chapter 4: The Balance Sheet

standing how transactions ultimately affect the ¬nancial statements will help
managers better understand and interpret their content.
The transactions that ¬‚ow to the income statement are relatively ap-
parent. For example, net patient service revenue and related expenses stem
directly from the provision of patient services and the expectation of receiving
payment. Thus, the provision of services that have a third-party payer reim-
bursement amount of $1,000 would increase the net patient services revenue
account by $1,000. Similarly, the obligation to pay wages to an employee of
$150 for a day™s work would increase the salaries expense line by a like amount.
However, the transactions that ¬‚ow to the balance sheet are less ob-
vious. In this section, ten typical balance sheet transactions are presented.
Understanding these transactions will help readers understand how an or-
ganization™s economic events are transformed into ¬nancial statement data.
The primary concept behind all balance sheet transactions is that the basic
accounting equation must be preserved (i.e., the balance sheet must balance).
Thus, each transaction must have a dual effect, either one on the left side and
one on the right side, or offsetting effects on the same side.

1. Investment by owners. Suppose ¬ve radiologists decide to open a
diagnostic center that they incorporate as an investor-owned business
called Bayshore Radiology Center. They each invest $200,000 cash in the
business in exchange for $200,000 of common stock. The transaction
results in an equal increase in both assets and equity. In this case, there
is an increase in the cash account of $1,000,000 and an increase in the
common stock account of $1,000,000. After the transaction, the balance
sheet looks like this:
Cash $1,000,000 Common stock $1,000,000
Total assets $1,000,000 Total claims $1,000,000

2. Purchase of equipment for cash. To support operations, the business
needs diagnostic equipment. Assume that the ¬rst piece of equipment
purchased costs $200,000, and it is paid for in cash. This transaction
results in an equal increase and decrease in total assets. The composition
of assets is changed, however:

Cash $ 800,000 Common stock $1,000,000
Gross ¬xed assets 200,000
Total assets $1,000,000 Total claims $1,000,000

Total assets and total claims still amount to $1,000,000 because no new
capital was acquired by the business.
3. Purchase of supplies on credit. Assume that Bayshore purchases
medical supplies for $20,000. The supplier™s terms give the center 60
days to pay the bill. Assets are increased by this transaction because
108 Healthcare Finance

of the expected bene¬t of using these supplies to provide services.
Also, liabilities (accounts payable) are increased by the amount due the
Cash $ 800,000 Accounts payable $ 20,000
Supplies 20,000 Common stock 1,000,000
Gross ¬xed assets 200,000
Total assets $1,020,000 Total claims $1,020,000

4. Services rendered for credit. Assume that Bayshore provides $50,000
of services (at net prices) that are billed to third-party payers. This
transaction will increase assets (accounts receivable) and the retained
earnings portion of equity. The $50,000 would also show up on the
income statement as revenue, which, after expenses and dividends are
deducted, would ultimately ¬‚ow through to the balance sheet and hence
support the increase in equity:
Cash $ 800,000 Accounts payable $ 20,000
Accounts receivable 50,000 Common stock 1,000,000
Supplies 20,000 Retained earnings 50,000
Gross ¬xed assets 200,000
Total assets $1,070,000 Total claims $1,070,000

Retained earnings (equity) is increased when revenues are earned, even
though no cash has been generated. When accounts receivable are
collected at a later date, cash will be increased and receivables will be
decreased (see Transaction 10).
5. Purchase of advertising on credit. Bayshore receives a bill for $10,000
from the Daily News for advertising its grand opening, but it does
not have to pay the newspaper for 30 days. The transaction results in
an increase in liabilities and a decrease in equity; speci¬cally, accounts
payable is increased and retained earnings is decreased. The decrease in
equity will work its way through the income statement as $10,000 in
advertising expense:
Cash $ 800,000 Accounts payable $ 30,000
Accounts receivable 50,000 Common stock 1,000,000
Supplies 20,000 Retained earnings 40,000
Gross ¬xed assets 200,000
Total assets $1,070,000 Total claims $1,070,000

Equity is reduced when expenses are incurred. When payment is made
at a later date, both payables and cash will decrease (see Transaction 8).
Advertising is an expense, as opposed to an asset (like supplies), because
the bene¬ts of the outlay have been immediately realized.
Chapter 4: The Balance Sheet

6. Payment of expenses. Assume that the center paid $50,000 in cash for
rent, salaries, and utilities. These payments result in an equal decrease in
cash and equity. The decrease in equity will be matched by a reduction
in net income on the income statement:
Cash $ 750,000 Accounts payable $ 30,000


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