Start by reading and following these instructions: 1. Quickly skim the questions or assignment below and the assignment rubric to help you focus. 2. Read the required chapter(s) of the textbook and an

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2019181716 54321 Library of Congress Cataloging-in-Publication Data Gapenski, Louis C. author.

Healthcare finance : an introduction to accounting and financial management / Louis C.

Gapenski and Kristin L. Reiter. Sixth edition.

pages cm Includes index.

ISBN 978-1-56793-741-1 (alk. paper) 1. Health facilities Finance Textbooks. 2. Health facilities Accounting Textbooks.

I. Reiter, Kristin L. (Kristin Leanne) author. II. Title.

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Health Administration Press Association of University Programs A division of the Foundation of the American in Health Administration College of Healthcare Executives 2000 North 14th Street One North Franklin Street, Suite 1700 Suite 780 Chicago, IL 60606-3529 Arlington, VA 22201 (312) 424-2800 (703) 894-0940 BRIEF CONTENTS Preface....................................................................................................xvii Part I The Healthcare Environment Chapter 1. Healthcare Finance Basics .................................................3 Chapter 2. Healthcare Insurance and Reimbursement Methodologies ................................................................39 Part II Financial Accounting Chapter 3. The Income Statement and Statement of Changes in Equity...........................................................75 Chapter 4. The Balance Sheet and Statement of Cash Flows...........119 Part III Managerial Accounting Chapter 5. Organizational Costing and Profit Analysis....................159 Chapter 6. Departmental Costing and Cost Allocation ...................201 Chapter 7. Service Line Costing and Pricing...................................233 Chapter 8. Financial Planning and Budgeting.................................269 Part IV Basic Financial Management Concepts Chapter 9. Time Value Analysis ......................................................305 Chapter 10. Financial Risk and Required Return ..............................351 Part V Long-Term Financing Chapter 11. Long-Term Debt Financing ..........................................393 Chapter 12. Equity Financing and Securities Markets .......................437 Brief Contents Chapter 13. Capital Structure and the Cost of Capital .....................475 Part VI Capital Investment Decisions Chapter 14. The Basics of Capital Budgeting....................................519 Chapter 15. Project Risk Analysis .....................................................561 Part VII Other Topics Chapter 16. Revenue Cycle and Current Accounts Management ......599 Chapter 17. Financial Condition Analysis .........................................639 Glossary .................................................................................................687 Index .....................................................................................................705 About the Authors ..................................................................................739 DETAILED CONTENTS Preface....................................................................................................xvii Part I The Healthcare Environment Chapter 1. Healthcare Finance Basics.................................................3 Learning Objectives ..........................................................3 Introduction .....................................................................3 Before You Begin..............................................................3 Defining Healthcare Finance.............................................7 Concept of a Business .......................................................9 The Role of Finance in Health Services Organizations ....10 The Structure of the Finance Department.......................12 Health Services Settings ..................................................13 Current Managerial Challenges .......................................14 Alternative Legal Forms of Businesses .............................14 Alternative Corporate Ownership....................................17 Organizational Goals.......................................................21 Healthcare Reform and Finance ......................................23 Key Concepts..................................................................28 Questions and Problems..................................................30 Resources........................................................................31 Supplement. Health Services Settings ..............................32 Introduction ...................................................................32 Settings...........................................................................32 Chapter 2. Healthcare Insurance and Reimbursement Methodologies................................................................39 Learning Objectives ........................................................39 Introduction ...................................................................39 Insurance Concepts.........................................................40 Third-Party Payers ..........................................................44 Managed Care Plans........................................................48 Detailed Contents Healthcare Reform and Insurance ...................................49 Generic Reimbursement Methodologies..........................52 Provider Incentives Under Alternative Reimbursement Methodologies ...........................................................55 Medical Coding: The Foundation of Fee-for-Service Reimbursement ..........................................................57 Specific Reimbursement Methods....................................59 Healthcare Reform and Reimbursement Methods ...........62 Key Concepts..................................................................65 Questions........................................................................67 Resources........................................................................67 Supplement. Additional Medicare Payment Methods ........69 Introduction ...................................................................69 Outpatient Hospital Services...........................................69 Ambulatory Surgery Centers...........................................69 Inpatient Rehabilitation Facilities ....................................70 Psychiatric Hospital Services............................................70 Skilled Nursing Facility Services ......................................71 Home Health Care Services ............................................71 Critical Access Hospitals..................................................71 Hospice Services .............................................................72 Ambulance Services.........................................................72 Part II Financial Accounting Chapter 3. The Income Statement and Statement of Changes in Equity..........................................................................75 Learning Objectives ........................................................75 Introduction ...................................................................75 Historical Foundations of Financial Accounting ..............75 The Users of Financial Accounting Information..............77 Regulation and Standards in Financial Accounting ..........78 Conceptual Framework of Financial Reporting................82 Accounting Methods: Cash Versus Accrual......................85 Recording and Compiling Financial Accounting Data .....88 Income Statement Basics.................................................90 Revenues.........................................................................92 Expenses .........................................................................95 Operating Income...........................................................99 Nonoperating Income...................................................100 Detailed Contents Net Income...................................................................101 Net Income Versus Cash Flow ......................................103 Income Statements of Investor-Owned Businesses.........105 Statement of Changes in Equity....................................107 A Look Ahead: Using Income Statement Data in Financial Statement Analysis.................................108 Key Concepts................................................................109 Questions......................................................................111 Problems.......................................................................112 Resources......................................................................116 Chapter 4. The Balance Sheet and Statement of Cash Flows ...........119 Learning Objectives ......................................................119 Introduction .................................................................119 Assets............................................................................123 Liabilities ......................................................................129 Net Assets (Equity).......................................................133 Fund Accounting..........................................................136 Statement of Cash Flows...............................................138 Balance Sheet Transactions............................................143 Another Look Ahead: Using Balance Sheet Data in Financial Statement Analysis .....................................147 Key Concepts................................................................148 Questions......................................................................150 Problems.......................................................................151 Resources......................................................................156 Part III Managerial Accounting Chapter 5. Organizational Costing and Profit Analysis ....................159 Learning Objectives ......................................................159 Introduction .................................................................159 The Basics of Managerial Accounting............................159 Fixed Versus Variable Costs...........................................161 Underlying Cost Structure............................................162 Profit Analysis ...............................................................165 Breakeven Analysis ........................................................171 Profit Analysis in a Discounted Fee-for-Service Environment ............................................................175 Profit Analysis in a Capitated Environment ...................180 The Impact of Cost Structure on Financial Risk............187 Detailed Contents Chapter 6.

Chapter 7.

Key Concepts................................................................189 Questions......................................................................190 Problems.......................................................................190 Resources......................................................................194 Supplement. Semi-fixed Costs and Operating Leverage ...................................................195 Semi-fixed Costs ...........................................................195 Operating Leverage.......................................................196 Departmental Costing and Cost Allocation.....................201 Learning Objectives ......................................................201 Introduction .................................................................201 Direct Versus Indirect (Overhead) Costs .......................201 Introduction to Cost Allocation....................................202 Cost Allocation Basics...................................................204 Cost Allocation Methods...............................................208 Direct Method Illustration............................................210 Cost Allocation and Departmental Profitability .............217 Changing to a More Effective Cost Driver....................219 Final Thoughts on Cost Allocation................................222 Key Concepts................................................................223 Questions......................................................................224 Problems.......................................................................225 Resources......................................................................229 Supplement. Step-Down Method Illustration ..................230 Service Line Costing and Pricing....................................233 Learning Objectives ......................................................233 Introduction .................................................................233 Service Line Costing .....................................................234 Healthcare Providers and the Power to Set Prices .........244 Price-Setting Strategies..................................................246 Target Costing..............................................................248 Setting Fee-for-Service Prices on Individual Services .....249 Setting Prices Under Capitation....................................251 Key Concepts................................................................255 Questions......................................................................256 Problems.......................................................................257 Resources......................................................................262 Supplement. Making Service Decisions ..........................264 Detailed Contents Chapter 8. Financial Planning and Budgeting .................................269 Learning Objectives ......................................................269 Introduction .................................................................269 Strategic Planning.........................................................270 Operational Planning ....................................................271 Financial Planning.........................................................274 Introduction to Budgeting............................................276 Initial Budgeting Decisions ...........................................277 Budget Types................................................................280 Constructing a Simple Operating Budget......................282 Variance Analysis...........................................................285 Key Concepts................................................................294 Questions......................................................................296 Problems.......................................................................296 Resources......................................................................302 Part IV Basic Financial Management Concepts Chapter 9. Time Value Analysis ......................................................305 Learning Objectives ......................................................305 Introduction .................................................................305 Time Lines....................................................................306 Future Value of a Lump Sum: Compounding................307 Present Value of a Lump Sum: Discounting ..................313 Opportunity Costs ........................................................316 Annuities.......................................................................320 Perpetuities ...................................................................325 Uneven Cash Flow Streams...........................................327 Using Time Value Analysis to Measure Return on Investment ...............................................................330 Semiannual and Other Compounding Periods...............333 Key Concepts................................................................338 Questions......................................................................339 Problems.......................................................................340 Resources......................................................................344 Supplement. Interest Rate and Time Calculations and Amortization .............................................................345 Solving for Interest Rate and Time................................345 Amortized Loans ..........................................................348 Detailed Contents Chapter 10. Financial Risk and Required Return ...............................351 Learning Objectives ......................................................351 Introduction .................................................................351 The Many Faces of Financial Risk..................................352 Introduction to Financial Risk.......................................353 Risk Aversion ................................................................355 Probability Distributions ...............................................356 Expected and Realized Rates of Return.........................357 Stand-Alone Risk...........................................................359 Portfolio Risk and Return .............................................361 Measuring the Risk of Investments Held in Portfolios .............................................................371 The Relationship Between Component and Portfolio Betas..........................................................376 Relevance of the Risk Measures.....................................377 Interpretation of the Risk Measures...............................379 The Relationship Between Risk and Required Return.......................................................380 Key Concepts................................................................384 Questions......................................................................386 Problems.......................................................................387 Resources......................................................................390 Part V Long-Term Financing Chapter 11. Long-Term Debt Financing .............................................393 Learning Objectives ......................................................393 Introduction .................................................................393 The Cost of Money.......................................................394 Common Long-Term Debt Instruments.......................395 Debt Contracts .............................................................402 Credit Ratings...............................................................403 Interest Rate Components ............................................405 Debt Valuation..............................................................409 Key Concepts................................................................422 Questions......................................................................424 Problems.......................................................................425 Resources......................................................................428 Detailed Contents Supplement. Credit Enhancement, Term Structure of Interest Rates, and Economic Factors That Influence Interest Rate Levels...................................................430 Credit Enhancement .....................................................430 The Term Structure of Interest Rates............................431 Economic Factors That Influence Interest Rate Levels .......................................................................434 Chapter 12. Equity Financing and Securities Markets .......................437 Learning Objectives ......................................................437 Introduction .................................................................437 Equity in For-Profit Businesses......................................438 Types of Common Stock...............................................441 Procedures for Selling New Common Stock..................442 Equity in Not-for-Profit Corporations...........................445 Common Stock Valuation .............................................447 Security Market Equilibrium .........................................455 Informational Efficiency................................................456 The Risk/Return Trade-Off..........................................460 Key Concepts................................................................461 Questions......................................................................463 Problems.......................................................................463 Resources......................................................................466 Supplement. The Market for Common Stock, Securities Markets Regulation, and the Investment Banking Process........................................................467 The Market for Common Stock....................................467 Securities Market Regulation.........................................468 The Investment Banking Process...................................471 Chapter 13. Capital Structure and the Cost of Capital .......................475 Learning Objectives ......................................................475 Introduction .................................................................475 Capital Structure Basics.................................................476 Impact of Debt Financing on Accounting Risk and Return...............................................................476 Capital Structure Theory...............................................480 Identifying the Optimal Capital Structure in Practice.....................................................................483 Detailed Contents Not-for-Profit Businesses...............................................485 Using the Target Capital Structure................................487 Cost-of-Capital Basics ...................................................487 Cost of Debt Capital.....................................................489 Cost of Equity Capital...................................................492 The Corporate Cost of Capital......................................501 Cost-of-Capital Estimation for Small Businesses............504 An Economic Interpretation of the Corporate Cost of Capital .........................................................507 Key Concepts................................................................510 Questions......................................................................511 Problems.......................................................................512 Resources......................................................................515 Part VI Capital Investment Decisions Chapter 14. The Basics of Capital Budgeting ....................................519 Learning Objectives ......................................................519 Introduction .................................................................519 Project Classifications....................................................520 The Role of Financial Analysis in Healthcare Capital Budgeting.....................................................521 Overview of Capital Budgeting Financial Analysis .........522 Cash Flow Estimation ...................................................523 Cash Flow Estimation Example.....................................529 Breakeven Analysis ........................................................537 Return on Investment (Profitability) Analysis ................539 Some Final Thoughts on Breakeven and Profitability Analyses....................................................................545 Capital Budgeting in Not-for-Profit Businesses..............545 The Post-audit..............................................................549 Using Capital Budgeting Techniques in Other Contexts...................................................................550 Key Concepts................................................................551 Questions......................................................................553 Problems.......................................................................554 Resources......................................................................560 Chapter 15. Project Risk Analysis.....................................................561 Learning Objectives ......................................................561 Detailed Contents Introduction .................................................................561 Types of Project Risk ....................................................562 Relationships Among Stand-Alone, Corporate, and Market Risk.......................................................564 Risk Analysis Illustration ...............................................565 Sensitivity Analysis.........................................................567 Scenario Analysis...........................................................570 Monte Carlo Simulation................................................573 Qualitative Risk Assessment...........................................576 Incorporating Risk into the Decision Process ................577 Making the Final Decision ............................................581 Adjusting Cash Outflows for Risk..................................582 Divisional Costs of Capital ............................................585 An Overview of the Capital Budgeting Decision Process.......................................................586 Capital Rationing..........................................................588 Key Concepts................................................................589 Questions......................................................................591 Problems.......................................................................592 Resources......................................................................596 Part VII Other Topics Chapter 16. Revenue Cycle and Current Accounts Management.........599 Learning Objectives ......................................................599 Introduction .................................................................599 An Overview of Current Accounts Management ...........600 Cash Management ........................................................601 The Cash Budget..........................................................605 Marketable Securities Management ...............................610 Revenue Cycle Management .........................................611 Supply Chain Management ...........................................620 Current Liability Management ......................................623 Key Concepts................................................................630 Questions......................................................................632 Problems.......................................................................634 Resources......................................................................636 Chapter 17. Financial Condition Analysis..........................................639 Learning Objectives ......................................................639 Detailed Contents Introduction .................................................................639 Financial Statement Analysis..........................................640 Financial Ratio Analysis.................................................643 Tying the Financial Ratios Together: Du Pont Analysis ....................................................................656 Other Analytical Techniques..........................................659 Operating Indicator Analysis .........................................660 Limitations of Financial Ratio and Operating Indicator Analyses.....................................................664 Benchmarking...............................................................665 Key Performance Indicators and Dashboards.................667 Key Concepts................................................................668 Questions......................................................................669 Problems.......................................................................670 Resources......................................................................677 Supplement. Market Value Ratios, Common Size Analysis, Percentage Change Analysis, and Economic Value Added..............................................................679 Market Value Ratios......................................................679 Common Size Analysis..................................................680 Percentage Change Analysis ..........................................682 Economic Value Added.................................................682 Glossary .................................................................................................687 Index .....................................................................................................705 About the Authors ..................................................................................739 PREFACE The beginnings of Healthcare Finance: An Introduction to Accounting and Financial Management trace back almost 20 years. At that time, we recognized a need to make available material for courses in traditional, nontraditional, and clinician-oriented master of health administration (MHA) programs in which students do not have a formal educational background in finance-related topics. Finance courses in such programs require a book that provides basic information on foundation topics. Furthermore, these courses often are part of programs that contain just one healthcare finance course, so the course must cover both accounting and financial management. Some texts that were published at that time were strong in accounting, and others were strong in financial management. However, none gave equal emphasis to both components of healthcare finance, giving rise to the first edition of this book.

Concept of the Book The overall concept of this book has not changed since the first edition: to create a text that introduces students to the most important principles and applications of healthcare finance, with roughly equal coverage of accounting and financial management. Furthermore, because the book is intended for use primarily in health services administration programs, in which students are trained for professional positions within healthcare provider organizations, its focus is on healthcare finance as practiced in such organizations.

Thus, the examples within the book are based on such organizations as hospitals, medical practices, clinics, home health agencies, nursing homes, and managed care organizations.

Another consideration in writing the book is that most readers would be seeing the material for the first time, so it is important that the material be explained as clearly and succinctly as possible. We have tried hard to create a book that readers will find user-friendly one that they will enjoy reading and can learn from on their own. If students don t find a book interesting, understandable, and useful, they won t read it.

The book begins with an introduction to healthcare finance and a description of the current financial environment in which providers operate, Preface with emphasis on healthcare insurance and reimbursement methodologies.

From there, it takes students through the basics of financial and managerial accounting. Here, our goal is not to turn generalist managers into accountants, but to present those accounting concepts that are most critical to managerial decision making. The book then discusses the basic foundations of financial management and demonstrates how healthcare managers can apply financial management principles to help make better decisions, where better is defined as decisions that promote the financial well-being of the organization.

Relationship to Other Books Understanding Healthcare Financial Management (UHFM) (coauthored with George H. Pink) UHFM is very similar to a traditional corporate finance text, except that it focuses on the financial management of health services organizations. It does not include explicit accounting content that typically is taught in managerial and financial accounting courses, so UHFM assumes that students have some familiarity with financial statements and other basic accounting concepts. The book includes a great deal of theory, but the emphasis is on using the theory, as well as the concepts and tools, to make managerial decisions that maximize financial, and hence mission, performance.

The book is designed primarily for use in graduate-level courses for students who have already had exposure to accounting and financial management courses. It can be used for other student clienteles, but the absence of explicit accounting content, the amount of theory, and the nature of the ancillaries make the book most suitable for MHA and MBA (healthcare concentration) students. Also, because UHFM is designed to provide students with a higher level of cognition according to Bloom s Taxonomy, the end-of-chapter problems are provided on spreadsheets rather than printed in the textbook. Finally, student comprehension is maximized when UHFM is paired with cases, specifically, those contained in Cases in Healthcare Finance (see below).

Fundamentals of Healthcare Finance (FHF) FHF differs from Healthcare Finance in that it focuses primarily on financial decisions made at the clinical department level, so it includes only limited content related to those decisions, such as organizational financing and capital structure, made by the financial staff. Because it focuses on those accounting and financial management concepts and decisions most relevant to clinical managers, it is shorter in length than Healthcare Finance.

The book is designed primarily for use in undergraduate-level courses for health science or health services management students and for Preface undergraduate or graduate courses in clinical programs such as medicine, nursing, and physical or occupational therapy. It is also useful for professional development programs in healthcare finance.

Cases in Healthcare Finance (CHF) (coauthored with Pink) CHF contains 11 accounting cases, 21 financial management cases, and seven ethics mini-cases. The finance cases generally focus on a single decision, such as marginal cost pricing or outsourcing, while the ethics mini-cases discuss situations that arise in healthcare finance that present ethical dilemmas. The casebook has spreadsheet models for most of the cases and questions that instructors can provide to students if they require more structure.

The casebook is designed to provide students with a higher level of cognition through the application of healthcare finance theory, concepts, and tools to real world settings. CHF typically is used in conjunction with UHFM or Healthcare Finance in graduate courses for health services management students, but it can be used with other textbooks and in other settings. The cases are especially appreciated by students with work experience, but the availability of questions permits significant leeway in student clienteles.

Intended Market and Use Healthcare Finance is not targeted for specific types of educational programs.

Rather, it is designed to teach health services management students, in one course, the fundamental concepts of healthcare finance, including both accounting and financial management. Thus, the book can be used in a wide variety of settings: undergraduate and graduate programs, traditional and executive programs, on-campus and distance learning programs, and even independently for professional development.

The key to the book s usefulness is not the educational program but the focus of the course. If the course is a stand-alone course for management students designed to cover both healthcare accounting and financial management, the book will fit. In fact, the book easily can be used across a two-course healthcare finance sequence, especially in modular programs where each course is two credit hours. Typically, such a sequence begins with an accounting course and ends with a financial management course. This book, supplemented by cases (and possibly readings), would work well in such a sequence.

The book should also be useful to practicing healthcare professionals who, for one reason or another, must increase their understanding of healthcare finance. Such professionals include clinicians who have some management responsibilities as well as line managers who now require additional finance skills. As an alternative, Fundamentals of Healthcare Finance could Preface be used for this purpose, especially when the readers will remain clinicians as opposed to moving into organizational (corporate) management positions.

Finally, many members of financial staffs, especially those who work exclusively in a single area, such as patient accounts, would benefit from having a broader understanding of healthcare finance principles and would find this book useful.

Changes in the Sixth Edition Since the publication of the fifth edition of this book, we have used it numerous times in various settings. In addition, we have received many comments from users at other universities. The reaction of students, other professors, and the marketplace in general has been overwhelmingly positive every comment received indicates that the basic concept of the book is sound. Even so, nothing is perfect, and the healthcare environment is evolving at a dizzying pace. Thus, many changes have been made to the book, the most important of which are listed here:

First and foremost, this edition was coauthored by Kristin L. Reiter, an associate professor at the University of North Carolina at Chapel Hill.

Kristin, who worked as a senior accountant and an auditor before joining academe, brings a wealth of accounting knowledge and experience to the book that will have an immediate impact. In addition, Kristin s teaching and research endeavors bring new insights to the book s content and pedagogy that will have a profound and positive impact over time.

The contents of chapters 1 and 2 have been reorganized to focus exclusively on issues of greatest relevance to healthcare finance. For example, Chapter 2 is now fully devoted to health insurance and reimbursement methodologies. Also, coverage of healthcare reform is significantly expanded.

The managerial accounting chapters (5 8) have been reorganized to create a more logical progression of concepts. Although much of the material is the same, the approach is different. Now, instead of focusing on techniques, the emphasis is on the level of analysis:

first organizational costing, then departmental costing, and finally service line costing. Furthermore, coverage of service line costing is significantly expanded to include four methods: cost-to-charge ratio (CCR), relative value unit (RVU), activity-based costing (ABC), and time-driven activity-based costing (TDABC).

Chapter 18 of the fifth edition (Lease Financing and Business Valuation) has been removed from the textbook and placed online. This material, although important to the financial staff, is not of prime relevance to Preface most student users of this book. In addition, Chapter 19 (Distributions to Owners: Bonuses, Dividends, and Repurchases) is now available online.

Some sections of the text, considered nonessential, have been moved from within the chapter to the very end of the chapter in sections called Chapter Supplements. For example, sections on lesser-used Medicare payment methods, service decisions (contract analysis), and securities market regulation were placed in supplements. For the most part, these sections are both noncritical and technical in nature and their new placement allows students to better focus on essential content.

Financial accounting coverage was updated to conform to the latest formats released by the American Institute of Certified Public Accountants. Thus, the income statement format now includes both operating income and net income and places the provision for bad debts in the revenue section rather than listing it as an expense.

Correspondingly, ratio coverage now includes a more complete discussion of the differences between operating margin and total margin.

The end-of-chapter problem sets were expanded by two problems per chapter. Users of the book have indicated that textbooks cannot have too many problems.

Finally, the following minor changes to the text have occurred:

Coverage of the revenue cycle has been increased; use of alternative (nonhospital) settings has been increased; use of sidebars (boxes) has been increased to add interest to the text; and endnotes have been eliminated, with comments of importance placed in the text.

The lecture presentation software was updated and improved based on continual use and suggestions from adopters and students alike.

All in all, these changes improve the quality and value of the book without affecting its basic concept and approach to learning.

Ancillary Materials for Instructors Three important teaching aids are available for instructors who adopt this book. To request access to online instructor resources, please e-mail [email protected].

End-of-chapter solutions. A comprehensive set of solutions to the end-of-chapter questions and problems is available to instructors who can, in turn, provide them to students if desired.

Test bank. An online test bank with approximately 350 multiple- choice questions (roughly 20 25 per chapter) is available to adopters.

Preface Lecture presentation software. A set of PowerPoin slides that cover all the essential issues contained in each chapter is also available.

Concepts, graphs, tables, lists, and calculations are presented in about 40 slides per chapter. Furthermore, electronic or hard copies of the slides can be provided to students for use as lecture notes. Many instructors will find these slides useful, either as is or customized to best meet the situation at hand.

Ancillary Materials for Students Two additional chapters are available to students on the Health Administration Press Book Companion website at ache.org/books/HCFinance6.

Chapter 18: Lease Financing and Business Valuation Chapter 19: Distributions to Owners: Bonuses, Dividends, and Repurchases Acknowledgments This book reflects the efforts of many people. First and foremost, we would like to thank Mark Covaleski of the University of Wisconsin, who made significant contributions to the accounting content when the book was first written.

In fact, without his materials, advice, and counsel, the book would not have been born. In addition, Anna McAleer of Arcadia University provided many useful comments for improving both the text and the instructor s manual.

Colleagues, students, and staff at the University of Florida and University of North Carolina at Chapel Hill provided inspirational support, as well as more tangible support, during the development and class testing of the text. Also, the Health Administration Press staff was instrumental in ensuring the quality and usefulness of the book.

Errors in the Book In spite of the significant effort that has been expended by many individuals on this book, it is safe to say that some errors exist. In an attempt to create the most error-free and useful book possible, we strongly encourage both instructors and students to write or e-mail one of us with comments and suggestions for improving the book. We certainly welcome your input. (Please note that some of the healthcare organizations used as examples in this and Preface previous editions are fictitious. Any similarities in organizational name and characteristics are unintentional.) Conclusion In the environment faced by healthcare providers today, good financial decision making is more important than ever to the economic well-being of the enterprise. Managers of all types and at all levels should be thoroughly grounded in finance principles and applications, but this is easier said than done. We hope that Healthcare Finance: An Introduction to Accounting and Financial Management will help you understand the finance problems currently faced by healthcare providers and, more important, that it will provide guidance on how best to solve them.

Louis C. Gapenski, PhD Kristin L. Reiter, PhD Box 100195 Health Science 1104H McGavran-Greenberg Hall Center 135 Dauer Drive, Campus Box 7411 University of Florida University of North Carolina Gillings Gainesville, FL 32610-0195 School of Global Public Health [email protected] Chapel Hill, NC 27599-7411 [email protected] THE HEALTHCARE ENVIRONMENT Two factors make the provision of health services different from other services.

First, many providers are organized as not-for-profit corporations as opposed to being investor owned. Second, payment for services typically is made by third parties rather than by the patients who receive the services. Thus, in the study of healthcare finance, it is necessary for students to understand the environment that creates the unique framework for the practice of healthcare finance.

Part I contains many introductory topics that are designed to provide readers with the structural framework in which finance is practiced within healthcare organizations. Such topics include the definition of healthcare finance, the organization and role of the finance staff, health services settings, and key issues facing healthcare managers. In addition, Part I contains information on health insurance, the third-party payer system, alternative reimbursement methodologies, and the impact of healthcare reform.

HEALTHCARE FINANCE BASICS 1 Learning Objectives After studying this chapter, readers will be able to Describe the organization of this book and the learning aids contained in each chapter.

Define the term healthcare finance as it is used in this book.

Describe the key characteristics of a business.

Discuss the structure of the finance department, the role of finance in health services organizations, and how this role has changed over time.

Describe the major players in the health services industry.

List the key operational issues currently faced by healthcare managers.

Describe the alternative forms of business organization and corporate ownership and their organizational goals.

Discuss the key elements of healthcare reform and its expected effect on the provision of health services.

Introduction In today s healthcare environment, where financial realities play an important role in health services decision making, it is vital that managers at all levels understand the basic concepts of healthcare finance and how these concepts are used to enhance the financial well-being of the organization. In this chapter, we introduce readers to the book, including its purpose, goals, and organization.

Furthermore, we present some basic background information about healthcare finance and the health services system. We sincerely hope that this book will be a significant help to you in your quest to increase your professional competency in the important area of healthcare finance.

Before You Begin Before you begin the study of healthcare finance, here are a few tips about the book that will make the process easier.

Purpose of the Book Many books cover the general topics of accounting and financial management, so why is a book needed that focuses on healthcare finance? The reason is that while all industries have certain individual characteristics, the health services industry is truly unique. For example, the provision of healthcare services is dominated by not-for-profit corporations, both private and governmental, and such entities are inherently different from investor-owned businesses. Also, the majority of payments made to healthcare providers are not made by the individuals who use the services but by third-party payers (e.g., employers, commercial insurance companies, government programs). Throughout this book, the ways in which the unique features of the health services industry influence the application of finance principles and practices are emphasized.

This book is designed to introduce students to healthcare finance, which has two important implications. First, the book assumes no prior knowledge of the subject matter; thus, the book is totally self-contained, with each topic explained from the beginning in basic terms. Furthermore, because clarity is so important when concepts are introduced, the chapters have been written in an easy-to-read fashion. None of the topics is inherently difficult, but new concepts often take some effort to understand. This process is made easier by the writing style used.

Second, because this book is introductory, it contains a broad overview of healthcare finance. The good news here is that the book presents virtually all the important healthcare finance principles that are used by managers in health services organizations. The bad news is that the large number of topics covered prevents us from covering principles in great depth or from including a wide variety of illustrations. Thus, students who use this book are not expected to fully understand every nuance of every finance principle and practice that pertains to every type of health services organization. Nevertheless, this book provides sufficient knowledge of healthcare finance so that readers will be better able to function as managers, judge the quality of financial analyses performed by others, and incorporate sound principles and practices into their own personal finance decisions.

Naturally, an introductory finance book does not contain everything that a healthcare financial manager must know to competently perform his or her job. Nevertheless, the book is useful even for those working in finance positions within health services organizations because it presents an overview of the finance function. Often, when one is working in a specific area of finance, it is too easy to lose sight of the context of one s work. This book will help provide that context.

Organization of the Book In Alice s Adventures in Wonderland, Lewis Carroll wrote: If you don t know where you are going, any road will get you there. Because not just any road will ensure that this book meets its goals, the destination has been carefully charted: to provide an introduction to healthcare finance. Furthermore, the book is organized to pave the road to this destination.

Part I, The Healthcare Environment, contains fundamental background material essential to the practice of healthcare finance. In essence, Part I introduces the book, provides insights into the uniqueness of the health services industry, and provides additional information on how healthcare providers obtain their revenues. Healthcare finance cannot be studied in a vacuum because the practice of finance is profoundly influenced by the economic and social environment of the industry, including alternative types of ownership and reimbursement methods.

Part II, Financial Accounting, begins the actual discussion of healthcare finance principles and practices. Financial accounting, which involves the creation of statements that summarize a business s financial status, is most useful for outsiders and for long-term planning and management. In this part, we discuss the format and interpretation of the four primary financial statements.

Part III, Managerial Accounting, which consists of four chapters, focuses on the creation of data used in the day-to-day management and control of a business. Here, the emphasis begins with the overall organization, then it shifts to the subunit (department) level, and finally it reaches the individual service level. The key topics in Part III include costing methods and behavior, profit planning, cost allocation, pricing and service decisions, and financial planning and budgeting.

In Part IV, Basic Financial Management Concepts, the focus moves from accounting to financial management. Here we first cover time value analysis, which provides techniques for valuing future cash flows. The second of the two chapters in this part discusses financial risk and required return. Taken together, these chapters provide readers with knowledge of two of the most important concepts used in financial decision making.

Part V, Long-Term Financing, turns to the capital acquisition process.

Businesses need capital, or funds, to purchase assets, and this part examines the two primary types of financing long-term debt and equity. In addition, the final chapter of Part V provides the framework for analyzing a business s appropriate financing mix and assessing its cost.

Part VI, Capital Investment Decisions, considers the vital topic of how businesses analyze new capital investment opportunities (capital budgeting).

Because major capital projects take years to plan and execute, and because these decisions generally are not easily reversed and will affect operations for many years, their impact on the future of an organization is profound. The two chapters in this part first focus on basic capital investment analysis concepts and then turn to project risk assessment and incorporation.

Part VII, Other Topics, covers two diverse topics. The first chapter in this part discusses the revenue cycle and the management of short-term assets, such as cash and inventories, as well as how such assets are financed.

The techniques used to analyze a business s financial and operating condition are discussed in the book s final chapter. Health services managers must be able to assess the current financial condition of their organizations. Even more important, managers must be able to monitor and control current operations and assess ways in which alternative courses of action will affect the organization s future financial condition.

In addition to the printed text, two chapters are available from the publisher s website for this book. Chapter 18, Lease Financing and Business Valuation, contains information on leasing and how to value entire businesses, and Chapter 19, Distributions to Owners: Bonuses, Dividends, and Repurchases, discusses how profits in investor-owned businesses are returned to owners. To access these chapters, visit ache.org/books/HCFinance6.

How to Use This Book As mentioned earlier, the book is designed to introduce students to healthcare finance. The book contains several features designed to make the process as easy as possible.

First, pay particular attention to the Learning Objectives listed at the beginning of each chapter. These objectives provide a feel for the most important topics in each chapter and what readers should set as learning goals for the chapter.

Following each major section in a chapter (except the chapter s Introduction), one or more Self-Test Questions are included. As you finish reading each major section, try to provide reasonable answers to these questions. Your responses do not have to be perfect, but if you are not satisfied with your answer, it would be best to reread the section before proceeding. Answers are not provided for the self-test questions, so a review of the section is indicated if you are in doubt about whether your answers are satisfactory.

It is useful for readers to have important equations both embedded in the text to illustrate their use and broken out separately to permit easy identification and review. The Key Equation boxes can be used both for section and chapter review and as an aid to working end-of-chapter problems. In addition, the book contains several types of boxes, such as For Your Consideration and Industry Practice boxes. Each of these boxes presents an important issue relevant to the text discussion and allows readers to pause for a few moments to think about the issue presented, generate opinions, and draw conclusions.

Many instructors use these boxes to stimulate in-class discussions.

Within the book, italics and boldface are used to indicate importance.

Italics are used whenever a key term is introduced; thus, italics alert readers that a new and important concept is being presented. Boldface indicates terms that are defined in each chapter s running glossary, which complements the glossary at the back of the book, and is also occasionally used for emphasis.

In addition to in-chapter learning aids, materials designed to help readers learn healthcare finance are included at the end of each chapter. First, each chapter ends with a summary section titled Key Concepts, which briefly summarizes the most important principles and practices covered in that chapter. If the meaning of a key concept is not apparent, you may find it useful to review the applicable section. Each chapter also contains a series of Questions designed to assess your understanding of the qualitative material in the chapter. In most chapters, the questions are followed by a set of Problems designed to assess your understanding of the quantitative material. Additionally, each chapter ends with a set of Resources. The books and articles cited can provide a more in-depth understanding of the material covered in the chapter. Finally, some chapters contain a Chapter Supplement, whose purpose is to present additional information pertaining to topics in the chapter that is useful but not essential.

Taken together, the pedagogic structure of the book is designed to make learning healthcare finance as easy and enjoyable as possible.

1. Why is it necessary to have a book dedicated to healthcare finance?

2. What is the purpose of this book?

3. Briefly describe the organization of this book.

4. What features in the book are designed to make learning easier?

Defining Healthcare Finance What is healthcare finance? Surprisingly, there is no single answer to that question because the definition of the term depends, for the most part, on the context in which it is used. Thus, in writing this book, the first step was to establish the definition of healthcare finance.

We began by examining the healthcare sector of the economy, which consists of a diverse collection of subsectors that involve, either directly or indirectly, the healthcare of the population. The major subsectors include the following:

Health services. The health services subsector consists of providers of health services, including medical practice, hospital, nursing home, home health care, and hospice industries.

Health insurance. The health insurance subsector, which makes most of the payments to health services providers, includes government programs and commercial insurers as well as self-insurers. Also included here are managed care companies, such as health maintenance organizations, which incorporate both insurance and health services (provider) functions.

SELF-TEST QUESTIONS Provider An organization that provides healthcare services (treats patients).

Accounting The field of finance that involves the measuring and recording of events, in dollar terms, that reflect an organization s operational and financial status.

Financial management The field of finance that provides the theory, concepts, and tools used by healthcare managers to make financial decisions.

SELF-TEST QUESTIONS Medical equipment and supplies. These subsectors include the makers of diagnostic equipment, such as X-ray machines; durable medical equipment, such as wheelchairs; and expendable medical supplies, such as disposable surgical instruments and hypodermic syringes.

Pharmaceuticals and biotechnology. These subsectors develop and market drugs and other therapeutic products.

Other. This category includes a diverse collection of organizations ranging from consulting firms to educational institutions to government and private agencies.

Most users of this book will become (or already are) managers at health services organizations or at companies such as insurance and consulting firms that deal directly with health services organizations. Thus, to give this book the most value to its primary users, we focus on finance as it applies within the health services subsector. Of course, the principles and practices of finance cannot be applied in a vacuum but must be based on the realities of the current healthcare environment, including how health services are financed. Furthermore, insurance involves payment to healthcare providers; much of managed care involves utilization management of providers, either directly or through contracts; and most consulting work is done for providers, so the material in this book is also relevant for managers in industries related to health services.

Now that we have defined the healthcare focus of this book, the term finance must be defined. Finance, as the term is used within health services organizations and as it is used in this book, consists of both the accounting and financial management functions. (In many settings, accounting and financial management are separate disciplines.) Accounting, as its name implies, is concerned with the recording, in financial terms, of economic events that reflect the operations, resources, and financing of an organization. In general, the purpose of accounting is to create and provide to interested parties, both internal and external, useful information about an organization s operations and financial status.

Whereas accounting provides a rational means by which to measure a business s financial performance and assess operations, financial management provides the theory, concepts, and tools necessary to help managers make better financial decisions. Of course, the boundary between accounting and financial management is blurred; certain aspects of accounting involve decision making, and much of the application of financial management theory and concepts requires accounting data.

1. What is meant by the term healthcare finance?

2. What is the difference between accounting and financial management?

Concept of a Business This book focuses on finance as practiced within health services businesses, so it is reasonable to ask this question: What is a business? If this question were asked to a group of accountants, the answer probably would involve financial statements, such as the income statement and balance sheet, which we cover in chapters 3 and 4. However, if the question were posed to a group of lawyers, the answer likely would include legal forms of business, which we describe later in this chapter.

From a financial (economic) perspective, a business can be thought of as an entity (its legal form does not matter) that (1) obtains financing (capital) from the marketplace; (2) uses those funds to buy land, buildings, and equipment; (3) operates those assets to create goods or services; and then (4) sells those goods or services to create revenue. To be financially viable, a business has to have sufficient revenue to pay all of the costs associated with creating and selling its goods or services.

Although this description of a business is surprisingly simple, it tells a great deal about the basic decisions that business managers must make. One of the first decisions is to choose the best legal form for the business. Then, the manager must decide how the business will raise the capital that it needs to get started. Should it borrow the money (use debt financing), raise the money from owners (or from the community if not- for-profit), or use some combination of the two sources? Next, once the start-up capital is raised, what physical assets (facilities and equipment) should be acquired to create the services that (in the case of healthcare providers) will be offered to patients?

Note that businesses are profoundly different from pure charities. A business, such as a hospital or medical practice, sustains itself financially by selling goods or services. Thus, it is in competition with other businesses for the consumer dollar.

A pure charity, such as the American Heart Association, on the other hand, does not sell goods or services. Rather, it obtains funds by soliciting contributions and then uses For Your Consideration Businesses, Pure Charities, and Governmental Entities A healthcare business relies on revenues from sales to create financial sustainability. For example, if a hospital s revenues exceed its costs, cash is being generated that can be used to provide new and improved patient services and the hospital can continue to meet community needs. On the other hand, pure charities, such as the American Red Cross, rely on contributions for revenues, so the amount of charitable services provided (which typically are free) is limited by the amount of contributions received. Finally, most governmental units are funded by tax receipts, so, as with charities, the amount of services provided is limited, but in this case by the taxing authority s ability to raise revenues. Yet, in spite of differences, all three types of organizations must operate in a financially prudent manner.

What do you think? From a finance perspective, how different are these types of organizations?

How does the day-to-day functioning of their respective finance departments vary? Is finance more important in one type of organization than in another?

SELF-TEST QUESTIONS Budget A detailed plan, in dollar terms, of how a business and its subunits will acquire and utilize resources during a specified period of time.

Financial statements Statements prepared by accountants that convey the financial status of an organization.

The four primary statements are the income statement, balance sheet, statement of changes in equity, and statement of cash flows.

those funds to supply charitable (free) services. In essence, a pure charity is a budgetary organization in that the amount of contributions fixes its budget for the year.

Also, businesses are different from governmental agencies such as local public health departments. In general, governmental agencies do not receive revenues by selling services or by soliciting contributions. Rather, the revenues are derived from taxing the populations that benefit from the governmental services, so providing additional services typically uses resources without generating additional income. Thus, like a pure charity, a governmental agency has a budget that is fixed, but by appropriations rather than by contributions.

1. From a financial perspective, briefly describe a business.

2. What is the difference between a business and a pure charity?

Between a business and a governmental agency?

The Role of Finance in Health Services Organizations The primary role of finance in health services organizations, as in all businesses, is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise. As we discuss in the next section, the two broad areas of finance accounting and financial management are separate functions in larger organizations, although the accounting function usually is carried out under the direction of the organization s chief financial officer and hence falls under the overall category of finance.

In general, finance activities include the following:

Planning and budgeting. First and foremost, healthcare finance involves evaluating the financial effectiveness of current operations and planning for the future. Budgets play an important role in this process.

Financial reporting. For a variety of reasons, it is important for businesses to record and report to outsiders the results of operations and current financial status. This is typically accomplished by a set of financial statements.

Capital investment decisions. Although capital investment is more important to senior management, managers at all levels must be concerned with the capital investment decision-making process.

Decisions that result from this process, which are called capital budgeting decisions, focus on the acquisition of land, buildings, and equipment. They are the primary means by which businesses implement strategic plans, and hence they play a key role in an organization s financial future.

Financing decisions. All organizations must raise capital to buy the assets necessary to support operations. Such decisions involve the choice between internal and external funds, the use of debt versus equity capital, the use of long-term versus short-term debt, and the use of lease versus conventional financing. Although senior managers typically make financing decisions, these decisions have ramifications for managers at all levels.

Revenue cycle and current accounts management. Revenue cycle management includes the billing and collections function, while current accounts management involves the organization s short-term assets, such as cash and inventories, and short-term liabilities, such as accounts payable and debt. Such functions and accounts must be properly managed both to ensure operational effectiveness and to reduce costs. Generally, managers at all levels are involved to some extent in revenue cycle and current accounts management.

Contract management. In today s healthcare environment, health services organizations must negotiate, sign, and monitor contracts with managed care organizations and third-party payers. The financial staff typically has primary responsibility for these tasks, but managers at all levels are involved in these activities and must be aware of their effects on operating decisions.

Financial risk management. Many financial transactions that take place to support the operations of a business can themselves increase the business s risk. Thus, an important finance activity is to control financial risk.

These specific finance activities often are summarized by the four Cs:

costs, cash, capital, and control. The measurement and minimization of costs is vital to the financial success of any business. Rampant costs, as compared to revenues, usually spell doom for any business. A business can be profitable but still face a crisis due to a shortage of cash. Cash is the lubricant that makes the wheels of a business run smoothly without it, the business grinds to a halt. Capital represents the funds used to acquire land, buildings, and equipment. Without capital, businesses would not have the physical resources needed to provide goods and services. Finally, a business must have adequate control mechanisms to ensure that its capital is being wisely employed and its physical resources are protected for future use.

In times of high profitability and abundant financial resources, the finance function tends to decline in importance. Thus, at the time when most healthcare providers were reimbursed on the basis of costs incurred, the role of Capital budgeting The process of analyzing and choosing new long-term assets such as land, buildings, and equipment.

Capital The funds raised by a business that will be invested in assets, such as land, buildings, and equipment, that support the organizational mission.

Four Cs A mnemonic for the basic finance activities: costs, cash, capital, and control.

Cost A resource use associated with providing or supporting a specific service.

finance was minimal. The most critical finance function was cost identification because it was more important to account for costs than it was to control them.

In response to payer (primarily Medicare) requirements, providers (primarily hospitals) churned out a multitude of reports both to comply with regulations and to maximize revenues. The complexities of cost reimbursement meant that a large amount of time had to be spent on cumbersome accounting, billing, and collection procedures. Thus, instead of focusing on value-adding activities, most finance work focused on bureaucratic functions.

In recent years, however, providers have been redesigning their finance functions in recognition of the changes that have occurred in the health services industry. Although billing and collections remain important, to be of maximum value to the enterprise today the finance function must support cost containment efforts, third-party payer contract negotiations, joint venture decisions, and integrated delivery system participation. In essence, finance must help lead organizations into the future rather than merely record what has happened in the past.

In this book, the emphasis is on the finance function, but there are no unimportant functions in healthcare organizations. Senior executives must understand a multitude of other functions, such as operations, marketing, facilities management, and human resource management, in addition to finance.

Still, all business decisions have financial implications, so all managers whether in operations, marketing, personnel, or facilities must know enough about finance to properly incorporate any financial implications into decisions made within their own specialized areas.

SELF-TEST QUESTIONS 1. What is the role of finance in today s health services organizations?

2. How has this role changed over time?

3. What are the four Cs?

The Structure of the Finance Department The size and structure of the finance department within health services organizations depend on the type of provider and its size. Still, the finance department within larger provider organizations generally follows the model described here.

The head of the finance department holds the title chief financial officer (CFO) or sometimes vice president finance. This individual typically reports directly to the organization s chief executive officer (CEO) and is responsible for all finance activities within the organization. The CFO directs two senior managers who help manage finance activities. First is the comptroller (pronounced, and sometimes spelled, controller ), who is responsible for accounting and reporting activities such as routine budgeting, preparation of financial statements, payables management, and patient accounts management.

For the most part, the comptroller is involved in those activities covered in chapters 3 through 8 of this text.

Second is the treasurer, who is responsible for the acquisition and management of capital (funds). Treasurer activities include the acquisition and employment of capital, cash and debt management, lease financing, financial risk management, and endowment fund management (within not-for-profits).

In general, the treasurer is involved in those activities discussed in chapters 11 through 17 of this text.

Of course, in larger organizations, the comptroller and treasurer have managers with responsibility for specific functions, such as the patient accounts manager, who reports to the comptroller, and the cash manager, who reports to the treasurer.

In very small businesses, many of the finance responsibilities are combined and assigned to just a few individuals. In the smallest health services organizations, the entire finance function is managed by one person, often called the business (practice) manager.

SELF-TEST 1. Briefly describe the typical structure of the finance department QUESTION within a health services organization.

Health Services Settings Health services are provided in numerous settings, including hospitals, ambulatory care facilities, long-term care facilities, and even at home. Before the 1980s, most health services organizations were freestanding and not formally linked with other organizations. Those that were linked tended to be part of horizontally integrated systems that controlled a single type of healthcare facility, such as hospitals or nursing homes. Over time, however, many health services organizations have diversified and become vertically integrated through either direct ownership or contractual arrangements.

Most readers of this text are familiar with health services settings either through previous courses or by working in the field. For those readers who have not had exposure to health services settings, the Chapter 1 Supplement provides additional information.

SELF-TEST QUESTION 1. Name a few settings in which health services are provided.

Current Managerial Challenges In recent years, the American College of Healthcare Executives (ACHE) has surveyed CEOs regarding the most critical concerns of healthcare managers.

Financial concerns have headed the list of challenges on every survey conducted since the survey began in 2002. When asked to rank their specific financial concerns, CEOs put reimbursement at the forefront, with Medicaid, Medicare, and bad debt losses as their top payer concerns. (Reimbursement is discussed in Chapter 2.) In a survey of healthcare CFOs conducted by the Healthcare Financial Management Association, they reported that their most pressing issue was balancing clinical and financial issues in essence, determining how to improve financial performance without having a negative impact on clinical performance. Other issues of concern included improving the revenue cycle (billing and collecting on a timely basis) and developing different ways to access (raise) capital.

Taken together, the results of these surveys confirm the fact that finance is of primary importance to today s healthcare managers. The remainder of this book is dedicated to helping you confront and solve these issues.

SELF-TEST QUESTION 1. What are some important issues facing healthcare managers today?

Alternative Legal Forms of Businesses Throughout this book, the focus is on business finance that is, the practice of accounting and financial management within business organizations. There are three primary legal forms of business organization: proprietorship, partnership, and corporation. In addition, there are several hybrid forms. Because most health services managers work for corporations and because not-forprofit businesses are organized as corporations, this form of organization is emphasized. However, some medical practices are organized as proprietorships, and partnerships and hybrid forms are common in group practices and joint ventures, so health services managers must be familiar with all forms of business organization.

Proprietorship A simple form of Proprietorships business owned by A proprietorship, sometimes called a sole proprietorship, is a business owned a single individual.

Also called sole by one individual. Going into business as a proprietor is easy the owner proprietorship.

merely begins business operations. However, most cities require even the smallest businesses to be licensed, and state licensure is required for most healthcare professionals.

Partnerships A partnership is formed when two or more persons associate to conduct a business that is not incorporated. Partnerships may operate under different degrees of formality, ranging from informal oral understandings to formal agreements filed with the state in which the partnership does business. Both the proprietorship and partnership forms of organization are easily and inexpensively formed, are subject to few governmental regulations, and pay no corporate income taxes. All earnings of the business, whether reinvested in the business or withdrawn by the owner(s), are taxed as personal income to the proprietor or partner.

Proprietorships and partnerships have several disadvantages, including the following:

Selling their interest in the business is difficult for owners.

The owners have unlimited personal liability for the debts of the business, which can result in losses greater than the amount invested in the business. In a proprietorship, unlimited liability means that the owner is personally responsible for the debts of the business. In a partnership, it means that if any partner is unable to meet his or her obligation in the event of bankruptcy, the remaining partners are responsible for the unsatisfied claims and must draw on their personal assets if necessary.

The life of the business is limited to the life of the owners.

It is difficult for proprietorships and partnerships to raise large amounts of capital. This is no particular problem for a very small business or when the owners are very wealthy, but the difficulty of attracting capital becomes a real handicap if the business needs to grow substantially to take advantage of market opportunities.

Corporations A corporation is a legal entity that is separate and distinct from its owners and managers. The creation of a separate business entity gives these primary advantages:

A corporation has unlimited life and can continue in existence after its original owners and managers have died or left the company.

It is easy to transfer ownership in a corporation because ownership is divided into shares of stock that can be sold.

Owners of a corporation have limited liability.

Partnership A nonincorporated business entity that is created by two or more individuals.

Corporation A legal business entity that is separate and distinct from its owners (or community) and managers.

Limited liability partnership (LLP) A partnership form of organization that limits the professional (malpractice) liability of its partners.

To illustrate limited liability, suppose that an individual made an investment of $10,000 in a partnership that subsequently went bankrupt, owing $100,000. Because the partners are liable for the debts of the partnership, that partner could be assessed for a share of the partnership s debt in addition to the loss of his or her initial $10,000 contribution. In fact, if the other partners were unable to pay their shares of the indebtedness, one partner would be held liable for the entire $100,000. However, if the $10,000 had been invested in a corporation that went bankrupt, the potential loss for the investor would be limited to the $10,000 initial investment. (However, in the case of small, financially weak corporations, the limited liability feature of ownership is often fictitious because bankers and other lenders will require personal guarantees from the stockholders.) With these three factors unlimited life, ease of ownership transfer, and limited liability corporations can more easily raise money in the financial markets than can sole proprietorships or partnerships.

The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation once at the corporate level and then again at the personal level. Second, setting up a corporation, and then filing the required periodic state and federal reports, is more costly and time consuming than what is required to establish a proprietorship or partnership.

Setting up a corporation requires that the founders, or their attorney, prepare a charter and a set of bylaws. Today, attorneys have standard forms for charters and bylaws on their computers, so they can set up a no frills corporation with modest effort. In addition, several companies offer online services that help with the incorporation process. Still, setting up a corporation remains relatively difficult when compared to a proprietorship or partnership, and it is even more difficult if the corporation has nonstandard features, such as multiple classes of stock.

Hybrid Forms of Organization Although the three basic forms of organization proprietorship, partnership, and corporation historically have dominated the overall business scene, several hybrid forms of organization have become quite popular in recent years.

In general, the hybrid forms are designed to limit owners liability without having to fully incorporate. For example, in a limited liability partnership (LLP), the partners have joint liability for all actions of the partnership, including personal injuries and indebtedness. However, all partners enjoy limited liability regarding professional malpractice because partners are only liable for their own individual malpractice actions, not those of the other partners.

In spite of limited malpractice liability, the partners are jointly liable for the partnership s debts. Other hybrid forms of organization include limited liability companies (LLCs), professional corporations (PCs), and professional associations (PAs).

1. What are the three primary forms of business organization, and how do they differ?

2. What is the purpose of hybrid forms?

Alternative Corporate Ownership In the previous section, we discussed alternative legal forms of businesses.

Now, we turn our attention to the two alternative ownership forms of corporations:

for-profit and not-for-profit. Unlike other sectors in the economy, not-for-profit corporations play a major role in the healthcare sector, especially among providers. For example, about 60 percent of the hospitals in the United States are private, not-for-profit hospitals. Only 15 percent of all hospitals are investor owned; the remaining 25 percent are governmental. Furthermore, not-for-profit ownership is common in the nursing home, home health care, hospice, and health insurance industries.

Investor-Owned Corporations When the average person thinks of a corporation, he or she probably thinks of an investor-owned, or for-profit, corporation. For example, Ford, IBM, and Microsoft are investor-owned corporations. In health services, corporations such as HCA and Community Health Systems are examples of large for-profit hospital systems; Kindred Healthcare and Emeritus Senior Living are examples of long-term care providers; Select Medical and HealthSouth offer rehabilitation services; and MEDNAX offers pediatric services. Individuals become owners of for-profit corporations by buying shares of common stock in the company.

The stockholders (also called shareholders) are the owners of investor- owned corporations. As owners, they have two basic rights:

The right of control. Common stockholders have the right to vote for the corporation s board of directors, which oversees the management of the company. Each year, a company s stockholders receive a proxy ballot, which they use to vote for directors and to vote on other issues that are proposed by management or stockholders. In this way, stockholders exercise control. In the voting process, stockholders cast one vote for each common share held.

A claim on the residual earnings of the firm. A corporation sells products or services and realizes revenues from the sales. To produce these revenues, the corporation must incur expenses for materials, labor, insurance, debt capital, and so on. Any excess of revenues over expenses the residual earnings belongs to the shareholders of the business. Often, a portion of these earnings is paid out in the SELF-TEST QUESTIONS Investor-owned (for-profit) corporation A corporation that is owned by shareholders who furnish capital and expect to earn a return on their investment.

Tax-exempt (not-for-profit) corporation A corporation that has a charitable purpose, is tax exempt, and has no owners. Also called nonprofit corporation.

form of dividends, which are merely cash payments to stockholders, or stock repurchases, in which the company buys back shares held by stockholders. However, management typically elects to reinvest some (or all) of the residual earnings in the business, which presumably will produce even higher payouts to stockholders in the future. (See Chapter 19, which is available online at ache.org/books/HCFinance6, for more information about how corporate earnings are distributed to shareholders.) When compared to not-for-profit corporations (discussed below), three key features make investor-owned corporations different. First, the owners (stockholders) of the corporation are well defined and exercise control of the business by voting for directors. Second, the residual earnings of the business belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Finally, investor-owned corporations are subject to various forms of taxation at the local, state, and federal levels.

Not-for-Profit Corporations If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt corporations are sometimes called nonprofit corporations. Because nonprofit businesses (as opposed to pure charities such as the American Red Cross) need profits to sustain operations, and because it is hard to explain why nonprofit corporations should earn profits, the term not-for-profit is more descriptive of such health services corporations. Examples of not-for-profit health services corporations include the Kaiser Foundation, Catholic Health Initiatives, and the Mayo Clinic Health System.

Tax-exempt status is granted to corporations that meet the tax definition of a charitable organization as defined by Internal Revenue Service (IRS) Tax Code Section 501(c)(3) or (4). Hence, such corporations are also known as 501(c)(3) or (4) corporations. The tax code defines a charitable organization as any corporation, community chest, fund, or foundation that is organized and operated exclusively for religious, charitable, scientific, public safety, literary, or educational purposes. Because the promotion of health is commonly considered a charitable activity, a corporation that provides healthcare services can qualify for tax-exempt status, provided that it meets other requirements.

In addition to the charitable purpose, a not-for-profit corporation must be organized and run so that it operates exclusively for the public, rather than private, interest. Thus, no profits can be used for private gain and no direct political activity can be conducted. Also, if the corporation is liquidated or sold to an investor-owned business, the proceeds from the liquidation or sale must be used for charitable purposes. Because individuals cannot benefit from the profits of not-for-profit corporations, such organizations cannot pay dividends. However, prohibition of private gain from profits does not prevent parties, such as managers and physicians, from benefiting through salaries, perquisites, contracts, and so on.

Not-for-profit corporations differ significantly from investor-owned corporations. Because not-for-profit firms have no shareholders, no single body of individuals has ownership rights to the firm s residual earnings or exercises control of the firm. Rather, control is exercised by a board of trustees that is not constrained by outside oversight, as is the board of directors of a for-profit corporation, which must answer to stockholders. Also, not-for-profit corporations are generally exempt from taxation, including both property and income taxes, and have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organizations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital.

For-profit corporations must file annual income tax returns with the IRS. The equivalent filing for not-for-profit corporations is IRS Form 990, titled Return of Organization Exempt from Income Tax. Its purpose is to provide both the IRS and the public with financial information about not- for-profit organizations, and it is often the only source of such information.

It is also used by government agencies to prevent organizations from abusing their tax-exempt status. Form 990 requires significant disclosures related to governance and boards of directors. In addition, hospitals are required to file Schedule H to Form 990, which includes financial information on the amount and type of community benefit (primarily charity care) provided, bad debt losses, Medicare patients, and collection practices. IRS regulations require not- for-profit organizations to provide copies of their three most recent Form 990s to anyone who requests them, whether in person or by mail, fax, or e-mail.

Form 990s are also available to the public through several online services.

The financial problems facing most federal, state, and local governments have caused politicians to take a closer look at the tax subsidies provided to not-for-profit hospitals. For example, several bills have been introduced in Congress that require hospitals to provide minimum levels of care to the indigent to retain tax-exempt status. Such efforts by Congress prompted the American Hospital Association (AHA) in 2007 to publish guidelines for charity care that include (1) giving discounts to uninsured patients of limited means ; (2) establishing a common definition of community benefit, which encompasses the full range of services provided to the population served; and (3) improving transparency, or the ability of outsiders to understand a business s governance structure and policies, including executive compensation.

Likewise, officials in several states have proposed legislation that mandates the minimum amount of charity care to be provided by not-for-profit Form 990 A form filed by not-for-profit organizations with the Internal Revenue Service that reports on governance and charitable activities.

Schedule H An attachment to Form 990 filed by not-for-profit hospitals that gives additional information on charitable activities.

For Your Consideration Making Not-for-Profit Hospitals Do Good Many people have criticized not-for-profit hospitals for not earning their charitable exemptions.

In one of the latest relevant court rulings, in 2010 the Illinois Supreme Court concluded that Provena Covenant hospital, located in Urbana, Illinois, was not a charitable institution for property tax purposes. The court s opinion reasoned that the primary use of the hospital property was providing medical services for a fee, while charity means providing a gift to the community. The opinion further pointed out that (1) the charity care being provided was subsidized by payments from other patients; (2) many patients granted partial charity care still paid enough to cover costs; and (3) the hospital s community benefit activities, such as a residency program and an education program for emergency responders, also benefited the hospital and thus were not truly gifts to the community. Thus, the hospital property was not in charitable use.

Most not-for-profit hospitals today are, of course, primarily supported by payments for services rather than by charitable contributions.

Under the opinion s reasoning, the property tax exemption may well be hard to maintain. However, a partial dissent by two justices suggests that this case is not the end of the story. The dissent argues that the plurality opinion impinges on the legislative function of setting specific standards for tax exemption, and the issue should be settled by legislative action rather than by courts.

What do you think? Should not-for-profit hospitals lose their property tax or income tax exemptions? Should legislatures set standards that hospitals must meet to maintain their tax- exempt status? If so, how might such standards be specified?

hospitals and the types of billing and collections procedures applied to the uninsured.

For example, Texas has established minimum requirements for charity care, which hold not-for-profit hospitals accountable to the public for the tax exemptions they receive. The Texas law specifies four tests, and each hospital must meet at least one of them. The test that most hospitals use to comply with the law requires that at least 4 percent of net patient service revenue be spent on charity care. Also, Ohio legislators have held hearings to discuss whether a law should be passed requiring Ohio s not-forprofit hospitals to make payments in lieu of taxes, or PILOTS.

Finally, money-starved municipalities in several states have attacked the property tax exemption of not-for-profit hospitals that have neglected their charitable missions.

For example, tax assessors are fighting to remove property tax exemptions from not-for-profit hospitals in several Pennsylvania cities after an appellate court ruling supported the Erie School District s authority to tax a local hospital that had strayed too far from its charitable purpose. According to one estimate, if all not-for-profit hospitals had to pay taxes comparable to their investor-owned counterparts, local, state, and federal governments would garner an additional $3.5 billion in tax revenues.

This estimate explains why tax authorities in many jurisdictions are pursuing not-forprofit hospitals as a source of revenue.

The inherent differences between investor-owned and not-for-profit organi zations have profound implications for many elements of healthcare financial management, including organizational goals, financing decisions (i.e., the choice between debt and equity financing and the types of securities issued), and capital investment decisions. Ownership s effect on the application of healthcare financial management theory and concepts is addressed throughout the text.

1. What are the major differences between investor-owned and not- for-profit corporations?

2. What pressures recently have been placed on not-for-profit hospitals to ensure that they meet their charitable mission?

3. What are the purpose and content of IRS Form 990?

Organizational Goals Healthcare finance is not practiced in a vacuum; it is practiced with some objective in mind. Finance goals within an organization clearly must be consistent with, as well as supportive of, the overall goals of the business. Thus, by discussing organizational goals, a framework for financial decision making within health services organizations can be established.

Small Businesses In a small business, regardless of its legal form, the owners generally are also its managers. In theory, the business can be operated for the exclusive benefit of the owners. If the owners want to work very hard to get rich, they can.

On the other hand, if every Wednesday is devoted to golf, no outside owner is hurt by such actions. (Of course, the business still has to satisfy its customers or it will not survive.) It is in large, publicly held corporations, in which owners and managers are separate parties, that organizational goals become important to the practice of finance.

Publicly Held Corporations From a finance perspective, the primary goal of large investor-owned corporations is generally assumed to be shareholder wealth maximization, which translates to stock price maximization. Investor-owned corporations do, of course, have other goals. Managers, who make the actual decisions, are interested in their own personal welfare, in their employees welfare, and in the good of the community and society at large. Still, the goal of stock price maximization is a reasonable operating objective upon which to build financial decision-making rules.

Not-for-Profit Corporations Corporations consist of a number of classes of stakeholders, which include all parties that have an interest, usually of a financial nature, in the organization.

For example, a not-for-profit hospital s stakeholders include the board of trustees; managers; employees; physician staff; creditors; suppliers; patients; and even potential patients, which may include the entire community. An investor-owned hospital has the same set of stakeholders, plus stockholders, SELF-TEST QUESTIONS who dictate the goal of shareholder wealth maximization. While managers of investor-owned companies have to please primarily one class of stakeholders the shareholders to keep their jobs, managers of not-for-profit firms face a different situation. They have to try to please all of the organization s stakeholders because no single well-defined group exercises control.

Many people argue that managers of not-for-profit corporations do not have to please anyone at all because they tend to dominate the boards of trustees that are supposed to exercise oversight. Others argue that managers of not-forprofit corporations have to please all of the business s stakeholders to a greater or lesser extent because all are necessary to the successful performance of the business. Of course, even managers of investor-owned corporations should not For Your Consideration Does the Finance Function Differ Among Providers?

Readers of this book understand the difference between for-profit and not-for-profit providers.

Not-for-profit providers have a charitable mission, while for-profits are in business to make money for owners. Furthermore, all not-for-profit earnings must be reinvested in the enterprise, while some (or all) profits of for-profit health services businesses may be returned to owners in the form of dividends or stock repurchases. Although many studies have tried to assess which type of ownership is better for patients, no consensus has been reached.

But what about the finance function? That is, what about the day-to-day activities of operational managers and the finance staff? Are these appreciably different at not-for-profit providers than at for-profit providers? What about different types of providers say, medical group practices versus hospitals? If those activities differ, might you benefit from taking two healthcare finance courses one for investor-owned providers and another for not-for-profit providers? Or should separate healthcare finance courses be offered for different types of providers, for example, one for hospitals and another for nursing homes?

What do you think? Is the finance function at not-for-profit providers appreciably different from that at for-profit providers, or is there an appreciable difference between types of providers? If there are differences, what are they?

attempt to enhance shareholder wealth by treating other stakeholders unfairly, because such actions ultimately will be detrimental to shareholders.

Typically, the goal of not-for-profit corporations is stated in terms of a mission statement. For example, here is the current mission statement of Riverside Memorial Hospital, a 450-bed, not-for-profit acute care hospital:

Riverside Memorial Hospital, along with its medical staff, is a recognized, innovative healthcare leader dedicated to meeting the needs of the community. We strive to be the best comprehensive healthcare provider through our commitment to excellence.

Although this mission statement provides Riverside s managers and employees with a framework for developing specific goals and objectives, it does not provide much insight into the goal of the hospital s finance function. For Riverside to accomplish its mission, its managers have identified the following five financial goals:

1. The hospital must maintain its financial viability.

2. The hospital must generate sufficient profits to continue to provide the current range of healthcare services to the community. This means that current buildings and equipment must be replaced as they become obsolete.

3. The hospital must generate sufficient profits to invest in new medical technologies and services as they are developed and needed.

4. Although the hospital has an aggressive philanthropy program in place, it does not want to rely on this program or government grants to fund its operations.

5. The hospital will strive to provide services to the community as inexpensively as possible, given the above financial requirements.

In effect, Riverside s managers are saying that to achieve the hospital s commitment to excellence as stated in its mission, the hospital must remain financially strong and profitable. Financially weak organizations cannot continue to accomplish their stated missions over the long run.

What is interesting is that Riverside s five financial goals are probably not much different from the financial goals of Jefferson Regional Medical Center (JRMC), a for-profit competitor. Of course, JRMC has to worry about providing a return to its shareholders, and it receives only a very small amount of contributions and grants. However, to maximize shareholder wealth, JRMC also must retain its financial viability and have the financial resources necessary to offer new services and technologies. Furthermore, competition in the market for hospital services does not permit JRMC to charge appreciably more for services than its not-for-profit competitors.

SELF-TEST 1. What is the difference in goals between investor-owned and not-QUESTION for-profit businesses?

Healthcare Reform and Finance The Patient Protection and Affordable Care Act (ACA) of 2010 has been called the most significant healthcare legislation since Medicare and Medicaid in 1965. The law, which was enacted on March 23, 2010, was designed to provide all US citizens and legal residents with access to affordable health insurance, to reduce healthcare costs, and to improve care and quality. This legislation puts in place comprehensive health insurance exchanges to expand coverage, hold insurance companies accountable for product cost and quality, lower costs across the system, guarantee more choices, and enhance the quality of care all of which are intended to transform the US healthcare system and make it more sustainable.

The ACA has numerous major aims. However, the central goal is to expand healthcare coverage through shared responsibility between government, Accountable care organization (ACO) A network of healthcare providers joined together for the purpose of increasing patient service quality and reducing costs.

individuals, and employers. This involves requiring all US citizens and legal residents to have health insurance coverage, which may be obtained through health insurance exchanges at an affordable cost if the individual does not have health insurance available from other sources.

Some of the benefits of the ACA include free preventive care, the banning of preexisting-condition coverage limitations, prescription discounts for seniors, extended coverage for young adults, lifetime coverage on most benefits, prevention of coverage cancellation by insurers, transparency on increases in insurance premium rates, and patient selection (rather than insurer assignment) of primary care doctors from the provider network.

The major implications of the ACA for health insurance are addressed in Chapter 2, while the major implications for the delivery of healthcare services, and hence healthcare finance, are discussed in the following sections.

Accountable Care Organizations One of the ways the ACA seeks to decrease healthcare costs and increase quality is by encouraging providers to form accountable care organizations (ACOs). An ACO is a network of physicians, other clinicians, and hospitals and clinics that shares responsibility for providing coordinated care to patients.

Providers in an ACO not only are jointly accountable for the health of their patients but also receive financial incentives to cooperate and reduce costs by avoiding unnecessary tests and procedures, eliminating duplication of services, and coordinating patient care.

An ACO can take one of many forms, such as the following:

An integrated delivery system that has common ownership of hospitals and physician practices and uses electronic health records, offers team- based care, and makes available resources to support cost-effective care A multispecialty group practice that has strong affiliations with hospitals and contracts with multiple health plans A physician hospital organization that is a subset of a hospital s medical staff and that functions like a multispecialty group practice An independent practice association composed of individual physician practices that come together to contract with health plans A virtual physician organization that sometimes includes physicians in rural areas ACOs are paid through the traditional fee-for-service system (see Chapter 2); however, they are offered bonuses as an incentive to reduce the cost of care.

Doctors and hospitals have to meet specific quality benchmarks that focus on prevention and careful management of patients with chronic diseases. In other words, providers get paid more for keeping patients healthy and out of the hospital. If an ACO is unable to save money, it could be liable for the costs of the investments made to improve care; it also may have to pay a penalty if it does not meet performance and cost-savings benchmarks.

Medical Homes A medical home (or patient-centered medical home) is a team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient s lifetime with the goal of maximizing health outcomes.

The medical home is responsible for providing all of a patient s healthcare needs or appropriately arranging care with other qualified professionals. This includes the provision of preventive services, treatment of acute and chronic illnesses, and assistance with end-of-life issues. It is a model of practice in which a team of healthcare professionals, coordinated by a personal physician, works collaboratively to ensure coordinated and integrated care, patient access and communication, quality, and safety. The medical home model is independent of the ACO concept, but it is anticipated that ACOs will provide an organizational setting that facilitates implementation of the model.

Supporters of the model claim that it will allow better access to healthcare, increase patient satisfaction, and improve health. Although the development and implementation of the medical home model is in its infancy, its key characteristics at this time are the following:

Personal physician. Each patient has an ongoing relationship with a personal physician trained to provide first-contact, continuous, and comprehensive care.

Whole-person orientation. The personal physician is responsible for providing all of a patient s healthcare needs or for appropriately arranging care with other qualified professionals. In effect, the personal physician leads a team of clinicians who collectively take responsibility for patient care.

Coordination and integration. The personal physician coordinates care across specialists, hospitals, home health agencies, nursing homes, and hospices.

Quality and safety. Quality and patient safety are ensured by a care- planning process, evidence-based medicine, clinical decision support tools, performance measurement, active participation of patients in decision making, use of information technology, and quality improvement activities.

Enhanced access. Medical care and information are available at all times through open scheduling, expanded hours of service, and new and innovative communications technologies.

Payment-for-value methodologies. It is essential that payment methodologies recognize the added value provided to patients.

Payments should reflect the value of work that falls outside of Medical home A team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient s lifetime with a goal of maximizing health outcomes.

Population health management The concept that the health of all individuals is improved when the health of the entire population is improved.

face-to-face visits, should support adoption and use of health information technology for quality improvement, and should recognize differences in the patient populations treated within the practice.

Industry Consolidation The ACA is driving the consolidation of healthcare organizations. It has accelerated health systems acquisition of hospitals and hospitals acquisition of physician practices, and that trend is likely to continue for many years. With the greater focus on clinical integration, quality of care, and changing reimbursement methodologies, healthcare organizations are seeking to restructure healthcare delivery to operate more efficiently and improve coordination between patients and providers. Healthcare organizations are looking to gain a competitive advantage from combining assets, staff, and resources. Consolidation not only provides organizations access to capital, economies of scale, and market share but also may lead to improvement in patient care by making it easier to share patient information, adhere to clinical practice guidelines (thus reducing variations in care), and access high-quality specialist physicians.

Population Health The ACA is moving providers toward the population health management approach to care provision. The goal of population health management is to shift from focusing on treating illness to maintaining or improving health. The idea is to prevent costly illnesses when possible and hence avoid unnecessary care, which is encouraged by reimbursement models such as capitation, payment bundling, and shared savings (discussed in Chapter 2). Instead of just providing preventive and chronic care when patients come in for acute problems, ACOs track and monitor the health status of the entire patient population, requiring greater use of health information technology. The keys to success in population health management are greater awareness of the health status of the population and proactive intervention to reduce the use of provider resources and to achieve the best population outcomes.

Clinical Integration A fundamental component to achieving the goals of the ACA is clinical integration.

Clinical integration aims to coordinate patient care across conditions, providers, settings, and time to achieve care that is safe, timely, effective, efficient, and patient focused. New payment models and advances in health information systems are used to facilitate the transition to the clinical integration model and to manage the continuum of care for patients. Provider payments are tied to results for quality, access, and efficiency with the objective of establishing coordination between hospitals and physicians. Health information technology aims to capture patient information and make it accessible to authorized providers at the point of care. Complete patient information facilitates optimal treatment strategies and reduces the chance of medication errors and conflicting treatment plans. There will be requirements for new and more comprehensive policies and procedures that protect patient privacy and that guarantee the security of data that are transferred between patients, caregivers, and organizations.

Data Analytics The emergence of ACOs and an increased emphasis on collaboration between clinicians and on quality patient care are making it necessary for healthcare organizations to invest in integrated information systems technology to collect large quantities of patient and provider data (so-called big data). Data analytic systems are capable of analyzing large amounts of patient data to better understand clinical processes and to identify problems and opportunities for improvement in the provision of healthcare services. New, complex information technology will facilitate analysis of care coordination, patient safety, and utilization of healthcare services.

Staffing Shortages The ACA is expected to increase the number of patients who can access the healthcare system. Healthcare organizations will see an influx of formerly uninsured patients now seeking care because they have insurance or better coverage. As a result, the demand for healthcare professionals especially physicians, nurse practitioners, and physician assistants will likely increase.

The ACA is also driving changes in hospital staffing by emphasizing prevention and value-based care, creating demand for primary care providers, emergency physicians, clinical pharmacists, and health information technology and data specialists. Some professional and industry associations are predicting that current shortages of various healthcare staff will worsen in the face of this growing demand. The ACA has identified several strategies to increase the supply of health professionals (including primary care physicians), such as scholarships and flexible loan repayment programs to help fund their education.

However, many healthcare organizations likely will face great competition for some healthcare staff.

SELF-TEST QUESTIONS 1. What is the primary purpose of healthcare reform?

2. Will reform have a greater impact on insurers or providers?

3. What is an accountable care organization (ACO), and what is it designed to accomplish?

4. What is the medical home model, and what is its purpose?

Key Concepts This chapter provided an introduction to healthcare finance. The key concepts of this chapter are as follows:

The term healthcare finance, as it is used in this book, means the accounting and financial management principles and practices used within health services organizations to ensure the financial wellbeing of the enterprise.

A business maintains its financial viability by selling goods or services, while a pure charity relies solely on contributions.

The primary role of finance in health services organizations, as in all businesses, is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise.

Finance activities generally include (1) planning and budgeting, (2) financial reporting, (3) capital investment decisions, (4) financing decisions, (5) revenue cycle and current accounts management, (6) contract management, and (7) financial risk management. These activities can be summarized by the four Cs: costs, cash, capital, and control.

The size and structure of the finance department within a health services organization depend on the type of provider and its size. Still, the finance department within a larger provider organization generally consists of a chief financial officer (CFO), who typically reports directly to the chief executive officer (CEO) and is responsible for all finance activities within the organization.

Reporting to the CFO are the comptroller, who is responsible for accounting and reporting activities, and the treasurer, who is responsible for the acquisition and management of capital (funds).

In larger organizations, the comptroller and treasurer direct managers who have responsibility for specific functions, such as the patient accounts manager, who reports to the comptroller, and the cash manager, who reports to the treasurer.

In small health services organizations, the finance responsibilities are combined and assigned to one individual, often called the business (practice) manager.

All business decisions have financial implications, so all managers whether in operations, marketing, personnel, or facilities must know enough about finance to incorporate those implications into their own specialized decision-making processes.

Healthcare services are provided in numerous settings, including hospitals, ambulatory care facilities, long-term care facilities, and even at home.

Recent surveys of health services executives confirm the fact that healthcare managers view financial concerns as the most important current issue they face.

The three main forms of business organization are proprietorship, partnership, and corporation. Although each form of organization has its own unique advantages and disadvantages, most large organizations, and all not-for-profit entities, are organized as corporations.

Investor-owned corporations have stockholders who are the owners of the corporation. As owners, stockholders have claim on the residual earnings of the corporation. Investor-owned corporations are fully taxable.

Charitable organizations that meet certain criteria can be organized as not-for-profit corporations. Rather than having a well- defined set of owners, such organizations have a large number of stakeholders who have an interest in the organization. Not-forprofit corporations do not pay taxes; they can accept tax-deductible contributions, and they can issue tax-exempt debt.

In lieu of tax filings, not-for-profit corporations must file Form 990, which reports on an organization s governance structure and community benefit services, with the Internal Revenue Service.

From a financial management perspective, the primary goal of investor-owned corporations is shareholder wealth maximization, which translates to stock price maximization. For not-for-profit corporations, a reasonable goal for financial management is to ensure that the organization can fulfill its mission, which translates to maintaining financial viability.

Healthcare reform is federal legislation that was signed into law in 2010 and is expected to have a significant impact on health insurers and providers.

Accountable care organizations (ACOs) are a method of integrating local physicians with other members of the healthcare community and rewarding them for controlling costs and improving quality.

A medical home (or patient-centered medical home) is a team-based model of care led by a personal physician who provides continuous and coordinated care throughout a patient s lifetime to maximize health outcomes.

In the next chapter, we continue the discussion of the healthcare environment, with emphasis on health insurance and reimbursement methodologies.

Questions and Problems 1.1 Briefly describe the purpose and organization of this book and the learning tools embedded in each chapter.

1.2 a. What are some of the industries in the healthcare sector?

b. What is meant by the term healthcare finance as used in this book?

c. What are the two broad areas of healthcare finance?

d. Why is it necessary to have a book on healthcare finance as opposed to a generic finance book?

1.3 What is the difference between a business and a pure charity?

1.4 a. Briefly discuss the role of finance in the health services industry.

b. Has this role increased or decreased in importance in recent years?

1.5 What is the structure of the finance department within health services organizations?

1.6 a. (Hint: the material reviewed in this question is covered in the Chapter Supplement.) Briefly describe the following health services settings:

Hospitals Ambulatory care Home health care Long-term care Integrated delivery systems b. What are the benefits attributed to integrated delivery systems?

1.7 What are the major current concerns of healthcare managers?

1.8 What are the three primary forms of business organization? Describe their advantages and disadvantages.

1.9 What are the primary differences between investor-owned and not- for-profit corporations?

1.10 a. What is the primary goal of investor-owned corporations?

b. What is the primary goal of most not-for-profit healthcare corporations?

c. Are there substantial differences between the finance goals of investor-owned and not-for-profit corporations? Explain.

1.11 Briefly describe the main provisions of healthcare reform and its implications for the practice of healthcare finance.

1.12 Describe the primary features of accountable care organizations (ACOs) and medical homes. What benefits are attributed to them?

Resources For a general introduction to the healthcare system in the United States, see Barton, P. L. 2010. Understanding the U.S. Health Services System. Chicago: Health Administration Press.

Shi, L., and D. A. Singh. 2013. Essentials of the U.S. Health Care System. Burlington, MA: Jones and Bartlett Learning.

For the latest information on events that affect health services organizations, see Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

For ideas on the future of healthcare in the United States and other information pertinent to this chapter, see Bisognano, M. 2011. Finance is Key to Achieving Quality and Cost Goals. Healthcare Financial Management (April): 68 71.

Giniat, E. J. 2009. Finance Needs to Sit at the Head Table. Healthcare Financial Management (May): 80 82.

Kim, C., D. Majka, and J. H. Sussman. 2011. Modeling the Impact of Healthcare Reform. Healthcare Financial Management (January): 51 60.

Lee, J. G., G. Dayal, and D. Fontaine. 2011. Starting a Medical Home: Better Health at Lower Cost. Healthcare Financial Management (June): 71 80.

Mulvany, C. 2011. Medicare ACOs No Longer Mythical Creatures. Healthcare Financial Management (June): 96 104.

Nguyen, J., and B. Choi. 2011. Accountable Care: Are You Ready? Healthcare Financial Management (August): 92 100.

Reynolds, M. 2011. Managing the Risks of Accountable Care. Healthcare Financial Management (July): 49 56.

Selvam, A. 2013. Reform Unease Fading Among CEOs: But Financial Challenges Remain Top Concern in ACHE s Annual Survey. Modern Healthcare (January 14): 22 23.

Smith, P. C., and K. Noe. 2012. New Requirements for Hospitals to Maintain Tax- Exempt Status. Journal of Health Care Finance (Spring): 16 21.

Song, P. H., S. D. Lee, J. A. Alexander, and E. E. Seiber. 2013. Hospital Ownership and Community Benefit: Looking Beyond Uncompensated Care. Journal of Healthcare Management (March/April): 126 42.

For current information on how the Internet affects health and the provision of health services, see Journal of Medical Internet Research, www.jmir.org.

1 HEALTH SERVICES SETTINGS Introduction Health services are provided in numerous settings, including hospitals, ambulatory care facilities, long-term care facilities, and even at home. Before the 1980s, most health services organizations were freestanding and not formally linked with other organizations. Those that were linked tended to be part of horizontally integrated systems that controlled a single type of healthcare facility, such as hospitals or nursing homes. Recently, however, many health services organizations have diversified and become vertically integrated either through direct ownership or contractual arrangements.

Settings Hospitals Hospitals provide diagnostic and therapeutic services to individuals who require more than several hours of care, although most hospitals are actively engaged in ambulatory (walk-in) services as well. To ensure a minimum standard of safety and quality, hospitals must be licensed by the state and undergo inspections for compliance with state regulations. In addition, most hospitals are accredited by The Joint Commission. Joint Commission accreditation is a voluntary process that is intended to promote high standards of care. Although the cost to achieve and maintain compliance with Joint Commission standards can be substantial, accreditation provides eligibility for participation in the Medicare program, and hence most hospitals seek accreditation.

Recent environmental and operational changes have created significant challenges for hospital managers. For example, many hospitals are experiencing decreasing admission rates and shorter lengths of stay, which result in excess capacity. At the same time, hospitals have been pressured to give discounts to private third-party payers, governmental payments have failed to keep up with the cost of providing services, and indigent care and bad debt losses have increased. Because of the changing payer environment and resultant cost containment pressures, the number of hospitals (and beds) has declined in recent years.

Hospitals differ in function, average length of patient stay, size, and ownership. These factors affect the type and quantity of assets, services offered, and management requirements and often determine the type and level of reimbursement. Hospitals are classified as either general acute care facilities or specialty facilities. General acute care hospitals, which provide general medical and surgical services and selected acute specialty services, are short-stay facilities and account for the majority of hospitals. Specialty hospitals, such as psychiatric, children s, women s, rehabilitation, and cancer facilities, limit admission of patients to specific ages, sexes, illnesses, or conditions. The number of specialty hospitals has grown significantly in the past few decades because of the increased need for such services.

Hospitals vary in size, from fewer than 25 beds to more than 1,000 beds; general acute care hospitals tend to be larger than specialty hospitals.

Small hospitals, those with fewer than 100 beds, usually are located in rural areas. Many rural hospitals have experienced financial difficulties in recent years because they have less ability than larger hospitals to lower costs in response to ever-tighter reimbursement rates. Most of the largest hospitals are academic health centers or teaching hospitals, which offer a wide range of services, including tertiary services. (Tertiary care is highly specialized and technical in nature, with services for patients with unusually severe, complex, or uncommon problems.) Hospitals are classified by ownership as private not-for-profit, investor owned, and governmental. Governmental hospitals, which make up 25 percent of all hospitals, are broken down into federal and public (nonfederal) entities.

Federal hospitals, such as those operated by the military services or the US Department of Veterans Affairs, serve special populations.

Public hospitals are funded wholly or in part by a city, county, tax district, or state. In general, federal and public hospitals provide substantial services to indigent patients. In recent years, many public hospitals have converted to other ownership categories primarily private not-for-profit because local governments have found it increasingly difficult to fund healthcare services and still provide other necessary public services. In addition, the inability of politically governed organizations to respond quickly to the changing healthcare environment has contributed to many conversions as managers try to create organizations that are more responsive to external change.

Private not-for-profit hospitals are nongovernmental entities organized for the sole purpose of providing inpatient healthcare services. Because of the charitable origins of US hospitals and a tradition of community service, roughly 80 percent of all private hospitals (60 percent of all hospitals) are not-for-profit entities. In return for serving a charitable purpose, these hospitals receive numerous benefits, including exemption from federal and state income taxes, exemption from property and sales taxes, eligibility to receive tax-deductible charitable contributions, favorable postal rates, favorable tax-exempt financing, and tax-favored annuities for employees.

Chapter 1 Supplement Chapter 1 Supplement Chapter 1 Supplement The remaining 20 percent of private hospitals (15 percent of all hospitals) are investor owned. This means that they have owners (typically shareholders) that benefit directly from the profits generated by the business. Historically, most investor-owned hospitals were owned by physicians, but now most are owned by large corporations such as HCA, which owns about 160 hospitals; Community Health Systems, which owns about 130 hospitals; and Tenet Healthcare, which owns about 80 hospitals.

Unlike not-for-profit hospitals, investor-owned hospitals pay taxes and forgo the other benefits of not-for-profit status. However, investor-owned hospitals typically do not embrace the charitable mission of not-for-profit hospitals. Despite the expressed differences in mission between investor-owned and not-for-profit hospitals, not-for-profit hospitals are being forced to place greater emphasis on the financial implications of operating decisions than in the past. This trend has raised concerns in some quarters that many not-for-profit hospitals are now failing to meet their charitable mission. As this perception grows, some people argue that these hospitals should lose some, if not all, of the benefits associated with their not-for-profit status.

Hospitals are labor intensive because of their need to provide continuous nursing supervision to patients, in addition to the other services they provide through professional and semiprofessional staffs. Physicians petition for privileges to practice in hospitals. While they admit and provide care to hospitalized patients, physicians, for the most part, are not hospital employees and hence are not directly accountable to hospital management. However, physicians retain a major responsibility for determining which hospital services are provided to patients and how long patients are hospitalized, so physicians play a critical role in determining a hospital s costs and revenues and hence its financial condition.

Ambulatory (Outpatient) Care Ambulatory care, also known as outpatient care, encompasses services provided to noninstitutionalized patients. Traditional outpatient settings include medical practices, hospital outpatient departments, and emergency departments. In addition, the 1980s and early 1990s witnessed substantial growth in nontraditional ambulatory care settings such as home health care, ambulatory surgery centers, urgent care centers, diagnostic imaging centers, rehabilitation/sports medicine centers, and clinical laboratories. In general, the new settings offer patients increased amenities and convenience compared with hospital-based services and, in many situations, provide services at a lower cost than hospitals do. For example, urgent care and ambulatory surgery centers are typically less expensive than their hospital counterparts because hospitals have higher overhead costs.

Many factors have contributed to the expansion of ambulatory services, but technology has been a leading factor. Often, patients who once required hospitalization because of the complexity, intensity, invasiveness, or risk associated with certain procedures can now be treated in outpatient settings. In addition, third-party payers have encouraged providers to expand their outpatient services through mandatory authorization for inpatient services and by payment mechanisms that provide incentives to perform services on an outpatient basis. Finally, fewer entry barriers to developing outpatient services relative to institutional care exist. Ordinarily, ambulatory facilities are less costly and less often subject to licensure and certificate-of-need regulations (exceptions are hospital outpatient units and ambulatory surgery centers).

As outpatient care consumes an increasing portion of the healthcare dollar and as efforts to control outpatient spending are enhanced, the traditional role of the ambulatory care manager is changing. Ambulatory care managers historically have focused on such routine management tasks as billing, collections, staffing, scheduling, and patient relations, while the owners, often physicians, have tended to make the more important business decisions.

However, reimbursement changes and increased affiliations with insurers and other providers are requiring a higher level of management expertise. This increasing environmental complexity, along with increasing competition, is forcing managers of ambulatory care facilities to become more sophisticated in making business decisions, including finance decisions.

Long-Term Care Long-term care entails the provision of healthcare services, as well as some personal services, to individuals who lack some degree of functional ability.

It usually covers an extended period of time and includes both inpatient and outpatient services, which often focus on mental health, rehabilitation, and nursing home care. Although the greatest use is among the elderly, long-term care services are used by individuals of all ages.

Long-term care is concerned with levels of independent functioning, specifically activities of daily living such as eating, bathing, and locomotion.

Individuals become candidates for long-term care when they become too mentally or physically incapacitated to perform necessary tasks and when their family members are unable to provide needed services. Long-term care is a hybrid of healthcare services and social services; nursing homes are a major source of such care.

Three levels of nursing home care exist: (1) skilled nursing facilities, (2) intermediate care facilities, and (3) residential care facilities. Skilled nursing facilities (SNFs) provide the level of care closest to hospital care. Services must be provided under the supervision of a physician and must include 24-hour daily nursing care. Intermediate care facilities (ICFs) are intended for individuals who do not require hospital or SNF care but whose mental or physical conditions require daily continuity of one or more medical services. Residential care facilities are sheltered environments that do not provide professional Chapter 1 Supplement Chapter 1 Supplement Chapter 1 Supplement healthcare services and thus for which most health insurance programs do not provide coverage.

Nursing homes are more abundant than hospitals and are smaller, with an average bed size of about 100 beds, compared with about 170 beds for hospitals. Nursing homes are licensed by states, and nursing home administrators are licensed as well. Although The Joint Commission accredits nursing homes, only a small percentage participate because accreditation is not required for reimbursement and the standards to achieve accreditation are much higher than they are for licensure requirements.

The long-term care industry has experienced tremendous growth in the past 50 years. Long-term care accounted for only 1 percent of healthcare expenditures in 1960, but by 2010 it accounted for about 6 percent of expenditures.

Further demand increases are anticipated, as the percentage of the US population aged 65 or older increases, from less than 15 percent in 2013 to a forecasted 20 percent in 2030. The elderly are disproportionately high users of healthcare services and are major users of long-term care.

Although long-term care is often perceived as nursing home care, many new services are being developed to meet society s needs in less institutional surroundings, such as adult day care, life care centers, and hospice programs.

These services tend to offer a higher quality of life, although they are not necessarily less expensive than institutional care. Home health care, provided for an extended time period, can be an alternative to nursing home care for many patients, but it is not as readily available as nursing home care in many rural areas. Furthermore, third-party payers, especially Medicare, have sent mixed signals about their willingness to adequately pay for home health care.

In fact, many home health care businesses have been forced to close in recent years as a result of a new, less generous Medicare payment system.

Integrated Delivery Systems Many healthcare experts have extolled the benefits of providing hospital care, ambulatory care, long-term care, and business support services through a single entity called an integrated delivery system. The hypothesized benefits of such systems include the following:

Patients are kept in the corporate network of services (patient capture).

Providers have access to managerial and functional specialists (e.g., reimbursement and marketing professionals).

Information systems that track all aspects of patient care, as well as insurance and other data, can be developed more easily, and the costs to develop them are shared.

Linked organizations have better access to capital.

The ability to recruit and retain management and professional staff is enhanced.

Integrated delivery systems are able to offer payers a complete package of services ( one-stop shopping ).

Integrated delivery systems are better able to plan for and deliver a full range of healthcare services to meet the needs of a defined population, including chronic disease management and health improvement programs. Many of these population-based efforts typically are not offered by stand-alone providers.

Incentives can be created that encourage all providers in the system to work together for the common good of the system, which has the potential to improve quality and control costs.

Although integrated delivery systems can be structured in many different ways, the defining characteristic of such systems is that the organization has the ability to assume full clinical responsibility for the healthcare needs of a defined population. Because of current state laws, which typically mandate that the insurance function be assumed only by licensed insurers, integrated delivery systems typically contract with insurers rather than directly with employers.

Sometimes, the insurer, often a managed care plan, is owned by the integrated delivery system itself, but generally it is separately owned. In contracts with managed care plans, the integrated delivery system often receives a fixed payment per plan member and hence assumes both the financial and clinical risks associated with providing healthcare services.

To be an effective competitor, integrated delivery systems must minimize the provision of unnecessary services because additional services create added costs but do not necessarily result in additional revenues. Thus, the objective of integrated delivery systems is to provide all needed services to its member population in the lowest-cost setting. To achieve this goal, integrated delivery systems invest heavily in primary care services, especially prevention, early intervention, and wellness programs. The primary care gatekeeper concept is frequently used to control utilization and hence costs. While hospitals continue to be centers of technology, integrated delivery systems have the incentive to shift patients toward lower-cost settings. Thus, clinical integration among the various providers and components of care is essential to achieving quality, cost efficiency, and patient satisfaction.

1. What are some different types of hospitals, and what trends are occurring in the hospital industry?

2. What trends are occurring in outpatient and long-term care?

3. What is an integrated delivery system?

4. Do you think that integrated delivery systems will be more or less prevalent in the future? Explain your answer.

SELF-TEST QUESTIONS Chapter 1 Supplement HEALTHCARE INSURANCE AND 2 REIMBURSEMENT METHODOLOGIES Learning Objectives After studying this chapter, readers will be able to Explain the overall concept of insurance, including adverse selection and moral hazard.

Briefly describe the third-party payer system.

Explain the different types of generic payment methods.

Describe the incentives created by the different payment methods and their impact on provider risk.

Describe the purpose and organization of managed care plans.

Explain the impact of healthcare reform on insurance and reimbursement methodologies.

Explain the importance and types of medical coding.

Introduction For the most part, the provision of healthcare services takes place in a unique way. First, often only a few providers of a particular service exist in a given area. Next, it is difficult, if not impossible, to judge the quality of competing services. Then, the decision about which services to purchase is usually not made by the consumer but by a physician or some other clinician. Also, full payment to the provider is not normally made by the user of the services but by a healthcare insurer. Finally, for most individuals, health insurance from third-party payers is totally paid for or heavily subsidized by employers or government agencies, so many patients are partially insulated from the costs of healthcare.

This highly unusual marketplace for healthcare services has a profound effect on the supply of, and demand for, such services. In this chapter, we discuss the concept of insurance, the major providers of healthcare insurance, and the methods used by insurers to pay for health services.

Insurance Concepts Healthcare services are supported by an insurance system composed of a wide variety of insurers of all types and sizes. Some are investor owned, while others are not-for-profit or government sponsored. Some insurers require their policyholders, who may or may not be the beneficiaries of the insurance, to make the policy payments, while other insurers collect partial or total payments from society at large. Because insurance is the cornerstone of the healthcare system, an appreciation of the nature of insurance will help you better understand the marketplace for healthcare services.

A Simple Illustration To better understand insurance concepts, consider a simple example. Assume that no health insurance exists and you face only two medical outcomes in the coming year:

Outcome Probability Cost Stay healthy 0.99 $ 0 Get sick 0.01 20,000 Furthermore, assume that everyone else faces the same medical outcomes at the same odds and with the same associated costs. What is your expected healthcare cost E(Cost) for the coming year? To find the answer, we multiply the cost of each outcome by its probability of occurrence and then sum the products:

E(Cost) = (Probability of outcome 1 . Cost of outcome 1) + (Probability of outcome 2 . Cost of outcome 2) = (0.99 . $0) + (0.01 . $20,000) = $0 + $200 = $200.

Now, assume that you, and everyone else, make $20,000 a year. With this salary, you can easily afford the $200 expected healthcare cost. The problem is, however, that no one s actual bill will be $200. If you stay healthy, your bill will be zero, but if you are unlucky and get sick, your bill will be $20,000. This cost will force you, and most people who get sick, into personal bankruptcy.

Next, suppose an insurance policy that pays all of your healthcare costs for the coming year is available for $250. Would you purchase the policy, even though it costs $50 more than your expected healthcare costs? Most people would. In general, individuals are risk averse, so they would be willing to pay a $50 premium over their expected costs to eliminate the risk of financial ruin. In effect, policyholders are passing to the insurer the costs associated with the risk of getting sick.

Would an insurer be willing to offer the policy for $250? If an insurance company sells a million policies, its expected total policy payout is 1 million times the expected payout for each policy, or 1 million . $200 = $200 million.

If there were no uncertainty about the $20,000 estimated medical cost per claim, the insurer could forecast its total claims precisely. It would collect 1 million . $250 = $250 million in health insurance premiums; pay out roughly $200 million in claims; and hence have about $50 million to cover administrative costs, create a reserve in case realized claims are greater than predicted by its actuaries, and make a profit.

Basic Characteristics of Insurance The simple example of health insurance we just provided illustrates why individuals would seek health insurance and why insurance companies would be formed to provide such insurance. Needless to say, the concept of insurance becomes much more complicated in the real world. Insurance is typically defined as having four distinct characteristics:

1. Pooling of losses. The pooling, or sharing, of losses is the heart of insurance. Pooling means that losses are spread over a large group of individuals so that each individual realizes the average loss of the pool (plus administrative expenses) rather than the actual loss incurred.

In addition, pooling involves the grouping of a large number of homogeneous exposure units people or things having the same risk characteristics so that the law of large numbers can apply. (In statistics, the law of large numbers states that as the size of the sample increases, the sample mean gets closer and closer to the population mean.) Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy.

2. Payment only for random losses. A random loss is one that is unforeseen and unexpected and occurs as a result of chance. Insurance is based on the premise that payments are made only for losses that are random. We discuss the moral hazard problem, which concerns losses that are not random, in a later section.

3. Risk transfer. An insurance plan almost always involves risk transfer.

The sole exception to the element of risk transfer is self-insurance, which is the assumption of a risk by a business (or an individual) itself rather than by an insurance company. (Self-insurance is discussed in a later section.) Risk transfer is transfer of a risk from an insured to an insurer, which typically is in a better financial position to bear the risk than the insured because of the law of large numbers.

Adverse selection The problem faced by insurance companies because individuals who are more likely to have claims are also more likely to purchase insurance.

Moral hazard The problem faced by insurance companies because individuals are more likely to use unneeded health services when they are not paying the full cost of those services.

4. Indemnification. The final characteristic of insurance is indemnification for losses that is, reimbursement to the insured if a loss occurs. In the context of health insurance, indemnification takes place when the insurer pays the insured, or the provider, in whole or in part for the expenses related to an insured s illness or injury.

Adverse Selection One of the major problems facing healthcare insurers is adverse selection.

Adverse selection occurs because individuals and businesses that are more likely to have claims are more inclined to purchase insurance than those that are less likely to have claims. For example, an individual without insurance who needs a costly surgical procedure will likely seek health insurance if she can afford it, whereas an individual who does not need surgery is much less likely to purchase insurance. Similarly, consider the likelihood of a 20-year-old to seek health insurance versus the likelihood of a 60-year-old to do so. The older individual, with much greater health risk due to age, is more likely to seek insurance.

If this tendency toward adverse selection goes unchecked, a disproportionate number of sick people, or those most likely to become sick, will seek health insurance, and the insurer will experience higher-than-expected claims.

This increase in claims will trigger a premium increase, which only worsens the problem, because the healthier members of the plan will seek insurance from other firms at a lower cost or may totally forgo insurance. The adverse- selection problem exists because of asymmetric information, which occurs when individual buyers of health insurance know more about their health status than do insurers.

In today s world of health reform, ushered in by the Patient Protection and Affordable Care Act (ACA; introduced in Chapter 1), which requires insurers to take on patients regardless of preexisting conditions, the best strategy for healthcare insurers to combat adverse selection is to create a large, well- diversified pool of subscribers. If the pool is sufficiently large and diversified, the costs of adverse selection can be absorbed by the large number of enrollees.

Moral Hazard Insurance is based on the premise that payments are made only for random losses, and from this premise stems the problem of moral hazard. The most common case of moral hazard in a casualty insurance setting is the owner who deliberately sets a failing business on fire to collect the insurance. Moral hazard is also present in health insurance, but it typically takes a less dramatic form; few people are willing to voluntarily sustain injury or illness for the purpose of collecting health insurance. However, undoubtedly there are people who purposely use healthcare services that are not medically required. For example, some people might visit a physician or a walk-in clinic for the social value of human companionship rather than to address a medical necessity. Also, some hospital discharges might be delayed for the convenience of the patient rather than for medical purposes.

Finally, when insurance covers the full cost or most of the cost of healthcare services, individuals often are quick to agree to an expensive MRI (magnetic resonance imaging) scan or other high-cost procedure that may not be necessary. If the same test required total out-of-pocket payment, individuals would think twice before agreeing to such an expensive procedure unless they clearly understood the medical necessity involved.

All in all, when somebody else is paying the costs, patients consume more healthcare services.

Even more insidious is the impact of insurance on individual behavior. Individuals are more likely to forgo preventive actions and embrace unhealthy behaviors when the costs of not taking those actions will be borne by insurers. Why stop smoking if the monetary costs associated with cancer treatment are carried by the insurer? Why lose weight if others will pay for the adverse health consequences likely to result?

The primary weapon that insurers have against the moral hazard problem is coinsurance, which requires insured individuals to pay a certain percentage of eligible medical expenses say, 20 percent in excess of the deductible amount. (Insurers also use copayments, which are similar to coinsurance but are expressed as a dollar amount: $20 per primary care visit, for example.) To illustrate coinsurance, assume that George Maynard, who has employer- provided medical insurance that pays 80 percent of eligible expenses after the $100 deductible is satisfied, incurs $10,000 in medical expenses during the year. The insurer will pay 0.80 . ($10,000 . $100) = 0.80 . $9,900 = $7,920, so George s responsibility is $10,000 . $7,920 = $2,080.

The purposes of coinsurance and copayments are to reduce premiums to employers For Your Consideration Who Should Pay for Health Services?

Users or Insurers?

One of the most confounding questions that arises when discussing healthcare services is who should bear the responsibility for payment.

Should the patient be responsible, or should some third party such as the government or an insurance company foot the bill?

Many people argue that when individuals bear the cost of their own healthcare, they will be responsible consumers and only pay for necessary services. In addition, they will choose providers on the basis of cost and quality and hence create the incentive for providers to offer better yet less expensive services. It is estimated that this action alone would reduce total healthcare costs in the United States by some 20 30 percent, or even more.

Other people argue that individuals cannot make rational decisions regarding their own healthcare because they do not sufficiently understand the nature of illness and injury. Furthermore, there is insufficient information about provider quality and costs available to guide individuals to good decisions. Finally, individuals would skimp on routine preventive healthcare services to save money, which would create healthcare problems down the road and ultimately lead to higher future costs.

What do you think? Should individuals be held more responsible for their own costs of healthcare services? What about the arguments stated above? Is there some way of balancing the need for more consumerism in healthcare service purchases with the need to protect individuals against the very high costs of many services?

SELF-TEST QUESTIONS Third-party payer A generic term for any outside party, typically an insurance company or a government program, that pays for part or all of a patient s healthcare services.

and to prevent overutilization of healthcare services. Because insured individuals pay part of the cost, premiums can be reduced. Additionally, by being forced to pay some of the costs, insured individuals will presumably seek fewer and more cost-effective treatments and embrace a healthier lifestyle.

1. Briefly explain the following characteristics of insurance:

a. Pooling of losses b. Payment only for random losses c. Risk transfer d. Indemnification 2. What is adverse selection, and how do insurers deal with the problem?

3. What is the moral hazard problem, and how do insurers mitigate the problem?

Third-Party Payers Up to this point in the chapter, we have focused on basic insurance concepts because a large proportion of the health services industry receives its revenues not directly from the users of their services the patients but from insurers known collectively as third-party payers. Because an organization s revenues are critical to its financial viability, this section contains a brief examination of the sources of most revenues in the health services industry. In the next section, the reimbursement methodologies employed by these payers are reviewed in more detail.

Health insurance originated in Europe in the early 1800s when mutual benefit societies were formed to reduce the financial burden associated with illness or injury. Since then, the concept of health insurance has changed dramatically. Today, health insurers fall into two broad categories: private insurers and public programs.

Private Insurers In the United States, the concept of public, or government, health insurance is relatively new, while private health insurance has been in existence since the early 1900s. In this section, the major private insurers are discussed: Blue Cross/Blue Shield, commercial insurers, and self-insurers.

Blue Cross/Blue Shield Blue Cross/Blue Shield organizations trace their roots to the Great Depression, when both hospitals and physicians were concerned about their patients ability to pay healthcare bills. One example is Florida Blue (formerly Blue Cross and Blue Shield of Florida), which offers healthcare insurance to individuals and families, Medicare beneficiaries, and business groups that reside in Florida.

Blue Cross originated as a number of separate insurance programs offered by individual hospitals. At that time, many patients were unable to pay their hospital bills, but most people, except the poorest, could afford to purchase some type of hospitalization insurance. Thus, the programs were initially designed to benefit hospitals as well as patients. The programs were all similar in structure: Hospitals agreed to provide a certain amount of services to program members who made periodic payments of fixed amounts to the hospitals whether services were used or not. In a short time, these programs were expanded from single hospital programs to community-wide, multihospital plans that were called hospital service plans. The Blue Cross name was officially adopted by most of these plans in 1939.

Blue Shield plans developed in a manner similar to Blue Cross plans, except that the providers were physicians instead of hospitals. Today, there are 37 Blue Cross/Blue Shield ( the Blues ) organizations. Some offer only one of the two plans, but most offer both plans. The Blues are organized as independent corporations, including some for-profit entities, but all belong to a single national association that sets standards that must be met to use the Blue Cross/Blue Shield name. Collectively, the Blues provide healthcare coverage for more than 100 million individuals in all 50 states, the District of Columbia, and Puerto Rico.

Commercial Insurers Commercial health insurance is issued by life insurance companies, by casualty insurance companies, and by companies that were formed exclusively to offer healthcare insurance. Examples of commercial insurers include Aetna, Humana, and UnitedHealth Group. All commercial insurance companies are taxable (for-profit) entities. Commercial insurers moved strongly into health insurance following World War II. At that time, the United Auto Workers negotiated the first contract with employers in which fringe benefits were a major part of the contract. Like the Blues, the majority of individuals with commercial health insurance are covered under group policies with employee groups, professional and other associations, and labor unions.

Self-Insurers The third major form of private insurance is self-insurance. Although it might seem as if all individuals who do not have some form of health insurance are self-insurers, this is not the case. Self-insurers make a conscious decision to bear the risks associated with healthcare costs and then set aside (or have available) funds to pay future costs as they occur. Individuals, except the very Medicare A federal government health insurance program that primarily provides benefits to individuals aged 65 or older.

wealthy, are not good candidates for self-insurance because they face too much uncertainty concerning healthcare expenses. On the other hand, large groups, especially employers, are good candidates for self-insurance. Today, most large groups are self-insured. For example, employees of the State of Florida are covered by health insurance, the costs of which are paid directly by the state.

Florida Blue is paid a fee to administer the plan, but the state bears all risks associated with cost and utilization uncertainty.

Public Insurers Government is a major insurer as well as a direct provider of healthcare services.

For example, the federal government provides healthcare services directly to qualifying individuals through the medical facilities of the US Department of Veterans Affairs; the US Department of Defense and its TRICARE program (health insurance for uniformed service members and their families); and the Public Health Service, part of the US Department of Health and Human Services (HHS). In addition, government either provides or mandates a variety of insurance programs, such as workers compensation. In this section, however, the focus is on the two major government insurance programs: Medicare and Medicaid.

Medicare Medicare was established by Congress in 1965 primarily to provide medical benefits to individuals aged 65 or older. About 50 million people have Medicare coverage, which pays for about 17 percent of all US healthcare services.

Over the decades, Medicare has evolved to include four major coverages:

(1) Part A, which provides hospital and some skilled nursing facility coverage; (2) Part B, which covers physician services, ambulatory surgical services, outpatient services, and other miscellaneous services; (3) Part C, which is managed care coverage offered by private insurance companies and can be selected in lieu of Parts A and B; and (4) Part D, which covers prescription drugs. In addition, Medicare covers healthcare costs associated with selected disabilities and illnesses, such as kidney failure, regardless of age.

Part A coverage is free to all individuals eligible for Social Security benefits.

Individuals who are not eligible for Social Security benefits can obtain Part A medical benefits by paying monthly premiums. Part B is optional to all individuals who have Part A coverage, and it requires a monthly premium from enrollees that varies with income level. About 97 percent of Part A participants purchase Part B coverage, while about 20 percent of Medicare enrollees elect to participate in Part C, also called Medicare Advantage Plans, rather than Parts A and B. Part D offers prescription drug coverage through plans offered by private companies. Each Part D plan offers somewhat different coverage, so the cost of Part D coverage varies widely.

The Medicare program falls under HHS, which creates the specific rules of the program on the basis of enabling legislation. Medicare is administered by an agency in HHS called the Centers for Medicare & Medicaid Services (CMS). CMS has eight regional offices that oversee the Medicare program and ensure that regulations are followed. Medicare payments to providers are not made directly by CMS but by contractors for 12 Medicare Administrative Contractor (MAC) jurisdictions.

Before we close our discussion of Medicare, note that many private insurers offer coverage called Medicare supplement insurance, or Medigap. Such insurance is designed to help pay some of the healthcare costs that traditional Medicare does not cover, such as copayments, coinsurance, and deductibles.

In addition, some Medigap policies offer coverage for services that Medicare doesn t include, for example, medical care when traveling outside of the United States. When an individual buys Medigap coverage, Medicare will first pay its share of the Medicare-approved amount for covered costs, and then the Medigap policy pays its share.

Medicaid Medicaid began in 1966 as a modest program to be jointly funded and operated Medicaid A federal and by the states and the federal government that would provide a medical safety state government net for low-income mothers and children and for elderly, blind, and disabled health insurance individuals who receive benefits from the Supplemental Security Income (SSI) program that program. Congress mandated that Medicaid cover hospital and physician care, provides benefits to low-income but states were encouraged to expand on the basic package of benefits either by individuals.

increasing the range of benefits or extending the program to cover more people.

States with large tax bases were quick to expand coverage to many groups, while states with limited abilities to raise funds for Medicaid were forced to construct more limited programs. A mandatory nursing home benefit was added in 1972.

Over the years, Medicaid has provided access to healthcare services for many low-income individuals who otherwise would have no insurance coverage.

Furthermore, Medicaid has become an important source of revenue for healthcare providers, especially for nursing homes and other providers that treat large numbers of indigent patients. However, Medicaid expenditures have been growing at an alarming rate, which has forced both federal and state policymakers to search for more effective ways to improve the program s access, quality, and cost.

SELF-TEST QUESTIONS 1. What are some different types of private insurers?

2. Briefly, what are the origins and purpose of Medicare?

3. What is Medicaid, and how is it administered?

Managed care plan A combined effort by an insurer and a group of providers with the purpose of both increasing quality of care and decreasing costs.

Managed Care Plans Managed care plans strive to combine the provision of healthcare services and the insurance function into a single entity. Traditional plans are created by insurers who either directly own a provider network or create one through contractual arrangements with independent providers.

One type of managed care plan is the health maintenance organization (HMO). HMOs are based on the premise that the traditional insurer provider relationship creates perverse incentives that reward providers for treating patients illnesses while offering little incentive for providing prevention and rehabilitation services. By combining the financing and delivery of comprehensive healthcare services into a single system, HMOs theoretically have as strong an incentive to prevent illnesses as to treat them. However, from a patient perspective, HMOs have several drawbacks, including a limited network of providers and the assignment of a primary care physician who acts as the initial contact and authorizes all services received from the HMO.

Another type of managed care plan, the preferred provider organization (PPO), evolved during the early 1980s. PPOs are a hybrid of HMOs and traditional health insurance plans that use many of the cost-saving strategies developed by HMOs. PPOs do not mandate that beneficiaries use specific providers, although financial incentives are created that encourage members to use those providers that are part of the provider panel those providers that have contracts (usually at discounted prices) with the PPO. Furthermore, PPOs do not require beneficiaries to use preselected gatekeeper physicians. In general, PPOs are less likely than HMOs to provide preventive services and do not assume any responsibility for quality assurance because enrollees are not constrained to use only the PPO panel of providers.

In an effort to achieve the potential cost savings of managed care plans, most insurance companies now apply managed care strategies to their conventional plans. Such plans, which are called managed fee-for-service plans, use preadmission certification, utilization review, and second surgical opinions to control inappropriate utilization.

Although the distinctions between managed care and conventional plans were once quite apparent, considerable overlap now exists in the strategies and incentives employed. Thus, the term managed care now describes a continuum of plans, which can vary significantly in their approaches to providing combined insurance and healthcare services. The common feature in managed care plans is that the insurer has a mechanism by which it controls, or at least influences, patients utilization of healthcare services.

1. What is meant by the term managed care?

2. What are some different types of managed care plans?

SELF-TEST QUESTIONS Healthcare Reform and Insurance The ACA introduced a number of provisions to expand insurance coverage and improve insurance affordability and access. Here are some of the act s provisions that focus on healthcare insurance.

Insurance Standards A number of new insurance standards have been specified in the ACA. In terms of coverage, these include the following:

Children and dependents are permitted to remain on their parents insurance plans until their twenty-sixth birthday.

Insurance companies are prohibited from dropping policyholders if they become sick and from denying coverage to individuals due to preexisting conditions.

Individuals have a right to appeal and request that the insurer review denial of payment.

In terms of costs, the standards include the following:

Insurers are required to charge the same premium rate to all applicants of the same age and geographic location, regardless of preexisting conditions or sex.

Insurers are required to spend at least 80 percent of premium dollars on health costs and claims instead of on administrative costs and profits. If the insurer violates this standard, it must issue rebates to policyholders.

Lifetime limits on most benefits are prohibited for all new health insurance plans.

In terms of care, the standards include the following:

All plans must now include essential benefits, such as ambulatory patient services; emergency services; hospitalization; maternity and newborn care; mental health and substance use disorder services; prescription drugs; laboratory services; preventive and wellness services; chronic disease management; and pediatric services, including oral and vision care.

Preventive services, such as childhood immunizations, adult vaccinations, and basic medical screenings, must be available to patients free of charge.

Individuals are permitted to choose a primary care doctor outside the plan s network.

Health insurance exchange (HIE) An online marketplace created primarily by the states or the federal government that insurers use to post plan details and consumers use to purchase healthcare insurance.

Individuals can seek emergency care at a hospital outside the health plan s network.

Individual Mandate All eligible individuals (US citizens and legal residents) who are not covered by an employer-sponsored health plan, Medicaid, or Medicare are required to have a health insurance policy. If they do not maintain minimum essential coverage for themselves and their dependents, they face tax penalties assessed by the Internal Revenue Services at the end of each tax year.

Health Insurance Exchanges Health insurance exchanges (HIEs) are an important part of ensuring that healthcare access is available to all Americans and legal immigrants. People who have no employer-sponsored insurance, the unemployed, or the self-employed can purchase coverage through an exchange. HIEs are online marketplaces where people can research and review their options and purchase health insurance.

It is estimated that more than 10 million people are using HIEs to buy healthcare insurance coverage. To ensure price transparency, all participating insurance companies are required to post on HIEs the rates for their various health insurance plans. This mandate permits individuals and businesses shopping for insurance to compare all plans and rates side by side and select plans that are affordable and meet their needs.

There are different types of HIEs. Public exchanges are created by state or federal government and are open to both individuals seeking personal insurance and small-group employers seeking insurance for their workers. All plans listed on an HIE are required to offer core benefits called essential health benefits such as preventive and wellness services, prescription drugs, and hospital stays. Private exchanges, on the other hand, are created by private- sector firms, such as health insurance companies. Private HIEs are expected to increase in number over time as more employers offer defined healthcare contribution plans (discussed in a later section in this chapter) to their employees, who then must purchase health insurance on their own.

Medicaid Expansion One of the provisions of the ACA is the expansion of Medicaid. Nearly all US citizens and legal residents between the ages of 19 and 64 who have household incomes below 133 percent of the federal poverty level now qualify for Medicaid. This expansion benefits childless adults who previously did not qualify for Medicaid regardless of their income level as well as low-income parents who previously did not qualify even if their children did qualify. As a result, it is estimated that an additional 16 million people will receive coverage through Medicaid.

Originally, under the ACA, Medicaid expansion was mandatory for all states; states that did not comply were to be penalized by the federal government.

However, the US Supreme Court ruled that states can opt out of the Medicaid expansion, leaving this decision to participate in the hands of the state s leaders. As of 2015, 31 states have participated in the Medicaid expansion program. The managed Medicaid market may be an area of high growth potential for insurance companies as more states move Medicaid beneficiaries into managed care plans.

High-Deductible Health Plans Many individuals are now choosing high-deductible health plans (HDHPs) for their health insurance coverage. HDHPs are growing in popularity because they are among the least expensive options available on HIEs. In fact, the rate of enrollment in HDHPs has more than doubled since 2009. These plans have low premiums and high deductibles and are linked with savings accounts established to pay for healthcare services. HDHPs aim to provide individuals more control over their healthcare expenditures and hence may offer an incentive to control healthcare costs.

New Insurance Markets Before health reform, the health insurance industry focused on selling group plans to employers. Now it must re-create itself to cater to an entirely new, huge market of individual consumers. Many insurers have little idea how costly it is to provide coverage to these new customers, many of whom are not working and have not been insured for a long time (or even at all). One of the biggest challenges that insurance companies will face is attempting to accurately price and administer these plans without dramatic premium increases.

Another problem is that the newly insured often need education about how to use their health plan effectively and how to access different types of care.

Focus on Chronic Care As insurers and providers continue to partner in new accountable care organizations (ACOs), the shared savings programs will likely increasingly focus on consumers with chronic conditions. That means implementing more patient- centered medical homes that aim to manage chronic conditions with specific care pathways that address behavioral health needs and decrease hospital admissions and emergency department visits. ACOs and medical homes will also increasingly make use of personal health coaches, who motivate patients on a one-on-one basis and help coordinate patient care with all caregivers.

SELF-TEST 1. Briefly describe the impact of the ACA on health insurance. QUESTIONS 2. What is a health insurance exchange (HIE)?

Generic Reimbursement Methodologies Fee-for-service A reimbursement methodology that provides payment each time a service is provided.

Capitation A reimbursement methodology that is based on the number of covered lives as opposed to the amount of services provided.

Cost-based reimbursement A fee-for-service reimbursement method based on the costs incurred in providing services.

Charge-based reimbursement A fee-for-service reimbursement method based on charges (chargemaster prices).

Chargemaster A list of all items and services provided by a health services organization containing their gross (list) prices.

Regardless of the payer for a particular healthcare service, only a limited number of payment methodologies are used to reimburse providers. Payment methodologies fall into two broad classifications: fee-for-service and capitation.

In fee-for-service payment, of which many variations exist, the greater the amount of services provided, the higher the amount of reimbursement.

Under capitation, a fixed payment is made to providers for each covered life, or enrollee, that is independent of the amount of services provided. In this section, we discuss the mechanics, incentives created, and risk implications of alternative reimbursement methodologies.

Fee-for-Service Methods The three primary fee-for-service methods of reimbursement are cost based, charge based, and prospective payment.

Cost-Based Reimbursement Under cost-based reimbursement, the payer agrees to reimburse the provider for the costs incurred in providing services to the insured population. Reimbursement is limited to allowable costs, usually defined as those costs directly related to the provision of healthcare services. Nevertheless, for all practical purposes, cost-based reimbursement guarantees that a provider s costs will be covered by payments from the payer. Typically, the payer makes periodic interim payments (PIPs) to the provider, and a final reconciliation is made after the contract period expires and all costs have been processed through the provider s managerial (cost) accounting system.

During its early years (1966 1982), Medicare reimbursed hospitals on the basis of costs incurred. Now most hospitals are reimbursed by Medicare, and other payers, using a per diagnosis prospective payment system (see the later subsection on this topic). However, critical access hospitals, which are small rural hospitals that provide services to remote populations that do not have easy access to other hospitals, are still reimbursed on a cost basis by Medicare.

Charge-Based Reimbursement When payers pay billed charges, or simply charges, they pay according to a rate schedule established by the provider, called a chargemaster. To a certain extent, this reimbursement system places payers at the mercy of providers in regards to the cost of healthcare services, especially in markets where competition is limited. In the early days of health insurance, all payers reimbursed providers on the basis of billed charges. Some insurers still reimburse providers according to billed charges, but the trend for payers is toward other, less generous reimbursement methods. If this trend continues, the only payers that will be expected to pay billed charges are self-pay, or private-pay, patients. Even then, low-income patients often are billed at rates less than charges.

Some payers that historically have reimbursed providers on the basis of billed charges now pay by negotiated, or discounted, charges. This is especially true for insurers that have established managed care plans. Additionally, many conventional insurers have bargaining power because of the large number of patients that they bring to a provider, so they can negotiate discounts from billed charges. Such discounts generally range from 20 to 50 percent, or even more, of billed charges. The effect of these discounts is to create a system similar to hotel or airline pricing, where there are listed rates (chargemaster prices for providers, and rack rates or full fares for hotels and airlines) that few people pay.

Prospective Payment In a prospective payment system, the rates paid by payers are established by the payer before the services are provided. Furthermore, payments are not directly related to either costs or chargemaster rates. Here are some common units of payment used in prospective payment systems:

Per procedure. Under per procedure reimbursement, a separate payment is made for each procedure performed on a patient. Because of the high administrative costs associated with this method when applied to complex diagnoses, per procedure reimbursement is more commonly used in outpatient than in inpatient settings.

Per diagnosis. In the per diagnosis reimbursement method, the provider is paid a rate that depends on the patient s diagnosis.

Diagnoses that require higher resource utilization, and hence are more costly to treat, have higher reimbursement rates. Medicare pioneered this basis of payment in its diagnosis-related group (DRG) system, which it first used for hospital inpatient reimbursement in 1983.

Per day (per diem). If reimbursement is based on a per diem payment, the provider is paid a fixed amount for each day that service is provided, regardless of the nature of the service. Note that per diem rates, which are applicable only to inpatient settings, can be stratified.

For example, a hospital may be paid one rate for a medical/surgical day, a higher rate for a critical care unit day, and yet a different rate for an obstetrics day. Stratified per diems recognize that providers incur widely different daily costs for providing different types of care.

Bundled. Under bundled payment, payers make a single prospective payment that covers all services delivered in a single episode, whether the services are rendered by a single provider or by multiple providers.

For example, a bundled payment may be made for all obstetric services Prospective payment A fee-for-service reimbursement method that is established beforehand by the third-party payer and, in theory, not related to costs or charges.

Per diem payment A fee-for-service reimbursement method that pays a set amount for each inpatient day.

Bundled (global) payment The fee-for-service payment of a single amount for the complete set of services required to treat a single episode.

For Your Consideration Creating the Proper Provider Incentives An article in the Wall Street Journal (February 18, 2015, page A1) describes how one patient in a Kindred Healthcare long-term care hospital was discharged after 23 days of treatment for complications from a previous knee surgery. According to family members, the timing of his release did not appear to be related to any improvement in his medical condition. However, it did result in a higher reimbursement that the hospital received for his stay.

According to billing documents, Kindred collected $35,887.79 from Medicare for his treatment, the maximum amount it could earn for treating patients with his condition. Under Medicare s reimbursement rules, if the patient had left the hospital one day earlier, Kindred would have received a per diem rate that would have resulted in a total payment of roughly $20,000. If he had stayed longer than 23 days, the hospital likely would not have received any additional reimbursement other than the $35,887.79 single payment for an extended stay.

What do you think? What incentives are created for providers under the reimbursement method used by Medicare for long-term (as opposed to acute care) hospitals? Can you think of a payment system that would encourage longterm care hospitals to discharge patients at the appropriate time?

associated with a pregnancy provided by a single physician, including all prenatal and postnatal visits as well as the delivery.

For another example, a bundled payment may be made for all physician and hospital services associated with a cardiac bypass operation. Finally, note that, at the extreme, a bundled payment may cover an entire population. In this situation, the payment becomes a global payment, which, in effect, is a capitation payment as described in the next section.

Capitation Up to this point, the prospective payment methods presented have been fee-for-service methods that is, providers are reimbursed on the basis of the amount of services provided.

The service may be defined as a visit, a diagnosis, a hospital day, an episode, or in some other manner, but the key feature is that the more services that are performed, the greater the reimbursement amount.

Capitation, although a form of prospective payment, is an entirely different approach to reimbursement and hence deserves to be treated as a separate category. Under capitated reimbursement, the provider is paid a fixed amount per covered life per period (usually a month) regardless of the amount of services provided. For example, a primary care physician might be paid $15 per member per month for handling 100 members of an HMO plan.

Capitation payment, which is used primarily by managed care plans, dra matically changes the financial environment of healthcare providers. It has implica tions for financial accounting, managerial accounting, and financial management.

Discussion of how capitation, as opposed to fee-for-service reimbursement, affects healthcare finance is provided throughout the remainder of this book.

SELF-TEST QUESTIONS 1. Briefly explain the following payment methods:

Cost based Charge based and discounted charges Per procedure Per diagnosis Per diem Bundled Capitation 2. What is the major difference between fee-for-service reimbursement and capitation?

Provider Incentives Under Alternative Reimbursement Methodologies Providers, like individuals and businesses, react to the incentives created by the financial environment. For example, individuals can deduct mortgage interest from income for tax purposes, but they cannot deduct interest payments on personal loans. Loan companies have responded by offering home equity loans that are a type of second mortgage. The intent is not that such loans would always be used to finance home ownership, as the tax laws assumed, but that the funds could be used for other purposes, including paying for vacations and purchasing cars or appliances. In this situation, tax laws created incentives for consumers to have mortgage debt rather than personal debt, and the mortgage loan industry responded accordingly.

In the same vein, it is interesting to examine the incentives that alternative reimbursement methods have on provider behavior. Under cost-based reimbursement, providers are given a blank check in regard to acquiring facilities and equipment and incurring operating costs. If payers reimburse providers for all costs, the incentive is to incur costs. Facilities will be lavish and conveniently located, and staff will be available to ensure that patients are given deluxe treatment. Furthermore, as in billed charges reimbursement, services that may not truly be required will be provided because more services lead to higher costs and hence lead to higher revenues.

Under charge-based reimbursement, providers have the incentive to set high charge rates, which lead to high revenues. However, in competitive markets, there will be a constraint on how high providers can go. But, to the extent that insurers, rather than patients, are footing the bill, there is often considerable leeway in setting charges. Because billed charges is a fee-forservice type of reimbursement in which more services result in higher revenue, a strong incentive exists to provide the highest possible amount of services.

In essence, providers can increase utilization, and hence revenues, by churning creating more visits, ordering more tests, extending inpatient stays, and SELF-TEST QUESTIONS so on. Charge-based reimbursement does encourage providers to contain costs because (1) the spread between charges and costs represents profits, and the more the better, and (2) lower costs can lead to lower charges, which can increase volume. Still, the incentive to contain costs is weak because charges can be increased more easily than costs can be reduced. Note, however, that discounted charge reimbursement places additional pressure on profitability and hence increases the incentive for providers to lower costs.

Under prospective payment reimbursement, provider incentives are For Your Consideration Value-Based Purchasing Value-based purchasing rests on the concept that buyers of healthcare services should hold providers accountable for quality of care as well as costs. In April 2011, HHS launched the Hospital Value-Based Purchasing program, which marks the beginning of a historic change in how Medicare pays healthcare providers. For the first time, 3,500 hospitals across the country are being paid for inpatient acute care services based on care quality, not just the quantity of the services provided.

Changing the way we pay hospitals will improve the quality of care for seniors and save money for all of us, said former HHS Secretary Kathleen Sebelius. Under this initiative, Medicare will reward hospitals that provide high- quality care and keep their patients healthy. It s an important part of our work to improve the health of our nation and drive down costs. As hospitals work to improve quality, all patients not just Medicare patients will benefit. The initial measures to determine quality focus on how closely hospitals follow best clinical practices and how well hospitals enhance patients care experiences.

The better a hospital does on its quality measures, the greater the reward it will receive from Medicare.

What do you think? Should providers be reimbursed based on quality of care? How should quality be measured? Should the additional reimbursement to high-quality providers be obtained by reductions in reimbursement to low- quality providers?

altered. First, under per procedure reimbursement, the profitability of individual procedures varies depending on the relationship between the actual costs incurred and the payment for that procedure. Providers, usually physicians, have the incentive to perform procedures that have the highest profit potential. Furthermore, the more procedures the better, because each procedure typically generates additional profit. The incentives under per diagnosis reimbursement are similar. Providers, usually hospitals, will seek patients with those diagnoses that have the greatest profit potential and discourage (or even discontinue) those services that have the least potential. Furthermore, to the extent that providers have some flexibility in selecting procedures (or assigning diagnoses) to patients, an incentive exists to up code procedures (or diagnoses) to ones that provide the greatest reimbursement.

In all prospective payment methods, providers have the incentive to reduce costs because the amount of reimbursement is fixed and independent of the costs actually incurred. For example, when hospitals are paid under per diagnosis reimbursement, they have the incentive to reduce length of stay and hence costs. Note, however, when per diem reimbursement is used, hospitals have an incentive to increase length of stay.

Because the early days of a hospitalization typically are more costly than the later days, the later days are more profitable. However, as mentioned previously, hospitals have the incentive to reduce costs during each day of a patient stay.

Under bundled pricing, providers do not have the opportunity to be reimbursed for a series of separate services, which is called unbundling. For example, a physician s treatment of a fracture could be bundled, and hence billed as one episode, or it could be unbundled with separate bills submitted for making the diagnosis, taking x-rays, setting the fracture, removing the cast, and so on. The rationale for unbundling is usually to provide more detailed records of treatments rendered, but often the result is higher total charges for the parts than would be charged for the entire package. Also, bundled pricing, when applied to multiple providers for a single episode of care, forces involved providers (e.g., physicians and a hospital) to jointly offer the most cost-effective treatment. Such a joint view of cost containment may be more effective than each provider separately attempting to minimize its treatment costs because lowering costs in one phase of treatment could increase costs in another.

Finally, capitation reimbursement totally changes the playing field by completely reversing the actions that providers must take to ensure financial success. Under all fee-for-service methods, the key to provider success is to work harder, increase utilization, and hence increase profits; under capitation, the key to profitability is to work smarter and decrease utilization. As with prospective payment, capitated providers have the incentive to reduce costs, but now they also have the incentive to reduce utilization. Thus, only those procedures that are truly medically necessary should be performed, and treatment should take place in the lowest-cost setting that can provide the appropriate quality of care. Furthermore, providers have the incentive to promote health, rather than just treat illness and injury, because a healthier population consumes fewer healthcare services.

SELF-TEST 1. What are the provider incentives created under fee-for-service QUESTION reimbursement? Under capitation?

Medical Coding: The Foundation of Fee-for-Service Reimbursement Medical coding Medical coding, or medical classification, is the process of transforming The process of descriptions of medical diagnoses and procedures into code numbers that transforming can be universally recognized and interpreted. The diagnoses and procedures medical diagnoses and procedures are usually taken from a variety of sources within the medical record, such into universally as doctor s notes, laboratory results, and radiological tests. In practice, the recognized basis for most fee-for-service reimbursement is the patient s diagnosis (in the numerical codes.

International Classification of Diseases (ICD) codes Numerical codes for designating diseases plus a variety of signs, symptoms, and external causes of injury.

Current Procedural Terminology (CPT) codes Codes applied to medical, surgical, and diagnostic procedures.

case of inpatient settings) or the procedures performed on the patient (in the case of outpatient settings). Thus, a brief background on clinical coding will enhance your understanding of the reimbursement process.

Diagnosis Codes The International Classification of Diseases (most commonly known by the abbreviation ICD) is the standard for designating diseases plus a wide variety of signs, symptoms, and external causes of injury. Published by the World Health Organization, ICD codes are used internationally to record many types of health events, including hospital inpatient stays and death certificates. (ICD codes were first used in 1893 to report death statistics.) The codes are periodically revised; the most recent version is ICD-10.

However, US hospitals are still using a modified version of the ninth revision, called ICD-9-CM, where CM stands for Clinical Modification. The ICD-9 codes consist of three, four, or five digits. The first three digits denote the disease category, and the fourth and fifth digits provide additional information. For example, code 410 describes an acute myocardial infarction (heart attack), while code 410.1 is an attack involving the anterior wall of the heart. (However, the conversion to ICD-10 codes will occur October 1, 2015, although hospitals will not be penalized if they continue to use ICD-9 codes for one additional year. The conversion process is consuming and costly because there are more than five times as many individual codes in ICD-10 as in ICD-9. Of course, the information provided by the new code set will be more detailed and complete.) In practice, the application of ICD codes to diagnoses is complicated and technical. Hospital coders have to understand the coding system and the medical terminology and abbreviations used by clinicians. Because of this complexity, and because proper coding can mean higher reimbursement from third-party payers, ICD coders require a great deal of training and experience to be most effective.

Procedure Codes While ICD codes are used to specify diseases, Current Procedural Terminology (CPT) codes are used to specify medical procedures (treatments). CPT codes were developed and are copyrighted by the American Medical Association.

The purpose of CPT is to create a uniform language (set of descriptive terms and codes) that accurately describes medical, surgical, and diagnostic procedures. CPT and its corresponding codes are revised periodically to reflect current trends in clinical treatments. To increase standardization and the use of electronic health records, federal law requires that physicians and other clinical providers, including laboratory and diagnostic services, use CPT for the coding and transfer of healthcare information. (The same law also requires that ICD codes be used for hospital inpatient services.) To illustrate CPT codes, there are ten codes for physician office visits.

Five of the codes apply to new patients, while the other five apply to established patients (repeat visits). The differences among the five codes in each category are based on the complexity of the visit, as indicated by three components: (1) extent of patient history review, (2) extent of examination, and (3) difficulty of medical decision making. For repeat patients, the least complex (typically shortest) office visit is coded 99211, while the most complex (typically longest) is coded 99215.

Because government payers (Medicare and Medicaid) as well as other insurers require additional information from providers beyond that contained in CPT codes, an enhanced version called the Healthcare Common Procedure Coding System (HCPCS, commonly pronounced hick picks ) was developed. This system expands the set of CPT codes to include nonphysician services and durable medical equipment such as ambulance services and prosthetic devices.

Although CPT and HCPCS codes are not as complex as the ICD codes, coders still must have a high level of training and experience to use them correctly.

As in ICD coding, correct CPT coding ensures correct reimbursement.

Coding is so important that many businesses offer services, such as books, software, education, and consulting, to hospitals and medical practices to improve coding efficiency.

1. Briefly describe the coding system used in hospitals (ICD codes) and medical practices (CPT codes).

2. What is the link between coding and reimbursement?

Specific Reimbursement Methods There are many specific reimbursement methods in use today. Typically, the methods differ from one insurer to another. In addition, insurers use different methods for different types of providers and services, such as hospitals versus physicians or even hospital inpatients versus outpatients. In this section, we discuss the specific methods used by Medicare to reimburse hospitals for inpatient services and physicians for all services. We discuss other specific reimbursement methods used by Medicare in the chapter supplement.

Hospital Inpatient Services The Medicare inpatient prospective payment system (IPPS) is a prospective payment methodology based on an inpatient s diagnosis at discharge. It starts with two national base payment rates (operating and capital expenses), which Healthcare Common Procedure Coding System (HCPCS) A medical coding system that expands the CPT codes to include nonphysician services and durable medical equipment.

SELF-TEST QUESTIONS Inpatient prospective payment system (IPPS) The method, based on diagnosis, that Medicare uses to reimburse providers for inpatient services.

are then adjusted to account for two factors that affect the costs of providing care: (1) the patient s condition and treatment and (2) market conditions in the facility s geographic location (Exhibit 2.1).

Discharges are assigned to one of 751 Medicare severity diagnosis-related groups (MS DRGs), which designate the diagnoses of patients with similar clinical problems and, hence, who are expected to consume similar amounts of hospital resources. Each MS DRG has a relative weight that reflects the expected cost of inpatients in that group. The payment rates for MS DRGs in each local market are determined by adjusting the base payment rates to reflect the local input price level and then multiplying them by the relative weight for each MS DRG. The operating and capital payment rates are increased for facilities that operate an approved resident training program EXHIBIT 2.1 Medicare Adjusted for geographic factors Hospital Acute Inpatient Services Payment System + .

1.0 Hospital wage index MS DRG Patient characteristics for area wages Principal diagnosis Procedure Complications and comorbidities Adjusted for case mixWage index 1.0 Wage index Operating base payment rate Adjusted base payment rate 69.6% adjusted for area wages 62% adjusted Non-labor- related portion Base rate adjusted for geographic factors MS DRG weight Adjustment for transfers Policy adjustments for hospitals that qualify + + Indirect medical education payment Disproportionate share payment = If case is extraordinarily costly Full LOS Short LOS and discharged Payment** to other acute IPPS hospital diem or post-acute care* Per case payment rate rate Per payment Adjusted base payment rate High- cost outlier (payment + outlier payment) Note: MS DRG (Medicare severity diagnosis-related group), LOS (length of stay), IPPS (inpatient prospective payment system). Capital payments are determined by a similar system.

* Transfer policy for cases discharged to post-acute care settings applies for cases in 275 selected MS DRGs.

** Additional payment made for certain rural hospitals.

Source: Reprinted from MedPAC. 2014. Hospital Acute Inpatient Services Payment System. Figure 1. Revised October. www.medpac.gov/documents/payment-basics/hospital-acute- inpatient-services-payment-system-14.pdf.

or that treat a disproportionate share of low-income patients. Rates are reduced for various transfer cases, and outlier payments are added for cases that are extraordinarily costly to protect providers from large financial losses due to unusually expensive cases.

Both operating and capital payment rates are updated annually.

The IPPS rates are intended to cover the costs that reasonably efficient providers would incur in providing high-quality care. If the hospital is able to provide the services for less than the fixed reimbursement amount, it can keep the difference.

Conversely, if a Medicare patient s treatment costs are more than the reimbursement amount but do not meet the definition of an outlier, the hospital must bear the loss.

Physician Services Medicare pays for physician services using a resource-based relative value scale (RBRVS) system. In the RBRVS system, payments for services are determined by the resource costs needed to provide them as measured by weights called relative value units (RVUs).

RVUs consist of three components: (1) a work RVU, which includes the skill level and training required along with the intensity and time required for the service; (2) a practice expense RVU, which includes equipment and supplies costs as well as office support costs, including labor; and (3) a malpractice expense RVU, which accounts for the relative risk and cost of potential malpractice claims. To illustrate, the (total) RVU is 0.52 for a minimal office visit, 1.32 for an average office visit, and 3.06 for a comprehensive office visit. Furthermore, the average office visit RVU is composed of a work RVU of 0.67, a practice expense RVU of 0.62, and a malpractice expense RVU of 0.03.

The RVU values then are adjusted to reflect variations in local input prices, and the total is multiplied by a standard dollar value called the conversion factor to arrive at the payment amount. Medicare s payment rates may also be adjusted to reflect provider characteristics, geographic Industry Practice Using RVUs for Physician Compensation Traditionally, there have been a number of ways of estimating physician productivity when tying compensation to performance. For many years, productivity was measured by volume-based metrics such as number of patients seen or amount of revenue billed.

Today, however, physician productivity measures and compensation models are rapidly moving toward models based on relative value units (RVUs).

Work RVUs, which are one of three components of RVUs, measure the relative level of time, skill, training, and intensity required of a physician to provide a given service. As such, they are a good proxy for the training required and volume of work expended by a physician in treating patients. A routine well-patient visit, for example, would be assigned a lower RVU than an invasive surgical procedure would. Given this relative scale, a physician seeing two or three complex or high-acuity patients per day could accumulate more RVUs than a physician seeing ten or more low- acuity patients per day. Thus, the nature of the work, rather than number of patients or billings, is being measured and hence used for compensation levels.

According to the Medical Group Management Association (MGMA), well over half of all physicians are compensated, at least in part, on the basis of productivity as measured by work RVUs. Usually, work RVUs are combined with other productivity and quality measures in determining productivity and compensation, but there is little doubt that work RVUs have the dominant role.

Relative value unit (RVU) A measure of the amount of resources consumed to provide a particular service.

When applied to physicians, a measure of the amount of work, practice expenses, and liability costs associated with a particular service.

EXHIBIT 2.2 Medicare Total RVUs from physician fee schedule Physician Work GPCI PLI GPCI PE GPCI Conversion factor Work RVU PE RVU PLI RVU Complexity Services of service and expenses Payment Adjusted .

.

.

.

+ + for:

System Geographic factors Payment modifier Adjusted fee schedule payment rate SELF-TEST QUESTIONS Adjusted fee schedule payment rate Note: RVU (relative value unit), GPCI (geographic practice cost index), PE (practice expense), PLI (professional liability insurance), HPSA (health professional shortage area). This figure depicts Medicare payments only. The fee schedule lists separate PE RVUs for facility and nonfacility settings. Fee schedule payments are reduced when specified nonphysician practitioners bill Medicare separately, but not when services are provided incident to a physician.

Source: Reprinted from MedPAC. 2014. Physician and Other Health Professionals Payment System. Figure 1. Revised October. http://medpac.gov/documents/payment-basics/physicianand- other-health-professionals-payment-system-14.pdf.

designations, and other factors. The provider is paid the final amount, less any beneficiary coinsurance (Exhibit 2.2).

1. Briefly describe the method used by Medicare to reimburse for inpatient services.

2. Explain the method used by Medicare to reimburse for physician services.

Healthcare Reform and Reimbursement Methods In addition to improving healthcare delivery through focusing on access and quality, the ACA has significantly changed the way providers are reimbursed.

The key reforms include a move from a fee-for-service model to a prospective payment model, which may include bundled payments or capitation. These new payment methods aim to move reimbursement from that based on the amount of services provided (volume) to that based on value and better outcomes.

Policy adjustments (multiplicative) Provider type Geographic Service type HPSA bonus Primary Major surgical care procedures = (decreases) (increases) (increases) Nonphysician Nonparticipating Payment The new payment methods are specifically designed to accomplish the following:

Encourage providers to deliver care in a high-quality, cost-efficient manner Support coordination of care among multiple providers Adopt evidence-based care standards and protocols that result in the best outcomes for patients Provide accountability and transparency Discourage overtreatment and medically unnecessary procedures Eliminate or reduce the occurrence of adverse events Discourage cost shifting The sections that follow describe a few of the important implications for provider payments.

Value-Based Purchasing Value-based purchasing (VBP) is a Medicare initiative that rewards acute care hospitals with incentive payments for providing high-quality care to Medicare beneficiaries, which should lead to better clinical outcomes for all hospitalized patients. The amounts of these payments are based on how closely the institution followed best clinical practices, how well it enhanced patients care experiences, how well it achieved quality goals, and how much it improved on each measure compared to its performance during the baseline period. Note that some VBP programs are paired with shared savings programs (discussed later) to reward cost reduction as well as quality of care.

Quality-Based Clinician Compensation In addition to VBP for hospitals, the ACA requires Medicare to factor quality into payments for physicians and most other clinicians. Quality-based compensation is part of Medicare s effort to shift medicine away from the volume- based focus, where clinicians are paid for each service regardless of quality.

Clinicians can earn additional compensation based on the quality of care they provide to their patients. Bonuses and penalties are calculated on the basis of performance on quality measures, which vary by specialty. As with VBP programs for hospitals, quality-based clinician reimbursement programs can be paired with shared savings programs.

Shared Savings Programs Shared savings is an approach to reducing healthcare costs and, potentially, a mechanism for encouraging the creation of ACOs. Under shared savings, if a provider reduces total healthcare spending for its patients below the level Value-based purchasing (VBP) An approach to provider reimbursement that rewards quality of care rather than quantity of care.

that the payer expected, the provider is then rewarded with a portion of the savings. The benefits are twofold: (1) The payer spends less than it would otherwise, and (2) the provider gets more revenue than it expected. The savings can arise from the more efficient, cost-effective use of hospital or outpatient services that enhance quality, reduce costs over time, and improve outcomes.

It can be applied to hospital episodes of care, including physician services, or to physician office care.

New Bundled Payment Models Bundled payment models are a form of fee-for-service reimbursement in which a single sum covers all healthcare services related to a specific procedure. The objective of bundled payments is to promote more efficient use of resources and reward providers for improving the coordination, quality, and efficiency of care. If the cost of services is less than the bundled payment, the physicians and other providers retain the difference. But if the costs exceed the bundled payment, physicians and other providers are not compensated for the difference.

In some circumstances, an ACO may receive the bundled payment and subsequently divide the payment among participating physicians and providers.

In other situations, the payer may pay participating physicians and providers independently, but it may adjust each payment according to negotiated predefined rules to ensure that the total payments to all the providers do not exceed the total bundled payment amount. This type of reimbursement is called virtual bundling. For providers, the challenges of bundled payments include determining who owns the episode of care and apportioning the payment among the various providers.

Readmission Reduction Program With the passage of the ACA, Medicare now has the authority to penalize hospitals if they experience excessive readmission rates compared to expected levels of readmission. The readmissions are based on a 30-day readmission measure for heart attack, heart failure, and pneumonia.

Hospital-Acquired Conditions In a relatively new initiative, hospitals will be penalized by Medicare for hospital- acquired conditions. Hospital-acquired conditions include bedsores, infections, complications from extended use of catheters, and injuries caused by falls.

Hospitals will face a 1 percent reduction in Medicare inpatient payments for all discharges if they rank in the top 25 percent of hospital-acquired conditions for all hospitals in the previous year.

SELF-TEST QUESTION 1. Briefly describe the impact of the ACA on payments to providers.

Key Concepts This chapter covers important background material related to healthcare insurance and provider reimbursement. The key concepts of this chapter are as follows:

Health insurance is widely used in the United States because individuals are risk averse and insurance firms can take advantage of the law of large numbers.

Insurance is based on four key characteristics: (1) pooling of losses, (2) payment for random losses, (3) risk transfer, and (4) indemnification.

Adverse selection occurs when individuals most likely to have claims purchase insurance while those least likely to have claims do not.

Moral hazard occurs when an insured individual purposely sustains a loss, as opposed to a random loss. In a health insurance setting, moral hazard is more subtle, producing such behaviors as seeking more services than needed and engaging in unhealthy behavior because the costs of the potential consequences are borne by the insurer.

Most provider revenue is not obtained directly from patients but from healthcare insurers, known collectively as third-party payers.

Third-party payers are classified as private insurers (Blue Cross/ Blue Shield, commercial, and self-insurers) and public insurers (Medicare and Medicaid).

Managed care plans, such as health maintenance organizations (HMOs), strive to combine the insurance function and the provision of healthcare services.

Third-party payers use many different payment methods that fall into two broad classifications: fee-for-service and capitation. Each payment method creates a unique set of incentives and risk for providers.

When payers pay billed charges, they pay according to a schedule of rates established by the provider called a chargemaster.

Negotiated charges, which are discounted from billed charges, are used by insurers with sufficient market power to demand price reductions.

Under a cost-based reimbursement system, payers agree to pay providers certain allowable costs incurred when providing services to the payers enrollees.

(continued) (continued from previous page) In a prospective payment system, the rates paid by payers are determined in advance and are not tied directly to reimbursable costs or billed charges. Typically, prospective payments are made on the basis of the following service definitions: (1) per procedure, (2) per diagnosis, (3) per diem (per day), or (4) bundled pricing.

Capitation is a flat periodic payment to a physician or another healthcare provider; it is the sole reimbursement for providing services to a defined population. Capitation payments are generally expressed as some dollar amount per member per month, where the word member typically refers to an enrollee in some managed care plan.

Medical coding is the foundation of fee-for-service reimbursement systems. In inpatient settings, ICD codes are used to designate diagnoses, while in outpatient settings, CPT codes are used to specify procedures.

Medicare uses the inpatient prospective payment system (IPPS) for hospital inpatient reimbursement. Under IPPS, the amount of the payment is determined by the patient s Medicare severity diagnosis- related group (MS DRG).

To provide some cushion for the high costs associated with severely ill patients within each diagnosis, IPPS includes a provision for outlier payments.

Physicians are reimbursed by Medicare using the resource-based relative value scale (RBRVS). Under RBRVS, reimbursement is based on relative value units (RVUs), which consist of three resource components: (1) physician work, (2) practice expenses, and (3) malpractice insurance expenses. The RVU for each service is multiplied by a dollar conversion factor to determine the payment amount.

The ACA is having a significant impact on health insurance and on the way providers are reimbursed. More people now have access to insurance coverage, and the new provider payment methods emphasize value and patient outcomes over volume.

Because the managers of health services organizations must make financial decisions within the constraints imposed by the economic environment, the insurance and reimbursement concepts discussed in this chapter will be used over and over throughout the remainder of the book.

Questions 2.1 Briefly explain the following characteristics of insurance:

a. Pooling of losses b. Payment only for random losses c. Risk transfer d. Indemnification 2.2 What is adverse selection, and how do insurers deal with the problem?

2.3 What is the moral hazard problem?

2.4 Briefly describe the major third-party payers.

2.5 a. What are the primary characteristics of managed care plans?

b. Describe different types of managed care plans.

2.6 What is the difference between fee-for-service reimbursement and capitation?

2.7 Describe the provider incentives under each of the following reimbursement methods:

a. Cost based b. Charge based (including discounted charges) c. Per procedure d. Per diagnosis e. Per diem f. Bundled payment g. Capitation 2.8 What medical coding systems are used to support fee-for-service payment methodologies?

2.9 Briefly describe how Medicare pays for the following:

a. Inpatient services b. Physician services 2.10 What are some features of the ACA that affect healthcare insurance and reimbursement?

Resources For the latest information on events that affect the healthcare sector, see Modern Healthcare, published weekly by Crain Communications Inc., Chicago.

Other resources pertaining to this chapter include Beagle, J. T. 2010. Episode-Based Payment: Bundling for Better Results. Healthcare Financial Management (February): 36 39.

D Cruz, M. J., and T. L. Welter. 2010. Is Your Organization Ready for Value-Based Payments? Healthcare Financial Management (January): 64 72.

. 2008. Major Trends Affecting Hospital Payment. Healthcare Financial Management (January): 53 60.

Harris, J., I. Elizondo, and A. Isdaner. 2014. Medicare Bundled Payment: What Is It Worth to You? Healthcare Financial Management (January): 76 82.

Kentros, C., and C. Barbato. 2013. Using Normalized RVU Reporting to Evaluate Physician Productivity. Healthcare Financial Management (August): 98 105.

Kim, C., D. Majka, and J. H. Sussman. 2011. Modeling the Impact of Healthcare Reform. Healthcare Financial Management (January): 51 60.

Mulvany, C. 2013. Insurance Market Reform: The Grand Experiment. Healthcare Financial Management (April): 82 88.

. 2010. Healthcare Reform: The Good, the Bad, and the Transformational. Healthcare Financial Management (June): 52 57.

Patton, T. L. 2009. The IRS s Version of Community Benefit: A Look at the Redesigned Form 990 and New Schedule H. Healthcare Financial Management (February): 50 54.

Pearce, J. W., and J. M. Harris. 2010. The Medicare Bundled Payment Pilot Program:

Participation Considerations. Healthcare Financial Management (September):

52 60.

Ronning, P. L. 2011. ICD-10: Obligations and Opportunities. Healthcare Financial Management (August): 48 51.

Saqr, H., O. Mikhail, and J. Langabeer. 2008. The Financial Impact of the Medicare Prospective Payment System on Long-Term Acute Care Hospitals. Journal of Health Care Finance (Fall): 58 69.

Shoemaker, P. 2011. What Value-Based Purchasing Means to Your Hospital. Healthcare Financial Management (August): 61 68.

Tyson, P. 2010. Preparing for the New Landscape of Payment Reform. Healthcare Financial Management (December): 42 48.

Wilensky, G. R. 2011. Continuing Uncertainty Dominates the Healthcare Landscape. Healthcare Financial Management (March): 34 35.

Williams, J. 2013. A New Model for Care: Population Management. Healthcare Financial Management (March): 69 76.

Woodson, W., and S. Jenkins. 2010. Payment Reform: How Should Your Organization Prepare? Healthcare Financial Management (January): 74 79.

ADDITIONAL MEDICARE PAYMENT 2 METHODS Introduction In Chapter 2, we discussed the inpatient prospective payment system (IPPS) and the resource-based relative value scale (RBRVS) system used by Medicare to reimburse hospitals for inpatient services and physicians for all services. In this supplement, we provide information on the other primary reimbursement methods used by Medicare.

Outpatient Hospital Services The outpatient prospective payment system (OPPS) is essentially a fee schedule.

The unit of payment under the OPPS is the individual service as identified by the Healthcare Common Procedure Coding System (HCPCS), which contains codes for about 6,700 distinct services. Medicare groups services into ambulatory payment classifications (APCs) on the basis of clinical and cost similarity. Each APC has a relative weight that measures the resource requirements of the service and is based on the median cost of services in that APC. The Centers for Medicare & Medicaid Services (CMS) sets payments for individual APCs using a conversion factor that translates the relative weights into dollar payment rates with adjustments for geographic differences in input prices. Hospitals also can receive additional payments in the form of outlier adjustments for extraordinarily high-cost services and pass-through payments for selected new technologies (Exhibit S2.1).

Ambulatory Surgery Centers Medicare pays for surgery-related facility services provided in ambulatory surgery centers (ASCs) based on the individual surgical procedure. Each of the nearly 3,600 approved procedures is assigned an APC from the same payment groups as used for hospital outpatient services. The relative weights for most procedures in the ASC payment system are the same as the relative weights used in the OPPS. Like the OPPS, the ambulatory surgical center payment system sets payments for individual services using a conversion factor and adjustments for geographic differences in input prices. Note that the payment for facilities services is separate from the payment for physician services.

EXHIBIT S2.1 Medicare Adjusted for Payment adjusted for Policy adjustments for geographic factors complexity of service hospitals that qualify Outpatient Hospital Services Hospital wage index Conversion factor 60% adjusted 40% for area wages related non-labor- portion = .

+ + + APC Conversion factor adjusted for APC geographic factors weight relative 7.1% add-on for rural SCHs + Payment System Hold harmless for cancer and children s hospitals Payment If patient is extraordinarily costly High- cost outlier (payment + outlier payment) Chapter 2 Supplement Measures resource requirements of service Note: APC (ambulatory payment classification), SCH (sole community hospital). The APC is the service classification system for the outpatient prospective payment system. Medicare adjusts outpatient prospective payment system payment rates for 11 cancer hospitals so that the payment-to-cost ratio (PCR) for each cancer hospital is equal to the average PCR for all hospitals.

Source: Reprinted from MedPAC. 2014. Outpatient Hospital Services Payment System. Figure 1.

Revised October. www.medpac.gov/documents/payment-basics/outpatient-hospital-servicespayment- system.pdf.

Inpatient Rehabilitation Facilities Inpatient rehabilitation facilities are paid predetermined, per discharge rates based primarily on the patient s condition (diagnoses, functional and cognitive status, and age) and market area wages. Discharges are assigned to one of 92 intensive rehabilitation categories called case-mix groups (CMGs), which are groups of patients with similar clinical problems. Within each of these CMGs, patients are further categorized into one of four tiers on the basis of comorbidities, with each tier having a specific payment that reflects the costliness of patients in that tier relative to others in the CMG.

Psychiatric Hospital Services Medicare uses the inpatient psychiatric facility prospective payment system for psychiatric hospital services, which is based on a per diem rate plus additional payments for ancillary services and capital costs. A base per diem payment is adjusted to account for cost-of-care differences related to patient characteristics, such as age, diagnosis, comorbidities, and length of stay, and facility characteristics, such as local wages, geographic location, teaching status, and emergency department status.

Skilled Nursing Facility Services Medicare uses a prospective payment system for skilled nursing facilities (SNFs) that pays facilities a predetermined daily rate for each day of care, up to 100 days. The rates are expected to cover all operating (nursing care, rehabilitation services, and other goods and services) and capital costs that efficient facilities would incur in providing SNF services. Various high-cost, low-probability ancillary services are covered separately. Patients are assigned to one of 66 categories, called resource utilization groups (RUGs), on the basis of patient characteristics and services used that are expected to require similar resources. Nursing and therapy weights are applied to the base payment rates of each RUG. Daily base payment rates are also adjusted to account for geographic differences in labor costs.

Home Health Care Services Medicare uses a prospective payment system that pays home health agencies a predetermined rate for each 60-day episode of home health care. If fewer than five visits are delivered during a 60-day episode, the home health agency is paid per visit, by visit type. Patients who receive five or more visits are assigned to one of 153 home health resource groups, which are based on clinical and functional status and service use as measured by the Outcome and Assessment Information Set (OASIS). The payment rates are adjusted to reflect local market input prices and special circumstances, such as high-cost outliers.

Critical Access Hospitals The Balanced Budget Act of 1997 created a new category of hospitals called critical access hospitals (CAHs), which operate primarily in rural areas. Each of the approximately 1,300 CAHs is limited to 25 beds, and patients are limited to a four-day length of stay. The limited size and short length-of-stay requirements are designed to encourage CAHs to focus on providing inpatient and outpatient care for common, less complex conditions while referring more complex patients to larger, more distant hospitals. Unlike most other acute care hospitals (which are paid using prospective payment systems), Medicare pays CAHs on the basis of reported costs. As of this writing, each CAH receives 99 percent of the costs it incurs in providing outpatient, inpatient, laboratory, and therapy services and post-acute care. The cost of treating Medicare patients is estimated using cost accounting data from Medicare cost reports. The purpose of the different reimbursement system for CAHs is to enhance the financial performance of small rural hospitals and thus reduce hospital closures.

Chapter 2 Supplement Chapter 2 Supplement Chapter 2 Supplement Hospice Services Medicare pays hospice providers a daily rate for each day a beneficiary is enrolled in the hospice program, regardless of the amount of services provided, even on days when no services are provided. The daily payment rates are intended to cover costs of providing services included in patients care plans. Payments are made according to a fee schedule for four different categories of care: routine home care, continuous home care, inpatient respite care, and general inpatient care. The four categories of care differ by the location and intensity of the services provided, and the base payments for each category reflect variation in expected input cost differences.

Ambulance Services Medicare pays for ambulance services using a dedicated fee schedule, which has set rates for nine payment categories of ground and air ambulance transport.

Historical costs are used as the basis to establish relative values for each payment category. These relative values are multiplied by a dollar amount that is standard across all nine categories and then adjusted for geographic differences. This amount is added to a mileage payment to arrive at the total ambulance payment amount. Medicare payments for ambulance services may also be adjusted by one of several add-on payments based on additional geographic characteristics of the transport.

II FINANCIAL ACCOUNTING Part I discusses the unique environment that creates the framework for the practice of healthcare finance. Now, in Part II, we begin the actual coverage of healthcare finance by discussing financial accounting, which involves the preparation of a business s financial statements. These statements are designed to provide pertinent financial information about an organization both to its managers and to the public at large.

The coverage of financial accounting extends over several chapters.

Chapter 3 begins the coverage with an introduction to basic financial accounting concepts and an explanation of how organizations report financial performance, specifically revenues, expenses, and profits. Then, in Chapter 4, the discussion is extended to the reporting of financial status, which includes an organization s assets, liabilities, and equity. In addition, Chapter 4 covers the way in which organizations report cash flows. Finally, note that Chapter 17 is related to financial accounting in that it also discusses financial statements, but the focus is on how interested parties use financial statement data to assess the financial condition of an organization. That material has purposely been placed at the end of the book because the nuances of financial statement analysis can be better understood after learning more about the financial workings of a business. Part II and Chapter 17, taken together, will provide readers with a basic understanding of how financial statements are created and used to make judgments regarding the operational status and financial condition of health services organizations.

THE INCOME STATEMENT AND STATEMENT 3 OF CHANGES IN EQUITY Learning Objectives After studying this chapter, readers will be able to Explain why financial statements are so important both to managers and to outside parties.

Describe the standard-setting process under which financial accounting information is created and reported, as well as the underlying principles applied.

Describe the components of the income statement revenues, expenses, and profitability and the relationships within and among these components.

Explain the differences between operating income and net income, and between net income and cash flow.

Describe the format and use of the statement of changes in equity.

Introduction Financial accounting involves identifying, measuring, recording, and communicating in dollar terms the economic events and status of an organization.

This information is summarized and presented in a set of financial statements, or just financials. Because these statements communicate important information about an organization, financial accounting is often called the language of business. Managers of health services organizations must understand the basics of financial accounting because financial statements are the best way to summarize a business s financial status and performance.

Historical Foundations of Financial Accounting It is all too easy to think of financial 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 Financial accounting The field of accounting that focuses on the measurement and communication of the economic events and status of an entire organization.

numbers. If readers of financial statements understand how and why financial accounting began and how financial statements are used, they can better visualize what is happening within a business and why financial accounting information is so important.

Many thousands of years ago, individuals and 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 spearheads, others at making clothing, and so on. With specialization came trade, initially by bartering one type of goods for another. At first, 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 profits from past dealings to enterprising shop owners and traders who needed money to expand their operations.

When the first loans were made, lenders could physically inspect borrowers assets and judge the likelihood of repayment. Eventually, though, lending became much more complex. Industrial borrowers were developing large factories, merchants were acquiring fleets of ships and wagons, and loans were being made to finance 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 profits 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 enterprises were being operated, and governments needed information to assess taxes. For all these reasons, a need arose for financial statements, for accountants to prepare the statements, and for auditors to verify the accuracy of the accountants work.

The economic systems of industrialized countries have grown enormously since the early days of trade, and financial 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 investment decisions; managers need it to operate their organizations efficiently; and taxing authorities need it to assess taxes in an equitable manner.

It should be no surprise that problems can arise when translating physical assets and economic events into accounting numbers. Nevertheless, that is what accountants must do when they construct financial statements. To illustrate the translation problem, the numbers shown on the balance sheet to reflect a business s assets and liabilities generally reflect 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 owed to the business may be uncollectible. Also, some liabilities, such as obligations to make lease payments, 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 (the loss of value of buildings and equipment), do not even represent current cash expenses. When examining a set of financial statements, it is best to keep in mind the physical reality that underlies the numbers and to recognize that many problems occur in the translation process.

SELF-TEST 1. What are the historical foundations of financial accounting QUESTIONS statements?

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 financial accounting information are those parties that have a financial interest in the organization and hence are concerned with its economic status. All organizations, whether not-for-profit or investor owned, have stakeholders that have an interest in the business. In a not-for-Stakeholder profit organization, such as a community hospital, the stakeholders include A party that managers, staff physicians, employees, suppliers, creditors, patients, and even has an interest, often financial, the community at large. Investor-owned hospitals have essentially the same in a business.

set of stakeholders, plus owners. Because all stakeholders, by definition, have Stakeholders can an interest in the organization, all stakeholders have an interest in its financial condition.

be affected by the business s actions, objectives, or Of all the outside stakeholders, investors, who supply the capital (funds) policies.

needed by businesses, typically have the greatest financial interest in health services organizations. Investors fall into two categories: (1) owners who supply equity capital to investor-owned businesses and (2) creditors (or lenders) who supply debt capital to both investor-owned and not-for-profit businesses.

(In a sense, communities supply equity capital to not-for-profit organizations, so they, too, are investors.) In general, there is only one category of owners.

However, creditors constitute a diverse group of investors that includes banks, suppliers granting trade credit, and bondholders. Because of their direct financial interest in healthcare businesses, investors are the primary outside users of financial accounting information. They use the information to make judgments about whether to make a particular investment as well as to set SELF-TEST QUESTIONS Securities and Exchange Commission (SEC) The federal government agency that regulates the sale of securities and the operations of securities exchanges.

Also has overall responsibility for the format and content of financial statements.

the return required on the investment. (Investor-supplied capital is covered in greater detail in chapters 11, 12, and 13.) Although the field of financial accounting developed primarily to meet the information 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 financial capability 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 not only are involved with creating financial statements but also are important users of the statements, both to assess the current financial condition of the organization and to formulate plans to ensure that the future financial condition of the organization will support its goals.

In summary, investors and managers are the predominant users of financial accounting information as a result of their direct financial interest in the organization. Furthermore, investors are not merely passive users of financial accounting information; they do more than just read and interpret the statements.

Often, they create financial targets based on the numbers reported in financial statements that managers must attain or suffer some undesirable consequence. For example, many debt agreements require borrowers to maintain stated financial 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.

1. What is a stakeholder?

2. Who are the primary users of financial accounting information?

3. 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 financial information constructed and presented according to standardized rules allows investors to make the best-informed decisions. The newly formed (at that time) Securities and Exchange Commission (SEC), an independent regulatory agency of the US government, was given the authority to establish and enforce the form and content of financial statements. Nonconforming companies are prohibited from selling securities to the public, so many businesses comply to gain better access to capital. Not-for-profit corporations that do not sell securities still must file financial statements with state authorities that conform to SEC standards. Finally, most for-profit businesses that do not sell securities to the public are willing to follow the SEC-established guidelines to ensure uniformity of presentation of financial data. The end result is that all businesses, except for the smallest, create SEC-conforming financial statements.

Rather than directly manage the process, the SEC designates other organizations to create and implement the standards system. For the most part, the SEC has delegated the responsibility for establishing reporting standards to the Financial Accounting Standards Board (FASB) a private organization whose mission is to establish and improve standards of financial accounting and reporting for private businesses. (The Government Accounting Standards Board [GASB] has the identical responsibility for businesses that are partially or totally funded by a government entity.) Typically, the guidance issued by FASB, which is promulgated by numbered statements, applies across a wide range of industries and, by design, is somewhat general in nature. More specific implementation guidance, especially when industry- unique circumstances must be addressed, is provided by industry committees established by the American Institute of Certified Public Accountants (AICPA) the professional association of public (financial) accountants. For example, financial statements in the health services industry are based on the AICPA Audit and Accounting Guide titled Health Care Entities, which was published most recently on September 1, 2014.

Because of the large number of statements and pronouncements that have been issued by FASB and other standard-setting organizations, FASB combined all of the previously issued standards into a single set called the FASB Accounting Standards Codification, which became effective on September 15, 2009. The purpose of the codification is to simplify access to accounting standards by placing them in a single source and creating a system that allows users to more easily research and reference accounting standards data.

When even more specific guidance is required than provided by the standards, other professional organizations may participate in the process, although such work does not have the same degree of influence as codification has. For example, the Healthcare Financial Management Association has established the Principles and Practices Board, which develops position statements and analyses on issues that require further guidance for example, its statement regarding the valuation and financial statement presentation of charity care and bad debt losses, which was issued in 2006 and revised in 2012.

When taken together, all the guidance contained in the codification and the amplifying information constitute a set of guidelines called generally accepted accounting principles (GAAP). GAAP can be thought of as a set of objectives, conventions, and principles that have evolved through the years to guide the preparation and presentation of financial statements. In essence, GAAP sets the rules for the financial statement preparation game.

Financial Accounting Standards Board (FASB) A private organization whose mission is to establish and improve the standards of financial accounting and reporting for private businesses.

American Institute of Certified Public Accountants (AICPA) The professional association of public (financial) accountants.

Generally accepted accounting principles (GAAP) The set of guidelines that has evolved to foster the consistent preparation and presentation of financial statements.

Note, however, that GAAP applies only to the area of financial accounting (financial statements), as distinct from other areas of accounting, such as managerial accounting (discussed in later chapters) and tax accounting.

It should be no surprise that the field of financial accounting is typically classified 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 setting standards are continuously reviewing and revising GAAP to ensure the best possible development and presentation of financial data. This task, which is essential to economic prosperity, is motivated by the fact that the US economy is constantly evolving, with new types of business arrangements and securities being created almost daily.

For large organizations, the final link in the financial statement quality assurance process is the external audit, which is performed by an independent (outside) auditor usually one of the major accounting firms. The results of For Your Consideration International Financial Reporting Standards As the globalization of business continues, it becomes more and more important for financial accounting standards to be uniform across countries.

At this time, FASB and the International Accounting Standards Board (IASB) are working jointly on convergence, a process to develop a common set of standards that would be accepted worldwide. These standards, called International Financial Reporting Standards (IFRS), ultimately will be applicable to for-profit businesses in more than 150 countries, including the United States.

Currently, over 100 countries have adopted IFRS standards, but not the United States.

Needless to say, a large number of details must be worked out, and differences between current US and international standards must be resolved. Thus, it is expected that total convergence will not occur for a number of years. Also, the impact of international standards on not-forprofit organizations is uncertain at this time.

What do you think? Should financial accounting standards be applicable to for-profit businesses worldwide as opposed to country by country? What is the rationale behind your opinion? Should not-for-profit organizations be subject to international standards? Support your position.

the external audit are reported in the auditor s opinion, which is a letter attached to the financial statements stating whether or not the statements are a fair presentation of the business s operations, cash flows, and financial position as specified by GAAP.

There are several categories of opinions given by auditors. The most favorable, which is essentially a clean bill of health, is called an unqualified opinion. Such an opinion means that, in the auditor s opinion, the financial statements conform to GAAP, are presented fairly and consistently, and contain all necessary disclosures. A qualified 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 financial status of the business. The entire audit process, which is performed by the organization s internal auditors and the external auditor, is a means of verifying and validating the organization s financial statements. Of course, an unqualified opinion gives users, especially those external to the organization, more confidence that the statements truly represent the business s current financial condition.

Although one would think that the guidance given under GAAP, along with auditing rules, would be sufficient to prevent fraudulent financial statements, in the early 2000s several large companies, including HealthSouth, which operates the nation s largest network of rehabilitation services, were found to be cooking the books. Because the US financial system is so dependent on the reliability of financial statements, in 2002 Congress passed the Sarbanes- Oxley Act, generally known as SOX, as a measure to improve transparency in financial accounting and to prevent fraud. (According to the SEC, transparency means the timely, meaningful, and reliable disclosure of a business s financial information.) Here are just a few of the more important provisions of SOX:

An independent body, the Public Accounting Oversight Board, was created to oversee the entire audit process.

Auditors can no longer provide non-auditing (consulting) services to the companies that they audit.

The lead partners of the audit team for any company must rotate off the team every five years (or more often).

Senior managers involved in the audits of their companies cannot have been employed by the auditing firm 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 officer (CEO) and chief financial officer (CFO) shall personally certify that the business s financial statements are complete and accurate. Penalties for certifying reports that are known to be false range up to a $5 million fine, 20 years in prison, or both. In addition, if the financial statements must be restated because they are false, certain bonuses and equity-based compensation that certifying executives earned must be returned to the company.

It is hoped that these provisions, along with others in SOX, will deter future fraudulent behavior by managers and auditors. So far, so good.

SELF-TEST QUESTIONS 1. Why are widely accepted principles important for the measurement and recording of economic events?

2. What entities are involved in regulating the development and presentation of financial statements?

3. What does GAAP stand for, and what is its primary purpose?

4. What is the purpose of the auditor s opinion?

5. What is the purpose of SOX, and what are some of its provisions?

Accounting entity The entity (business) for which a set of accounting statements applies.

Conceptual Framework of Financial Reporting Because the actual preparation of financial statements is done by accountants, a detailed presentation of accounting theory is not required in this book.

However, to better understand the content of financial statements, it is useful to discuss some aspects of the conceptual framework that accountants apply when they develop financial accounting data and prepare an organization s financial statements. By understanding this framework, readers will be better prepared to understand and interpret the financial statements of healthcare organizations.

The goal of financial accounting is to provide information about organizations that is useful to present and future investors and other users in making rational financial and investment decisions. To achieve this objective, GAAP specifies recognition and measurement concepts that include four assumptions, four principles, and two constraints.

Assumptions Accounting Entity The first assumption is the ability to define the accounting entity, which is important for two reasons. First, for investor-owned businesses, financial 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 defines the specific areas of the business to be included in the statements.

For example, a healthcare system may create one set of financial statements for the system as a whole and separate sets of statements for its subsidiary hospitals. In effect, the accounting entity specification establishes boundaries that tell readers what business (or businesses) is being reported on.

Going Concern It is assumed that the accounting entity will operate as a going concern and hence will have an indefinite life. This means that assets, in general, should be valued on the basis of their contribution to an ongoing business as opposed to their current fair market 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 they are 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 influence the data presented in financial statements.

The going concern assumption, coupled with the fact that financial statements must be prepared for relatively short periods (as explained next), means that financial accounting data are not exact but represent logical and systematic approaches applied to complex measurement problems.

Periodicity Because accounting entities are assumed to have an indefinite life but users of financial statements require timely information, it is common to report financial results on a relatively short periodic basis. The period covered, called an accounting period, can be any length of time over which an organization s managers, or outside parties, want to evaluate operational and financial results.

Most health services organizations use calendar periods months, quarters, and years as their accounting periods. However, occasionally an organization will use a fiscal year (financial year) that does not coincide with the calendar year. For example, the federal government has a fiscal year that runs from October 1 to September 30, and the State of Florida has a fiscal year that runs from July 1 to June 30. Although annual accounting periods are typically used for illustrations in this book, financial statements commonly are prepared for periods shorter than one year. For example, many organizations prepare semiannual and quarterly financial statements in addition to annual statements.

Monetary Unit The monetary unit provides the common basis by which economic events are measured. In the United States, this unit is the dollar, unadjusted for inflation or deflation. Thus, all transactions and events must be expressed in dollar terms.

Principles Historical Costs The historical cost principle requires organizations to report the values of most assets based on acquisition costs rather than fair market value, which implies that the dollar has constant purchasing power over time. In other words, land that cost $1 million 20 years ago might be worth $2 million today, but it is still reported at its initial cost of $1 million. The accounting profession has grappled with the inflation impact problem for years but has not yet developed a feasible solution. The historical cost principle ensures reliable information, which removes subjectivity, but it does not provide the most current information.

We should note, however, that some items (primarily security holdings) are reported at fair market value.

Revenue Recognition The revenue recognition principle requires that revenues be recognized in the period in which they are realizable and earned. Generally, this is the period in which the service is rendered, because at that point the price is known (realizable) and the service has been provided (earned). However, in some instances, difficulties in revenue recognition arise, primarily when there are uncertainties surrounding the revenue amount or the completion of the service.

Accounting period The period (amount of time) covered by a set of financial statements often a year, but sometimes a quarter or another time period.

Fiscal year The year covered by an organization s financial statements.

It usually, but not necessarily, coincides with a calendar year.

Historical cost In accounting, the purchase price of an asset.

Revenue recognition principle The concept that revenues must be recognized in the accounting period in which they are realizable and earned.

Expense Matching The expense-matching principle requires that an organization s expenses be matched, to the extent possible, with the revenues to which they are related.

In essence, after the revenues have been allocated to a particular accounting period, all expenses associated with producing those revenues should be matched to the same period. Although the concept is straightforward, implementation of the matching principle creates many problems. For example, consider long-lived assets such as buildings and equipment. Because such assets for example, an MRI machine provide revenues for several years, the expense- matching principle dictates that its acquisition cost should be spread over the same number of years. However, there are many alternative ways to do this, and no single method is clearly best.

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 financial statements must be relevant to a diversity of users, the full-disclosure principle pushes preparers to include even more information in financial statements. However, the complexity of the information presented can be mitigated to some extent by placing some information in the notes or supplementary information sections as opposed to the body of the financial statements.

Constraints Materiality If the financial statements contained all possible information, they would be so long and detailed that making inferences about the organization would be difficult without a great deal of analysis. Thus, to keep the statements manageable, only entries that are important to the operational and financial status of the organization need to be separately identified. For example, medical equipment manufacturers carry large inventories of materials that are both substantial in dollar value relative to other assets and instrumental to their core business, so such businesses report inventories 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. In general, the materiality constraint affects the presentation of the financial statements rather than their aggregate financial content (i.e., the final numbers).

Cost Benefit There are costs associated with financial statement information for both the preparers of the statements and the users. Preparers must collect, record, verify, and report financial information, while users must analyze and interpret the information. As a result, financial statements cannot report all possible information that every potential user might find relevant. When deciding what information should be reported, and how that information should be reported, standards setters and accountants must determine whether the benefits of the information outweigh the associated costs.

1. Why is it important to understand the basic accounting concepts that underlie the preparation of financial statements?

2. What is the goal of financial accounting?

3. Briefly explain the following assumptions, principles, and constraints as they apply to the preparation of financial statements:

Accounting entity Going concern Accounting period Monetary unit Historical cost Revenue recognition Expense matching Full disclosure Materiality Cost benefit Accounting Methods: Cash Versus Accrual In the implementation of the conceptual framework 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 specifies that only the accrual method can receive an unqualified auditor s opinion, so accrual accounting dominates the preparation of financial statements. Still, many small businesses that do not require audited financial statements use the cash method, and knowledge of the cash method helps our understanding of the accrual method, so we discuss both methods here.

Cash Accounting Under cash accounting, often called cash basis accounting, economic events are recognized put into the financial statements when the cash transaction SELF-TEST QUESTIONS Cash accounting The recording of economic events when a cash exchange takes place.

Accrual accounting The recording of economic events in the periods in which the events occur, even if the associated cash receipts or payments happen in a different period.

occurs. For example, suppose Sunnyvale Clinic, a large multispecialty group practice, provided services to a patient in December 2015. At that time, the clinic billed Florida Blue (Blue Cross and Blue Shield of Florida) $700, the full amount that the insurer was obligated to pay. However, Sunnyvale did not receive payment from the insurer until February 2016. If it used cash accounting, the $700 obligation on the part of Florida Blue would not appear in Sunnyvale s 2015 financial statements. Rather, the revenue would be recognized when the cash was actually received in February 2016.

The core argument in favor of cash accounting is that the most important event to record on the financial statements is the receipt of cash, not the provision of the service (i.e., the obligation to pay). Similarly, Sunnyvale s costs of providing services 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 flow 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 financial statements. Second, cash accounting is closely aligned to accounting for tax purposes, and hence it is easy to translate cash accounting statements into income tax filing 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 here but use a hybrid method called modified cash basis accounting.

The modified statements combine some features of cash accounting, usually to report revenues and expenses, with some features of accrual accounting, usually to report assets and liabilities. Still, the cash method presents an incomplete picture of the financial 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 financial transaction, rather than the transaction itself, provides the basis for the accounting entry. When applied to revenues, the accrual concept implies that revenue earned does not necessarily correspond to the receipt of cash. Why? Earned revenue is recognized in financial statements when a service has been provided that creates a payment obligation on the part of the payer, rather than when the payment is actually received.

For healthcare providers, the payment obligation typically falls on the patient, a third-party payer, or both. If the obligation is satisfied immediately, such as when a patient makes full payment at the time the service is rendered, the revenue is in the form of cash. In such cases, the revenue is recorded at the time of service whether cash or accrual accounting is used.

However, in most cases, the bulk of the payment for services comes from third-party payers and 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 financial 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 been collected.

Consider the Sunnyvale Clinic example presented in our discussion of cash accounting. Although the services were provided in December 2015, the clinic did not receive its $700 payment until February 2016. 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 2015 financial statements, even though no cash was collected. When accrual accounting is used, the amount of revenues not collected is listed as a receivable (the amount due to Sunnyvale) in the financial statements, so users will know that not all reported revenues represent cash receipts.

The accrual accounting concept also applies to expenses. To illustrate, assume that Sunnyvale had payroll obligations of $20,000 for employees work during the last week of 2015 that would not be paid until the first payday in 2016. Because the employees actually performed the work, the obligation to pay the salaries was created in 2015. An expense will be recorded in 2015 even though no cash payment will be made until 2016. Under cash basis accounting, Sunnyvale would not recognize the labor expense until it was paid, in this case in 2016. But under accrual accounting, the $20,000 will be shown as an expense on the financial statements in 2015 and, at the same time, the statements will indicate that a $20,000 liability (or obligation to pay employees) exists.

SELF-TEST QUESTIONS 1. Briefly explain the differences between cash and accrual accounting, and give an example of each.

2. What is modified cash basis accounting?

3. Why does GAAP favor accrual over cash accounting?

General ledger The master listing of an organization s primary accounts, which record the transactions that ultimately are used to create a business s financial statements.

Chart of accounts A document that assigns a unique numerical identifier to every account of an organization.

Recording and Compiling Financial Accounting Data The ultimate goal of a business s financial accounting system is to produce financial statements. However, the road from the recording of basic accounting data to the completion of the financial statements is long and arduous, especially for large, complex organizations. The starting point for the identification and recording of financial accounting information is a transaction, which is defined as an exchange of goods or services from one individual or enterprise to another. To ensure that the transaction is faithfully represented and verifiable two qualitative characteristics of useful financial information under the conceptual framework each transaction must be supported by relevant documentation, which is retained for some required length of time.

Once a transaction is identified, it must be recorded, or posted, to an account, which is a record of transactions for one uniquely identified 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 subsidiary accounts that support the primary accounts. The subsidiary accounts, which pertain to specific assets or liabilities or to individual patients or vendors, are aggregated to create data for a primary (general ledger) account. For example, individual patient charges, which are carried in subsidiary accounts, are aggregated into one or more general ledger revenue accounts.

To help manage the large number of accounts, businesses have a document 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 account for checks written might have the code 1-1100-00. The first 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 specific cash account.

Further numbers are available should the organization decide to subdivide either the till cash or the checks-written accounts into subsidiary accounts.

For example, the next digit of the checks-written account might indicate the purpose of the check: 1 for payroll, 2 for vendor payments, and so on. 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 they are posted to the correct account.

Within the system of primary and subsidiary accounts, accounts are further classified 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 five-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 five 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 chapter, there is a contra account associated with depreciation expense, which accounts for the loss of value of buildings and equipment due to wear and tear. 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 at least two different accounts once as a debit and once as a credit. Such a system ensures consistency among the financial statements. 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 in the equity account indicating that the business s value has increased by the amount of the cash revenue.

Note that whether an entry is a debit or a credit depends both on the nature of the entry (revenue or expense) and the type of account, so these entries may be counterintuitive to someone not familiar with the double entry system.

Ultimately, the journal entries are verified, consolidated, and reconciled in a trial balance, and the trial balance is formatted into the business s financial statements. Often, the primary means for disseminating this information to outsiders is the business s annual report. It typically begins with a descriptive 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 descriptive section is followed by the business s financial statements.

Because the actual financial statements cannot possibly contain all relevant information, additional information is provided in the notes section.

For health services organizations, these notes contain information on such topics as inventory accounting practices, the composition of long-term debt, pension plan status, the amount of charity care provided, and the cost of malpractice insurance.

Double entry system The system used to make accounting journal entries. Called double entry because each transaction has to be entered in at least two different accounts.

Annual report A report issued annually by an organization to its stakeholders that contains descriptive information and historical financial statements.

In addition to the body of the financial statements and the notes section, GAAP requires organizations to provide certain supplementary information.

Other supplementary information may be voluntarily provided by the reporting organization. For example, a healthcare system may report the revenues of its primary subsidiaries as supplementary data even though the statements focus on the aggregate revenues of the entire system. Because the notes and supplementary information sections contain a great deal of information essential to a good understanding of the financial statements, a thorough examination always considers the information contained in these two sections.

SELF-TEST QUESTIONS 1. Briefly explain the following terms used in the recording and compiling of accounting data:

Transaction Account Posting Chart of accounts General ledger T account Double entry system 2. Why are the notes and supplementary information sections important parts of the financial statements?

Income Statement Basics In this section, we begin our coverage of the four primary financial statements by discussing the income statement. Then, in a later section, we discuss the statement of changes in equity. In Chapter 4, the remaining two statements the balance sheet and the statement of cash flows are discussed. Unfortunately, the names of the statements are not consistent across types of organizations.

We will introduce the alternative names of each statement as it is discussed.

The purpose of our financial accounting discussion is to provide readers with a basic understanding of the preparation, content, and interpretation of a business s financial statements. Unfortunately, the financial statements of large organizations can be long and complex, and there is significant leeway regarding the format used, even within health services organizations. Thus, in our discussion of the statements, we use simplified illustrations that focus on key issues. In a sense, the financial statements presented here are summaries of actual financial statements, but 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 it making money? The income statement summarizes the operations (activities) of an organization with a focus on its revenues, expenses, and profitability. Thus, the income statement is also called the statement of operations, statement of activities, or statement of revenues and expenses.

The income statements of Sunnyvale Clinic are presented in Exhibit 3.1.

Most financial statements contain two or three years of data, with the most recent year presented first. The title section tells us that these are annual income statements, ending on December 31, for the years 2015 and 2014. Whereas the balance sheet, which is covered in Chapter 4, reports a business s financial position at a single point in time, the income statement contains operational results over a specified period of time. Because these income statements are part of Sunnyvale s annual report, the time (accounting) period is one year. Also, the dollar amounts reported are listed in thousands of dollars, so the $148,118 listed as net patient service revenue for 2015 is actually $148,118,000.

The core components of the income statement are straightforward:

revenues, expenses, and profitability (net operating income and net income).

Revenues, as discussed previously in the section on cash versus accrual accounting, represent both the cash received and the unpaid obligations of payers for 2015 2014 Operating Revenues:

Patient service revenue Less: Provision for bad debts Net patient service revenue Premium revenue Other revenue Net operating revenues Expenses:

Salaries and benefits Supplies Insurance Lease Depreciation Interest Total expenses Operating income Nonoperating income:

Contributions Investment income Total nonoperating income Net income $ 150,118 2,000 $ 148,118 18,782 3,079 $ 169,979 $ 126,223 20,568 4,518 3,189 6,405 5,329 $ 166,232 $ 3,747 $ 243 3,870 $ 4,113 $ 7,860 $123,565 1,800 $ 121,765 16,455 2,704 $140,924 $ 102,334 18,673 3,710 2,603 5,798 3,476 $ 136,594 $ 4,330 $ 198 3,678 $ 3,876 $ 8,206 Income statement A financial statement, prepared in accordance with generally accepted accounting principles (GAAP), that summarizes a business s revenues, expenses, and profitability.

EXHIBIT 3.1 Sunnyvale Clinic:

Statements of Operations, Years Ended December 31, 2015 and 2014 (in thousands) services provided during each year presented. For healthcare providers, the revenues result mostly from the provision of patient services. However, in addition to revenues from patient and patient-related services, some revenues, designated contributions and investment income in Exhibit 3.1, stem from donations and securities investments, respectively, and hence have nothing to do with patient services.

To produce revenues, organizations must incur expenses, which are classified as operating or capital (financial). Although not separately broken out on the income statement, operating expenses consist of salaries, supplies, insurance, and other costs directly related to 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 profitability of a business, so expenses are subtracted from revenues to determine an organization s profitability. Sunnyvale s income statement reports two different measures of profitability: operating income and net income.

The income statement, then, summarizes the ability of an organization to generate profits. Basically, it lists the organization s revenues (and income), the expenses that must be incurred to produce the revenues, and the differences between the two. In the following sections, the major components of the income statement are discussed in detail.

SELF-TEST QUESTIONS 1. What is the primary purpose of the income statement?

2. In regard 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 that of 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 as Exhibit 17.1, for examples of income statements from other types of providers.) Sunnyvale s operating revenues section (see Exhibit 3.1) focuses on revenues that stem from the provision of patient services; in other words, they derive from operations. As we discuss in a later section, Sunnyvale also has revenues from contributions and securities investments (nonoperating income), but because such income is not related to core business activities, it is reported separately on the income statement.

The first line of the operating revenues section reports patient service revenue of $150,118,000 for 2015. The key term here is patient service. This line contains revenues that stem solely from patient services, as opposed to revenues that stem from related sources, such as parking fees or food services, which are reported on a separate line in the operating revenues section. Also, as discussed later, patient service revenue that stems from capitated patients may be reported separately. If this is the case, the $150,118,000 reported by Sunnyvale as patient service revenue includes only revenue from fee-forservice patients.

Sunnyvale, like all healthcare providers, has a charge description master file, or chargemaster, that contains the charge code and gross price for each item and service that it provides. However, the chargemaster price rarely represents the amount the clinic expects to be paid for a particular service. For example, the price for a particular service might be $800, while the contract with a particular payer might specify a 40 percent discount from charges, which would result in a reimbursement of only $480. In addition to negotiated discounts, governmental payers such as Medicare and Medicaid reimburse providers a set amount that often is well below the chargemaster (gross) price.

Because recorded revenue must reflect only amounts that are realizable (collectible), differences between chargemaster prices and actual reimbursement amounts are incorporated before the revenue is recorded on the patient service revenue line. Thus, the patient service revenue shown on the income statement is reported after contractual allowances have been considered and hence represents the actual reimbursement amount expected.

To add to the complexity of revenue reporting, some services have been provided as charity care to indigent patients. (Indigent patients are those who presumably are willing to pay for services provided but do not have the ability to do so.) Sunnyvale has no expectation of ever collecting for these services, so, like contractual allowances, charges for charity care services are not reflected in the $150,118,000 patient service revenue reported for 2015.

Finally, some payments for patient services that are owed, and hence reported as patient service revenue, will never be collected and ultimately will become bad debt losses. To recognize that Sunnyvale does not really expect to collect the entire $150,118,000 patient service revenue reported, the second entry in the operating revenues section for 2015 lists a $2,000,000 provision for bad debts. When this amount is subtracted, the result is a net patient service revenue of $148,118,000 for 2015. Note the distinction between charity care and bad debt losses. Charity care represents services that are provided to patients who do not have the capacity to pay. Typically, such patients are identified before the service is rendered. Bad debt losses result from the failure to collect revenues from patients or third-party payers who do have the capacity to pay.

Patient service revenue Revenue that stems solely from the provision of patient services. In some situations, may only reflect revenue from fee-for-service patients.

Industry Practice Revenue Reporting in the Good Old Days About 20 years ago, hospital revenues were reported differently from today. Back then, the revenues section would begin with gross patient services revenue based on chargemaster prices.

In other words, every service provided would be recorded at its chargemaster price and those prices would be aggregated to calculate reported revenues.

Then, the total amount of discounts and allowances would be listed, followed by the total amount of charity care provided, and these values would be subtracted from gross patient service revenue to obtain net patient service revenue.

In this format, discounts and allowances and charity care were prominently displayed at the top of the income statement. Today, however, if these amounts are listed at all, they typically are listed in the notes to the financial statements as opposed to the income statement itself.

Also, the treatment of bad debt losses has recently changed. Whereas the provision for bad debts had been listed on the income statement as an expense, it is now listed as a deduction to patient service revenue.

What do you think? Is the old way or the current system best? Why do you think GAAP was changed to report only the net amount expected to be collected, as opposed to the gross amount billed? Also, why was the provision for bad debt losses moved from an expense item to the revenues section?

Premium revenue Patient service revenue that stems from capitated patients as opposed to fee-forservice patients.

A description of policies regarding discounts and charity care often appears in the notes to the financial statements. Sunnyvale s financial statements include the following two notes:

Revenues. Sunnyvale has entered into agreements with third-party payers, including governmental programs, under which it is paid for services on the basis of established charges, the cost of providing services, predetermined rates, 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 final settlements are determined. The adjustments to estimated settlements for prior years are not considered material and thus are not shown in the financial statements or footnotes.

Charity care. Sunnyvale has a policy of providing charity care to indigent patients in emergency situations. These services, which are not reported as revenues, amounted to $67,541 in 2015 and $51,344 in 2014.

Even though Sunnyvale ultimately expects to collect all of its reported net patient service revenue not yet received, the clinic did not actually receive $148,118,000 in cash payments from fee- for-service patients and insurers in 2015. 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 (see Exhibit 4.1) as net patient accounts receivable.

If a provider has a significant amount of revenue stemming from capita tion contracts, it is often reported separately in the operating revenues section as premium revenue. Sunnyvale reported premium revenue of $18,782,000 for 2015. 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 revenue 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 related to, but not arising directly from, patient services, and Sunnyvale is no exception. In 2015, Sunnyvale reported other revenue of $3,079,000. Examples of other revenue include parking fees; nonpatient food service charges; office and concession rentals; and sales of pharmaceuticals to employees, staff, and visitors.

When all the revenue associated with patient services is totaled, the amount reported as net operating revenues for 2015 is $169,979,000. This amount represents the net amount of revenue that stems from a provider s core operations the provision of patient services. Income that results from noncore activities primarily contributions and securities investments will be reported at the bottom of the income statement.

1. What categories of revenue are reported on the income statement?

2. Briefly, 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:

Contractual discounts and allowances Charity care Bad debt losses 4. Is income from securities investments included in the revenue section? If not, why not?

Expenses Expenses are the costs of doing business. As shown in Exhibit 3.1, Sunnyvale reports its expenses in categories such as salaries and benefits, supplies, insurance, and so on. According to GAAP, expenses may be reported using either a natural classification, which classifies expenses by the nature of the expense, as Sunnyvale does, or a functional classification, which classifies expenses by purpose, such as inpatient services, outpatient services, and administrative.

SELF-TEST QUESTIONS Expenses The costs of doing business. Or, the dollar amount of resources used in providing services.

The number and nature of expense items reported on the income statement can vary widely depending on the nature and complexity of the organization. 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 financial statements would prefer more, as well as a mixing of classifications, 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). To assist readers, some organizations present additional detail on expenses in the notes to the financial statements.

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 benefits of $126,223,000 for 2015, which amounts to 75 percent of Sunnyvale s total expenses. The detail of how these expenses are broken down by department or contract, or the relationship of these expenses to the volume or type of services provided, is not part of the financial accounting information system. However, such information, which is very important to managers, is available in Sunnyvale s managerial accounting system. Chapters 5 through 8 focus on managerial accounting matters.

The expense item titled supplies represents the cost of supplies (primarily 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 manager estimates the usage of individual supply items, orders them beforehand, and then maintains a 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 $20,568,000 of the supplies actually consumed in providing patient services for 2015. Thus, the expense reported for supplies does not reflect the actual cash spent by Sunnyvale on supplies purchased during the year. In theory, Sunnyvale could have several years worth of supplies in its inventories at the beginning of 2015, could have used some of these supplies without replenishing the stocks, and hence might not have actually spent one dime on supplies during 2015.

Sunnyvale uses commercial insurance to protect against many risks, including property risks, such as fire 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, which for 2015 amounted to $4,518,000.

Sunnyvale owns all of its land and buildings but leases (rents) much of its diagnostic equipment. The total amount of lease payments $3,189,000 for 2015 is reported as lease expense on the income statement. There are many reasons that health services organizations lease rather than purchase equipment, including protection against technological obsolescence. Chapter 18, which is available online, contains more information on leases and how they are analyzed.

The next expense category, depreciation, requires closer examination.

Businesses require property and equipment (fixed assets) to provide goods and services. Although some of these assets are leased, Sunnyvale owns most of the fixed assets necessary to support its mission. When fixed assets are initially purchased, Sunnyvale does not report their cost as an expense on the income statement. The reason is found in the expense-matching principle, which dictates that such costs be matched to the accounting periods during which the asset produces revenues. A more pragmatic reason for not reporting the costs of fixed assets when they are acquired is that reported earnings would fluctuate widely from year to year on the basis of the amount of fixed assets acquired.

To match the cost of fixed assets to the revenues produced by such long-lived assets, accountants use the concept of depreciation expense, which spreads the cost of a fixed 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. Here, the term cost is applied to the actual cash outlay for a fixed 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 fixed asset in any year generally is not closely related to the actual usage of the asset or its loss in fair market value. To illustrate, Sunnyvale owns a piece of diagnostic equipment that it uses infrequently. In 2014 it was used 23 times, while in 2015 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 financial statement entries, is calculated in accordance with GAAP. The calculation typically uses the straight-line method that is, the depreciation expense is obtained by dividing the historical 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 final disposition occurs at the end of an asset s useful life.) The result is the asset s annual depreciation expense, which is the charge reflected in each year s income statement over the estimated life of the asset 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 Depreciation A noncash charge against earnings on the income statement that reflects the wear and tear on a business s fixed assets (property and equipment).

declines evenly like a straight line over time.) In 2015, Sunnyvale reported a depreciation expense of $6,405,000, which represents the total amount of deprecation taken on all of the clinic s fixed assets during the year.

In addition to depreciation calculated for financial statement purposes, which is called book depreciation, for-profit 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 financial reporting or tax purposes.

In closing our discussion of depreciation expense, note that depreciation is a noncash expense, meaning there is no actual payment associated with the expense. The cash payment was made some time, possibly many years, before the expense appears on the income statement. The impact of noncash expenses on a business s cash flows will be covered in a later section.

Key Equation: Straight-Line Depreciation Calculation Suppose Sunnyvale Clinic purchases an X-ray machine for $150,000. Its useful life, according to accounting guidelines, is ten years, and the machine s expected value at that time is $25,000. The annual depreciation expense, calculated as follows, is $12,500:

Annual depreciation expense = (Initial cost . Salvage value) Useful life = ($150,000 . $25,000) 10 years = $125,000 10 = $12,500.

The final expense line reports interest expense. Sunnyvale owes or paid its lenders $5,329,000 in interest expense for debt capital supplied during 2015.

Not all of the interest expense reported has been paid because Sunnyvale typically pays interest monthly or semiannually, and hence interest has accrued on some loans that will not be paid until 2016. The amount of interest expense reported by an organization is influenced primarily by its capital structure, which reflects 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 statements contain a catchall category labeled other. Listed here are general and administrative expenses that individually are too small to list separately, including items such as marketing expenses and external auditor fees. Although organizations cannot possibly report every expense item separately, it is frustrating for users of financial statement information to come across a large, unexplained expense item. Thus, income statements that include the other category often add a note that provides additional detail regarding these expenses.

1. What is an expense?

2. Briefly, what are some of the commonly reported expense categories?

3. What is the logic behind depreciation expense?

SELF-TEST QUESTIONS Operating Income Although the reporting of revenues and expenses is clearly important, the most important information on the income statement is profitability. As shown in Exhibit 3.1, two different profit measures can be reported on the income statement. (Not all healthcare organizations report both measures. Some report only the final measure net income.) The first profitability measure reported by Sunnyvale Clinic is operat-Operating income The earnings ing income, calculated in Exhibit 3.1 as net operating revenues minus total of a business expenses. The precise calculation is tied to the format of the income statement, directly related but the general idea of operating income is to focus on revenues and expenses to core activities.

that are related to operations (the provision of patient services). For a healthcare provider, earnings Because net operating revenues in Exhibit 3.1 are all related to patient related to patient services, operating income measures the profitability of core operations services.

(patient services and related endeavors).

Many healthcare providers, especially large ones, have significant revenues that stem For Your Consideration from non-patient-service-related activi- Will the Real Operating Income Please ties, so it is useful to report the inherent Stand Up?

profitability of the core business sepa- Who would think it would be hard to measure rately from the overall profitability of the operating income? After all, the basic definition is enterprise. straightforward: operating revenues minus oper ating expenses. Still, different analysts can look Sunnyvale reported $3,747,000 of at the same set of revenue and expense data and operating income in 2015, which means calculate different values for operating income.

that the provision of healthcare services and The problem in calculating operating income directly related activities generated a profit lies primarily in the definition of what constitutes of that amount. Operating income is an a provider s operations (core activities). Here, important measure of a healthcare business s there are at least three approaches: Operations include (1) only patient care activities; (2) patient profitability because it focuses on the core care and directly related activities, such as cafete activities of the business. Some healthcare ria and parking garage operations; and (3) patient businesses report a positive net income (net (continued) income is discussed below) but a negative operating income (an operating loss). This (continued from previous page) situation is worrisome, because a business is care, directly related activities, and government on shaky financial ground if its core opera- appropriations. Each definition results in a different value for operating income. In general, as the tions are losing money, especially if they do definition of core operations expands, the value so year after year.

calculated for operating income increases.

Note that the operating income What do you think? Consider the hospital reported on the income statement is defined industry. What activities should be considered by GAAP and represents an estimate of the part of core operations? Should hospitals be long-run operating profitability of the busi required by GAAP to report multiple measures of operating income, each using a different defini-ness. It has some shortcomings for one, tion of core activities? it does not represent cash flow that are similar to the shortcomings related to net income discussed in a later section. Still, measuring the core profitability of a business is critical to understanding its financial status.

SELF-TEST QUESTIONS 1. What is operating income?

2. Why is operating income such an important measure of profitability?

Nonoperating Income Nonoperating The next section of the income statement lists nonoperating income. As men- income tioned earlier, reporting the income of operating and nonoperating activities The earnings of separately is useful. The nonoperating income section of Sunnyvale s income a business that are unrelated to statement shown in Exhibit 3.1 reports the income generated from activities core activities. unrelated to the provision of healthcare services.

For a healthcare The first category of nonoperating income listed is contributions. Many provider, the most not-for-profit organizations, especially those with large, well-endowed foun common sources are contributions dations, rely heavily on charitable contributions as an income source. Those and investment charitable contributions that can be used immediately (spent now) are reported income.

as nonoperating income. However, contributions that create a permanent endowment fund, and hence are not available for immediate use, are not reported on the income statement.

The second category of nonoperating income is investment income, another type of income on which not-for-profit-organizations rely heavily. It stems from two primary sources:

1. Healthcare businesses usually have funds available that exceed the minimum necessary to meet current cash expenses. Because cash earns no interest, these excess funds usually are invested in short-term, interest-earning securities, such as Treasury bills or money market mutual funds. Sometimes these invested funds can be quite large say, when a business is building up cash to make a tax payment or to start a large construction project. Also, prudent businesses keep a reserve of funds on hand to meet unexpected emergencies. The interest earned on such funds is listed as investment income.

2. Not-for-profit businesses may have a large amount of endowment fund contributions. When these contributions are received, they are not reported as income because the funds are not available to be spent.

However, the income from securities purchased with endowment funds is available to the healthcare organization, and hence this income is reported as nonoperating (investment) income.

In total, Sunnyvale reported $4,113,000 of nonoperating income for 2015, consisting of $243,000 in spendable contributions and $3,870,000 earned on the investment of excess cash and endowments. Nonoperating income is not central to the core business, which is providing healthcare services.

Overreliance on nonoperating income could mask operational inefficiencies that, if not corrected, could lead to future financial problems. Note that the costs associated with creating nonoperating income are not separately reported.

Thus, the expenses associated with soliciting contributions or investing excess cash and endowments must be deducted before the income is reported on the income statement.

Finally, note that the income statements of some providers do not contain a separate section titled nonoperating income. Rather, nonoperating income is included in the revenue section that heads the income statement. In this situation, total revenues include both operating and nonoperating revenues.

SELF-TEST 1. What is nonoperating income? QUESTIONS 2. Why is nonoperating income reported separately from revenues? Is this always the case?

Net Income Net income The total earnings of a business, including both The second profitability measure reported by Sunnyvale Clinic is net income, which in Exhibit 3.1 is equal to Operating income + Total nonoperating operating and income. Sunnyvale reported net income of $7,860,000 for 2015: $3,747,000 nonoperating + $4,113,000 = $7,860,000. (Not-for-profit organizations use the term excess income.

of revenues over expenses, but we call this measure net income because that is the more universally recognized term. Also, one could argue that there are three profitability measures on Sunnyvale s income statement: operating income, nonoperating income, and net income. We wouldn t object to that position, but accountants generally view nonoperating income as an entry on the statement rather than a calculated profitability measure.) Because of its location on the income statement and its importance, net income is referred to as the bottom line. In spite of the fact that Sunnyvale is a not-for-profit organization, it still must make a profit. If the business is to offer new services in the future, it must earn a profit today to produce the funds needed for new assets. Furthermore, because of inflation, Sunnyvale could not even replace its existing assets as they wear out or become obsolete without the funds generated by positive profitability. Thus, turning a profit is essential for all businesses, including not-for-profits.

What happens to a business s net income? For the most part, it is reinvested in the business. Not-for-profit corporations must reinvest all earnings in the business. An investor-owned corporation, 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 profits reinvested in an investor-owned business, therefore, is net income minus the amount paid out as dividends. (Some for-profit businesses distribute profits to owners in the form of bonuses, which often occurs in medical practices. However, when this is done, the distribution becomes an expense item that reduces net income rather than a distribution of net income. The end result is the same monies are distributed to owners but the reporting mechanism is much different.) Note that both operating income and net income measure profitability as defined by GAAP. In establishing GAAP, accountants have created guidelines that attempt to measure the economic income of a business, which is a difficult task because economic gains and losses often are not tied to easily identifiable events.

Furthermore, some of the income statement items are estimates (e.g., provision for bad debt losses) and others (e.g., depreciation expense) do not represent actual cash costs. Because of accrual accounting and other factors, the fact that Sunnyvale reported net income of $7,860,000 for 2015 does not mean that the business actually experienced a net cash inflow of that amount.

This point is discussed in greater detail in the next section.

SELF-TEST QUESTIONS 1. Why is net income called the bottom line ?

2. What is the difference between net income and operating income?

3. What happens to net income?

Net Income Versus Cash Flow As stated previously, the income statement reports total profitability (net income), which is determined in accordance with GAAP. Although net income is an important measure of profitability, an organization s financial condition, at least in the short run, depends more on the actual cash that flows 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 financial damage. How can these things happen?

The problem is that the income statement is like a mixture of apples and oranges. Consider Exhibit 3.1. Sunnyvale reported net operating revenues of $169,979,000 for 2015. Yet, this is not the amount of cash that was actually collected during the year, because some of these revenues will not be collected until 2016. Furthermore, some revenues reported for 2014 were actually collected in 2015, but these do not appear on the 2015 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 outflows. To make matters even worse, not one cent of depreciation expense was paid out as cash.

Depreciation expense is an accounting reflection of the cost of fixed assets, but Sunnyvale did not actually pay out $6,405,000 in cash to someone called the collector of depreciation. According to the balance sheet (see Exhibit 4.1), Sunnyvale actually paid out $88,549,000 sometime in the past to purchase the clinic s total fixed assets, of which $6,405,000 was recognized in 2015 as a cost of doing business, just as salaries and fringe benefits are a cost of doing business.

Can net income be converted to cash flow the actual amount of cash generated during the year? As a rough estimate, cash flow can be thought of as net income plus noncash expenses. Thus, the cash flow generated by Sunnyvale in 2015 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 flow because it initially was subtracted from revenues to obtain net income even though there was no associated cash outlay.

Key Equation: Net Income to Cash Flow Conversion Because of accrual accounting, net income does not represent an estimate of the organization s cash flow for the reporting period. This equation is used to convert net income to a rough estimate of cash flow: Cash flow = Net income + Noncash expenses. Because depreciation often is (continued) (continued from previous page) the only noncash expense, the equation can be rewritten as Cash flow = Net income + Depreciation. To illustrate, Sunnyvale reported net income of $8,206,000 and depreciation of $5,798,000 in 2014. Thus, a rough measure of its 2014 cash flow is $14,004,000:

Cash flow = Net income + Depreciation = $8,206,000 + $5,798,000 = $14,004,000.

Here is another way of looking at cash flow versus accounting income:

If Sunnyvale showed no net income for 2015, it would still be generating cash of $6,405,000 because that amount was deducted from revenues 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 cash expenses, this year and in future years. Eventually, the accumulated total of depreciation cash flow would be used by Sunnyvale to replace its fixed 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 fixed 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, sufficient to replace existing fixed assets in the future at inflated costs or even to expand the asset base. It appears that Sunnyvale does have such capabilities, as reflected in its $7,860,000 net income and $14,265,000 cash flow for 2015.

It is important to understand that the $14,265,000 cash flow calculated here is only an estimate of actual cash flow for 2015, because almost every item of revenues and expenses listed on the income statement does not equal its cash flow counterpart. The greater the difference between the reported values and cash values, the less reliable is the rough estimate of cash flow defined 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 flows, which can be thought of as an income statement that is recast to focus on cash flow.

SELF-TEST QUESTIONS 1. What is the difference between net income and cash flow?

2. How can income statement data be used to estimate cash flow?

3. What is depreciation cash flow, and what is its expected use?

4. Why do not-for-profit businesses need to make a profit?

Income Statements of Investor-Owned Businesses Our income statement discussion focused on a not-for-profit organization:

Sunnyvale Clinic. What do the income statements for investor-owned businesses, such as Community Health Systems and Brookdale Senior Living, look like?

The financial statements of investor-owned and not-for-profit businesses are generally similar except for entries, such as tax payments, that are applicable only to one form of ownership. Because the transactions of all health services organizations are similar in nature, ownership plays only a minor role in the presentation of financial statement data. In reality, more differences exist in financial statements because of lines of business (e.g., hospitals versus nursing homes versus managed care plans) than because of ownership.

The impact of taxes and depreciation on net income and cash flow for for-profit businesses deserves discussion. Exhibit 3.2 contains four income statements that are based on Sunnyvale s 2015 income statement presented in Exhibit 3.1. First, note that the Exhibit 3.2 statements are condensed to show only total revenues (including nonoperating income); all expenses except depreciation; depreciation; and net income. Lines for taxable income, taxes, and cash flow have also been added. The column labeled Not-for-Profit presents Sunnyvale s income statement assuming not-for-profit status (zero taxes), so the reported net income and cash flow are the same, as discussed previously.

Now consider the column labeled For-Profit A, which assumes that Sunnyvale is a for-profit business with a 20 percent tax rate. Here, the clinic EXHIBIT 3.2 Sunnyvale Clinic: Condensed Income Statements Under Alternative Tax Assumptions, Year Ended December 31, 2015 (in thousands) Not-for-Profit For-Profit A For-Profit B For-Profit C (Tax rate = 0%) (Tax rate = 20%) (Tax rate = 40%) (Tax rate = 40%) Total revenues $174,092 $174,092 $174,092 $174,092 Expenses:

All except depreciation $159,827 $159,827 $159,827 $159,827 Depreciation 6,405 6,405 6,405 0 Total expenses $166,232 $166,232 $166,232 $159,827 Taxable income $ 7,860 $ 7,860 $ 7,860 $ 14,265 Taxes 0 1,572 3,144 5,706 Net income $ 7,860 $ 6,288 $ 4,716 $ 8,559 Cash flow $ 14,265 $ 12,693 $ 11,121 $ 8,559 (NI + depreciation) Note: Total revenues = Net operating revenues + Total nonoperating income. NI (net income).

must pay taxes of 0.20 . $7,860,000 = $1,572,000, which reduces net income by a like amount: $7,860,000 . $1,572,000 = $6,288,000. In the next column, labeled For-Profit B, the tax rate is assumed to be 40 percent, which results in higher taxes of $3,144,000 and a lower net income of $4,716,000.

The impact of taxes on net income is clear: The addition of taxes reduces net income, and the greater the tax rate, the greater the reduction.

Finally, let s examine the impact of depreciation and taxes on cash flow (net income plus depreciation). The right column, labeled For-Profit C, is the same as the For-Profit B column, except the depreciation expense is assumed to be zero rather than $6,405,000. What is the impact of depreciation expense? Depreciation expense lowers taxable income by a like amount and hence lowers taxes by T . Depreciation expense, where T is the tax rate.

The amount of taxes saved 0.40 . $6,405,000 = $2,562,000 is called the depreciation shield. It is the dollar amount of taxes that will not have to be paid because of the business s depreciation expense.

Let s check our work. According to Exhibit 3.2, the taxes due without depreciation expense are $5,706,000, but with depreciation taxes they are $3,144,000. Thus, the depreciation expense has saved the business $5,706,000 . $3,144,000 = $2,562,000, which is the amount of the depreciation shield just calculated. Also, note that the cash flow is higher by the same amount, so the depreciation expense, which reduces taxes but does not impact cash flow, has increased cash flow by the amount of the tax reduction (the depreciation shield).

Key Equation: Depreciation Shield Because depreciation expense reduces taxes, it is said to shield a for-profit business from taxes, and the amount of taxes saved is called the depreciation shield. If a business has $500,000 in depreciation expense and pays taxes at a 30 percent rate, its depreciation shield is $150,000:

Depreciation shield = T . Depreciation expense = 0.30 . $500,000 = $150,000.

SELF-TEST QUESTIONS 1. Are there appreciable differences in the income statements of not- for-profit businesses and investor-owned businesses?

2. What are the impacts of taxes and depreciation on net income and cash flow?

3. What is the depreciation shield?

2015 2014 Net income $ 7,860 $ 8,206 Equity (net assets), beginning of year 46,208 38,002 Equity (net assets), end of year $54,068 $46,208 Statement of Changes in Equity As discussed in a previous section, all or some portion of a business s net income will be retained in the business. The statement of changes in equity, also called statement of changes in net assets, is a financial statement that indicates how much of an organization s net income will be retained in the business and hence increase the amount of equity shown on the balance sheet.

Exhibit 3.3 contains Sunnyvale s statements of changes in equity. Because we have simplified the financial statements presented in this book to facilitate understanding, the statements shown here are very basic. In most situations, the Exhibit 3.3 statements would contain several more lines reflecting transactions that affect the amount transferred to the balance sheet.

Exhibit 3.3 tells us that, in 2015, the entire amount of Sunnyvale s net income was retained in the business, hence the equity (net assets) of the clinic increased from $46,208,000 at the beginning of the year to $54,068,000 at the end of the year. This can be confirmed by the amount of equity shown for 2015 in Exhibit 4.1 (see Chapter 4).

To illustrate more complex statements of changes in equity, consider Exhibit 3.4, which assumes that Sunnyvale is a for-profit entity. Now, some portion of the earnings (net income) of the business is paid out as dividends.

In 2015, the business had a net income of $7,860,000, but $2,000,000 of this amount was paid to owners. Thus, only $7,860,000 . $2,000,000 = $5,860,000 is available to increase the balance sheet equity account. Note that, in total, the 2015 ending equity was $54,068,000 . $50,168,000 = $3,900,000 greater in Exhibit 3.3 than in Exhibit 3.4. The difference is caused by the fact that Sunnyvale, when assumed to be for-profit, paid out $3,900,000 total in dividends over 2014 and 2015; hence, the amount retained in the business was reduced by a like amount. (For simplicity, we did not reduce the net income in Exhibit 3.4 by the amount of taxes that would be paid if Sunnyvale were for-profit.) EXHIBIT 3.3 Sunnyvale Clinic: Statements of Changes in Equity (Net Assets), Years Ended December 31, 2015 and 2014 (in thousands) Statement of changes in equity A financial statement that reports how much of a business s income statement earnings flows to the balance sheet equity account.

1. What is the purpose of the statement of changes in equity (net assets)?

2. How does the statement differ between not-for-profit and for- profit entities?

SELF-TEST QUESTIONS EXHIBIT 3.4 Sunnyvale Clinic:

Statements of Changes in Equity Assuming For- Profit Status, Years Ended December 31, 2015 and 2014 (in thousands) Total (profit) margin Net income divided by total revenues.

It measures the amount of total profit per dollar of total revenues.

Operating margin Operating income divided by net operating revenues. It measures the amount of operating profit per dollar of operating revenues and focuses on the core activities of a business.

2015 2014 Net income $ 7,860 $8,206 Less: Dividends paid 2,000 1,900 Increase in equity $ 5,860 $6,306 Equity, beginning of year 44,308 38,002 Equity, end of year $50,168 $44,308 A Look Ahead: Using Income Statement Data in Financial Statement Analysis Chapter 17 discusses in some detail the techniques used to analyze financial statements to gain insights into a business s financial condition. At this point, however, it would be worthwhile to introduce financial ratio analysis one of the techniques used in financial condition analysis. In financial ratio analysis, values found on the financial statements are combined to form ratios that have economic meaning and help managers and investors interpret the numbers.

To illustrate, total profit margin, usually just called total margin, is defined as net income divided by total revenues, which includes nonoperating income. For Sunnyvale Clinic, the total margin for 2015 was $7,860,000 ($169,979,000 + $4,113,000) = $7,860,000 $174,092,000 = 0.045 = 4.5%.

Thus, each dollar of revenues and income generated by the clinic produced 4.5 cents of profit (i.e., net income). By implication, each dollar of revenues and income required 95.5 cents of expenses. The total margin is a measure of expense control; for a given amount of revenues and income, the higher the net income, and hence total margin, the lower the expenses. If the total margin for other similar 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 2014 was $8,206,000 $144,800,000 = 0.057 = 5.7%, so the clinic s total margin slipped from 2014 to 2015. This finding should alert managers to examine carefully the increase in expenses in 2015. In effect, Sunnyvale s expenses increased faster than its revenues plus investment income, which resulted in falling profitability as measured by total margin. If this trend continues, it would not take long for the clinic to be operating in the red (i.e., losing money).

Finally, let s take a quick look at Sunnyvale s operating margin, which is defined as operating income divided by net operating revenues. For 2015, Sunnyvale s operating margin was $3,747,000 $169,979,000 = 0.022 = 2.2%. Thus, each dollar of operating revenues generated by the clinic produced 2.2 cents of profit (operating income). Because operating margin does not include noncore revenues (contributions and investment income), it is lower than Sunnyvale s total margin, which does include such income.

A complete discussion of financial 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 financial statement data can be used to make judgments about a business s financial condition.

SELF-TEST QUESTIONS 1. Explain how ratio analysis can be used to help interpret income statement data.

2. What is the total profit 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 presented in four primary financial statements: the income statement, the statement of changes in equity, the balance sheet, and the statement of cash flows. The key concepts of this chapter are as follows:

The predominant users of financial accounting information are parties who have a direct financial interest in the economic status of a business primarily its managers and investors.

Generally accepted accounting principles (GAAP) establish the standards for financial 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 refined by the American Institute of Certified Public Accountants (AICPA) and other organizations.

The goal of financial accounting is to provide information about organizations that is useful to present and future investors and other users in making rational financial and investment decisions.

The preparation and presentation of financial accounting data are based on the following set of assumptions, principles, and constraints: (1) accounting entity, (2) going concern, (3) accounting period, (4) monetary unit, (5) historical cost, (6) revenue recognition, (7) expense matching, (8) full disclosure, (9) materiality, and (10) cost benefit.

Under cash accounting, economic events are recognized when the cash transaction occurs. Under accrual accounting, economic (continued) (continued from previous page) events are recognized when the obligation to make payment occurs. GAAP requires that businesses use accrual accounting because it provides a better picture of a business s true financial status.

The collection and recording of financial accounting data use 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 one or more profit measures.

Operating revenues are monies collected or expected to be collected that are related to the core business, namely, patient services.

Operating 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.

Nonoperating income reports earnings that are unrelated to patient services, typically unrestricted contributions and investment income.

Operating income focuses on the profitability of a provider s core operations (patient services), while net income represents the total economic profitability of a business as defined 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 flow, noncash expenses (primarily depreciation) must be added back to net income.

The income statements of investor-owned and not-for-profit 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 content.

For-profit (taxable) entities must include taxes as an income statement expense item. Because depreciation expense reduces operating (taxable) income, and hence a business s tax liability, it creates a depreciation shield equal to the tax rate times the depreciation expense. However, as a noncash expense, depreciation itself does not reduce cash flow, so the greater the amount of depreciation (and therefore, the depreciation shield), the greater the cash flow.

The statement of changes in equity indicates how much of the total profitability (net income) is retained for use by the reporting organization.

Financial ratio analysis, which combines values that are found in the financial statements, helps managers and investors interpret the data with the goal of making judgments about the financial condition of the business.

In this chapter, we focused on financial accounting basics, the income statement, and the statement of changes in equity. In Chapter 4, the discussion of financial accounting continues with the remaining two statements: the balance sheet and statement of cash flows.

Questions 3.1 a. What is a stakeholder?

b. What stakeholders are most interested in the financial condition of a healthcare provider?

c. What is the goal of financial accounting?

3.2 a. What are generally accepted accounting principles (GAAP)?

b. What is the purpose of GAAP?

c. What organizations are involved in establishing GAAP?

3.3 Briefly describe the following concepts as they apply to the preparation of financial statements:

a. Accounting entity b. Going concern c. Accounting period d. Monetary unit e. Historical cost f. Revenue recognition g. Expense matching h. Full disclosure i. Materiality j. Cost benefit 3.4 Explain the difference between cash accounting and accrual accounting. Be sure to include a discussion of the revenue recognition and matching principles.

3.5 Briefly describe the format of the income statement.

3.6 a. What is the difference between gross revenues and net revenues?

(Hint: Think about discounts, charity care, and bad debt.) b. What is the difference between patient service revenue and other revenue?

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 the difference between operating income and net income?

b. Why is net income called the bottom line ?

c. What is the difference between net income and cash flow?

d. Is financial condition more closely related to net income or to cash flow?

3.9 a. What is the purpose of the statement of changes in equity?

b. What is its basic format?

Problems 3.1 Entries for the Warren Clinic 2015 income statement are listed below in alphabetical order. Reorder the data in proper format.

Depreciation expense $ 90,000 General/administrative expenses 70,000 Interest expense 20,000 Investment income 40,000 Net income 30,000 Net operating revenues 410,000 Other revenue 10,000 Patient service revenue 440,000 Provision for bad debts 40,000 Purchased clinic services 90,000 Salaries and benefits 150,000 Total expenses 460,000 3.2 Consider the following income statement:

BestCare HMO Statement of Operations Year Ended June 30, 2015 (in thousands) Revenue:

Premiums earned $26,682 Coinsurance 1,689 Interest and other income 242 Total revenues $28,613 Expenses:

Salaries and benefits $15,154 Medical supplies and drugs 7,507 Insurance 3,963 Depreciation 367 Interest 385 Total expenses $27,376 Net income $ 1,237 a. How does this income statement differ from the one presented in Exhibit 3.1?

b. Did BestCare spend $367,000 on new fixed assets during fiscal year 2015? If not, what is the economic rationale behind its reported depreciation expense?

c. What is BestCare s total profit margin? How can it be interpreted?

3.3 Consider this income statement:

Green Valley Nursing Home, Inc.

Statement of Income Year Ended December 31, 2015 Revenue:

Patient service revenue $3,163,258 Less provision for bad debts (110,000) Net patient service revenue $3,053,258 Other revenue 106,146 Net operating revenues $3,159,404 (continued) (continued from previous page) Expenses:

Salaries and benefits $1,515,438 Medical supplies and drugs 966,781 Insurance and other 296,357 Depreciation 85,000 Interest 206,780 Total expenses $3,070,356 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 Exhibit 3.1 and Problem 3.2?

b. Why does Green Valley show a provision for income taxes while the other two income statements do not?

c. What is Green Valley s total profit margin? How does this value compare with the values for Sunnyvale Clinic and BestCare?

d. The before-tax profit margin for Green Valley is operating income divided by total revenues. Calculate Green Valley s before-tax profit margin. Why might this be a better measure of expense control when comparing an investor-owned business with a not- for-profit business?

3.4 Great Forks Hospital reported net income for 2015 of $2.4 million on total revenues of $30 million. Depreciation expense totaled $1 million.

a. What were total expenses for 2015?

b. What were total cash expenses for 2015? (Hint: Assume that all expenses, except depreciation, were cash expenses.) c. What was the hospital s 2015 cash flow?

3.5 Brandywine Homecare, a not-for-profit business, had revenues of $12 million in 2015. 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 2015 income statement.

b. What were Brandywine s net income, total profit margin, and cash flow?

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 profit margin, and cash flow?

d. Suppose the change had halved, rather than doubled, the firm s depreciation expense. Now, what would be the impact on net income, total profit margin, and cash flow?

3.6 Assume that Mainline Homecare, a for-profit 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 (operating) income.

Assuming that the same revenues and expenses reported for financial accounting purposes would be reported for tax purposes, redo Problem 3.5 for Mainline.

3.7 Consider Southeast Home Care, a for-profit business. In 2015, its net income was $1,500,000 and it distributed $500,000 to owners in the form of dividends. Its beginning-of-year equity balance was $12,000,000. Use this information to construct the business s statement of changes in equity. What is the ending 2015 value of the business s equity account?

3.8 Bright Horizons Skilled Nursing Facility, an investor-owned company, constructed a new building to replace its outdated facility. The new building was completed on January 1, 2015, and Bright Horizons began recording depreciation immediately. The total cost of the new facility was $18,000,000, comprising (a) $10 million in construction costs and (b) $8 million for the land. Bright Horizons estimated that the new facility would have a useful life of 20 years. The salvage value of the building at the end of its useful life was estimated to be $1,500,000.

a. Using the straight-line method of depreciation, calculate annual depreciation expense on the new facility.

b. Assuming a 40 percent income tax rate, how much did Bright Horizons save in income taxes for the year ended December 31, 2015, as a result of the depreciation recorded on the new facility (i.e., what was the depreciation shield)?

c. Does the depreciation shield result in cash or noncash savings for Bright Horizons? Explain.

3.9 Integrated Physicians & Associates, an investor-owned company, had the following general ledger account balances at the end of 2015:

Gross patient service revenue (total charges) $975,000 Contractual discounts and allowances to third-party payers 250,000 Charges for charity (indigent) care 100,000 Estimated provision for bad debts 50,000 a. Construct the revenue section of Integrated Physicians & Associates income statement for the year ended December 31, 2015.

b. Suppose the 2015 contractual discounts and allowances balance reported above is understated by $50,000. In other words, the correct balance should be $300,000. Assuming a 40 percent income tax rate, what would be the effect of the misstatement on Integrated Physicians & Associates 2015 reported:

1. Net patient service revenue?

2. Total expenses, including income tax expense?

3. Net income?

For each item (1 3), indicate whether the balance is overstated, understated, or not affected by the misstatement. If overstated or understated, indicate by how much.

Resources American Institute of Certified Public Accountants (AICPA). 2014. Audit and Accounting Guide for Healthcare Entities. New York: AICPA.

Bailey, S., D. Franklin, and K. Hearle. 2010. A Form 990 Schedule H Conundrum:

How Much of Your Bad Debt Might Be Charity? Healthcare Financial Management (April): 86 87.

Center for Research in Ambulatory Health Care Administration (CRAHCA). 1996.

Medical Group Practice Chart of Accounts. Englewood, CO: CRAHCA.

Duis, T. E. 1994. Unravelling the Confusion Caused by GASB, FASB Accounting Rules. Healthcare Financial Management (November): 66 69.

. 1993. The Need for Consistency in Healthcare Reporting. Healthcare Financial Management (July): 40 44.

Giniat, E., and J. Saporito. 2007. Sarbanes-Oxley: Impetus for Enterprise Risk Management. Healthcare Financial Management (August): 65 70.

Healthcare Financial Management Association (HFMA). 2007. P&P Board Statement 15: Valuation and Financial Statement Presentation of Charity Care and Bad Debts by Institutional Healthcare Providers. Healthcare Financial Management (January): 94 103.

Heuer, C., and M. K. Travers. 2010. FASB Issues New Accounting Standards for Business Combinations. Healthcare Financial Management (June): 40 43.

Holmes, J. R., and D. Felsenthal. 2009. Depreciating and Stating the Value of Hospital Buildings: What You Need to Know. Healthcare Financial Management (October): 88 92.

Maco, P. S., and S. J. Weinstein. 2000. Accounting and Accountability: Observations on the AHERF Settlements. Healthcare Financial Management (October):

41 46.

Peregrine, M. W., and J. R. Schwartz. 2002. What CFOs Should Know and Do About Corporate Responsibility. Healthcare Financial Management (December):

60 63.

Reinstein, A., and N. T. Churyk. 2012. FASB s ASU 2011-7 Changes Financial Statement Reporting Requirements. Healthcare Financial Management (February):

40 42.

Seawell, L. V. 1999. Chart of Accounts for Hospitals. Chicago: Probus Publishing.

Valetta, R. M. 2005. Clear as Glass: Transparent Financial Reporting. Healthcare Financial Management (August): 59 66.

THE BALANCE SHEET AND STATEMENT OF 4 CASH FLOWS 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 interrelationships with the income statement and the statement of changes in equity.

Explain the purpose of the statement of cash flows.

Describe the contents of the statement of cash flows and how it differs from the income statement.

Describe how a business s transactions affect its income statement and balance sheet.

Introduction Although the income statement, which was covered in Chapter 3, contains information about an organization s revenues, expenses, and income, it does not provide information about the resources needed to produce the income or how those resources were financed. Another financial statement, the balance sheet, contains information concerning an organization s assets and the financing used to acquire those assets.

In addition to the need to disclose resources and financing, accountants and managers have become increasingly aware that income alone does not give a complete picture of an organization s financial condition. Although operating income and net income which reflect an organization s long-run economic profitability as defined by generally accepted accounting principles (GAAP) are important profitability measures, financial condition, especially in the short run, is also related to the actual flow of cash into and out of a business. The second financial statement discussed in this chapter, the statement of cash flows, focuses on this important determinant of financial condition.

Although understanding the composition of the financial statements is essential, it is also important that managers understand the relationships among the financial statements. Thus, emphasis is placed on the interrelationships Balance sheet A financial statement that lists a business s assets, liabilities, and equity (fund capital).

Asset An item that either possesses or creates economic benefit for the organization.

Liability A fixed financial obligation of the business.

Equity The book value of the ownership position in a business, where book value is the value that appears on a business s financial statements. In other words, the value according to GAAP.

among the statements throughout the chapter. Finally, the end of the chapter contains a brief introduction to how actual business transactions work their way into an organization s financial statements. Our purpose here is to provide readers with a feel for how financial 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 financial position of an organization at a given point in time. For this reason, the balance sheet is also called the statement of financial position. The balance sheet changes every day as a business increases or decreases its assets or changes the composition of its financing. The important point is that the balance sheet, unlike the income statement, reflects a business s financial 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 rapidly will have significant 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 financed. The balance sheet has the following basic structure:

Assets Liabilities and Equity Current assets Current liabilities Long-term assets Long-term liabilities Equity Total assets Total liabilities and equity The assets side (left side) of the balance sheet lists, in dollar terms, all the resources, or assets, owned by the organization. In general, assets are broken down into categories that distinguish short-lived (current) 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 financing (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 fixed 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 simply that it must balance that is, the left side must equal the right side. This relationship, which is called the accounting identity or basic accounting equation, is expressed in equation form as follows:

A = L + E, where A = total assets, L = total liabilities, and E = equity. Because liability claims are paid before equity claims are 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 also the fact that equity can be negative. If a business writes down (decreases) the value of its assets, perhaps due to obsolescence, 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, the equity reported on the balance sheet becomes a negative amount.

Exhibit 4.1 contains Sunnyvale s balance sheet, which follows the basic structure as previously explained. The title of the exhibit 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 subunits 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. As we discussed in Chapter 3, for ease of understanding, the balance sheet presented here is simplified as compared to most actual statements, but it contains all of the essential elements.

The time frame for the data in the balance sheet is also apparent in the title. The data are reported for 2015 and 2014 as of December 31. Whereas Sunnyvale s income statements indicate the data were for the year ended on December 31, the balance sheets merely indicate 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 financial position at 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, 2015, Sunnyvale had a total of $154,815,000 EXHIBIT 4.1 Assets 2015 2014 Sunnyvale Clinic:

Balance Sheets December 31, 2015 and 2014 (in thousands) Current Assets:

Cash and cash equivalents Short-term investments Net patient accounts receivable Inventories Total current assets Long-term investments Net property and equipment Total assets Liabilities and Equity $ 12,102 $ 6,486 10,000 5,000 28,509 25,927 3,695 2,302 $ 54,306 $ 39,715 48,059 25,837 52,450 49,549 $154,815 $ 115,101 SELF-TEST QUESTIONS 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 in assets that were financed by a total of $154,815,000 in liabilities and equity.

Besides the obvious confirmation that the balance sheet balances, this statement indicates that the total assets of Sunnyvale were valued, 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 fixed claims, and owners. Creditors and other claimants have first 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 equity, which are in the bottom section of Exhibit 4.1) reflects the manner in which Sunnyvale raised the capital needed to acquire its assets. Because the balance sheet must balance, each dollar on the asset (left) side must be matched by a dollar on the capital (right) side.

1. What is the purpose of the balance sheet?

2. What are the three major sections of the balance sheet?

3. What is the accounting identity, and what information does it provide?

4. What is the relationship between assets and capital?

Assets Assets either possess or create economic benefit for the organization. Exhibit 4.1 contains three major categories of assets: current assets, long-term investments, and net property and equipment. The following sections 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 2015. Suppose the short-term investments 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 2016. Of course, all else will not be the same, so Sunnyvale s 2016 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 2015 as they become due in 2016.

Thus, current assets are one element that contributes to 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 2015, Sunnyvale had net working capital of $54,306,000 . $15,425,000 = $38,881,000. From a pure liquidity standpoint, the greater the net working capital, the better. However, as we discuss in Chapter 16, 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 discuss in later chapters, there are other factors, such as expected cash inflows, that contribute to a business s overall liquidity.

Within Sunnyvale s current assets, there is $12,102,000 in cash and cash equivalents. Cash represents actual cash in hand plus money held in commercial checking accounts (demand deposits). Cash equivalents are short-term securities investments that are readily convertible into cash. In general, accountants interpret that to mean securities that have a maturity of three months or less.

Note that cash and cash equivalents are carried on the same line of the balance sheet, so readers cannot determine the relative sizes of each type of asset, which confirms the fact that these are considered to be identical in nature.

Current asset An asset that is expected to be converted into cash within one accounting period (often a year).

Net working capital A liquidity measure equal to current assets minus current liabilities.

Net patient accounts receivable (receivables) The amount of money billed for services provided but not yet collected.

In addition to cash and cash equivalents, there is $10,000,000 of short- term investments (sometimes called marketable securities), which represent cash that has been temporarily invested in highly liquid, low-risk securities such as bank savings accounts, money market mutual funds, US Treasury bills, or prime commercial paper having a maturity greater than 90 days but less than one year. (Money market mutual funds are mutual funds that invest in safe, short- term securities such as Treasury bills and commercial paper. Treasury bills are short-term debt instruments issued by the US government. Commercial paper is short-term debt issued by very large and financially strong corporations. All of these securities are relatively safe investments because there is virtually 100 percent assurance that the borrowers will repay the loans when they mature.) Organizations hold cash equivalents and short-term investments because cash earns no interest and money held in commercial checking accounts earns very little 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, short-term investments are built up periodically to meet projected nonoperating cash outlays such as tax payments, investments in property and equipment, and legal judgments.

Even though short-term investments pay relatively low interest, any return is better than none, so such investments are preferable to cash holdings.

Short-term investments 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, these securities may actually be worth more or less than their purchase price. Still, because short-term investments have maturities of less than one year, it is rare for their market values to be substantially different from their costs.

Net patient accounts receivable, often just called receivables, 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 healthcare services, and these payments often take weeks or months to be billed, processed, and ultimately paid. Sunnyvale s patient accounts receivable amount of $28,509,000 at the end of 2015 is listed on the balance sheet net of contractual allowances, charity care, and the provision for bad debt losses. Thus, the presentation on the balance sheet is consistent with the Chapter 3 discussion concerning net patient service revenue and the treatment of bad debt losses.

The $28,509,000 net receivable amount s relationship to the income statement s net operating revenues of $169,979,000 for 2015 (see Exhibit 3.1) is as follows. A total of $169,979,000 was billed to patients and payers, and was expected to be collected, during 2015. This is a net number as there is a higher amount of gross charges in Sunnyvale s managerial accounting system that reflects charges before deductions for contractual allowances and charity care and the provision for bad debt losses. The fact that $28,509,000 of this revenue remains to be collected suggests that the difference between $169,979,000 and $28,509,000, which totals $141,470,000, was collected during 2015.

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 2015, its patient accounts receivable balance of $28,509,000 would fall to zero when the entire amount was eventually collected (except for any errors in the bad debt loss forecast). However, if Sunnyvale continues as an ongoing enterprise, the receivables balance will never fall to zero because, although Sunnyvale s collections are lowering it, new services are constantly being provided that create new billings, and hence new receivables, that are added to it.

The final current asset listed in Exhibit 4.1 is inventories, which primarily reflects Sunnyvale s purchases of medical supplies. The value of supplies on hand at the end of 2015 was $3,695,000. As with the cash account, it is not in a business s best interest to hold excessive inventories. There is a certain level of supplies necessary to meet medical needs and to maintain a safety stock to guard against unexpected surges in use, but any inventories above this level create unnecessary costs.

Businesses that hold large amounts of inventories, such as medical supply companies, typically include a note to the financial statements that discusses the holdings in some detail. However, most healthcare providers hold relatively small levels of inventories, and hence extensive note information often is not provided. In fact, because of the materiality principle discussed in Chapter 3, some providers do not break out inventories as a separate item on their balance sheets but rather include the value of inventories in a catchall balance sheet 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 or very little return, and cash equivalents and short-term investments generally earn relatively low returns. The receivables account does not earn interest income or generate new patient service revenue, and inventories represent dollar amounts invested in items sitting on shelves, which earn no return until those items are used and patients are billed for their use. Because of the low (or zero) return earned on current assets, businesses try to minimize these account values yet ensure that the levels on hand are sufficient to support operations and maintain liquidity. (Readers will learn much more about current asset management in Chapter 16.) Note that the current assets section of the balance sheet is listed in order of liquidity, or nearness to cash. Cash and cash equivalents, as the most liquid Financial asset A security, such as a stock or bond, that represents a claim on a business s cash flows. Financial assets are purchased with the expectation of receiving future payments.

Real asset A physical asset, such as a medical practice or a piece of diagnostic equipment, that has the potential to generate future cash inflows.

assets, are listed first, while the least liquid of current assets inventories is listed last. Dollars invested in inventories will first move into patient accounts receivable as the patients are billed for the supplies used. Then, accounts receivable will be converted into cash when they are collected and, perhaps, shifted to securities if the cash is not needed to pay current bills.

The importance of converting nonearning current assets into short-term investments as quickly as possible, and hence converting zero-return assets into some-return assets, cannot be overemphasized. Under most reimbursement methods, providers first must build the current assets necessary to provide the services; they then must actually do the work; and finally, at some later time (often 45 days or more), they get paid. Providers that operate under capitation have a significant liquidity advantage compared with those that primarily receive fee-for-service revenue. Because capitated payments are received before the services are provided, organizations that are predominantly capitated will have much smaller accounts receivable balances and much larger cash and short-term investment balances than will providers, such as Sunnyvale, that operate in a predominantly fee-for-service environment.

Long-Term Investments The second major asset category, after current assets, is long-term investments, which reports the amount the organization has invested in various forms of long-term (maturities that exceed one year) securities. This account represents investments in financial assets, as opposed to investments in real assets such as buildings and MRI machines, which are listed next on the balance sheet as net property and equipment. The $48,059,000 reported by Sunnyvale at the end of 2015 represents the amount the clinic has invested in stocks, bonds, and other securities that have a longer maturity than its short-term investments in hopes they will provide higher returns.

Long-term securities investments are reported on the balance sheet at fair market value (or just fair 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 have additional financial statement implications that are beyond the scope of this book. A note to the financial statements usually will reveal the details of the types of security investments held by the organization and the resulting gains and losses. The income earned on both short-term and long-term investments is reported on the income statement under nonoperating income. As discussed in Chapter 3, Sunnyvale reported investment income of $3,870,000 for 2015.

The discussion of current assets emphasized that businesses try to minimize the amounts held, maintaining only the amounts necessary to support operations. One of the benefits of prudent current asset management is that more money can be moved into long-term investments, both financial and real, which are expected to generate greater returns than those provided by current assets. The ultimate rewards for minimizing an organization s current assets are the reduction in carrying costs (current assets cost money because each dollar in assets has to be matched by a dollar of financing) and the increased return expected from long-term investments.

Note, however, that Sunnyvale is not in the financial services business; it is in the business of providing healthcare services. Still, not-for-profit organizations typically carry large amounts of long-term securities investments, some funded from depreciation cash flow and hence often called funded depreciation.

(As we discussed in Chapter 3, depreciation is a noncash expense; hence it creates cash flow in addition to the amount of net income.) Eventually, these funds will be used to purchase real assets that provide new or improved services to Sunnyvale s patients. In essence, the long-term investments account is a savings account that ultimately will be used to purchase new land, buildings, and equipment that either replaces worn-out or obsolete assets or adds to the asset base to accommodate volume growth or provide new services.

In contrast, investor-owned businesses usually do not build up such reserves. Any cash flow above the amount needed for near-term reinvestment in the business would likely be returned to the capital suppliers (creditors and stockholders), either by debt repurchases or, more typically, by dividends or stock repurchases. When additional capital is needed for long-term investment in property and equipment, an investor-owned business simply goes to the capital (bond and stock) markets and obtains additional debt or equity financing.

Net Property and Equipment The third major asset category is net property and equipment, often called fixed assets. Fixed assets, as compared to current assets and even compared to long-term securities investments, are highly illiquid and typically are used over long periods of time by the organization. Whereas current assets rise and fall spontaneously with the organization s level of operations, fixed assets, such as land, buildings, and equipment, are normally maintained at a level sufficient to handle peak patient demand.

The property and equipment value listed on the balance sheet represents the value of Sunnyvale s fixed assets net of depreciation, so the effects of wear and tear are incorporated. The calculation of net property and equipment is included in the notes to the financial statements. To illustrate, Exhibit 4.2 contains Sunnyvale s calculation.

The fixed assets (land, buildings, and equipment) are first listed at historical cost (the purchase price). The total of such historical costs is labeled gross property and equipment. Accumulated depreciation represents the total dollars of depreciation that have been expensed on the income statement against the Fixed assets A business s longterm assets, such as land, buildings, and equipment.

Usually labeled net property and equipment on the balance sheet.

EXHIBIT 4.2 2015 2014 Sunnyvale Clinic: Net Property and Equipment Property and equipment Land Buildings and equipment Gross property and equipment Less: Accumulated depreciation Net property and equipment $ 2,954 $ 2,035 85,595 77,208 $88,549 $79,243 36,099 29,694 $52,450 $49,549 Book value The value of a business s assets, liabilities, and equity as reported on the balance sheet. In other words, the value in accordance with generally accepted accounting principles (GAAP).

historical cost of the organization s fixed assets. Numerically, the amounts of depreciation expense reported on the income statement each year are totaled (accumulated) over time to create the accumulated depreciation account. The accumulated depreciation 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 net property and equipment account. Contra accounts reduce the value of parent accounts; in this case, the parent account is gross property and equipment.

For Sunnyvale, the net balance of property and equipment is $52,450,000 at the end of 2015. The historical cost of these assets is $88,549,000. Some of the fixed assets were purchased in 2015, some in 2014, some in 2013, and some in prior years, but the total purchase price of all the fixed assets being used by Sunnyvale on December 31, 2015, is $88,549,000. The accumulated depreciation on these assets through December 31, 2015, 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, which reflects the remaining book value of the clinic s property and equipment, is the amount reported on the balance sheet. The connection of the balance sheet net property and equipment account to the income statement is through depreciation expense. The accumulated depreciation of $36,099,000 reported on the balance sheet notes at the end of 2015 is $6,405,000 greater than the 2014 amount of $29,694,000, where $6,405,000 is the 2015 depreciation expense reported on the income statement.

Depreciation, even though it typically does not reflect the true change in value of a fixed 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. Such adjustments, called impairment of capital by accountants, are routinely made to the plant and equipment accounts on the balance sheet (and to revenues and expenses on the income statement) when assets are sold or lose value. However, these adjustments are beyond the scope of this book.

In closing our discussion of assets, note that many providers report a fourth asset category: other assets. This is really a catchall category of miscellaneous long-term assets, which may or may not be significant. Examples include fixed 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 time.

1. What are the three major categories of asset accounts?

2. What is the primary difference between current assets and the remainder of the asset side of the balance sheet?

3. Give some examples of current asset accounts.

4. What is the difference between gross property and equipment and net property and equipment?

5. How does accumulated depreciation tie in to the income statement?

Liabilities Liabilities and equity, which comprise the right side of the balance sheet, are shown in the lower section of Exhibit 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 definition, total capital (the sum of liabilities and equity) must equal total assets. Another way of looking at this is that every dollar of assets on the left side of the balance sheet must be matched by a dollar of liabilities or equity on the right side.

Liabilities represent claims against the assets of an organization that are fixed 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-profit organizations, which do not pay income taxes, typically have unpaid payroll and withholding taxes on their employees.) However, the largest liability claims typically are by creditors (lenders) who have made loans (supplied debt capital) to the business.

Most creditors claims are unsecured, meaning that they are not tied to specific assets pledged 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.

SELF-TEST QUESTIONS Default Occurs when a borrower fails to make a promised debt payment.

Note that technical default occurs when the borrower fails to meet one of the restrictions in the loan agreement but is still making the required payments.

For Your Consideration Should Governments Report Like Businesses?

Historically, states and cities used cash accounting methods to report infrastructure assets such as roads, bridges, and water and sewer facilities.

Thus, the cost of an infrastructure investment was reported as an expense on the income statement when it occurred, but the value of the physical asset did not appear on the balance sheet. In other words, the value of all infrastructure assets was off the books. The theory behind this treatment is that infrastructure assets are, for the most part, immovable and of value only to the governmental unit (and its residents). Because infrastructure assets cannot be sold, there is no value to be reported on the balance sheet.

In actuality, of course, physical infrastructure assets like roads and bridges generally continue to have value, or usefulness, long after governmental units have incurred the cost of construction.

And, just as business assets depreciate in value, the value of infrastructure assets also declines over time. Thus, in 2001, the Government Accounting Standards Board (GASB) mandated that states and cities treat infrastructure assets just like businesses do record them on the balance sheet at initial cost and depreciate this value over time. The idea here is that the new treatment would (1) improve financial reporting, (2) enhance awareness of fiscal issues facing governmental units, and (3) emphasize the importance of maintaining infrastructure assets.

What do you think? Should governmental entities have been required to report financial status in the same way as businesses? Will the change in how infrastructure assets are treated cause states and cities to act differently?

If the assets of the business are sold (liquidated), bankruptcy law requires that any proceeds be used first to satisfy liability claims before any funds can be paid to owners or, in the case of not-for-profits, used for charitable purposes. Furthermore, the dollar value of each liability claim is fixed by the amount shown on the balance sheet, while the owners, including the community at large for not-for-profit organizations, have a claim to the residual proceeds of the liquidation rather than to a fixed amount. Finally, secured creditors have first right to the sale proceeds of assets pledged as collateral for the loan.

Like assets, the balance sheet presentation of liabilities follows a logical format.

Current liabilities, which are those liabilities that fall due (must be paid) within one accounting period (one year in this example), are listed first. Long-term debt, distinguished from short-term debt by having maturities greater than one accounting period, is listed second. As shown in Exhibit 4.1, Sunnyvale had total liabilities at the end of 2015 of $100,747,000, which consisted of two parts: total current liabilities of $15,425,000 and 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 defined as having a maturity of less than one accounting period to finance seasonal or cyclical working capital (current asset) needs. For example, in preparation for the busy winter season, the Fort Lauderdale walk-in clinic builds up its inventories of medical supplies, but when the season is over, the supplies fall back to a lower off-season level. This temporary increase in current assets typically is funded by a bank loan of some type. When listed on the balance sheet, short-term debt is called notes payable. We see that Sunnyvale had $4,334,000 of short-term debt outstanding at the end of 2015.

Accounts payable, as well as accrued expenses, represents payment obligations 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 vendors 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 2015, had extended Sunnyvale $5,022,000 worth of such credit.

Wages and benefits due to employees resulting from work performed at the end of the accounting period, interest due on debt financing, utilities expenses not yet paid, taxes due to government authorities, and similar items are included on the balance sheet as accrued expenses, or just accruals. Such expenses occur because the business has incurred the obligation to pay for services received but has not made payment before the financial accounting books are closed.

Sunnyvale s employees are used to illustrate the logic behind accruals.

Sunnyvale s staff earns its wages and benefits 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 in payment), 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. Sunnyvale reported $6,069,000 in accruals for 2015, which, when added to the other current liabilities, totals $15,425,000.

Long-Term Debt The long-term debt section of the balance sheet represents debt financing to the organization with maturities of more than one accounting period. In the Sunnyvale example, repayment is not required during the coming year. The long-term debt section lists any debt owed to banks and other creditors (e.g., bondholders) as well as obligations under certain types of lease arrangements.

Detailed information relative to the specific characteristics of the long-term debt is disclosed in the notes to the financial statements.

To help understand how debt financing is handled on the financial statements, it might be useful to briefly discuss the mechanics of a loan. Assume that Sunnyvale takes out a $300,000 bank loan with a maturity (term) of three years. For simplicity, assume that the loan agreement requires payments to the bank as shown in Exhibit 4.3.

When the loan is first obtained, $300,000 will be posted in the longterm debt account and will appear on the balance sheet. At the end of the first year, Sunnyvale will pay the bank a total of $130,000, consisting of Credit terms The statement of terms that extends credit to a buyer.

Trade credit The credit offered to businesses by suppliers (vendors) when credit terms are offered.

Accrued expenses A business liability that stems from the fact that some obligations, such as wages and taxes, are not paid immediately after the obligations are created.

EXHIBIT 4.3 Year 1 Year 2 Year 3 Sunnyvale Clinic: Bank Loan with Three- Year Maturity Loan Repayment Schedule:

Interest on loan Principal repayment$ 30,000 100,000 $ 20,000 100,000 $ 10,000 100,000 Total payment $130,000 $120,000 $110,000 Industry Practice Leasing and Financial Statements Under current accounting rules (GAAP), leases are reported on a lessee s balance sheets in two ways. For long-term (capital) leases, the leased property is reported as an asset and the present value of lease payments is reported as a liability.

But for short-term (operating) leases, the leased property does not appear on the balance sheet at all. Rather, operating lease obligations are reported in the notes to the financial statements.

Because short-term leases are not shown directly on the balance sheet, such leases are called off- balance-sheet financing. Note, however, that all lease payments are listed as expenses on the income statement, regardless of length.

It is likely that the current rules, in effect since 1977, will be replaced by new standards in 2016 or 2017. Although a complete discussion of old and new rules is beyond the scope of this text, we note here that the most important proposed change is that leases would no longer be classified by accountants as operating or capital. Instead, almost all leases would be accounted for in the same way on the balance sheet there would be no difference between short-term and long-term leases. All leased property would be listed on the asset side as right-to-use assets and on the liability side as lease liabilities. The ultimate effect of the proposed rule would be to eliminate operating leases as a source of off-balance-sheet financing.

What do you think about the proposed rule change? Would analysts find it easier to perform financial statement analyses? Do you think that the new rules would reduce the amount of leasing that currently takes place? When all factors are considered, should the change take place?

$30,000 interest on the loan and $100,000 repayment on the principal portion of the loan. The $30,000 interest expense, which is paid to the bank for the use of its money, appears as an expense on the income statement.

The $100,000 principal repayment, on the other hand, is not an expense item, but rather it reduces the $300,000 carried in the long-term debt account on the balance sheet. In the second year, the loan will be treated in a similar way: $20,000 will appear as an expense on the income statement, and the loan amount on the balance sheet will be reduced by $100,000. (The features of long-term debt are discussed in detail in Chapter 11.) In this example, as with many sources of long-term debt financing, some portion of the borrowed amount (the principal) must be repaid in each year. In addition, some long-term debt that was issued in the past may mature (come due) in any given year. The portion of long-term debt that must be paid in the coming year (accounting period) is recorded on the balance sheet as a current liability titled current portion of long-term debt. Sunnyvale had no long-term debt payments due in either 2015 or 2014, but if it did, they would appear on the first line of the current liabilities section.

Liabilities Summary Sunnyvale had total liabilities, consisting of current liabilities and long-term debt, of $100,747,000 at the end of 2015. As we discuss in the next section, Sunnyvale reported $54,068,000 in net assets (equity), for total capital (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 financing than equity financing. The choice between debt and equity financing is discussed in Chapter 13, while Chapter 17 includes coverage of alternative ways to measure the amount of debt financing used and its effect on a business s financial condition.

1. What are liabilities?

2. What are some of the accounts that would be classified as current liabilities?

3. Use an example to explain the logic behind accruals.

4. What is the difference between notes payable and long-term debt?

5. What is the difference between long-term debt and current portions of long-term debt?

Net Assets (Equity) On the balance sheet, the ownership claim on an organization s assets is called net assets when the organization has not-for-profit 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 1, there is 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 is used, but the various terms all indicate the same thing: the amount of total assets financed by nonliability capital, or total assets minus total liabilities.

To determine what belongs to the owners, whether explicitly recognized in for-profit businesses or implied in not-for-profit organizations, fixed claims (liabilities) are subtracted from the book value of the business s assets. The remainder, the net assets (equity), represents the residual value of the assets of the organization.

The equity section of the balance sheet is extremely important because it, more than anything else in the financial statements, reflects the ownership status of the organization. Because Exhibit 4.1 lists the equity as net assets, it SELF-TEST QUESTIONS Net assets The dollar value, according to GAAP, of a business s assets after subtracting the business s liabilities. In not-for-profit businesses, the term often is used on the balance sheet in place of equity.

is obvious that Sunnyvale is a not-for-profit corporation. Some of the equity capital reported on the balance sheet 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. As discussed in Chapter 3, for a not-for-profit organization such as Sunnyvale, all earnings must be reinvested in the business.

Sunnyvale s equity increased by $54,068,000 . $46,208,000 = $7,860,000 from 2014 to 2015, which is the same amount that Sunnyvale reported as net income for 2015. 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-profit businesses, there is simply nowhere else for those earnings to go.

This highlights another connection between the balance sheet and the income statement. Of course, most organizations have adjustments to net income that either increase or decrease the amount that flows to the balance sheet equity account. Such adjustments are shown on the statement of changes in equity discussed in Chapter 3.

Sunnyvale s balance sheet shows an equal amount of assets and liabilities and equity (it 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 financing. The asset increases might be in cash, receivables, supplies, or some other account. The key point is that the equity balance is not a store of cash. As Sunnyvale earned profits over the years that increased the equity account, these funds were invested in supplies, property and equipment, and other assets to provide future services that would likely generate even larger profits in the future. Sunnyvale s total assets grew by $154,815,000 .

$115,101,000 = $39,714,000 in 2015, which was supported by an increase in total liabilities of $100,747,000 . $68,893,000 = $31,854,000 and an increase in equity of $54,068,000 . $46,208,000 = $7,860,000.

The net assets type of equity section shown in Exhibit 4.1 is typical of not-for-profit organizations such as community or religious hospitals. However, a relatively rare form of not-for-profit 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-profit 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.

EXHIBIT 4.4 2015 2014 Southeast Healthcare:

Stockholders Equity:

Balance Sheet Common stock $ 10,000 $10,000 Equity Section Retained earnings 44,068 36,208 December 31, Total equity $54,068 $46,208 2015 and 2014 (in thousands) Exhibit 4.4 contains the equity section of the balance sheet assuming that Sunnyvale, with a new name (Southeast Healthcare), is an investor-owned (forprofit) corporation. This is the type of presentation that would be seen on the balance sheets of for-profit health services businesses such as Community Health Systems and Brookdale Senior Living. The first major difference is the title of the section Stockholders Equity. This title, or a similar title such as Shareholders Equity, provides explicit recognition that stockholders (shareholders) own the business. (Chapter 12 provides details on stockholders rights and privileges.) Southeast Healthcare was incorporated in 1980, with the bylaws authorizing 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. Thus, this amount is shown in Exhibit 4.4 on the line labeled common stock. The retained earnings account represents the accumulation of earnings over time that are reinvested in the business. Each year, the amount of net income shown on the income statement, less the amount paid out to stockholders along with other adjustments, is transferred from the income statement to the balance sheet. Suppose that, as with Sunnyvale, Southeast Healthcare had actually earned $7,860,000 in 2015. Because the firm s retained earnings account increased by a like amount, no distributions were made to stockholders during the year.

Retained earnings, like all equity accounts, represent a claim against assets, and they are not necessarily available to buy new equipment, to pay dividends, or for any other purpose. The financing 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 and cash equivalents, short-term investments, and long-term investments accounts. Only the portion of retained earnings that is sitting in the cash account is immediately available to the business for use.

Although Exhibit 4.4 shows only the equity section, it is likely that there would be significant differences in the values of other balance sheet accounts between investor-owned and not-for-profit businesses. For example, it is unlikely that a for-profit healthcare business would amass such a large amount SELF-TEST QUESTIONS Fund accounting A system for recording financial statement data that categorizes accounts as restricted or unrestricted.

of long-term investments (securities) unless the funds were earmarked for a particular use in the next few years. Southeast s stockholders would question why the company had more than $48 million in long-term securities because they would prefer to have all of the business s capital invested in operating assets, which, as indicated earlier, usually earn a higher return than do securities investments. Thus, there would be stockholder pressure on management to either invest this capital in more financially productive operating assets or return it to owners (as dividends or stock repurchases) for redeployment.

Stockholders 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 financing or sell more common stock.

Access to the capital markets is seen as an economic advantage that for-profit businesses whether they are hospitals, medical practices, or managed care plans have over not-for-profit businesses. The ability to open the faucet to acquire more capital has certain advantages in today s highly competitive healthcare sector.

1. What are net assets (equity)?

2. What are the differences in the equity sections of not-for-profit 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 statement?

4. What is the purpose of the statement of changes in equity?

Fund Accounting One unique feature of many not-for-profit balance sheets is that they classify certain asset and net asset (equity) accounts as being restricted. When a not- for-profit organization receives contributions that donors have indicated must be used for a specific purpose, or the board of trustees specifies that funds are being accumulated for a single purpose, the organization must create multiple funds to account for its assets and equity.

A fund is defined as a self-contained pool set up to account for a specific activity or project. Each fund typically has assets, liabilities, and an equity balance. Because the balance sheet of an organization that receives restricted contributions is separated into restricted and unrestricted funds, this form of accounting is called fund accounting. Only contributions to not-for-profit organizations are tax deductible to the donor; hence, few contributions are 2015 2014 EXHIBIT 4.5 Sunnyvale Clinic:

Net Assets (Equity): Balance Unrestricted $ 45,762 $ 39,368 Sheet Net Temporarily restricted 3,455 2,669 Assets (Equity) Permanently restricted 4,851 4,171 Section Under Total net assets $54,068 $46,208 Fund Accounting December 31, made to investor-owned healthcare businesses. Thus, fund accounting is only applicable to not-for-profit organizations.

To gain a better appreciation of fund accounting, consider Exhibit 4.5, which contains Sunnyvale s net assets listing under fund accounting. Now, instead of a single line for net assets, the account is broken down into three subaccounts.

The first line lists unrestricted net assets. These include funds that are derived from operating activities (retained earnings) and unrestricted contributions in other words, funds that are not contractually required to be used for a specific purpose. Such funds, as they are generated, are available to Sunnyvale to pay operating expenses, to acquire new property and equipment, or for any other legitimate purpose. Remember, though, that the $45,762,000 in unrestricted net assets is not a pot of money available for use at the end of 2015. Most, or all, of it has already been spent.

The next line contains temporarily restricted net assets. These funds typically are provided by donors that have stipulated either time or predetermined goal restrictions. For example, a donor may specify that a contribution not be used until three years have elapsed or until the new children s hospital is built. When the temporary restriction is met, assuming there are no additional restrictions, such monies are transferred to the unrestricted fund.

The final line lists permanently restricted net assets. These usually are contributions that must be maintained permanently by the organization; however, all or part of the associated earnings can be spent. Thus, the permanently restricted portion of such funds is not available for discretionary use.

Restricted contributions impose legal and fiduciary responsibilities on health services organizations to carry out the written wishes of donors. Numerous rules are associated with fund accounting that go well beyond the scope of this book. The good news is that GAAP encourages organizations that use fund accounting to present outside parties with balance sheets that look roughly like the one presented in Exhibit 4.1. Thus, with the exception of further breakdown of some accounts into unrestricted and restricted components, such balance sheets have the same economic content as those prepared using standard accounting guidelines.

2015 and 2014 (in thousands) SELF-TEST QUESTIONS Statement of cash flows A financial statement that focuses on the cash flows that come into and go out of a business.

1. What is fund accounting?

2. What type of health services organization is most likely to use fund accounting?

3. Explain the differences between unrestricted, temporarily restricted, and permanently restricted funds.

4. Is there a significant difference in the economic content of balance sheets created using fund accounting and those prepared under conventional accounting guidelines?

Statement of Cash Flows The balance sheet and income statement are traditional financial statements that have been required for many years. In contrast, the statement of cash flows has only been required since 1989 for for-profit businesses and since 1995 for not-for-profit businesses. This relatively new financial statement was created by accountants in response to demands by users for better information about a firm s cash inflows and outflows.

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 detailed information on cash flows. 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 2015 by taking on more debt or by selling some fixed assets. Such flows, which are not shown on the income statement, affect a firm 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 firms, some may be paid out as dividends or used to repurchase stock. 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 flows details where a business gets its cash and what happens to it.

Two formats can be used for the statement of cash flows: the direct format and the indirect format. Most providers prefer the indirect format.

Sunnyvale s 2015 and 2014 statements are presented in Exhibit 4.6 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 Exhibit 4.6 will give readers an excellent appreciation of the value of the statement of cash flows.

EXHIBIT 4.6 2015 2014 Sunnyvale Cash Flows from Operating Activities:

Operating income Adjustments:

Depreciation Increase in net patient accounts receivable Increase in inventories Decrease in accounts payable Increase in accrued expenses Net cash from operations Cash Flows from Investing Activities:

Capital expenditures Nonoperating income Purchase of short-term securities Purchase of long-term securities Net cash from investing Cash Flows from Financing Activities:

Proceeds from bank loan (notes payable) Proceeds from issuance of long-term debt Net cash from financing Net increase (decrease) in cash Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year $ 3,747 6,405 (2,582) (1,393) (1,911) 1,032 $ 5,298 ($ 9,306) 4,113 (5,000) (22,222) ($ 32,415) $ 989 31,744 $ 32,733 $ 5,616 6,486 $ 12,102 $ 4,330 5,798 (1,423) (673) (966) 865 $ 7,931 ($ 1,953) 3,876 0 (20,667) ($ 18,744) $ 0 0 $ 0 ($10,813) 17,299 $ 6,486 Clinic:

Statements of Cash Flows Years Ended December 31, 2015 and 2014 (in thousands) The statement of cash flows is formatted to make it easy to understand why Sunnyvale s cash position increased by $5,616,000 during 2015. 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 flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

Cash Flows from Operating Activities The first section, cash flows from operating activities, focuses on the sources and uses of cash tied directly to operations. Of course, the most important source of operating cash flow is operating income, so its value for 2015 ($3,747,000) is listed first. However, operating income does not equal cash flow, so various adjustments must be made. The first, and typically most important, adjustment is to add back the noncash expenses that appear on the income statement. As we explained in Chapter 3, as a first approximation, the cash flow of a business can be approximated by adding back depreciation, so Operating cash flow = Operating income + Depreciation = $3,747,000 + $6,405,000 = $10,152,000. Thus, depreciation expense of $6,405,000 is the first adjustment entry.

Note that we have started the section labeled cash flows from operating activities with operating income. An alternative format is to begin the section with net income. This format does not separately identify operating and nonoperating income on the statement of cash flows. Because Sunnyvale does report operating income on the income statement, it makes the most sense to use it as the starting point for this section of the statement of cash flows.

Adjustments are then made for changes in those balance sheet current asset and liability accounts that are directly tied to operations. For Sunnyvale, this means the net patient accounts receivable, inventories, accounts payable, and accrued expenses accounts. The theory for these adjustments is that changes in the values of these accounts stem directly from operations; hence, any cash that is either generated by or used for these accounts should be included as part of cash flow from operations. In addition, using balance sheet data to calculate operating cash flow recognizes that, under accrual accounting, not every dollar of revenues or expenses listed on the income statement represents a dollar of cash flow.

Note that short-term investments and notes payable, although they are current accounts, reflect investment and financing decisions of a business rather than operations, and hence these accounts are not included in the first section of the statement of cash flows. Also, note that the entire statement focuses on the change in cash and equivalents, so that will be the output of the statement rather than one of its entries.

To illustrate the adjustments to operating cash flow, Sunnyvale s net patient accounts receivable increased from $25,927,000 to $28,509,000, or by $2,582,000, during 2015. Because this amount was included in 2015 revenues and hence reported as operating income, but it was added to receivables instead of collected, it is not available as cash flow to Sunnyvale. Thus, it appears as a deduction (negative adjustment) to operating cash flow. To make this point in another way, an increase in an asset account requires that the business use cash, so the $2,582,000 increase in receivables reduces the cash flow available for other purposes. For another illustration, accrued expenses increased by $1,032,000 in 2015. Because an increase in accruals, which is on the right side (liabilities and equity) of the balance sheet, creates financing 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 flow.

When all the adjustments were made, Sunnyvale reported $5,298,000 in net cash from operations for 2015. For a business, whether investor owned or not-for-profit, to be financially sustainable, it must generate a positive cash flow from operations. Thus, at least for 2015 and 2014, Sunnyvale s operations are doing what they should be doing generating cash. However, the clinic s cash flow from operations decreased from 2014 to 2015, so its managers should identify why this happened and then take appropriate action. Unlike Sunnyvale s situation, a consistent negative net cash flow 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 flows is cash flows from investing activities. For purposes of the statement of cash flows, investing activities are defined as both property and equipment (fixed assets) investments and securities investments.

Because depreciation is accounted for in the cash flows from operating activities section, the focus in this section is on the gross (total) investment in fixed assets. As detailed in Sunnyvale s notes to the financial statements and as reported earlier in this chapter, the 2014 to 2015 change in gross property and equipment is calculated as 2015 gross property and equipment . 2014 gross property and equipment = $88,549,000 . $79,243,000 = $9,306,000.

Thus, Sunnyvale spent this amount of cash to acquire additional fixed assets during 2015. This fact should not be alarming, even though the amount was greater than the cash flow from operations, as long as the investments are prudent. (Chapters 14 and 15 contain a great number of insights into what makes a prudent capital investment, at least from a financial perspective.) In addition to investments in fixed assets, Sunnyvale invests in securities and earns nonoperating income. As reported on the income statement, Sunnyvale earned $4,113,000 in total nonoperating income in 2015, which is reported on the second line of the investing section of the cash flow statement.

Finally, the clinic made additional securities investments in 2015. Sunnyvale s short-term investments account on the balance sheet increased by $5,000,000, which means it used this amount of cash to buy short-term securities, hence an outflow was posted in the statement of cash flows. Also from the balance sheet, long-term investments increased by $48,059,000 . $25,837,000 = $22,222,000, so this purchase of long-term securities is shown as an outflow in the cash flows from investing activities section.

When all of the 2015 investing activities are considered, Sunnyvale s resulting net cash flow is an outflow of $32,415,000. Even though it earned $4,113,000 in nonoperating income, it spent $9,306,000 on plant and equipment and further invested a total of $27,222,000 in short- and long-term securities.

Cash Flows from Financing Activities The final major section of the statement of cash flows is cash flows from financing activities, which focuses on Sunnyvale s use of securities to finance its operations and other business activities. The changes in balance sheet accounts from 2014 to 2015 indicate that the clinic took out a new bank loan of $989,000 and hence increased its notes payable by $989,000, which is a source of cash.

Additionally, Sunnyvale took on an additional $85,322,000 . $53,578,000 = $31,744,000 in long-term debt, another source of cash. On net, Sunnyvale generated a $32,733,000 cash inflow from financing activities.

The previous (cash flows from investing activities) section of the statement of cash flows shows that Sunnyvale used $27,222,000, the vast majority of the new debt financing, to purchase securities. In general, new debt would be used to acquire real assets rather than financial assets. However, Sunnyvale is planning to acquire a large group practice in 2016, and the financing activities undertaken in 2015 are in preparation for this purchase.

Net Increase (Decrease) in Cash and Equivalents and Reconciliation The next line of the statement of cash flows 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 $5,298,000 . $32,415,000 + $32,733,000 = $5,616,000 in 2015. Unlike the bottom line of the income statement, the change in cash line has limited value in assessing an organization s financial condition because it can be manipulated by financing activities.

If an organization is losing cash on operations but its managers want to report an increase in the cash and equivalents account, in most cases they simply can borrow the funds necessary to show a net cash increase on the statement of cash flows. Thus, the net cash from operations line is a more important indicator of financial well-being than is the net increase (decrease) in cash line.

The net increase (decrease) in cash line is used to verify the entries on the statement of cash flows. As shown in Exhibit 4.6, the $5,616,000 increase in cash reported by Sunnyvale for 2015 is added to the beginningof- year cash and equivalents balance, $6,486,000, to get an end-of-year total of $12,102,000. A check of the end-of-2015 cash and cash equivalents balance shown in Exhibit 4.1 confirms the amount calculated on the statement of cash flows.

In summary, the income statement focuses on accounting profitability, while the statement of cash flows 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 profitability as defined by GAAP, the statement of cash flows is concerned with cash viability. Is the organization generating, and will it continue to generate, sufficient cash to meet both short-term and long-term needs?

1. How does the statement of cash flows differ from the income statement?

2. Briefly 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?

Balance Sheet Transactions As we discussed in the last chapter, the recording of transactions by the accounting staff is the first step in the creation of a business s financial statements.

Understanding how transactions ultimately affect the financial statements will help managers better understand and interpret their content.

The transactions that flow to the income statement are relatively apparent.

For example, net operating revenues stem directly from the provision of patient services and there is an expectation of receiving payment. Thus, the provision of services that have a reimbursement amount of $1,000 would increase the net patient services revenue account by $1,000. Most expenses are treated in the same way: For example, the obligation to pay wages of $150 to an employee for a day s work would increase the salaries expense line by a like amount.

However, the transactions that flow to the balance sheet are less obvious.

In this section, ten typical balance sheet transactions are presented. Understanding these transactions will help readers understand how an organization s economic events are transformed into financial statement data. The primary concept behind all balance sheet transactions is that the basic accounting equation must be preserved that is, 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 five 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:

SELF-TEST QUESTIONS 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 first piece of equipment purchased costs $200,000 and it is paid for in cash. This transaction results in a change in the composition of the business s assets, but the totals are unaffected:

Cash $ 800,000 Common stock $1,000,000 Net fixed 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 of the expected benefit of using these supplies to provide services. Also, liabilities (accounts payable) are increased by the amount due the supplier:

Cash $ 800,000 Accounts payable $ 20,000 Supplies 20,000 Common stock 1,000,000 Net fixed assets 200,000 Total assets $1,020,000 Total claims $1,020,000 4. Services rendered for credit. Assume that Bayshore provides services that result in $50,000 in billings 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 any dividends are deducted, would ultimately flow through to the balance sheet and hence support the increase in equity:

Cash $ 800,000 Accounts payable $ 20,000 Accounts 50,000 Common stock 1,000,000 receivable Retained earnings 50,000 Supplies 20,000 Net fixed assets 200,000 Total assets $1,070,000 Total claims $1,070,000 Note here that 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; specifically, 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 50,000 Common stock 1,000,000 receivable Retained earnings 40,000 Supplies 20,000 Net fixed assets 200,000 Total assets $1,070,000 Total claims $1,070,000 Here, equity is reduced when expenses are incurred. When pay ment 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 sup plies), because the benefits of the outlay have been immediately realized.

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 Accounts 50,000 Common stock 1,000,000 receivable Retained earnings (10,000) Supplies 20,000 Net fixed assets 200,000 Total assets $1,020,000 Total claims $1,020,000 Note that Bayshore s retained earnings have been driven negative by this transaction. In essence, the equity of the center ($1,020,000 . $30,000 = $990,000) is now worth less than the total capital supplied by the center s physician stockholders.

7. Recognition of supplies used. Assume that $2,000 worth of supplies were used in providing healthcare services to Bayshore s patients. The cost of supplies used is an expense that decreases assets and equity. The expense is also shown on the income statement, and hence net income is reduced by a like amount:

Cash $ 750,000 Accounts payable $ 30,000 Accounts 50,000 Common stock 1,000,000 receivable Retained earnings (12,000) Supplies 18,000 Net fixed assets 200,000 Total assets $1,018,000 Total claims $1,018,000 Note, however, that supplies typically are expended in providing services, so revenue would be created that increases assets and equity.

8. Payment of accounts payable (advertising bill). Assume that the center paid its $10,000 advertising bill, which was due in 30 days.

(The supplies bill is not due for 60 days.) The advertising bill was previously recorded in Transaction 5 as a payable. This payment on an account for an expense already recognized decreases both assets (cash) and liabilities (payables):

Cash $ 740,000 Accounts payable $ 20,000 Accounts 50,000 Common stock 1,000,000 receivable Retained earnings (12,000) Supplies 18,000 Net fixed assets 200,000 Total assets $1,008,000 Total claims $1,008,000 Payment of a liability related to an expense that has previously been incurred does not affect equity.

9. Payment of accounts payable (supplies bill). One month later, assume that Bayshore paid its $20,000 supplies bill, which decreases cash and accounts payable. Recall that the supplies bill was previously recorded in Transaction 3 as an increase in both assets (supplies) and liabilities (accounts payable). Furthermore, part of the supplies were used and recorded in Transaction 7 as a decrease in assets (supplies) and equity:

Cash $720,000 Accounts payable $ Accounts 50,000 Common stock 1,000,000 receivable Retained earnings (12,000) Supplies 18,000 Net fixed assets 200,000 Total assets $988,000 Total claims $ 988,000 A payment of a liability related to an asset that has previously been booked does not affect equity. Equity is not affected until the asset has been consumed.

10. Receipt of cash from a third-party payer. Assume that $5,000 is received in payment for patient services rendered from one of Bayshore s third-party payers. This transaction does not change Bayshore s total assets or, because of the accounting identity, total claims. It does change the total assets composition by reducing receivables and increasing cash:

Cash $725,000 Accounts payable $ 0 Accounts 45,000 Common stock 1,000,000 receivable Retained earnings (12,000) Supplies 18,000 Net fixed assets 200,000 Total assets $988,000 Total claims $ 988,000 A collection for services previously billed and recorded does not affect equity. Revenue was already recorded in Transaction 4 and cannot be recorded again.

Of course, an almost limitless number of transactions occurs in everyday business activities. The purpose of this section was to give readers a sense of how transactions provide the foundation for a business s financial statements.

SELF-TEST 1. What condition must be met when entering transactions on the QUESTIONS balance sheet?

2. What is the effect on a business s equity account of a payment on a bill that has already been booked (recorded as an accounts payable)?

3. What is the effect of the collection of a receivable on a business s equity account?

Debt ratio Another Look Ahead: Using Balance Sheet Data in A debt utilization Financial Statement Analysis ratio that measures the proportion of debt In Chapter 3, readers were provided an introduction to ratio analysis. In this (versus equity) section, we continue the discussion using balance sheet data. The debt ratio financing. Typically (or debt-to-assets ratio) is defined as total debt divided by total assets. Total debt can be defined several ways, depending on the use of the ratio, but for defined as total debt (liabilities) divided by total purposes here, assume that total debt includes all liabilities (i.e., all nonequity assets.

capital). (An alternative would be to include only interest-bearing debt in our definition.) Using Exhibit 4.1 data, Sunnyvale s debt ratio at the end of 2015 was total debt (liabilities) divided by total assets = $100,747,000 $154,815,000 = 0.65 = 65%. This ratio reveals that each dollar of assets was financed by 65 cents of debt and, by inference, 35 cents of equity.

Sunnyvale s debt ratio at the end of 2014 was $68,893,000 $115,101,000 = 0.60 = 60%. Thus, the clinic increased its proportional use of debt financing by 5 percentage points in one year. That information is important to Sunnyvale s managers and creditors. (The consequences of increased debt utilization are discussed throughout this book, but primarily in Chapter 13.) Also, it should be clear that judgments about Sunnyvale s capital structure could not be made easily without constructing the debt ratio and other ratios; interpreting the dollar values directly is just too difficult.

Key Concepts Chapter 3 contains an introduction to financial accounting along with a discussion of the first two financial statements: the income statement and statement of changes in equity. This chapter extends the discussion to cover the balance sheet and statement of cash flows, with emphasis on the interrelationships among the four statements. A demonstration of how economic events (transactions) work their way onto the balance sheet is also presented here. The key concepts of this chapter are as follows:

The balance sheet may be thought of as a snapshot of the financial position of a business at a given point in time.

The accounting identity specifies that assets must equal liabilities plus equity (total assets must equal total claims). When rearranged, the accounting identity reminds us that a business s equity is a residual amount that represents the difference between assets and liabilities.

Assets identify the resources owned by a health services organization in dollars. Assets are listed by maturity (i.e., by order of when the assets are expected to be converted into cash).

Current assets are expected to be converted into cash during the next accounting period.

Liabilities are fixed claims by employees, suppliers, tax authorities, and lenders against a business s assets. Current liabilities those obligations that fall due within one accounting period are listed first. Long-term liabilities (typically debt with maturities greater than one accounting period) are listed second.

Equity is the ownership claim against total assets. Depending on the form of organization and ownership, this claim may be called net assets, stockholders equity, proprietor s net worth, or something else.

There are four important interrelationships between the balance sheet and the income statement. First, the annual depreciation expense shown on the income statement accumulates on the balance sheet in the accumulated depreciation account. Second, revenues recorded on the income statement that have not yet been collected are recorded on the balance sheet as net patient accounts receivable. Third, all earnings from the income statement that are reinvested in the business accumulate on the balance sheet in the equity account. (The statement of changes in equity creates the bridge between income statement earnings and balance sheet equity.) Finally, inventory balances on the balance sheet are reduced by the amount of inventory expense reported on the income statement.

The structure of the liabilities and equity side of the balance sheet (i.e., the proportions of debt and equity financing) defines the organization s capital structure.

Fund accounting is used by organizations that have restricted contributions. Under fund accounting, assets and equity are separated into unrestricted, temporarily restricted, and permanently restricted accounts. Fund accounting complicates internal accounting procedures and adds detail to the balance sheet.

However, fund accounting does not alter the basic format of the balance sheet or its economic interpretation.

The statement of cash flows shows where an organization gets its cash and how it is used. It combines information found on the income statement and the balance sheet.

The statement of cash flows has three major sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

The bottom line of the statement of cash flows is the net increase (decrease) in cash. Although this amount is useful in verifying the accuracy of the statement, its economic content is not as meaningful as the statement s component amounts.

Transactions are the primary underpinning of the measurement and reporting of financial accounting information. Understanding how transactions affect the financial statements leads to a better understanding of the statements themselves.

This temporarily ends the discussion of financial accounting. The next chapter begins our coverage of managerial accounting. However, the concepts presented in chapters 3 and 4 are used repeatedly throughout the remainder of the book. In addition, financial accounting concepts are revisited in Chapter 17, which focuses on using the financial statements to assess financial performance.

Questions 4.1 a. What is the difference between the income statement and balance sheet in regards to timing?

b. What is wrong with this statement: The clinic s cash balance for 2015 was $150,000, while its net income on December 31, 2015, was $50,000. 4.2 a. What is the accounting identity?

b. What is the implication of the accounting identity for the numbers on a balance sheet?

c. What does the accounting identity tell us about a business s equity?

4.3 a. What are assets?

b. What are the three major categories of assets?

4.4 a. What makes an asset a current asset?

b. Provide some examples of current assets.

c. What is net working capital, and what does it measure?

4.5 a. On the balance sheet, what is the difference between long-term investments and property and equipment?

b. What is the difference between gross fixed assets and net fixed assets?

c. How does depreciation expense on the income statement relate to accumulated depreciation on the balance sheet?

4.6 a. What is the difference between liabilities and equity?

b. What makes a liability a current liability?

c. Give some examples of current liabilities.

d. What is the difference between long-term debt and notes payable?

4.7 a. Explain the difference between the equity section of a not-forprofit business and an investor-owned business.

b. What is the relationship between net income on the income statement and the equity section on a balance sheet?

4.8 What is fund accounting, and why is it important to some healthcare providers?

4.9 a. What is the statement of cash flows, and how does it differ from the income statement?

b. What are the three major sections of the statement of cash flows?

c. What is the bottom line of the statement of cash flows, and how important is it?

Problems 4.1 Middleton Clinic had total assets of $500,000 and an equity balance of $350,000 at the end of 2014. One year later, at the end of 2015, the clinic had $575,000 in assets and $380,000 in equity. What was the clinic s dollar growth in assets during 2015, and how was this growth financed?

4.2 San Mateo Healthcare had an equity balance of $1.38 million at the beginning of the year. At the end of the year, its equity balance was $1.98 million.

a. Assume that San Mateo is a not-for-profit organization. What was its net income for the period?

b. Now, assume that San Mateo is an investor-owned business.

Assuming zero dividends, what was San Mateo s net income?

Assuming $200,000 in dividends, what was its net income?

Assuming $200,000 in dividends and $300,000 in additional stock sales, what was San Mateo s net income?

4.3 Here is financial statement information on four not-for-profit clinics:

Pittman Rose Beckman Jaffe December 31, 2014:

Assets $80,000 $100,000 g $150,000 Liabilities 50,000 d $75,000 j Equity a 60,000 45,000 90,000 December 31, 2015:

Assets b 130,000 180,000 k Liabilities 55,000 62,000 h 80,000 Equity 45,000 e 110,000 145,000 During 2015:

Total revenues c 400,000 i 500,000 Total expenses 330,000 f 360,000 l Fill in the missing values labeled a through l.

4.4 The following are selected account balances for Warren Clinic as of December 31, 2015, in alphabetical order. Create Warren Clinic s balance sheet.

Accounts payable $ 20,000 Accounts receivable, net 60,000 Cash 30,000 Equity 230,000 Long-term debt 120,000 Long-term investments 100,000 Net property and equipment 150,000 Other assets 40,000 Other long-term liabilities 10,000 4.5 Consider the following balance sheet:

BestCare HMO Balance Sheet June 30, 2015 (in thousands) Assets Current Assets:

Cash $2,737 Net premiums receivable 821 Supplies 387 Total current assets $3,945 Net property and equipment 5,924 Total assets $9,869 Liabilities and Net Assets Accounts payable medical $2,145 services Accrued expenses 929 Notes payable 382 Total current liabilities $3,456 Long-term debt 4,295 Total liabilities $7,751 Net assets unrestricted (equity) 2,118 Total liabilities and net assets $9,869 a. How does this balance sheet differ from the one presented in Exhibit 4.1 for Sunnyvale?

b. What is BestCare s net working capital for 2015?

c. What is BestCare s debt ratio? How does it compare with Sunnyvale s debt ratio?

4.6 Consider this balance sheet:

Green Valley Nursing Home, Inc.

Balance Sheet December 31, 2015 Assets Current Assets:

Cash $ 105,737 Short-term investments 200,000 Net patient accounts receivable 215,600 Supplies 87,655 Total current assets $ 608,992 Property and equipment $2,250,000 Less accumulated depreciation 356,000 Net property and equipment $1,894,000 Total assets $2,502,992 Liabilities and Shareholders Equity Current Liabilities:

Accounts payable $ 72,250 Accrued expenses 192,900 Notes payable 180,000 Total current liabilities $ 445,150 Long-term debt 1,700,000 Total liabilities $2,145,150 Shareholders Equity:

Common stock, $10 par value $ 100,000 Retained earnings 257,842 Total shareholders equity $ 357,842 Total liabilities and shareholders $2,502,992 equity a. How does this balance sheet differ from the ones presented in Exhibit 4.1 and Problem 4.5?

b. What is Green Valley s net working capital for 2015?

c. What is Green Valley s debt ratio? How does it compare with the debt ratios for Sunnyvale and BestCare?

4.7 Refer to the transactions pertaining to Bayshore Radiology Center presented in this chapter. Restate the impact of the transactions on Bayshore s balance sheet using these data:

a. Transaction 2: The $200,000 equipment purchase is made with long-term borrowings instead of cash.

b. Transaction 3: The $20,000 in supplies are purchased with cash instead of on trade credit.

c. Transaction 4: The $50,000 in services provided are immediately paid for by patients instead of billed to third-party payers.

4.8 Given below are balance sheets as of December 31, 2015, and December 31, 2014, for University Hospital. Using the balance sheets and the additional information provided, complete the income statement of University Hospital for the year ended December 31, 2015.

University Hospital Balance Sheets December 31 Assets Cash Accounts receivable Net property, plant, and equipment Total assets Liabilities Equity Total Liabilities and Equity Additional information:

2015 2014 $ 75,000 32,000 $ 50,00022,00090,000 $197,000 100,000 $172,000 $ 37,000 160,000 $ 30,000 142,000 $197,000 $172,000 University Hospital paid no dividends and there were no other transactions affecting equity during 2015.

There were no collections during 2015 on accounts receivable outstanding at December 31, 2014, but all receivables are considered collectible.

There was no charity care or contractual discounts and allowances during 2015.

University Hospital purchases all medical supplies on account.

University Hospital did not purchase or sell any property, plant, and equipment during 2015.

University Hospital Income Statement Year Ended December 31, 2015 Net patient service revenue ?

Total revenue ?

Supplies expense ?

Depreciation expense ?

Total expenses ?

Net income ?

4.9 Oak Street Clinic, a not-for-profit, began 2015 with the following account balances on January 1:

Cash $ 70,000 Accounts receivable 245,000 Allowance for doubtful accounts 18,000 Supplies inventory 24,000 Equipment 1,500,000 Accumulated depreciation 300,000 Accounts payable 21,000 Notes payable 500,000 Net assets 1,000,000 During 2015, the accounting clerk recorded the following transactions:

1. Billed patients for services rendered $1,700,000 2. Purchased medical supplies on 12,000 credit 3. Employee salaries earned 712,000 4. Employee salaries paid 683,000 5. Annual depreciation on equipment 150,000 6. Received a bank loan 250,000 7. Cash collections on patient billings 1,124,000 8. Estimated bad debts for year 44,000 9. Made payment on bank loan 75,000 10. Used medical supplies in patient care 10,000 Oak Street Clinic s year-end is December 31. Construct the 2015 balance sheet and income statement for the clinic, using the beginning account balances and incorporating the effects of each transaction.

Resources American Institute of Certified Public Accountants (AICPA). 2014. Audit and Accounting Guide for Healthcare Entities. New York: AICPA.

Doody, D. 2007. Fair Valuation of Alternatives: Clearing the Audit Hurdle. Healthcare Financial Management (September): 158 62.

. 2006. The Balance Sheet: A Snapshot of Your Financial Health. Healthcare Financial Management (May): 124 25.

Song, P. H., and K. L. Reiter. 2010. Trends in Asset Structure Between Not-for- Profit and Investor-Owned Hospitals. Medical Care Research and Review (August): 694 706.

Waldron, D. J. 2005. Technology Strategy and the Balance Sheet: 3 Points to Consider. Healthcare Financial Management (May): 70 76.

III MANAGERIAL ACCOUNTING Thus far, the book has concentrated on the healthcare finance environment and the basics of financial accounting. Part III focuses on managerial accounting, which is concerned with the development and use of information designed to help health services managers perform management and control functions within their organizations. In addition to an introduction to managerial accounting, the first chapter of Part III covers cost estimation at the organizational level and profit (cost-volume-profit) analysis topics that many consider the cornerstones of managerial accounting. Later chapters focus on costing at the department and service levels, pricing, and financial planning and budgeting.

After studying the four chapters that compose Part III, readers will have a good appreciation for the mechanics of managerial accounting and its value to health services managers.

ORGANIZATIONAL COSTING AND PROFIT 5 ANALYSIS Learning Objectives After studying this chapter, readers will be able to Explain the differences between financial and managerial accounting.

Describe how costs are classified according to their relationship with volume.

Conduct profit (cost-volume-profit) analyses to analyze the impact of changing assumptions on both profitability and breakeven points.

Explain the primary differences between profit analyses of fee-forservice reimbursement and capitation.

Introduction Managers of healthcare businesses have many responsibilities. Some of the more important ones are planning and budgeting, establishing policies that control the operations of the organization, and overseeing the day-to-day activities of subordinates. All of these activities require information a great deal of information. This information has to be presented in a format that facilitates analysis, interpretation, and decision making. This is where managerial accounting steps to the fore. Without a timely and effective managerial accounting system, healthcare managers would be left to wander in the dark rather than make decisions on the basis of good information. Of course, accurate information does not ensure good decision making, but without it the chances of making good decisions are almost nil.

The Basics of Managerial Accounting Whereas financial accounting focuses on organizational-level data for presentation in a business s financial statements, managerial accounting focuses on data at all levels within an organization including the entire business, Managerial (management) accounting The field of accounting that focuses on all levels within an organization and is used internally for managerial decision making.

departments, individual services, and even individual patients. Furthermore, managerial accounting data are used internally for managerial decision making such as for routine budgeting processes, allocation of managerial bonuses, and pricing decisions. Also, managerial accounting data can be compiled for special projects such as assessing alternative modes of delivery or projecting the profitability of a proposed third-party payer contract.

In short, the focus of managerial accounting is to develop information to meet the needs of managers at all levels within the organization, rather than interested parties (mainly investors) outside the organization. Thus, while financial accounting information is driven primarily by the needs of outsiders, managerial accounting information is driven by the needs of managers. Note that the term management accounting is sometimes used in place of managerial accounting. Although some accountants differentiate between managerial and management accounting, the differences are small and beyond the scope of this book. Thus, for purposes here, managerial accounting and management accounting are the same.

Managers are more concerned with what will happen in the future than with what has happened in the past. Thus, unlike financial accounting, managerial accounting is, for the most part, forward-looking. Because the past is known, while most of the future is unknown, managerial accounting information tends to be much less certain than financial accounting data. As managers embark on budgeting and pricing decisions, they often must make many assumptions regarding factors such as utilization (volume), reimbursement rates, and costs. This requirement for assumptions about the future, combined with the fact that there are no generally agreed-upon rules for developing managerial accounting data, makes those data much more flexible and uncertain than financial accounting data.

In general, financial accounting can be thought of as reporting work, while managerial accounting is best described as decision work. We do not mean to imply that there is little value in financial accounting data. Indeed, as you will see in Chapter 17, financial statements are essential to understanding a business s overall financial condition. Still, the managerial decisions made on a daily basis that create this condition are influenced much more by managerial accounting data, which focus on individual activities within the business, than by financial accounting data, which focus on the entire organization.

A critical part of managerial accounting is the measurement of costs.

In fact, the concept of costs is so important that it has spawned its own field of accounting cost accounting. Cost accounting generally is considered to be a subset of managerial accounting, although cost accounting systems also are used to develop the expense data reported on a business s income statement.

Therefore, cost accounting bridges managerial and financial accounting.

Unfortunately, there is no single definition of the term cost. Rather, there are different costs for different purposes. As a general rule for healthcare providers, a cost involves a resource use associated with providing or supporting a specific service. However, the cost per service identified for pricing purposes can differ from the cost per service used for management control purposes. Also, the cost per service used for long-range planning purposes may differ from the cost per service defined for short-term purposes. Finally, as we discussed in chapters 3 and 4, costs do not necessarily reflect actual cash outflows.

1. What are the primary differences between financial and managerial accounting?

2. What is meant by the term cost?

Fixed Versus Variable Costs We can classify costs in many different ways depending on the situation and managerial information needs. Let s begin by identifying two types of costs on the basis of their relationship to the amount of services provided, often referred to as activity, utilization, or volume. Such cost classifications require the specification of a likely range of volumes. In dealing with the future, there is always volume uncertainty the number of patient days, number of visits, number of enrollees, number of laboratory tests, and so on. However, healthcare managers often have some idea of the potential range of volume over some future time period. For example, the business manager of Northside Clinic, an urgent care clinic open seven days a week, might estimate that the number of visits next year could range from 12,000 to 14,000 (about 34 to 40 per day). If there is little likelihood that annual utilization will fall outside of these bounds, then the range of 12,000 to 14,000 visits defines the clinic s relevant range. Note that the relevant range pertains to a particular time period in this case, next year. For other time periods, the relevant range might differ from its estimate for the coming year.

Fixed Costs Some costs, called fixed costs, are more or less known with certainty, regardless of the level of volume within the relevant range. For example, Northside Clinic has a labor force of well-trained permanent employees who are capable of handling up to 14,000 patient visits. This force would be increased or decreased only under unusual circumstances. Thus, as long as volume falls within the relevant range of 12,000 to 14,000 visits, labor costs at the clinic are fixed for the coming year, regardless of the number of patient visits.

Other examples of fixed costs include expenditures on facilities, diagnostic equipment, information systems, and the like. After an organization has SELF-TEST QUESTIONS Relevant range The range of volume expected over some planning period.

Alternatively, the range over which fixed costs remain constant if volume falls outside the relevant range, the fixed cost estimate may be invalid.

Fixed cost A cost that is not related to the volume of services delivered, for example, facilities costs (within some relevant range).

Variable cost A cost that is directly related to the volume of services delivered.

For example, the cost of clinical supplies.

SELF-TEST QUESTIONS Underlying cost structure The relationship between an organization s fixed costs, variable costs, and total costs. Also just called cost structure.

acquired these assets, it typically is locked into them for some time, regardless of volume. Of course, no costs are fixed over the long run. At some point of increasing volume, healthcare businesses must incur additional fixed costs for new facilities and equipment, additional staffing, and so on. Likewise, if volume decreases by a substantial amount, an organization likely would reduce fixed costs by shedding part of its facilities and equipment and reducing its labor force.

Variable Costs Whereas some costs are fixed regardless of volume (within the relevant range), other resources are more or less consumed as volume dictates. Costs that are directly related to volume are called variable costs. For example, the costs of the clinical supplies (e.g., rubber gloves, tongue depressors, hypodermics) used by the clinic would be classified as variable costs. Also, some of the diagnostic equipment used in the clinic may be leased on a per procedure basis, which converts the cost of the equipment from a fixed cost to a variable cost. Finally, some health services organizations pay their employees on the basis of the amount of work performed, which converts labor costs from fixed to variable.

The main idea here is that some costs are more or less predictable because they are independent of volume, while other costs are much less predictable because they are related to volume.

In closing our discussion of variable costs, note that variable costs per unit of volume typically are considered to be independent of the relevant range, but they can vary over time. An example is when the costs of supplies increase due to inflation. Also, note that there are other cost classifications by volume in addition to fixed and variable. These include semi-fixed costs, which we discuss in the supplement to this chapter.

1. Define relevant range.

2. Explain the features and provide examples of fixed and variable costs.

3. How does time period affect the estimation of fixed and variable costs?

Underlying Cost Structure Health services managers are vitally interested in how costs are affected by changes in volume. The relationship between an organization s total costs and volume, called underlying cost structure, is used by managers in planning, controlling, and decision making. The primary reason for defining an organization s underlying cost structure is to provide healthcare managers with a tool for forecasting costs (and ultimately profits) at different volume levels.

To illustrate the concept of cost structure, consider the hypothetical cost data presented in Exhibit 5.1 for a hospital s clinical laboratory. The cost structure consists of both fixed and variable costs that is, some of the costs are expected to be volume sensitive and some are not. This structure of both fixed and variable costs is typical in healthcare organizations as well as most other businesses. To begin our discussion of cost structure, we unrealistically assume that the relevant range is from zero to 20,000 tests. In effect, we are assuming that the laboratory s cost structure holds (stays constant) for volumes of zero to 20,000 tests. (We are purposely using unrealistic volume and cost assumptions for ease of illustration.) As noted in Exhibit 5.1, the laboratory has $150,000 in fixed costs that consist primarily of labor, facilities, and equipment costs. These costs will occur even if the laboratory does not perform one test, assuming it is kept Variable cost rate open. In addition to the fixed costs, each test, on average, requires $10 in The variable cost laboratory supplies such as glass slides and reagents. The per unit (per test in of one unit of this example) variable cost of $10 is defined as the variable cost rate. If labo-output (volume).

ratory volume doubles for example, from 500 to 1,000 tests total variable costs double from $5,000 to $10,000. However, the variable cost rate of $10 EXHIBIT 5.1 Variable Costs per Test Fixed Costs per Year Cost Structure Illustration:

Laboratory supplies $10 Labor $100,000 Fixed and Other fixed costs 50,000 Variable Costs $150,000 Total Fixed Variable Total Average Volume Costs Costs Costs Cost per Test 0 $150,000 $ 0 $150,000 1 150,000 10 150,010 $150,010.00 50 150,000 500 150,500 3,010.00 100 150,000 1,000 151,000 1,510.00 500 150,000 5,000 155,000 310.00 1,000 150,000 10,000 160,000 160.00 5,000 150,000 50,000 200,000 40.00 10,000 150,000 100,000 250,000 25.00 15,000 150,000 150,000 300,000 20.00 20,000 150,000 200,000 350,000 17.50 per test remains the same whether the test is the first, the hundredth, or the thousandth. Total variable costs, therefore, increase or decrease proportionately as volume changes, but the variable cost rate remains constant as long as volume remains within the relevant range.

Fixed costs, in contrast to total variable costs, remain unchanged as the volume varies. When volume doubles from 500 to 1,000 tests, fixed costs remain at $150,000. Indeed, fixed costs are $150,000 for all volumes within the relevant range.

Because all costs in this example are either fixed or variable, total costs are merely the sum of the two. For example, at 5,000 tests, total costs are Fixed costs + Total variable costs = $150,000 + (5,000 . $10) = $150,000 + $50,000 = $200,000. Because total variable costs are tied to volume, total variable costs and hence total costs increase as the volume increases, even though fixed costs remain constant.

The rightmost column in Exhibit 5.1 contains average cost per unit of volume, which in this example is average cost per test. It is calculated by dividing total costs by volume. For example, at 5,000 tests, with total costs of $200,000, the average cost per test is $200,000 5,000 = $40. Because fixed costs, which by definition are constant, are spread over more tests as volume increases, the average cost per test declines as volume increases. For example, when volume doubles from 5,000 to 10,000 tests, fixed costs remain at $150,000, but the fixed cost per test declines from $150,000 5,000 = $30 to $150,000 10,000 = $15. With fixed cost per test declining from $30 to $15, the average cost per test declines from $30 + $10 = $40 to $15 + $10 = $25. The fact that higher volume reduces average fixed cost and average cost per unit of volume has important implications regarding the effect of volume changes on profitability. This point is made clear in a later section.

The cost structure presented in Exhibit 5.1 in tabular format is presented in graphical format in Exhibit 5.2. Here, costs are shown on the vertical (y) axis, and volume (number of tests) is shown on the horizontal (x) axis. Because fixed costs are independent of volume, they are shown as a horizontal dashed line at $150,000. Total variable costs appear as an upward-sloping dotted line that starts at the origin (0 tests, $0 costs) and rises at a rate of $10 for each additional test. Thus, the slope of the total variable costs line is the variable cost rate. When fixed and total variable costs are combined to obtain total costs, the result is the upward-sloping solid line parallel to the total variable costs line but beginning at the y-axis at a value of $150,000 (the fixed costs amount).

In effect, the total costs line is nothing more than the total variable costs line shifted upward by the amount of fixed costs.

Note that Exhibit 5.2 is not drawn to scale. Furthermore, the relevant range is unrealistically large. The intent here is to emphasize the general shape of a cost structure graph and not its exact position. Also, note that total EXHIBIT 5.2 Costs Cost Structure ($) Graph Total Costs 150,000 0 Fixed Costs Total Variable Costs Volume (Number of Tests) variable costs plot as a straight line (are linear) because the variable cost rate is assumed to be constant over the relevant range. Although a curved total variable costs line can occur in some situations, we assume throughout the book that the variable cost rate is constant, and hence total variable costs are linear, at least within the relevant range. Such an assumption is not unreasonable for most health services organizations in most situations.

1. What is meant by underlying cost structure?

2. Construct a simple table like the one in Exhibit 5.1, and discuss its elements.

3. Sketch and explain a simple diagram similar to Exhibit 5.2 to match your table.

Profit Analysis Profit analysis is an analytical technique primarily used to analyze the effects of volume changes on profit. However, the same procedures can be used to assess the effects of volume changes on costs, so this type of analysis is SELF-TEST QUESTIONS Profit analysis A technique applied to an organization s cost and revenue structure that analyzes the effect of volume changes on costs and profits. Also called CVP (cost-volumeprofit) analysis.

often called cost-volume-profit (CVP) analysis. CVP analysis allows managers to examine the effects of alternative assumptions regarding costs, volume, and prices. Clearly, such information is useful as managers evaluate future courses of action regarding pricing and the introduction of new services.

Basic Data Exhibit 5.3 presents the estimated annual costs for Atlanta Clinic, a subsidiary of Atlanta Health Services, for 2016. These costs are based on the clinic s most likely (best guess) estimate of volume 75,000 visits. The most likely estimate often is called the base case, so the data in Exhibit 5.3 represent the clinic s base case cost forecast. Expected total costs for 2016 are $7,080,962.

Because these costs support 75,000 visits, the forecasted average cost per visit is $7,080,962 75,000 = $94.41.

Focusing solely on total costs does not provide the clinic s managers with much information regarding potential alternative financial outcomes for 2016. In essence, a single (total cost) amount suggests that the clinic s costs will remain constant regardless of the number of patient visits. Similarly, the base case average cost per visit amount of $94.41 implicitly treats all costs as variable costs, suggesting that the cost per visit would be $94.41 regardless of volume. Total cost information is necessary and useful, but the detailed breakdown of costs given in Exhibit 5.3 gives the clinic s managers more insight into prospective financial outcomes for 2016 than is possible with only total cost information.

Exhibit 5.3 categorizes the clinic s total costs of $7,080,962 into two components: total variable costs of $2,113,500 and total fixed costs of $4,967,462. These cost amounts are fundamentally different, in both quantitative and qualitative terms. The total fixed costs of $4,967,462 are expected EXHIBIT 5.3 Atlanta Clinic:

Forecasted Cost Data for 2016 (based on 75,000 patient visits) Variable Costs Fixed Costs Total Costs Salaries and Benefits:

Management and supervision Coordinators Specialists Technicians Clerical/administrative Social security taxes Group health insurance Professional fees Supplies Utilities Allocated costs Total $ 0 442,617 0 681,383 71,182 89,622 115,924 325,489 313,283 74,000 0 $2,113,500 $ 928,687 $ 928,687 598,063 1,040,680 38,600 38,600 552,670 1,234,053 58,240 129,422 163,188 252,810 211,081 327,005 383,360 708,849 231,184 544,467 45,040 119,040 1,757,349 1,757,349 $4,967,462 $7,080,962 to be borne by the clinic regardless of the actual volume in 2016. However, total variable costs of $2,113,500 apply only to a volume of 75,000 patient visits. If the actual number of visits realized in 2016 is less than or greater than 75,000, total variable costs will be, respectively, less than or greater than $2,133,500. (Of course, this is the primary reason that costs are classified as fixed and variable in the first place.) The best way to highlight that total variable costs vary with volume is to express variable costs on a per unit (variable cost rate) basis. For Atlanta Clinic, the implied variable cost rate is $2,113,500 75,000 visits = $28.18 per visit. Thus, the clinic s total costs at any volume within the relevant range can be calculated as follows:

Total costs = Fixed costs + Total variable costs = $4,967,462 + ($28.18 . Number of visits).

Key Equation: Underlying Cost Structure The underlying cost structure of a healthcare entity defines the relationship between volume and costs. To illustrate, assume a clinical laboratory has fixed costs of $500,000 and a variable cost rate of $20. The underlying cost structure of the laboratory can be written as follows:

Total costs = Fixed costs + Total variable costs = $500,000 + ($20 . Volume).

Thus, at a volume of 20,000 tests, total costs equal $900,000:

Total costs = $500,000 + ($20 . 20,000) = $500,000 + $400,000 = $900,000.

This equation, Atlanta s underlying cost structure, explicitly shows that total costs depend on volume. To illustrate use of the cost structure model, consider three potential volumes for 2016: 70,000, 75,000, and 80,000 patient visits:

Volume = 70,000:

Total costs = $4,967,462 + ($28.18 . 70,000) = $4,967,462 + $1,972,600 = $6,940,062 Volume = 75,000:

Total costs = $4,967,462 + ($28.18 . 75,000) = $4,967,462 + $2,113,500 = $7,080,962 Volume = 80,000:

Total costs = $4,967,462 + ($28.18 . 80,000) = $4,967,462 + $2,254,400 = $7,221,862 When an organization s costs are expressed in this way, it is easy to see that higher volume leads to higher total costs.

Atlanta Clinic s underlying cost structure is plotted in Exhibit 5.4. (To simplify the graph, we assume that the relevant range extends to zero visits.) As first illustrated in Exhibit 5.2, fixed costs are shown as a horizontal dashed line and total costs are shown as an upward-sloping solid line with a slope (rise over run) equal to the variable cost rate $28.18 per visit. Unlike Exhibit 5.2, the graphical presentation in Exhibit 5.4 has been simplified by not showing total variable costs as a separate line starting at the origin. Of course, total variable costs are represented in Exhibit 5.4 by the vertical distance between the total costs line and the fixed costs line.

Note that Atlanta Clinic does not literally write out a check for $28.18 for each visit, although there may be examples of variable costs in which this is the case. Rather, Atlanta s cost structure indicates that the clinic uses certain resources that its managers have defined as inherently variable, and the best estimate of the value of such resources is $28.18 per visit.

EXHIBIT 5.4 Atlanta Clinic: Revenues and Costs CVP Graphical Total ($) Model Profit Loss Total Costs Fixed Costs Revenues 0 69,165 75,000 Volume (Number of Visits) 4,967,462 The cost structure data in Exhibit 5.3 could be estimated in several ways. One way would be to use time motion studies and interviews with clinic personnel. However, instead of such an intrusive approach, cost accountants could plot the total costs of the clinic at different volume levels for the past several years and then run a regression on these data. In this case, the beta term (slope) of the regression would be the variable cost rate $28.18 and the alpha term (intercept) would be fixed costs $4,967,462.

To complete the profit (CVP) model, a revenue component must be added. For 2016, Atlanta Clinic expects revenues, on average, to be $100 per patient visit. Total revenues are plotted on Exhibit 5.4 as an upward-sloping solid line starting at the origin and having a slope of $100 per visit. If there were no visits, total revenues would be zero; at one visit, total revenues would be $100; at ten visits, total revenues would be $1,000; at 75,000 visits, total revenues would be $7,500,000; and so on. Note that the vertical dashed line is drawn at the point where total revenues equal total costs, and the vertical dotted line is drawn at the base case volume estimate 75,000 visits. We examine the significance of these lines in later sections.

Before we close our discussion of Atlanta s cost structure, it is important to reemphasize the fact that this cost structure (primarily the fixed cost estimate) is valid only within the relevant range. After some analysis, the clinic s accountants conclude that the relevant range is from 65,000 to 85,000 visits.

The Projected P&L Statement One of the first steps that Atlanta Clinic s managers could take in terms of the profit analysis is to construct a statement that shows the forecasted profit for 2016, given the most likely assumptions. Such a forecast is called the base case profit and loss (P&L) statement. The term profit and loss distinguishes this statement from Atlanta Clinic s audited income statement. There are two primary differences between a P&L statement and an income statement. First, P&L statements, as with all managerial accounting data, can be developed to best serve decision-making purposes within the organization, as opposed to following generally accepted accounting principles (GAAP). Second, P&L statements can be created for any subunit within an organization, whereas income statements normally are created only for the overall organization and major subsidiaries.

Atlanta Clinic s 2016 base case projected P&L statement is shown in Exhibit 5.5. The bottom line, designated by a double underline, shows Atlanta s 2016 profit forecast using base case values for costs, volume, and prices (reimbursement rates). Note that the format of a P&L statement used for profit analysis purposes distinguishes between variable and fixed costs, whereas a typical income statement (or a P&L statement used for another purpose) does not make this distinction. Also, note that the projected P&L Profit and loss (P&L) statement A statement that summarizes the revenues, expenses, and profitability of either the entire organization or a subunit of it. Can be formatted in different ways for different purposes and does not conform to GAAP.

statement contains a line labeled total contribution margin. This important concept is discussed in the next section.

The projected P&L statement used in profit analysis contains four variables three of the variables are assumed and the fourth is calculated. In Exhibit 5.5, the assumed variables are expected volume (75,000 visits), expected price ($100 per visit reimbursement), and expected costs (delineated in terms of the clinic s underlying cost structure).

Profit, the fourth variable, is calculated on the basis of the values assumed for the other three variables.

The base case forecasted P&L state ment shown in Exhibit 5.5 represents only one point on the graphical model of Exhibit 5.4. This point is shown by the dotted vertical line at a volume of 75,000 patient visits.

Moving up along this dotted line, the distance from the x-axis to the horizontal fixed costs line represents the $4,967,462 in fixed costs. The distance from the fixed costs line to the total costs line represents the $2,113,500 in total variable costs. The distance between the total costs line and the total revenues line represents the $419,038 in profit. As in previous graphs, Exhibit 5.4 is not drawn to scale because it will not be used to develop numerical data. Rather, it provides the clinic s managers with a pictorial representation of Atlanta s projected financial future.

Contribution margin The difference Contribution Margin between per unit The base case forecasted P&L statement in Exhibit 5.5 introduces the concept revenue and per of contribution margin, which is defined as the difference between per unit unit cost (variable revenue and per unit variable cost (the variable cost rate). In this illustration, cost rate) and hence the amount the contribution margin is Per visit revenue . Variable cost rate = $100.00 .

that each unit of $28.18 = $71.82. What is the inherent meaning of this contribution margin volume contributes value of $71.82? The contribution margin has the look and feel of profit to cover fixed costs because it is calculated as revenue minus cost. However, none of the fixed and ultimately flows to profit. costs of providing service have been included in the cost amount used in the For Your Consideration Underlying Cost Structure and Relevant Range In general, an organization s underlying cost structure is defined for a specified relevant range.

For example, Atlanta Clinic s underlying cost structure is given as follows:

Total costs = Fixed costs + Total variable costs = $4,967,462 + ($28.18 . Number of visits), and the relevant range for this structure is 65,000 to 85,000 visits.

Now, assume that a new payer makes a proposal to the clinic that would increase next year s volume by 15,000 visits, which would increase the expected number of visits to 90,000. The financial staff presents you, the CEO, with an analysis of the proposal that uses the above cost structure. For example, total costs were calculated as follows:

Total costs = $4,967,462 + ($28.18 . 90,000) = $4,967,462 + $2,536,200 = $7,503,662.

What is your initial reaction to the analysis?

Is it valid, or must it be redone? What variable in the total costs calculation is most likely to change?

Total revenues ($100 . 75,000) $7,500,000 Total variable costs ($28.18 . 75,000) 2,113,500 Total contribution margin ($71.82 . 75,000) $5,386,500 Fixed costs 4,967,462 Profit $ 419,038 calculation, so it is not profit. Because variable costs have been subtracted from revenues rather than total costs, the contribution margin is the dollar amount per visit available to cover Atlanta Clinic s fixed costs. Only after fixed costs are fully covered does the contribution margin begin to contribute to profit.

With a contribution margin of $71.82 on each of the clinic s 75,000 visits, the projected base case total contribution margin for 2016 is $71.82 .

75,000 = $5,386,500, which is sufficient to cover the clinic s fixed costs of $4,967,462 and then provide a $5,386,500 . $4,967,462 = $419,038 profit.

After fixed costs have been covered, any additional visits contribute to the clinic s profit at a rate of $71.82 per visit. The contribution margin concept is used again and again as our discussion of profit analysis continues.

1. Construct a simple P&L statement like the one in Exhibit 5.5, and discuss its elements.

2. Sketch and explain a simple diagram to match your table.

3. Define and explain the contribution margin.

Breakeven Analysis In healthcare finance, breakeven analysis is applied in many different situations, so it is necessary to understand the context to fully understand the meaning of the term breakeven. Generically, breakeven analyses are used to determine a breakeven point, which is the value of a given input variable that produces some minimum desired result. For now, we will use breakeven analysis to determine the volume, called the breakeven volume, at which a business becomes financially self-sufficient. Although the breakeven analysis discussed here is actually part of profit (CVP) analysis, the concept is so important that it deserves separate consideration. Also, note that breakeven volume can be applied not only to entire businesses but also to subunits within businesses such as departments and individual services.

Volume breakeven can be defined in two different ways. Accounting breakeven is defined as the volume needed to produce zero profit. In other words, it is the volume that produces revenues equal to accounting costs.

EXHIBIT 5.5 Atlanta Clinic: 2016 Base Case Forecasted P&L Statement (based on 75,000 patient visits) SELF-TEST QUESTIONS Breakeven analysis A type of analysis that estimates the amount of some variable (such as volume or price or variable cost rate) needed to break even.

Accounting breakeven Accounting breakeven occurs when revenues are sufficient to cover all accounting costs; in other words, zero profitability.

Economic breakeven Economic breakeven occurs when revenues are sufficient to cover all accounting costs plus provide a specified profit level.

Alternatively, economic breakeven is defined as the volume needed to produce a specified profit level, that is, the volume that creates revenues equal to accounting costs plus some desired profit amount.

As mentioned in the previous section, the P&L statement format used here is a four-variable model. When the focus is profit, the three assumed variables are costs, volume, and price (reimbursement amount), while profit is calculated. When the focus is volume breakeven, the same four variables are used, but profit is now assumed to be known while volume is the unknown (calculated) value. However, it is also possible to assume a value for profit, volume, and price (or costs) and then calculate the breakeven value for costs (or price). To illustrate volume breakeven, the projected P&L statement presented in Exhibit 5.5 can be expressed algebraically as the following equation:

Total revenues . Total variable costs . Fixed costs = Profit ($100 . Volume) . ($28.18 . Volume) . $4,967,462 = Profit.

Here, we have merely taken the P&L statement, which is presented vertically, and transformed it into an equation, which is presented horizontally and which treats volume as an unknown quantity. By definition, at accounting breakeven the clinic s profit equals zero, so the equation can be rewritten with zero in place of the profit amount:

($100 . Volume) . ($28.18 . Volume) . $4,967,462 = $0.

Rearranging the terms so that only the terms related to volume appear on the left side produces this equation:

($100 . Volume) . ($28.18 . Volume) = $4,967,462.

Using basic algebra, the two terms on the left side can be combined because volume appears in both. The end result is this:

($100 . $28.18) . Volume = $4,967,462 $71.82 . Volume = $4,967,462.

Key Equation: Volume Breakeven Suppose a clinical laboratory has fixed costs of $500,000, a variable cost rate of $20, and average per test revenue of $50. Volume breakeven is obtained by solving the following equation for volume:

Total revenues . Total variable costs . Fixed costs = Profit ($50 . Volume) . ($20 . Volume) . $500,000 = Profit.

For accounting breakeven, profit is zero, so the equation becomes:

($50 . Volume) . ($20 . Volume) = $500,000.

And solving for volume gives the breakeven amount:

($30 . Volume) = $500,000 Volume = 16,667 tests.

Note that $30 is the contribution margin, so the equation for breakeven volume can be simplified as follows:

(Contribution margin . Volume) = $500,000 ($30 . Volume) = $500,000 Volume = 16,667 tests.

For economic breakeven, insert the desired profit amount on the right side of the equation in place of $0.

The left side of the breakeven equation now contains the contribution margin, $71.82, multiplied by volume. Here, the previous conclusion that the clinic will break even when the total contribution margin equals fixed costs is reaffirmed. Solving the equation for volume results in a breakeven point of $4,967,462 $71.82 = 69,165 visits. Any volume greater than 69,165 visits produces a profit for the clinic, while any volume less than 69,165 results in a loss.

The logic behind the breakeven point is this: Each patient visit brings in $100, of which $28.18 is the variable cost to treat the patient. This leaves a $71.82 contribution margin from each visit. If the clinic sets the contribution margin aside for the first 69,165 visits in 2016, it would have $4,967,430, which is enough (except for a small rounding difference) to cover its fixed costs. Once the clinic exceeds breakeven volume, each visit s contribution margin flows directly to profit. If the clinic achieves its volume estimate of 75,000 visits, the 5,835 visits above the breakeven point result in a total profit of 5,835 . $71.82 = $419,070, which matches the profit (again except for a rounding difference) shown on the clinic s base case forecasted P&L statement in Exhibit 5.5.

We can use the graph in Exhibit 5.4 to help visualize the breakeven concept. At accounting breakeven the profit is zero, so total revenues must equal total costs. In Exhibit 5.4, this condition holds at the intersection of the total revenues line and the total costs line. This point is indicated by a vertical dashed line drawn at a volume of 69,165 visits. The logic of the breakeven point shown in Exhibit 5.4 goes back to the nature of the clinic s fixed and variable cost structure. Before even one patient walks in the door, the clinic has already committed to $4,967,462 in fixed costs. Because the total revenues line is steeper than the total variable costs line, and hence the total costs line, as volume increases, total revenues eventually catch up to the clinic s total costs. Any utilization to the right of the breakeven point, which is shown as a dark-shaded area, produces a profit; any utilization to the left, which is shown as a light-shaded area, results in a loss.

The relationship between breakeven analysis and the forecasted P&L statement is important to understand. Based on the clinic s base case projection of 75,000 visits, it can anticipate a profit of $419,038. However, management may worry that the clinic will not achieve this projected volume and ask the following question: What is the minimum number of visits needed to at least break even? The answer is 69,165 visits.

To verify the breakeven point calculation, Exhibit 5.6 contains the forecasted P&L statement for 69,165 visits. Except for a small rounding difference, the profit at the accounting breakeven point is $0. (The breakeven point is actually 69,165.4 visits.) As mentioned previously, at breakeven the total contribution margin just covers fixed costs, resulting in zero profit.

This breakeven analysis contains important assumptions. The first assumption is that the price or set of prices for different types of patients and different payers is independent of volume. In other words, volume increases are not attained by lowering prices, and price increases are not met with volume declines. The second assumption is that costs can be reasonably subdivided into fixed and variable components. The third assumption is that both fixed costs and the variable cost rate are independent of volume over the relevant range, so both the total costs line and the total revenues line are linear.

Breakeven analysis is often performed in an iterative manner. After the breakeven volume is calculated, managers must determine whether the resulting volume can realistically be achieved at the price assumed in the analysis. If the price appears to be unreasonable for the breakeven volume, a new price has to be estimated and the breakeven analysis repeated. Likewise, if the cost structure used for the calculation appears to be unrealistic at the breakeven volume, operational assumptions and hence cost assumptions should be changed and the analysis repeated.

EXHIBIT 5.6 Atlanta Total revenues ($100 . 69,165) $6,916,500 Clinic: 2016 Projected P&L Statement (based on Total variable costs ($28.18 . 69,165) Total contribution margin Fixed costs Profit 1,949,070$4,967,430 4,967,462 ($ 32) 69,165 patient visits) Instead of seeking the number of visits needed for accounting break- even, Atlanta s managers may ask for the number of visits needed to achieve a $100,000 profit or, for that matter, any other profit level. By building a profit target into the breakeven analysis, the focus is now on economic breakeven. The clinic will have a $419,038 profit if it has 75,000 visits, and it will have no profit if it has 69,165 visits. Thus, the number of visits required to achieve a $100,000 profit target (economic breakeven) is somewhere between 69,165 and 75,000. In fact, the number of visits required is 70,558:

Total revenues . Total variable costs . Fixed costs = Profit ($100 . Volume) . ($28.18 . Volume) . $4,967,462 = $100,000 ($71.82 . Volume) . $4,967,462 = $100,000 $71.82 . Volume = $5,067,462 Volume = 70,558.

Note that we could calculate the economic breakeven of 70,558 using the contribution margin concept. With a contribution margin of $71.82, it takes $100,000 $71.82 = 1,392 visits to generate an additional $100,000 in profit contribution when all accounting costs are covered. Thus, economic breakeven occurs at a volume of Accounting breakeven + 1,392 = 69,165 + 1,392 = 70,557 visits. This is the same economic breakeven point (except for a rounding difference) that we calculated using the equation format above.

SELF-TEST 1. What is the purpose of breakeven analysis? QUESTIONS 2. What is the equation for volume breakeven?

3. Why is breakeven analysis often conducted in an iterative manner?

4. What is the difference between accounting and economic breakeven?

Profit Analysis in a Discounted Fee-for-Service Environment As noted in the previous discussion, profit analysis is valuable to healthcare managers in that it provides information about expected costs and profitability under alternative estimates of volume (or costs or prices). To learn more about its usefulness, suppose that one-third (25,000) of Atlanta Clinic s expected 75,000 visits come from Peachtree HMO, which has proposed that its new contract with the clinic contain a 40 percent discount from charges. Thus, the net price for its patients would be $60 instead of the undiscounted $100.

If the clinic refuses, Peachtree has threatened to take its members to another provider.

At first blush, Peachtree s proposal appears to be unacceptable. Among other reasons, $60 is less than the full cost of providing service, which was determined previously to be $94.41 per visit at a volume of 75,000. Thus, on a full-cost basis, Atlanta would lose $94.41 . $60 = $34.41 per visit on Peachtree s patients. With an estimated 25,000 visits, the discounted contract would result in a total profit loss of 25,000 . $34.41 = $860,250. However, before Atlanta s managers reject Peachtree s proposal, it must be examined more closely.

The Impact of Rejecting the Proposal If Atlanta s managers rejected the proposal, the clinic would lose market share an estimated 25,000 visits. The forecasted P&L statement that would result, which is based on 50,000 undiscounted visits, is shown in Exhibit 5.7. At the lower volume, the clinic s total revenues, total variable costs, and total contribution margin decrease proportionately (i.e., by one-third). However, fixed costs are not reduced, so Atlanta would not cover its fixed costs, and hence a loss of $3,591,000 . $4,967,462 = .$1,376,462 would occur. To view the situation another way, the expected volume of 50,000 visits is 19,165 short of the breakeven point, so the clinic would be operating to the left of the breakeven point in Exhibit 5.4. This shortfall from breakeven of 19,165 visits, when multiplied by the contribution margin of $71.82, produces a loss of $1,376,430, which is the same as shown in Exhibit 5.7 (except for a rounding difference).

Clearly, the major factor behind the projected loss is the clinic s fixed cost structure of $4,967,462. With a projected decrease in volume of 33 percent, perhaps the clinic could reduce its fixed costs. The relevant range of 65,000 to 85,000 visits for the existing cost structure provides some evidence that fixed costs could be reduced if volume falls to 50,000 visits.

If Atlanta s managers perceive the volume reduction to be permanent, they would begin to reduce the fixed costs currently in place to meet an anticipated volume of 75,000 visits. However, if the clinic s managers believe that the loss of volume is merely a temporary occurrence, they may choose to maintain the current fixed cost structure and absorb the loss expected for next year. It would not make sense for them to start selling off facilities and equipment, and laying off staff, only to reverse these actions one year later. The critical point, though, is that the loss of volume caused by rejecting Peachtree s EXHIBIT 5.7 Atlanta Clinic:

2016 Projected P&L Statement (based on 50,000 Total revenues ($100 . 50,000) Total variable costs ($28.18 . 50,000) Total contribution margin ($71.82 . 50,000) Fixed costs Profit $5,000,000 1,409,000$ 5,386,500 3,591,000 ($ 1,376,462) undiscounted patient visits) Undiscounted revenue ($100 . 50,000) Discounted revenue ($60 . 25,000) Total revenues ($86.67 . 75,000) Total variable costs ($28.18 . 75,000) Total contribution margin ($58.49 . 75,000) Fixed costs Profit $5,000,000 1,500,000 $6,500,000 2,113,500 $4,386,500 4,967,462 ($ 580,962) EXHIBIT 5.8 Atlanta Clinic:

2016 Projected P&L Statement (based on 50,000 visits at $100 and 25,000 visits at $60) proposal can have a significant negative impact on the clinic s profitability, which indicates that the clinic s fixed cost structure must be reexamined.

The Impact of Accepting the Proposal An alternative strategy for the clinic s managers would be to accept Peachtree s proposal. The resulting projected P&L statement is contained in Exhibit 5.8.

The average per visit revenue of serving these two different payer groups is (2/3 . $100) + (1/3 . $60) = $86.67. Total revenues based on this average revenue per visit would be 75,000 . $86.67 = $6,500,250, which equals the value for total revenues shown in the exhibit (except for a rounding difference).

With a lower average revenue per visit, the contribution margin falls to $86.67 . $28.18 = $58.49, which leads to a lower total contribution margin.

The critical point here is that the clinic s total revenues have decreased significantly from the previous situation in which all visits bring in $100 in revenue (see Exhibit 5.5). However, the clinic s total costs remain the same because it is handling the same number of visits 75,000. The impact of the discount is strictly on revenues, and the end result of accepting Peachtree s proposal is a projected loss of $580,962.

Another way of confirming the expected loss at 75,000 visits is to calculate the clinic s accounting breakeven point at the new average per visit revenue of $86.67. The new breakeven point is 84,928 visits, which confirms that the clinic will lose money at 75,000 visits. Because the clinic is projected to be 84,928 . 75,000 = 9,928 visits below breakeven, and the contribution margin is now $58.49, the projected loss is 9,928 . $58.49 = $580,689, which is the amount shown in Exhibit 5.8 (except for a rounding difference).

The change in breakeven point that results from accepting Peachtree s proposal is graphed in Exhibit 5.9, along with the original breakeven point.

The new total revenues line (the dot-dashed line) is flatter than the original line, so when it is combined with the existing cost structure, the breakeven point is pushed to the right, to 84,928 visits. However, any cost control actions taken by Atlanta s managers would either flatten (if variable costs are lowered) or lower (if fixed costs are reduced) the total costs line and hence push the breakeven point back to the left.

EXHIBIT 5.9 Atlanta Clinic:

Breakeven Point with Discounted Revenue Revenues and Costs ($) 4,967,462 Total Costs Fixed Costs Old Total Revenues New Total Revenues 0 69,165 84,928 Volume (Number of Visits) Nothing much has changed in terms of core economic underpinnings because of the new discounted-charge environment. The clinic is worse off economically, but the clinic s cost structure, managerial incentives, and solutions to financial problems are essentially the same. To increase profit, more services must be provided or costs must be cut. In short, the movement from charges to discounted charges is not that radical with regard to its impact on profit analysis and managerial decision making. The major difference is that the clinic is now under greater financial pressure. However, as we discuss in the next major section, the clinic s entire incentive structure will change if it moves to a capitated environment.

Evaluating the Alternative Strategies What should Atlanta s managers do? If Peachtree s discount proposal is accepted, the clinic is expected to lose $580,962 rather than make a profit of $419,038.

The difference is a swing of $1 million in profit in the wrong direction, hardly an enticing prospect. What happened to the missing $1 million? It is now in the hands of Peachtree HMO, which is paying $1 million less to one of its providers (25,000 visits . $40 savings = $1,000,000). This will be reflected as a cost savings on Peachtree s income statement and, if the savings is not passed on to the ultimate payers (typically employers), will result in a $1 million profit increase.

If market forces in Atlanta Clinic s service area suggest that making a counteroffer to Peachtree is not feasible perhaps because the clinic is being pitted against another provider the comparison of a loss of $580,792 to a profit of $419,038 is irrelevant. The only relevant issue at hand for the short term is the comparison of the $580,792 loss if the clinic accepts the proposal to the $1,376,462 loss if the proposal is rejected and Peachtree s patients are lost to the clinic. Although neither outcome is appealing, the acceptance of the discount appears to be the lesser of two evils. In fact, the acceptance of the discount is better by $1,376,462 . $580,792 = $795,670. Accepting the discount proposal appears to be Atlanta s best short-term strategy because Peachtree s patients still produce a positive contribution margin of $60 . $28.18 = $31.82 per visit, which would be forgone if the clinic were to rebuff Peachtree s offer.

That $31.82 per visit contribution margin, when multiplied by the expected 25,000 visits on the contract, puts $795,500 on the total contribution margin table that otherwise would be lost.

However, Atlanta s managers cannot ignore the long-term implications associated with accepting the proposal. These are not addressed in detail here, but clearly the clinic cannot survive either scenario in the long run because the clinic s revenues are not covering the full costs of providing services. In the meantime, bleeding $580,962 of losses in 2016 may be better than bleeding $1,376,462 until the clinic can adjust to market forces in its service area. This adjustment may be as simple as merely absorbing the losses while the clinic s competitors, perhaps in poorer financial condition, exit the market as they face the same difficult economic choices. Should this happen, a new equilibrium would be established in the marketplace that would allow the clinic to raise its prices. If the long-term solution is not that simple, Atlanta Clinic must reduce its cost structure or perish.

Another problem associated with accepting the discount offer is that the clinic s other payers will undoubtedly learn about the reduced payments and want to renegotiate their contracts with the same, or an even greater, discount. Such a reaction would clearly place the clinic under even more financial pressure, and a draconian change in either volume or operating costs would be required for survival.

Marginal Analysis The Atlanta/Peachtree illustration points out one way in which the contribution margin can be used in managerial decision making. To help reinforce the concept, the analysis can be viewed from a different perspective. Suppose the clinic is forecasting a base case volume of only 50,000 visits for 2016 and Peachtree HMO offers to provide the clinic 25,000 additional visits at $60 revenue per visit. These 25,000 visits are called marginal, or incremental, visits, because they add to the existing base of visits. Should Atlanta s managers accept this offer? (For purposes of this marginal analysis illustration, assume the relevant range begins at 50,000 visits.) Although each marginal visit from the contract brings in only $60 compared to $100 on the clinic s other contracts, the marginal cost, or Marginal cost The cost of one additional unit of volume (for example, one more inpatient day or patient visit).

incremental cost, which is the cost associated with each additional visit, is the variable cost rate of $28.18. If we assume that the relevant range extends to 75,000 patient visits, the clinic s $4,967,462 in fixed costs will be incurred whether the volume is 50,000 or 75,000 visits. Because fixed costs are assumed to be unaffected by the offer, these costs are not relevant to the analysis. In finance parlance, the clinic s fixed costs are said to be nonincremental to the decision. With each new visit having a contribution margin (the marginal contribution margin) of $60.00 . $28.18 = $31.82, each visit contributes positively to Atlanta s recovery of fixed costs and potentially to profits, so the offer must be seriously considered.

Note, however, that the analysis would change if 75,000 visits is beyond the relevant range. In that case, new fixed costs would have to be incurred, which would be incremental to the decision. In this situation, the marginal cost would consist of the variable cost rate plus the incremental fixed cost per additional visit. If this pushes the marginal cost per visit above $60, the offer loses its financial attractiveness. Of course, the clinic still faces the long-run problem of other payers requesting discounts discussed at the end of the previous section.

SELF-TEST QUESTIONS 1. What is the impact of a discount contract on fixed costs, total variable costs, and the breakeven point?

2. What is meant by marginal analysis?

3. What is meant by the statement, Marginal analysis is made more complicated by long-run considerations ?

4. Do marginal costs always consist only of variable costs?

Profit Analysis in a Capitated Environment The analysis changes when a provider operates in a capitated environment.

Although the extent of third-party payer use of capitation has varied over time, many people believe that capitation will be used more in the future as healthcare reform forces payers to grapple with the problem of increasing quality while constraining costs. For example, one payment strategy for accountable care organizations (ACOs) is to couple capitation payments to providers with meaningful incentives to ensure quality. Our discussion of a capitated payment profit analysis both provides an excellent review of the concepts presented in previous sections and highlights the basic differences between capitation and fee-for-service reimbursement methodologies.

To begin, assume that the purchaser of services from Atlanta Clinic is the Alliance, a local business coalition. As in previous illustrations, assume the Alliance is paying the clinic $7,500,000 to provide services for an expected 75,000 visits, but now the amount is capitated. Although projected total revenues remain the same as the previous base case (see Exhibit 5.5), the nature of the capitated revenues is different. The $7,500,000 that the Alliance is paying is not explicitly related to the amount of services (number of visits) provided by the clinic but to the size of the covered employee group.

In essence, Atlanta Clinic is no longer merely selling healthcare services as it had in the fee-for-service or discounted fee-for-service environment. Now the clinic is taking on the insurance function in the sense that it is responsible for the health status (utilization) of the covered population and must bear the attendant risks. If the total costs of services delivered by the clinic exceed the premium revenue (paid monthly on a per member basis), the clinic will suffer the financial consequences. However, if the clinic can efficiently manage the healthcare of the served population, it will be the economic beneficiary.

How might Atlanta s managers evaluate whether the $7,500,000 revenue attached to the contract is adequate? To do the analysis, they need two critical pieces of information: cost information and actuarial (utilization) information.

The clinic already has the cost accounting information the full cost per visit is expected to be $94.41 (at a volume of 75,000 visits), with an underlying cost structure of $28.18 per visit in variable costs and $4,967,462 in fixed costs.

For its actuarial information, Atlanta s managers estimate that the Alliance will have a covered population of 18,750 members with an expected utilization rate of four visits per member per year. Thus, the total number of visits expected is 18,750 . 4 = 75,000. Although this appears to be the same 75,000 visits as in the fee-for-service environment, the implications of the Alliance volume differ significantly. Because there is no direct link between the volume of services provided and revenues, utilization above expected levels will bring increased costs with no corresponding increase in revenues.

The revenues expected from this contract $7,500,000 exceed the expected costs of serving this population, which are 75,000 visits multiplied by $94.41 per visit, or $7,080,750. Thus, this contract is expected to generate a profit of $419,250, which, not surprisingly, is the same as the original base case fee-for-service result (except for a rounding difference) (see Exhibit 5.5).

A Graphical View in Terms of Utilization Exhibit 5.10 contains a graphical profit (CVP) analysis for the capitation contract that is constructed similar to the fee-for-service graphs shown previously for Atlanta Clinic in that the horizontal axis shows volume (number of visits) while the vertical axis shows revenues and costs. Also shown is the same underlying cost structure of $4,967,462 in fixed costs coupled with a variable cost rate of $28.18. One significant difference, however, is that instead of being upward sloping, the total revenues line is horizontal, which shows that total revenue is $7,500,000 regardless of volume as measured by the number of visits.

EXHIBIT 5.10 Atlanta Clinic:

Breakeven Point Under Capitation Using Number of Visits as the Volume Measure Revenues and Costs ($) Loss Profit Total Costs Fixed Costs 0 89,870 Volume (Number of Visits) 7,500,000 Total Revenues 4,967,462 Several subtle messages are inherent in this flat revenue line. First, it tells managers that revenue is being driven by something other than the volume of services provided. Under capitation, revenue is being driven by the insurance contract (i.e., by the premium payment and the number of covered lives, or enrollees). This change in the revenue source is the core of the logic switch from fee-for-service to capitation; the clinic is being rewarded to manage the healthcare of the population served rather than merely to provide services.

However, the clinic s costs are still driven by the amount of services provided (the number of visits).

A second critical point about Exhibit 5.10 is the difference between the flat revenue and the flat fixed-cost base. Atlanta has a spread of $7,500,000 . $4,967,462 = $2,532,538 to work with in managing the healthcare of this population for the period of the contract. If total variable costs equal $2,532,538, the clinic breaks even; if total variable costs exceed $2,532,538, the clinic loses. Thus, to make a profit, the number of visits must be less than $2,532,538 $28.18 = 89,870. If everyone in the organization, especially the managers and clinicians, does not understand the inherent utilization risk under capitation, the clinic could find itself in serious financial trouble. On the other hand, if Atlanta s managers and clinicians at all levels understand and manage this utilization risk, a handsome reward may be gained. (Note that the breakeven volume of 89,870 visits exceeds the relevant range maximum of 85,000 visits for the cost structure used. Thus, it is likely that costs would be greater than predicted and hence the breakeven volume is even less than 89,870 visits.) A key feature of capitation is the reversal of the profit and loss portions of the graph. To see this, compare Exhibit 5.10 with Exhibit 5.4. The idea that profits occur at lower volumes under capitation is contrary to the fee-for-service environment. It is obvious, however, when one recognizes that the contribution margin, on a per visit basis, is $0 . $28.18 = .$28.18. Thus, each additional visit increases costs by $28.18 without bringing in additional revenue.

The optimal short-term response to capitation from a purely financial perspective is to take the money and provide as few services as legally possible.

Of course, the clinic would not have the contract renewed in subsequent years, but it would have maximized short-term profit. Obviously, this course of action is neither appropriate nor feasible. Still, its implications are at the heart of concerns expressed by critics of capitation about the incentive created to withhold patient care. The solution to this problem is to monitor and reward (with bonus payments) providers that maintain or improve quality and, at the same time, reduce costs.

A Graphical View in Terms of Membership Looking at Exhibit 5.10 is like being Alice peering through the looking glass and finding that everything is reversed. The key to this problem is that the horizontal axis does not measure the volume to which revenues are related; that is, Exhibit 5.10 has number of visits on the horizontal axis, just as if Atlanta Clinic were selling healthcare services. It is not; it is now selling healthcare assurance to a defined population and is being paid on the basis of population size, so the appropriate horizontal axis value is the number of members (enrollees).

Exhibit 5.11 recognizes that membership, rather than the amount of services provided, drives revenues. With the number of members on the horizontal axis, the total revenues line is no longer flat; revenues only look flat when they are considered relative to the number of visits. The revenue earned by the clinic is actually $7,500,000 18,750 = $400 per member, which could be broken down to a monthly premium of $400 12 = $33.33.

Thus, the expected $7,500,000 revenue shown in Exhibit 5.5 results from an expected enrollee population of 18,750 members.

The cost structure can easily be expressed on a membership basis as well. Fixed costs are no problem within the relevant range; they are inherently volume insensitive whether volume is measured by number of visits or number of members. Thus, Exhibit 5.11 shows fixed costs as the same flat, dashed line as before. However, the variable cost rate based on number of enrollees is not the same as the variable cost rate based on number of visits.

EXHIBIT 5.11 Atlanta Clinic:

Breakeven Point Under Capitation Using Number of Members as the Volume Measure Revenues and Costs ($) 4,967,462 Loss Profit Total Costs Fixed Costs 17,2910 Volume (Number of Members) Total Revenues ($400 per Member) Per member variable cost must be estimated from two other factors: the variable cost rate of $28.18 per visit and the expected utilization rate of four visits per year. The combination of the two is 4 . $28.18 = $112.72, which is the clinic s expected variable cost per member. Expressed on a per member basis, the contribution margin is now $400 . $112.72 = $287.28, as opposed to the .$28.18 when volume is based on number of visits.

The analysis based on number of members reveals that two elements are critical to controlling total variable costs under capitation: the underlying variable cost of the service ($28.18 per visit) and the number of visits per member (four). The two-variable nature of the variable cost rate makes cost control more difficult under capitation. In a fee-for-service environment, cost control entails only minimizing per visit expenses; utilization is not an issue. If anything, utilization is good because per visit revenue almost always exceeds the variable cost rate. (In other words, there is a positive contribution margin.) Capitation requires a change in managerial thinking because utilization is now a component of the variable cost rate and hence total variable costs.

Of course, control of fixed costs is always financially prudent, regardless of the type of reimbursement.

Conversely, there is one positive feature of the variable cost structure under capitation. With two elements to control, the clinic has more opportunity to lower the variable cost rate under capitation than under fee-for-service reimbursement. The key is the ability of Atlanta s managers to control utilization.

If both utilization and per visit costs can be reduced, the clinic can reap greater benefits (profits) than are possible under fee-for-service reimbursement.

Projected P&L Statement Analysis Exhibit 5.12 contains three projected P&L statements in this capitated environment, each for a different volume level. Let s start with the middle col- umn the one that contains the expected 75,000 patient visits. The bottom line $419,038 is the same as in the fee-for-service analysis, which reinforces the point that, at least superficially, the capitated contract is not inherently better or worse than the fee-for-service contract.

What would happen if the clinic experienced more visits than predicted?

If the number of visits increases by 10 percent, or by 7,500, to 82,500, the right column in Exhibit 5.12 shows that profit would decrease by $419,038 . $207,688 = $211,350. This occurs because total revenues stay constant while costs increase at a rate of $28.18 for each additional visit. With 7,500 additional visits, the clinic s costs increase by 7,500 . $28.18 = $211,350.

Obviously, this is quite in contrast to the significant increase in profit at this volume level that would occur in a fee-for-service environment.

Under capitation, a decrease in visits will improve the profitability of the clinic. When the number of visits decreases to 69,165, which is the break- even point in a fee-for-service environment, profit in a capitated environment increases by $164,430 to $583,468. This increase is explained by the decrease in visits (5,835) multiplied by the contribution margin (.$28.18), which results in a $164,430 decrease in costs while revenues remain constant.

The Importance of Utilization Exhibit 5.12 provides information on the impact of utilization changes on profitability. The center column, the base case, is once again our starting point. With an assumed utilization of four visits for each of Peachtree s 18,750 members, 75,000 visits result in a projected profit of $419,038.

EXHIBIT 5.12 Number of Visits Atlanta Clinic:

69,165 75,000 82,500 2016 Projected P&L Statements Total revenues $7,500,000 $7,500,000 $7,500,000 Under Total variable costs ($28.18 . Volume) Total contribution margin Fixed costs Profit 1,949,070 $5,550,930 4,967,462 $ 583,468 2,113,500 $5,386,500 4,967,462 $ 419,038 2,324,850 $ 5,175,150 4,967,462 $ 207,688 Capitation (based on 69,165, 75,000, and 82,500 patient visits) However, if Atlanta s managers are not able to limit utilization to the level forecasted (or less), the clinic s profit will fall. Assume that realized utilization is actually 4.4 visits per member, rather than the 4.0 forecasted.

This higher utilization would result in 4.4 . 18,750 = 82,500 visits, which produces the profit of $207,688 shown in the rightmost column in Exhibit 5.12. Because revenues are fixed and total costs are tied to volume, higher utilization leads to higher costs and lower profit. With the same 82,500 visits but with total variable costs of $2,324,850 at the higher utilization rate, the variable cost per member increases to $2,324,850 18,750 = $123.99, which could also be found by multiplying 4.4 visits per member by the variable cost rate of $28.18.

The left-hand column of Exhibit 5.12 shows that the clinic s profitability would increase to $583,468 if utilization were reduced to 3.69 visits per member, producing about 69,165 total visits. With lower utilization, total variable costs are reduced and profit increases. The point is that the ability of a provider to control utilization is the primary key to profitability in a capitated environment. Less utilization means lower total costs, and lower total costs mean greater profit.

The Importance of the Number of Members Exhibit 5.13 contains the projected P&L statements under capitation, recast to focus on the number of members. Assuming a per member utilization of four visits per year, a 10 percent membership increase to 20,625 members increases the projected profit by about 128 percent. However, if membership declines to 17,291, the clinic just breaks even.

We can use the breakeven equation to verify the breakeven point:

Total revenues . Total variable costs . Fixed costs = Profit ($400 . Members) . ($112.72 . Members) . $4,967,462 = $0 $287.28 . Members = $4,967,462 Members = 17,291.

EXHIBIT 5.13 Atlanta Clinic: Number of Members 2016 Projected P&L Statements 17,291 18,750 20,625 Under Capitation Total revenues ($400 . Number $ 6,916,400 $7,500,000 $8,250,000 (based on of members) 17,291, 18,750, Total variable costs ($112.72 . Members) 1,949,042 2,113,500 2,324,850 and 20,625 Total contribution margin $4,967,358 $5,386,500 $ 5,925,150 members) Fixed costs 4,967,462 4,967,462 4,967,462 Profit ($ 104) $ 419,038 $ 957,688 Breakeven analysis reaffirms that the clinic needs 17,291 members in its contract with the Alliance to break even, given the assumed cost structure, which in turn assumes utilization of four visits per member and a variable cost rate of $28.18 per visit.

Assuming constant per member utilization, more members increases profitability because additional members create additional revenues that presumably exceed their incremental (variable) costs. Indeed, the degree of operating leverage (DOL) concept (discussed in the Chapter 5 Supplement) can be applied here. As shown in Exhibit 5.13, a 10 percent increase to 20,625 members from a base case membership of 18,750 results in a (roughly) 128.5 percent increase in profit (from $419,038 to $957,688, or by $538,650).

Thus, each 1 percent increase in membership increases profitability by 12.85 percent. Similarly, if membership decreases to the breakeven point of 17,291, a decrease of 7.8 percent, profitability falls by 7.8% . 12.85 = 100%, which leads to a profit of zero.

SELF-TEST 1. Under capitation, what is the difference between a CVP graph QUESTIONS with the number of visits on the x-axis and one with the number of members on the x-axis?

2. What is unique about the contribution margin under capitation?

3. Why is utilization management so important in a capitated environment?

4. Why is the number of members so important in a capitated environment?

The Impact of Cost Structure on Financial Risk The financial risk of a healthcare provider, at least in theory, is minimized by having a cost structure that matches its revenue structure. To illustrate, consider a clinic with all payers using fee-for-service reimbursement and hence generating revenues directly related to volume. If the clinic s cost structure consisted of all variable costs (no fixed costs), then each visit would incur costs but at the same time create revenues. Assuming that the per visit revenue amount exceeds the variable cost rate (per visit costs), the clinic would lock in a profit on each visit. The total profitability of the clinic would be uncertain, as it is tied to volume, but the ability of the clinic to generate a profit would be guaranteed.

At the other extreme, consider a clinic that is totally capitated. In this situation, assuming a fixed number of covered lives, the clinic s revenue stream is fixed regardless of the volume of services provided. Now, to match the revenue and cost structures, the clinic must have all fixed (no variable) For Your Consideration Matching Cost and Revenue Structures Healthcare providers can lower their financial risk by matching the cost structure to the revenue structure. For example, providers that are primarily reimbursed on a fee-for-service basis can lower risk by converting fixed costs to variable costs. Conversely, providers that are primarily reimbursed on a capitated basis can lower risk by converting variable costs to fixed costs.

Assume that you are the business manager of a large cardiology group practice. Virtually all of the practice s revenues are on a fee-for-service basis. However, the practice s two largest cost categories, labor and diagnostic equipment, are fixed. You are concerned about the potential for volumes to fall in the future and want to take some actions to reduce the financial risk of the practice.

What cost structure is optimal for the practice?

What can be done to labor costs to improve the cost structure? To equipment costs? Suppose the change in cost structure will increase overall practice costs at next year s expected volume.

How does that influence your actions?

SELF-TEST QUESTIONS costs. Assuming that annual fixed revenue exceeds annual fixed costs, the clinic has a guaranteed profit at the end of the year.

Note that in both illustrations, the key to minimizing risk (ensuring a profit) is to create a cost structure that matches the revenue structure: variable costs for fee-for-service revenues and fixed costs for capitated revenues. Of course, real world problems occur when a provider tries to implement a cost structure that matches its revenue structure. First, few providers are reimbursed solely on a fee-for-service or a capitated basis. Most providers encounter a mix of reimbursement methods. Still, they are either predominantly fee-for-service or predominantly capitated.

Second, providers do not have complete control over their cost structures. It is impossible for providers to create cost structures with all variable or all fixed costs.

Nevertheless, managers can take actions to change their existing cost structure to one that is more compatible with the revenue structure (has less risk). For example, assume a medical group practice is reimbursed almost exclusively on a per procedure basis. To minimize financial risk, the practice can take actions such as paying physicians on a per procedure basis and using per procedure leases for diagnostic equipment. The greater the proportion of variable costs in the practice s cost structure, the lower its financial risk.

1. Explain this statement: To minimize financial risk, match the cost structure to the revenue structure. 2. What cost structure would minimize risk if a provider had all fee- for-service reimbursement?

3. What cost structure would minimize risk if a provider were entirely capitated?

4. What are the real-world constraints on creating matching cost structures?

Key Concepts Managers rely on managerial accounting information to plan for and control a business s operations. A critical part of managerial accounting information is the measurement of costs and the use of this information in profit analysis. The key concepts of this chapter are as follows:

Costs can be classified by their relationship to the amount of services provided.

Variable costs are those costs that are expected to increase and decrease with volume (patient days, number of visits, and so on), while fixed costs are the costs that are expected to remain constant regardless of volume within some relevant range.

The relationship between cost and activity (volume) is called underlying cost structure.

Profit analysis, often called cost-volume-profit (CVP) analysis, is an analytical technique that typically is used to analyze the effects of volume changes on revenues, costs, and profit.

A projected profit and loss (P&L) statement is a profit projection that, in a profit analysis context, uses assumed values for volume, price, and costs.

Breakeven analysis is used to estimate the volume needed (or the value of another variable, such as price) for the organization to break even in profitability.

Accounting breakeven occurs when revenues equal accounting costs (zero profit), while economic breakeven occurs when revenues equal accounting costs plus some profit target.

Contribution margin is the difference between unit price and the variable cost rate. Hence, contribution margin is the per unit dollar amount available to first cover an organization s fixed costs and then to contribute to profits.

In marginal analysis, the focus is on the incremental (marginal) profitability associated with increasing or decreasing volume.

A capitated environment dramatically differs from a fee-forservice environment. In essence, a capitated provider takes on the insurance function.

The keys to success in a capitated environment are to manage (reduce) utilization and increase the number of members covered.

To minimize financial risk, a provider should strive to attain a cost structure that matches its revenue structure.

In Chapter 6, the discussion of managerial accounting continues with an examination of costing at the department level.

Questions 5.1 Explain the differences between fixed costs and variable costs.

5.2 Total costs are made up of what components?

5.3 a. What is cost-volume-profit (CVP) analysis?

b. Why is it so useful to health services managers?

5.4 a. Define contribution margin.

b. What is its economic meaning?

5.5 a. Write out and explain the equation for volume breakeven.

b. What role does contribution margin play in this equation?

5.6 What elements of profit analysis change when a provider moves from a fee-for-service to a discounted fee-for-service environment?

5.7 What are the critical differences in profit analysis when it is conducted in a capitated environment versus a fee-for-service environment?

5.8 How do provider incentives differ when the provider moves from a fee-for-service to a capitated environment?

5.9 a. What cost structure is best when a provider is primarily capitated?

Explain.

b. What cost structure is best when a provider is reimbursed primarily by fee-for-service? Explain.

Problems 5.1 Consider the CVP graphs below for two providers operating in a fee- for-service environment:

a. Assuming the graphs are drawn to the same scale, which provider has the greater fixed costs? The greater variable cost rate? The greater per unit revenue?

b. Which provider has the greater contribution margin?

c. Which provider needs the higher volume to break even?

d. How would the graphs below change if the providers were operating in a discounted fee-for-service environment? In a capitated environment?

Provider A Provider B 5.2 Consider the data in the table below for three independent health services organizations:

Total Fixed Total Revenues Variable Costs Costs Costs Profit a. $2,000 $1,400 ? $2,000 ?

b. ? 1,000 ? 1,600 $2,400 c. 4,000 ? $600 ? 400 Fill in the missing data indicated by question marks.

5.3 Assume that a radiologist group practice has the following cost structure:

Fixed costs $500,000 Variable cost per procedure 25 Charge (revenue) per procedure 100 Furthermore, assume that the group expects to perform 7,500 procedures in the coming year.

a. Construct the group s base case projected P&L statement.

b. What is the group s contribution margin? What is its breakeven point?

c. What volume is required to provide a pretax profit of $100,000? A pretax profit of $200,000?

d. Sketch out a CVP analysis graph depicting the base case situation.

e. Now assume that the practice contracts with one HMO, and the plan proposes a 20 percent discount from charges. Redo questions a, b, c, and d under these conditions.

5.4 General Hospital, a not-for-profit acute care facility, has the following cost structure for its inpatient services:

Fixed costs $10,000,000 Variable cost per inpatient day 200 Charge (revenue) per inpatient day 1,000 The hospital expects to have a patient load of 15,000 inpatient days next year.

a. Construct the hospital s base case projected P&L statement.

b. What is the hospital s breakeven point?

c. What volume is required to provide a profit of $1,000,000? A profit of $500,000?

d. Now assume that 20 percent of the hospital s inpatient days come from a managed care plan that wants a 25 percent discount from charges. Should the hospital agree to the discount proposal?

5.5 You are considering starting a walk-in clinic. Your financial projections for the first year of operations are as follows:

Revenues (10,000 visits) $400,000 Wages and benefits 220,000 Rent 5,000 Depreciation 30,000 Utilities 2,500 Medical supplies 50,000 Administrative supplies 10,000 Assume that all costs are fixed, except supply costs, which are variable.

Furthermore, assume that the clinic must pay taxes at a 30 percent rate.

a. Construct the clinic s projected P&L statement.

b. What number of visits is required to break even?

c. What number of visits is required to provide you with an after-tax profit of $100,000?

5.6 (Hint: The concept of operating leverage, reviewed in this problem, is covered in the Chapter 5 Supplement.) Review the walk-in clinic data presented in Problem 5.5. Construct projected P&L statements at volume levels of 8,000, 9,000, 10,000, 11,000, and 12,000 visits.

a. Assume that the base case forecast is 10,000 visits. What is the clinic s degree of operating leverage (DOL) at this volume level?

Confirm the net incomes at the other volume levels using the DOL combined with the percent changes in volume.

b. Now assume that the base case volume is 9,000 visits. What is the DOL at this volume?

5.7 Grandview Clinic has fixed costs of $2 million and an average variable cost rate of $15 per visit. Its sole payer, an HMO, has proposed an annual capitation payment of $150 for each of its 20,000 members.

Past experience indicates the population served will average two visits per year.

a. Construct the base case projected P&L statement on the contract.

b. Sketch two CVP analysis graphs for the clinic one with number of visits on the x-axis and one with number of members on the x-axis. Compare and contrast these graphs with the one in Problem 5.3.d.

c. What is the clinic s contribution margin on the contract? How does this value compare with the value in Problem 5.3.b?

d. What profit gain can be realized if the clinic can lower per member utilization to 1.8 visits?

5.8 Triangle Pediatrics currently provides 1,000 visits per year at a price of $50 per visit. The variable cost per visit (variable cost rate) is $30, and total fixed costs are $15,000. The business manager suggests that Triangle Pediatrics can increase the number of visits to 1,200 per year by cutting the price per visit by $5 and increasing the fixed advertising budget by $5,000.

a. Construct the base case projected P&L statement and the projected P&L statement incorporating the proposed changes.

Should Triangle Pediatrics make the suggested changes?

b. How much would visit volume need to increase in order for Triangle Pediatrics to break even with the proposed changes?

5.9 Charity Hospital, a not-for-profit, has a maximum capacity of 15,000 discharges per year. Variable patient service costs are $495 per discharge. Variable general and administrative costs are $5 per discharge. Fixed hospital overhead costs are $4,000,000 per year. The current reimbursement rate is $1,000 per discharge.

a. What is Charity s breakeven volume in number of discharges?

b. Now assume Charity s total discharges for 2014 totaled 10,000. In late 2014, a specialty cardiac hospital opened near Charity, so that discharges in 2015 will reach only 8,500. Management is planning to cut fixed costs so that the total for 2015 will be $1,000,000 less than in 2014. Management is also considering reducing variable staffing costs in order to earn a target profit that will be the same dollar amount as the profit earned in 2014. Charity has already had 4,000 discharges in 2015 at a reimbursement rate of $1,000 per discharge with variable costs unchanged. What contribution margin per unit is needed on the remaining 4,500 discharges in order to reach the target profit?

Resources For a more in-depth treatment of cost measurement in health services organizations, see Finkler, S. A., D. M. Ward, and T. D. Calabrese. 2011. Accounting Fundamentals for Health Care Management. Sudbury, MA: Jones & Bartlett.

Young, D. W. 2014. Management Accounting in Health Care Organizations. New York: Jossey-Bass.

In addition, see Al-Hajeri, M., M. Hartmann, S. Jabr, P. C. Smith, and M. Z. Younis. 2011. Cost- Volume-Profit Analysis and Expected Benefit of Health Services: A Study of Cardiac Catheterization Services. Journal of Health Care Finance (Spring):

87 100.

Angert, S., and H. Seabrook. 2011. Next-Generation Cost Management. Healthcare Financial Management (March): 47 52.

Arredondo, R. 2014. Why Revisit Your Cost-Accounting Strategy. Healthcare Financial Management (July): 68 73.

Cleverley, W. O., and J. O. Cleverley. 2011. A Better Way to Measure Volume and Benchmark Costs. Healthcare Financial Management (March): 78 86.

. 2010. Cost Reduction: Identifying the Opportunities. Healthcare Financial Management (March): 53 59.

Daly, R. 2014. Innovations in Cost Management. Healthcare Financial Management (March): 51 56.

Koutsakos, G. 2011. Measuring Cost When Inpatient Service Acuity Varies. Healthcare Financial Management (November): 52 56.

Liu, L. L., D. A. Forgione, and M. Z. Younis. 2012. A Comparative Analysis of the CVP Structure of Nonprofit Teaching and For-Profit Non-teaching Hospitals. Journal of Health Care Finance (Fall): 12 38.

Rauh, S. S., E. Wadsworth, and W. B. Weeks. 2010. The Fixed-Cost Dilemma:

What Counts When Counting Cost-Reduction Efforts? Healthcare Financial Management (March): 60 63.

Selivanoff, P. 2011. The Impact of Healthcare Reform on Hospital Costing Systems. Healthcare Financial Management (May): 110 16.

Spence, J. 2013. 5 Ways to Make Cost Accounting a Strategic Function in Hospitals. Healthcare Financial Management (March): 40.

SEMI-FIXED COSTS AND OPERATING 5 LEVERAGE Semi-fixed Costs Fixed and variable costs represent two ends of the volume classification spectrum.

Here, within the relevant range, the costs are either independent of volume (fixed) or directly related to volume (variable). A third classification, semi-fixed costs, falls in between the two extremes. A semi-fixed cost is one that is fixed over some range of volume, but this range is smaller than the relevant range used in the analysis. Note that another volume classification is semi-variable costs. Such costs have both a fixed and a variable component.

An example might be a business s telephone costs, which could have a fixed (base) charge component plus additional charges that depend on the number of minutes of usage.

To illustrate semi-fixed costs, assume that the actual relevant range of volume for the clinical laboratory discussed in the chapter is 10,000 to 20,000 tests. However, the laboratory s current workforce can only handle up to 15,000 tests per year, so an additional technician, at an annual cost of $35,000, would be required if volume were to exceed that level. Now, labor costs are fixed from 10,000 to 15,000 tests, and then again fixed at a higher level from 15,000 to 20,000 tests, but they are not fixed at the same level throughout the entire relevant range of 10,000 to 20,000 tests. Semi-fixed costs are fixed within ranges of volume, but there are multiple ranges of semi- fixed costs within the relevant range. Because a plot of semi-fixed costs versus volume looks like a step function, such costs sometimes are called step-fixed or step-variable costs.

Exhibits S5.1 and S5.2 illustrate the cost structure of the laboratory within the new relevant range and with the addition of semi-fixed costs. As shown in Exhibit S5.1, the inclusion of semi-fixed costs prevents average fixed cost and average cost per test from continuously declining throughout the relevant range. At volumes above 15,000 tests, the laboratory must add a technician at a cost of $35,000. This causes a jump in total fixed costs (consisting of fixed and semi-fixed costs), average fixed cost, total costs, and average cost per test. However, once this jump (or step) occurs, average fixed cost and average cost per test again begin to decline as volume increases.

EXHIBIT S5.1 Cost Structure Variable Costs per Test Fixed Costs per Year Semi-fixed Costs Chapter 5 Supplement Illustration:

Fixed, Semi-fixed, Laboratory supplies $10 Labor $100,000 Other fixed costs 50,000$150,000 Increase in labor costs above 15,000 tests $35,000 and Variable Costs Total Total Average Fixed Semi-fixed Fixed Variable Total Cost Volume Costs Costs Costs Costs Costs per Test 10,000 $150,000 $ 0 $150,000 $100,000 $250,000 $25.00 14,000 150,000 0 150,000 140,000 290,000 20.71 15,000 150,000 0 150,000 150,000 300,000 20.00 16,000 150,000 35,000 185,000 160,000 345,000 21.56 20,000 150,000 35,000 185,000 200,000 385,000 19.25 SELF-TEST QUESTIONS The jump in total costs is easily identified on the total costs line shown in Exhibit S5.2. Because of the negative impact of this sudden increase in total costs, the laboratory department head would probably try to avoid hiring an additional technician when volume exceeds 15,000 tests, especially if volume is expected to be only slightly above the jump point or is expected to be temporary. Perhaps new incentives could be put into place to encourage the current technicians to be more productive. Such an action could lower costs in general and create a situation in which the average cost per test would decline continuously throughout the relevant range.

Although semi-fixed costs are common within health services organizations, they add a level of complexity to profit (CVP) analysis without adding a great deal of additional insight. Thus, the examples presented in the main text of Chapter 5 assume that an organization s cost structure consists only of fixed and variable costs.

1. What is a semi-fixed cost?

2. How does the addition of semi-fixed costs change a cost structure graph?

3. What is the impact of semi-fixed costs on per unit average cost?

Operating Leverage As we demonstrate in the chapter, profit (CVP) analysis is used to examine how changes in volume affect profits and to estimate breakeven points. Assume Costs ($) 250,000 150,000 100,000 35,000 0 EXHIBIT S5.2 Cost Structure Graph Total Costs TotalVariable Costs Fixed Costs Semi-Fixed Costs 15,000 20,00010,000 Volume (Number of Tests) Chapter 5 Supplement now that Atlanta Clinic s managers believe that changes in the local market for healthcare services will occur that increase their volume estimate for 2016 to 82,500 visits an increase of 7,500 visits over the original 75,000 visit base case estimate. (The relevant range for Atlanta s cost structure is 65,000 to 85,000 visits.) Exhibit S5.3 contains the clinic s projected P&L statements at 69,165 (accounting breakeven), 75,000 (base case), and 82,500 visits. The first two columns were previously constructed in Chapter 5, while the third column, which represents the 82,500 visit estimate, is new.

Now that P&L statements have been created at three different volume levels, the consequences of volume changes can be better understood. As the clinic s forecasted volume moves from 75,000 visits to 82,500 visits, its profit increases by $957,688 . $419,038 = $538,650. This increase is equal to the additional 7,500 visits multiplied by the $71.82 contribution margin. When the volume is beyond the accounting breakeven point, any additional visits are gravy that is, the clinic s fixed costs are now covered, so all contribution margin additions flow directly to profit. Similarly, the outcome is known if the clinic s projected volume dropped from 75,000 to 69,165 visits. In this case, the decrease of 5,835 visits . $71.82 contribution margin = $419,070, which is the loss of profit (except for a rounding difference) that results from the volume decrease.

EXHIBIT S5.3 Atlanta Clinic:

2016 Projected P&L Statements (based on 69,165, 75,000, and 82,500 patient visits) Number of Visits 69,165 75,000 82,500 Total revenues ($100 . Volume) Total variable costs ($28.18 . Volume) Total contribution margin ($71.82 . Volume) Fixed costs Profit $6,916,500 1,949,070 $4,967,430 4,967,462 ($ 32) $7,500,000 2,113,500 $8,250,000 2,324,850$5,386,500 4,967,462 $ 419,038 $ 5,925,150 4,967,462 $ 957,688 Chapter 5 Supplement The movement from 75,000 to 82,500 visits resulted in a (82,500 .

75,000) 75,000 = 7,500 75,000 = 0.10 = 10% increase in volume and thus total revenues. While the top line of the P&L statement total revenues increased by 10 percent, the bottom line of the statement profit increased by 128.5 percent ($538,650 $419,038 = 1.285 = 128.5%). This incredible increase in profit occurs because the clinic is reaping the benefit of its cost structure, which includes fixed costs that do not increase with volume.

If a high proportion of a business s total costs are fixed, the business is said to have high operating leverage. In physics, leverage implies the use of a lever to raise a heavy object with a small amount of force. In politics, individuals who have leverage can accomplish much with the smallest word or action. In finance, high operating leverage means that a relatively small change in volume results in a large change in profit.

Operating leverage is measured by the degree of operating leverage (DOL), which in this illustration is calculated at any given volume by dividing the total contribution margin by profit. At a volume of 75,000 visits, Atlanta Clinic s degree of operating leverage is Total contribution margin Profit = $5,386,500 $419,038 = 12.85. The DOL indicates how much profit will change for each 1 percent change in volume. Thus, at a volume of 75,000 visits, each 1 percent change in volume produces a 12.85 percent change in profit, so a 10 percent increase in volume results in a 10% . 12.85 = 128.5% increase in profit. Note, however, that the DOL changes with volume, so the 12.85 DOL calculated here is applicable only to a starting volume of 75,000 visits.

Cost structures differ widely among industries and among organizations within a given industry. The DOL is greatest in health services organizations with a large proportion of fixed costs and, consequently, a low proportion of variable costs. The end result is a high contribution margin, which contributes to a high DOL. In economics terminology, high-DOL businesses are said to have economies of scale because higher volumes lead to lower per unit total costs. In such businesses, a small increase in revenue produces a relatively large increase in profit. However, high-DOL businesses have relatively high breakeven points, which increase the risk of losses. Also, operating leverage is a double-edged sword: High-DOL businesses suffer large profit declines, and potentially large losses, if volume falls.

To illustrate the negative effect of a high DOL, consider this question:

What would happen to Atlanta Clinic s profit if volume fell by 7.8 percent from the base case level of 75,000 visits? To answer this question, recognize that profit would decline by 7.8% . 12.85 = 100%, so the clinic s profit would fall to zero. The data in Exhibit S5.3 confirm this answer. At a projected volume of 69,165 visits (a decrease of 7.8 percent from 75,000 visits), the clinic s profit is zero (except for a rounding difference). Of course, this volume was previously identified in the chapter as the breakeven point.

To what extent can managers influence a business s operating leverage?

In many respects, operating leverage is determined by the inherent nature of the business. In general, hospitals and other institutional providers must make large investments in fixed assets (land, buildings, and equipment), and hence they have a high proportion of fixed costs and high operating leverage. Conversely, home health care businesses and other noninstitutional providers need few fixed assets, so they tend to have relatively low operating leverage. Still, managers can somewhat influence operating leverage. For example, organizations can make use of temporary, rather than permanent, employees to handle peak patient loads. Also, assets can be leased on a per use (per procedure) basis, rather than purchased or leased on a fixed rental basis. Actions such as these tend to reduce the proportion of fixed costs in an organization s cost structure and hence reduce operating leverage.

1. What is operating leverage, and how is it measured?

2. Why is the operating leverage concept important to managers?

3. Can managers influence their firms operating leverage?

4. How does an organization s cost structure affect its exposure to economies of scale?

SELF-TEST QUESTIONS Chapter 5 Supplement DEPARTMENTAL COSTING AND COST 6 ALLOCATION Learning Objectives After studying this chapter, readers will be able to Differentiate between direct and indirect (overhead) costs.

Explain why proper cost allocation is important to health services organizations.

Define a cost driver and explain the characteristics of a good driver as opposed to a poor one.

Describe the three primary methods used to allocate overhead costs among revenue-producing departments.

Apply cost allocation principles across a wide range of situations within health services organizations.

Introduction In Chapter 5 we discussed organizational costing, which requires the classification of costs according to their relationship to volume. In this chapter we introduce departmental costing, which requires an additional classification of costs the relationship between costs and the department being analyzed. In essence, we will see that some costs are unique to the department, while other costs stem from resources that belong to the organization as a whole. Once it is recognized that some costs are organizational in nature rather than department specific, it becomes necessary to create a system that allocates organizational costs to individual departments. For now, we will focus on costing at the department level.

In the next chapter, we will discuss costing (and pricing) of individual service lines. Although some of this chapter s material is conceptual in nature, much of it involves the application of various allocation techniques. Thus, a considerable portion of the chapter is devoted to examples of cost allocation in different settings.

Direct Versus Indirect (Overhead) Costs Some costs about 50 percent of a health services organization s cost structure are unique to the reporting subunit and hence usually can be identified Direct cost A cost that is tied exclusively to a subunit, such as the salaries of laboratory department employees.

When a subunit is eliminated, its direct costs disappear.

Indirect (overhead) cost A cost that is tied to shared resources rather than to an individual subunit of an organization; for example, facilities costs.

SELF-TEST QUESTIONS Cost allocation The process by which overhead costs are assigned (allocated) to individual departments.

with relative certainty. To illustrate, consider a hospital s clinical laboratory department. Certain costs are unique to the department: for example, the salaries and benefits for the managers and technicians who work there and the costs of the equipment and supplies used to conduct the tests. These costs, which would not occur if the laboratory were closed, are classified as the direct costs of the department.

Unfortunately, direct costs constitute only a portion of the department s entire cost structure. The remaining resources used by the laboratory are not unique to the laboratory; the department uses many shared resources of the hospital as a whole. For example, the laboratory shares the organization s physical space (facilities) as well as its infrastructure, which includes information systems, utilities, housekeeping, maintenance, medical records, and general administration. The costs that are not borne exclusively by the laboratory department are called indirect costs, or overhead costs.

Indirect costs, in contrast to direct costs, are much more difficult to measure at the department level for the precise reason that they arise from shared resources that is, if the laboratory department were closed, the indirect costs would not disappear. Perhaps some indirect costs could be reduced, but the hospital would still require a basic infrastructure to operate its remaining departments. The direct/indirect classification has relevance only at the subunit level; if the unit of analysis is the entire organization, all costs are direct by definition. Thus, in our Chapter 5 discussion of organizational costing, we did not have to introduce the concept of direct versus indirect costs.

Note that the two cost classifications (fixed/variable and direct/indirect) overlay one another. That is, fixed costs typically include both direct and indirect costs, while variable costs, in most cases, contain only direct costs (although they can include both direct and indirect costs). Conversely, direct costs usually include fixed and variable costs, while indirect costs typically include only fixed costs.

1. What is the difference between direct and indirect costs?

2. Give some examples of each type of cost for a hospital s emergency services department.

Introduction to Cost Allocation A critical part of cost measurement at the department level is the assignment, or allocation, of indirect costs. Cost allocation is essentially a pricing process within the organization whereby managers allocate the costs of one department to other departments. Because this pricing process does not occur in a market setting, no objective standard exists that establishes the price for the transferred services. Thus, cost allocation within a business must, to the extent possible, establish prices that proxy those that would be set under market conditions.

What costs within a health services organization must be allocated?

Typically, the overhead costs of the business, such as those incurred by administrators, facilities management personnel, financial staffs, and housekeeping and maintenance personnel, must be allocated to those departments that generate revenues for the organization (generally patient services departments).

The allocation of overhead costs to patient services departments is necessary because there would be no need for such costs in the first place if there were no patient services departments. Thus, decisions regarding pricing and service offerings by the patient services departments must be based on the full costs associated with each service, including both direct and overhead (indirect) costs. Clearly, the proper allocation of overhead costs is essential to good decision making within health services organizations.

The goal of cost allocation is to assign all of the costs of an organization to the activities that cause them to be incurred. With complete cost data accessible in the organization s managerial accounting system, managers can make better decisions regarding cost control, what services should be offered, and how these services should be priced. Of course, the more complex the managerial accounting system, the higher the costs of developing, implementing, and operating the system. As in all situations, the benefits associated with more accurate cost data must be weighed against the costs required to develop such data.

Interestingly, much of the motivation for more accurate cost allocation systems comes from the recipients of overhead services. Managers at all levels within health services organizations are under pressure to optimize financial performance, which translates to reducing costs. Indeed, many department heads are evaluated, and hence compensated and promoted, primarily on the basis of profitability, assuming that performance along other dimensions is satisfactory. For such a performance evaluation system to work, all parties must perceive the cost allocation process to be accurate and fair because managers are held accountable for both the direct and the indirect costs of their departments. In other words, department heads are held accountable for the full costs associated with services performed by their departments.

SELF-TEST QUESTIONS 1. What is meant by the term cost allocation? By the term full costs?

2. What is the goal of cost allocation?

3. Why is cost allocation important to health services managers?

Cost pool A group of overhead costs to be allocated; for example, facilities costs or marketing costs.

Cost driver The basis on which a cost pool is allocated; for example, square footage for facilities costs.

Allocation rate The numerical value used to allocate overhead costs; for example, $10 per square foot of occupied space for facilities costs.

Cost Allocation Basics To assign costs from one activity to another, two important elements must be identified: a cost pool and a cost driver. A cost pool is a grouping of similar costs to be allocated, while a cost driver is the basis upon which the allocation is made. To illustrate, the costs of a hospital s housekeeping department might be allocated to the other departments on the basis of the size of each department s physical space. The logic here is that the amount of housekeeping resources expended in each department is directly related to the physical size of that department. In this situation, total housekeeping costs would be the cost pool, and the number of square feet of occupied space would be the cost driver.

When the cost pool amount is divided by the total amount of the cost driver, the result is the overhead allocation rate. Thus, in the housekeeping illustration, the allocation rate is the total housekeeping costs of the organization divided by the total space (square footage) occupied by the departments receiving the allocation. This procedure results in an allocation rate measured in dollar cost per square foot of space used. In the patient services departments, full (total) costs would include the direct costs of each department and an allocation for housekeeping services, made on the basis of the amount of occupied space.

Cost Pools Typically, a cost pool consists of all of the direct costs of one support department.

However, if a single support department offers several substantially different services, and the patient services departments use those services in different relative amounts, it may be beneficial to separate the costs of that support department into multiple pools.

For example, suppose a hospital s financial services department provides two significantly different services: patient billing/collections and budgeting.

Furthermore, assume that the routine care department uses proportionally more patient billing/collections services than does the laboratory department, but the laboratory department uses proportionally more budgeting services than does the routine care department. In this situation, it would be best to create two cost pools for one support department. To do this, the total costs of financial services would be divided into a billing pool and a budgeting pool.

Then, cost drivers would be chosen for each pool and the costs allocated to the patient services departments as described in the following sections.

Cost Drivers Perhaps the most important step in the cost allocation process is the identification of proper cost drivers. Traditionally, overhead costs were aggregated across all support departments and then divided by a rough measure of organizational volume, resulting in an allocation rate of some dollar amount of generic overhead per unit of volume.

For example, the total inpatient overhead costs of a hospital might be divided by total inpatient days, giving an allocation rate of so many dollars per patient day, which is called the per diem overhead rate. If a hospital had 72,000 patient days in 2015 and its total inpatient overhead costs were $36 million, the overhead allocation rate would be $36,000,000 72,000 = $500 per patient day (per diem). Regardless of the type of patients treated within an inpatient services department (adult versus child, trauma versus illness, acute versus critical care, and so on), the $500 per diem allocation rate would be applied to determine the total indirect cost allocation for that department.

However, it is clear that not all overhead costs are tied to the number of patient days. For example, overhead costs associated with admission, discharge, and billing are typically not related to the number of patient days but to the number of admissions. Thus, tying all overhead costs to a single cost driver improperly allocates such costs, which distorts reported costs for patient services and hence raises concerns about the effectiveness of decisions based on such costs. In state-of-the-art cost management systems, the various types of overhead costs are separated into different cost pools, and the most appropriate cost driver for each pool is identified.

The theoretical basis for identifying cost drivers is the extent to which costs from a pool actually vary as the value of the driver changes. For example, does a patient services department with 10,000 square feet of space use twice the amount of housekeeping services as a department with only 5,000 square feet of space? The better the relationship (correlation) between actual resource expenditures at each subunit and the cost driver, the better the cost driver and the better the resulting cost allocations.

Effective cost drivers possess two important characteristics. First, and perhaps the less important of the two, is fairness that is, does the cost driver chosen result in an allocation that is fair to the patient services departments?

The second, and perhaps more important, characteristic is cost control that is, does the cost driver chosen create incentives for departments to use less of that overhead service?

For example, there is little that a patient services department manager can do to influence overhead cost allocations if the cost driver is patient days.

In fact, the action needed to reduce patient days might lead to negative financial consequences for the organization. An effective cost driver will encourage patient services department managers to take overhead cost reduction actions that do not have negative implications for the organization. The remainder of this chapter emphasizes the importance of effective cost drivers, including several illustrations that distinguish good drivers from poor ones.

Industry Practice Hospitals and Housekeeping Cost Drivers Most hospitals use square footage to allocate housekeeping costs. The rationale, of course, is that a patient services department that is twice as big as another will require twice the expenditure of housekeeping resources. The advantage of this cost driver is that it is easy to measure and does not change very often.

The disadvantage of using square footage as the cost driver is that some patient services departments require more housekeeping support because of the nature of the service, even when similar-sized spaces are occupied. For example, emergency departments require more intense housekeeping services than do neonatal care units.

Is there a better cost driver available for allocating housekeeping costs? If so, what is it?

Describe how the new and improved cost driver would work.

EXHIBIT 6.1 Prairie View Clinic:

Allocation of Housekeeping Overhead to the Physical Therapy Department The Allocation Process The steps involved in allocating overhead costs are summarized in Exhibit 6.1, which illustrates how Prairie View Clinic allocated its housekeeping costs for 2016. Cost allocation takes place both for historical purposes, in which realized costs over the past year are allocated, and for planning purposes, in which estimated future costs are allocated to aid in pricing and other decisions. The examples in this chapter generally assume that the purpose of the allocation is for financial planning and budgeting, so the data presented are estimated for the coming year 2016.

The first step in the allocation process is to establish the cost pool. In this case, the clinic is allocating housekeeping costs, so the cost pool is the projected total costs of the housekeeping department $100,000.

Next, the most effective cost driver must be identified. After considerable investigation, Prairie View s managers concluded that the best cost driver for housekeeping costs is labor hours that is, the number of hours of housekeeping services required by the clinic s departments is the variable most closely related to the actual cost of providing these services. The intent here, of course, is to pick the cost driver that provides the most accurate cause-and-effect relationship between the use of housekeeping services and the costs of the housekeeping Step One: Determine the Cost Pool The departmental costs to be allocated are for the housekeeping department, which has total budgeted costs for 2016 of $100,000.

Step Two: Determine the Cost Driver The best cost driver was judged to be the number of hours of housekeeping services provided. An expected total of 10,000 hours of such services will be provided in 2016 to those departments that will receive the allocation.

Step Three: Calculate the Allocation Rate $100,000 10,000 hours = $10 per hour of housekeeping services provided.

Step Four: Determine the Allocation Amount The physical therapy department uses 3,000 hours of housekeeping services, so its allocation of housekeeping department overhead is $10.3,000 = $30,000.

department. For 2016, Prairie View s managers estimate that the housekeeping department will provide 10,000 hours of service to the departments that will receive the allocation.

Now that the cost pool and cost driver have been defined and measured, the allocation rate is established by dividing the expected total overhead cost (the cost pool) by the expected total volume of the cost driver: $100,000 10,000 hours = $10 per hour of services provided.

Key Equation: Allocation Rate The allocation rate is the rate used to calculate each user department s allocation of an overhead cost pool. To illustrate, assume the financial services department has $1,000,000 in total costs (the cost pool) and the patient services departments in total generate 500,000 bills (the cost driver). Then, the allocation rate is $2 per bill:

Allocation rate = Cost pool amount Cost driver volume = $1,000,000 500,000 bills = $2 per bill.

The final step in the process is to make the allocation to each department.

To illustrate the allocation, consider the physical therapy (PT) department one of Prairie View s patient services departments. For 2016, PT is expected to use 3,000 hours of housekeeping services, so the dollar amount of housekeeping overhead allocated to PT is $10 . 3,000 = $30,000. Other departments within the clinic will also use housekeeping services, and their allocations would be made in a similar manner the $10 allocation rate per hour of services used is multiplied by the amount of each department s hourly utilization of housekeeping services. When all departments are considered, the 10,000 hours of housekeeping services is fully distributed among the using departments. For any one department, the amount allocated depends on both the allocation rate and the amount of housekeeping services used.

SELF-TEST QUESTIONS 1. What are the definitions of a cost pool, a cost driver, and an allocation rate?

2. Under what conditions should a single overhead department be divided into multiple cost pools?

3. On what theoretical basis are cost drivers chosen?

4. What two characteristics make an effective cost driver?

5. What are the four steps in the cost allocation process?

Cost Allocation Methods Mathematically, cost allocation can be accomplished in a variety of ways, and the method used is somewhat discretionary. No matter what method is chosen, all support department costs eventually must be allocated to the departments (generally patient services departments) that create the need for those costs.

The key differences among the methods are how support services provided by one department are allocated to other support departments. The direct method totally ignores services provided by one support department to another. Two other allocation methods address intrasupport department allocations.

The reciprocal method recognizes all of the intrasupport department services, and the step-down method represents a compromise that recognizes some, but not all, of the intrasupport department services. Regardless of the method, all of the support costs within an organization ultimately are allocated from support departments to the departments that generate revenues for the organization.

Exhibit 6.2 summarizes the three allocation methods. Prairie View Clinic, which is used in the illustration, has three support departments (human EXHIBIT 6.2 Prairie View Support Departments Patient Services Departments Clinic: Direct Method Alternative Human Resources Cost Allocation Methods Housekeeping Physical Therapy Internal Medicine Administration Reciprocal Method Human Resources Housekeeping Physical Therapy Administration Internal Medicine Step-Down Method Human Resources Housekeeping Physical Therapy Administration Internal Medicine resources, housekeeping, and administration) and two patient services departments (physical therapy and internal medicine).

Under the direct method, shown in the top section of Exhibit 6.2, each support department s costs are allocated directly to the patient services departments that use the services. Thus, none of the support services costs are allocated to other support departments. In the illustration, both physical therapy and internal medicine use the services of all three support departments, so the costs of each support department are allocated to both patient services departments. The key feature of the direct method and the feature that makes it relatively simple to apply is that no intrasupport department allocations are recognized. Thus, under the direct method, only the direct costs of the support departments are allocated to the patient services departments because no indirect costs have been created by intrasupport department allocations.

As shown in the center section of Exhibit 6.2, the reciprocal method recognizes the support department interdependencies among human resources, housekeeping, and administration, and hence it generally is considered to be more accurate and objective than the direct method. The reciprocal method derives its name from the fact that it recognizes all of the services that departments provide to and receive from other departments. The good news is that this method captures all of the intrasupport department relationships, so no information is ignored and no biases are introduced into the cost allocation process. The bad news is that the reciprocal method relies on the simultaneous solution of a series of equations representing the utilization of intrasupport department services. Thus, it is relatively complex, which makes it difficult to explain to department heads and typically more costly to implement.

The step-down method, which is shown in the lower section of Exhibit 6.2, represents a compromise between the simplicity of the direct method and the complexity of the reciprocal method. It recognizes some of the intrasupport department effects that the direct method ignores, but it does not recognize the full range of interdependencies as does the reciprocal method. The step- down method derives its name from the sequential, stair-step pattern of the allocation process, which requires that the allocation take place in a specific sequence. As shown in the exhibit, all the direct costs of human resources first are allocated to both the patient services departments and the other two support departments. Human resources is then closed out because all of its costs have been allocated. Next, housekeeping costs, which now consist of both direct and indirect costs (the allocation from human resources), are allocated to the patient services departments and the remaining support department administration. Finally, the direct and indirect costs of administration are allocated to the patient services departments. The final allocation from administration includes human resources and housekeeping costs because a portion of these support costs has been allocated or stepped down to administration.

Direct method A cost allocation method in which all overhead costs are allocated directly from the overhead departments to the patient services departments with no recognition that overhead services are provided to other support departments.

Reciprocal method A cost allocation method that recognizes all of the overhead services provided by one support department to another.

Step-down method A cost allocation method that recognizes some of the overhead services provided by one support department to another.

SELF-TEST QUESTIONS Profit center A business unit (in our examples, typically a department) that generates revenues as well as costs, and hence its profitability can be measured.

Cost center A business unit that does not generate revenues, and hence only its costs can be measured.

The critical difference between the step-down and reciprocal methods is that after each allocation is made in the step-down method, a support department is removed from the process. Even though housekeeping and administration provide support services back to human resources, these indirect costs are not recognized because human resources is removed from the allocation process after the initial allocation. Such costs are recognized in the reciprocal method.

1. What are the three primary methods of cost allocation?

2. Explain how they differ.

3. Which one do you think is best? Which is the worst?

Direct Method Illustration The best way to gain a more in-depth understanding of cost allocation is to work through several allocation illustrations. We begin with the direct method.

As shown in Exhibit 6.3, Kensington Hospital has three revenue-producing patient services departments: routine care, laboratory, and radiology. Accountants often call the patient services departments profit centers, because they not only incur costs but also create revenues. Conversely, overhead departments are called cost centers in that they incur costs but create no revenues.

Hospital costs are divided into those costs attributable to the profit centers (direct costs) and those costs attributable to the support departments (overhead costs). Of course, the overhead costs are direct costs to the support departments, but when they are allocated to the patient services departments, these direct costs become indirect (overhead) costs.

The data show that the revenues for each of the patient services departments are much greater than their direct costs. Furthermore, Kensington s projected total revenues of $27,000,000 exceed the hospital s projected total costs of $25,450,000. However, the aggregate revenue and cost amounts provide no information to Kensington s managers concerning the true profitability of each patient services department. To determine true profitability by profit center, the full costs of providing patient services, including both direct and indirect costs, must be measured. Only then can the hospital s managers develop rational pricing and cost control strategies.

As previously discussed, three decisions are required when allocating costs: how to define the cost pools, what the cost drivers are, and which method of allocation to use. We begin by illustrating the direct method of cost allocation. The step-down method is discussed in the Chapter 6 Supplement.

The cost pools (total costs) for the support departments are given in the lower section of Exhibit 6.3. Financial services costs are $1,500,000; Projected Revenues by Patient Services Department Routine Care Laboratory Radiology Total revenues Projected Costs for All Departments Patient Services Departments (Direct Costs):

Routine Care Laboratory Radiology Total costs Support Services Departments (Overhead Costs):

Financial Services Facilities Housekeeping General Administration Human Resources Total overhead costs Total costs of both patient and support services Projected profit $16,000,000 5,000,000 6,000,000 $27,000,000 $ 5,500,000 3,300,000 2,800,000 $ 11,600,000 $ 1,500,000 3,800,000 1,600,000 4,400,000 2,550,000 $ 13,850,000 $25,450,000 $ 1,550,000 EXHIBIT 6.3 Kensington Hospital: 2016 Revenue and Cost Projections facilities costs equal $3,800,000; housekeeping costs are $1,600,000; general administration costs total $4,400,000; and human resources costs equal $2,550,000. Thus, overhead costs at the hospital total $13,850,000, which ultimately must be allocated to the hospital s three patient services departments.

Kensington s managers believe that little is to be gained by dividing any of the support departments into multiple cost pools, so each support department constitutes one cost pool.

The next step in the allocation process is to identify the best cost drivers for each cost pool. Exhibit 6.4 provides a summary of the support departments and their assigned cost drivers. Unfortunately, the selection of cost drivers is not an easy process, and to a large extent the usefulness of the entire cost allocation process depends on choosing the most effective drivers.

As discussed later, Kensington s selection of cost drivers, like many selections made in real-world situations, is somewhat of a compromise between effectiveness and simplicity.

EXHIBIT 6.4 Kensington Hospital:

Assigned Cost Drivers Support Services Department Cost Driver Financial Services Patient services revenue Facilities Space utilization (square footage) Housekeeping Labor hours General Administration Salary dollars Human Resources Salary dollars The cost driver chosen for financial services is patient services revenue.

Financial services provides a full range of financial support to the hospital.

The bulk of its efforts are devoted to patient billing and collections, but it is also involved in financial and managerial accounting, budgeting and report preparation, and a host of other financial tasks. Tying the allocation of this support department to the amount of patient services revenues assumes a strong positive relationship between the amount of financial services provided to each patient services department and revenues generated by that department.

Clearly, patient services revenue is a relatively inaccurate cost driver, and hence the resulting cost allocation has limitations. In the next section, we discuss the benefits of moving from a poor cost driver to a better one.

The amount of space used (square footage) is the basis for allocating the costs of facilities. This cost driver is often used by health services organizations to allocate the initial costs of land, buildings, and equipment as well as the costs of maintenance and other facilities services. The logic applied here is that the patient services departments with the most space require the most facilities and hence the most facilities support. Of course, this assumption does not always hold. For example, in any year, facilities may be required to support a special large project for one of the patient services departments, resulting in costs that far exceed that department s proportional space utilization.

Nevertheless, over the long run at Kensington Hospital, the relative costs of facilities utilization by the patient services departments track closely with the space occupied by those departments.

Two of the remaining support departments, general administration and human resources, also use a relatively poor cost driver, salary dollars. If radiology has payroll costs that are five times larger than those of laboratory, radiology will be charged (allocated) five times as much of the costs incurred by administration and personnel. This cost driver is often used, but in reality it is not very good. Thus, the allocated costs from general administration and human resources probably do not truly represent the relative amounts of utilization of these overhead services.

Housekeeping has chosen perhaps the best cost driver namely, the number of labor hours of housekeeping services consumed. In many organizations, housekeeping costs are allocated on the basis of square footage, using the logic that the amount of space occupied by a department accurately reflects housekeeping efforts and hence costs. This assumption may or may not be valid, however. In effect, large-space departments may be subsidizing small- space departments, such as emergency services, where space may be limited but the intensity of work requires a significant amount of housekeeping services.

To account for such situations at Kensington Hospital, housekeeping is using a better cost driver one that more closely aligns to the actual resources expended in providing support to the patient services departments.

The development and use of the best cost driver is a cost benefit issue.

Housekeeping must devote resources to tracking where their workers spend their time, an effort that would not be required if the cost driver were square footage. The benefit, of course, is a cost driver that makes it easier for Kensington s senior managers to hold department heads responsible for both direct and indirect costs. If the head of the radiology department does not like the amount of housekeeping costs that are being charged to the department, she can do something about it: use fewer housekeeping services. With an inferior cost driver, such as square footage, there is little that patient services department heads can do if they do not like the housekeeping allocation. In most cases, reduction of square footage is not a practical way to deal with excessive housekeeping costs.

With labor hours consumed as the cost driver, the cost control solution for patient services department heads is to reduce the amount of housekeeping services used. If all patient services department heads are made to think this way by having the right incentive system in place, ultimately the hospital will discover it is as efficient as possible in using housekeeping services. In the long run, the direct costs of the housekeeping department currently $1,600,000 will fall as these services are more efficiently used. In reality, the secondary benefit of choosing a more effective cost driver is a more equitable allocation. The primary benefit is that a good cost driver creates an incentive to use less of the support service, which ultimately leads to lower overhead costs for the organization.

Exhibit 6.5 contains the initial data necessary for the allocation. The first column of the exhibit lists the patient services departments. The amounts of the chosen cost drivers consumed by each patient services department are listed after that: patient services revenue used for allocating financial services costs, square footage used for facilities allocations, housekeeping labor hours used for housekeeping allocations, and departmental salary dollars used for both general administration and human resources allocations.

If Kensington were using the step-down or reciprocal allocation methods, the information shown in Exhibit 6.5 would have to include the support departments because the data would be needed for intrasupport department EXHIBIT 6.5 Kensington Patient Hospital: Services Square Housekeeping Salary Patient Services Department Revenues Feet Labor Hours Dollars Departmental Summary Data Routine Care $16,000,000 199,800 76,000 $ 5,709,000 Laboratory 5,000,000 39,600 6,000 2,035,000 Radiology 6,000,000 61,200 9,000 2,439,000 Total $27,000,000 300,600 91,000 $10,183,000 allocations. By using the direct method, the hospital ignores intrasupport department dependencies, so the totals indicated at the bottom of each column reflect only the use of support services by the patient services departments, to which are allocated all of the support costs.

Exhibit 6.6 divides the dollar amount of each cost pool by the total amount of each cost driver to derive the allocation rates. For example, the cost pool (direct costs) for financial services totals $1,500,000, which will be allocated as indirect (overhead) costs to the patient services departments that have a total of $27,000,000 in patient services revenues. The allocation rate for financial services, therefore, is $1,500,000 $27,000,000 = $0.05556 per dollar of patient services revenue.

As previously mentioned, the allocation of indirect costs can be viewed as an internal pricing mechanism. Thus, the heads of the revenue-producing departments can look at Exhibit 6.6 and see the rate that they are being charged for support services, which amounts to the following:

$0.05556 for each dollar of patient services revenue generated for financial services support.

$12.64 per square foot of space used for facilities support.

EXHIBIT 6.6 Kensington Hospital:

Department Cost Pool (total costs) Cost Driver Total Utilization Allocation Ratea Overhead Allocation Rates Financial Services FacilitiesHousekeeping$1,500,000 3,800,000 1,600,000 Patient revenue Square feetLabor hours$27,000,000 300,600 91,000$0.05556 12.64 17.58 GeneralAdministration 4,400,000 Salary dollars $10,183,000 0.432 Human Resources 2,550,000 Salary dollars $10,183,000 0.250 a $ per unit of the cost driver $17.58 per labor hour consumed for housekeeping support.

$0.432 per salary dollar paid to department employees for general administrative overhead.

$0.250 per salary dollar for human resources support.

If radiology pays a technician $10 an hour in direct labor costs for each hour the technician works, the department will also be charged 0.432 . $10.00 = $4.32 for general administrative overhead and 0.250 . $10.00 = $2.50 for human resources overhead, plus additional allocations for financial services, facilities, and housekeeping support. Having two cost pools, in this case the general administration and human resources departments, that use the same cost driver (salary dollars) is not unusual. However, the allocation rate is different for the two support departments because they have different cost pool amounts.

The final step in the allocation process is to calculate the actual dollar allocation to each of the patient services departments, which is shown in Exhibit 6.7. The support departments are listed in the first column, along with the applicable allocation rate, while the patient services departments are listed across the top. To illustrate the calculations, consider the routine care department. It produces $16,000,000 in patient services revenue, and the overhead allocation rate for financial services is $0.05556 per dollar of patient services revenue, so the allocation for such support is 0.05556 . $16,000,000 = $888,960. Furthermore, routine care has 199,800 square feet of space; with a facilities rate of $12.64 per square foot, its allocation for facilities support is $12.64 . 199,800 = $2,525,472.

The allocations to the routine care department for housekeeping, general administration, and human resources support shown in Exhibit 6.7 were calculated similarly. The end result is that $8,644,050 out of a total of $13,850,000 of the indirect (overhead) costs of Kensington Hospital are allocated to routine care. Routine care also has direct costs of $5,500,000, so the full (total) costs of the department, including both direct and indirect, are $8,644,050 + $5,500,000 = $14,144,050. The cost allocations and total cost calculations for the laboratory and radiology departments shown in Exhibit 6.7 were done in a similar manner.

For general management purposes, understanding the mechanics of the allocation is less important than recognizing the value of choosing effective cost drivers. The cost driver for housekeeping services (i.e., the number of service hours provided) is good in the sense that it reflects the true level of effort expended by this department in support of the patient services departments.

The patient services department heads are being fairly charged for these services, and more important, patient services department heads can take actions to lower the allocated amounts by reducing the amount of housekeeping services used.

EXHIBIT 6.7 Kensington Hospital: Final Allocations Patient Services Department Support Department (allocation rate) Routine Care Laboratory Radiology Financial Services ($0.05556) . $16,000,000 = $ 888,960 . $5,000,000 = $ 277,800 . $6,000,000 = $ 333,360 Facilities ($12.64) . 199,800 = 2,525,472 . 39,600 = 500,544 . 61,200 = 773,568 Housekeeping ($17.58) . 76,000 = 1,336,080 . 6,000 = 105,480 . 9,000 = 158,220 Administration ($0.432) . 5,709,000 = 2,466,288 . 2,035,000 = 879,120 . 2,439,000 = 1,053,648 Personnel ($0.250) . 5,709,000 = 1,427,250 . 2,035,000 = 508,750 . 2,439,000 = 609,750 Total indirect costs $ 8,644,050 $ 2,271,694 $ 2,928,546 Direct costs $ 5,500,000 $ 3,300,000 $ 2,800,000 Total costs $ 14,144,050 $ 5,571,694 $ 5,728,546 Total indirect costs = $8,644,050 + $2,271,694 + $2,928,546 = $13,844,290.

Total costs = $14,144,050 + $5,571,694 + $5,728,546 = $25,444,290.

Note: Because of rounding in the allocation process, the totals here differ slightly from the values contained in Exhibit 6.3.

In closing this illustration, note how Exhibit 6.7, after the allocation process, reconciles with Exhibit 6.3, before the allocation process. First, as shown in Exhibit 6.3, total support services (overhead) costs are $13,850,000.

This is the same amount (except for a rounding difference) shown in Exhibit 6.7 as the total overhead allocated to the patient services departments:

$8,644,050 (to routine care) + $2,271,694 (to laboratory) + $2,928,546 (to radiology) = $13,844,290. The total after-allocation costs of $25,444,290 shown in Exhibit 6.7 also equal the original forecast for total costs in Exhibit 6.3 of $25,450,000 (again, except for a rounding difference).

SELF-TEST 1. Briefly outline the allocation procedures used by Kensington QUESTIONS Hospital.

2. What underlying characteristic creates a good cost driver?

3. What are the two properties of an effective cost driver?

4. What is the most important organizational benefit derived from the selection of an effective cost driver?

Cost Allocation and Departmental Profitability At this point, you must be thinking that Kensington Hospital spent a lot of time and effort in the cost allocation process. Was it all worth it? What did Kensington s managers gain from the effort? Well, the answer is this: They now know the profitability of the patient services departments when all costs, including indirect costs, are considered.

Exhibit 6.8 summarizes the profitability of Kensington s patient services departments when viewed from both direct cost and total (full) cost perspectives.

In effect, Exhibit 6.8 contains projected profit-and-loss statements for the patient services departments for 2016. Sections 1 and 2 list projected revenues and projected direct costs, respectively, of the three patient services departments. Then, Section 3 lists the profitability of each department when only direct costs are considered. As you see, all three patient services departments are profitable in this situation, which may make everyone happy, at least temporarily.

Note that the values in parentheses in Section 3 are profit margins, defined as Profit Revenues. For example, the profit margin listed for the routine care department is $10,500,000 $16,000,000 = 0.656 = 65.6%, which can be interpreted as each dollar of revenues leading to 65.6 cents in profits when only direct costs are considered. The higher the margin, the better (more profitable) the department. Profit margins make it easier for healthcare managers to compare the relative profitability of departments. Based on the margin values in Section 3, we see that the aggregate profit of all patient services departments is 57.0 percent, so routine care is doing better than average, EXHIBIT 6.8 Kensington Hospital: 2016 Patient Services Department Revenue, Cost, and Profitability Projections (margins listed in parentheses) 1. Projected Revenues Routine Care Laboratory Radiology Total revenues 2. Projected Direct Costs Routine Care Laboratory Radiology Total direct costs 3. Projected Profit on Direct Costs Routine Care Laboratory Radiology Aggregate profit on direct costs 4. Projected Indirect Costs Routine Care Laboratory Radiology Total indirect costs 5. Projected Profit on Total Costs Routine Care Laboratory Radiology Aggregate profit on total costs $ 16,000,000 5,000,000 6,000,000 $27,000,000 $ 5,500,000 3,300,000 2,800,000 $ 11,600,000 $ 10,500,000 (65.6%) 1,700,000 (34.0) 3,200,000 (53.3) $15,400,000 (57.0%) $ 8,644,050 2,271,694 2,928,546 $13,844,290 $ 1,855,950 (11.6%) .571,694 (.11.4) 271,454 (4.5) $ 1,555,710 (5.8%) Note: Because of rounding in the allocation process, some of the values here differ slightly from the values contained in Exhibit 6.3.

radiology is slightly worse than average, and laboratory is doing much worse than average. Still, all departments are profitable.

Section 4 of Exhibit 6.8 lists the indirect costs allocated to each patient services department, which were taken from Exhibit 6.7, and Section 5 lists patient services department profitability when total (full) costs, including direct and indirect, are considered. Now, based on Section 5 data, we see that one of the three patient services departments, laboratory, is expected to experience an 11.4 percent profit margin loss in 2016. In addition, the true profitability of the patient services departments is not nearly as high as shown in Section 3 when only direct costs were considered. Now, the aggregate (average) margin is only 5.8 percent as compared to 57.0 percent when only direct costs are considered.

The real moral of this story is that looking at departmental profitability solely on the basis of direct costs, although valuable for some purposes, does not give a complete picture of each department s financial status. To obtain the best measure of departmental profitability, it is necessary to include both direct and indirect costs in the analysis.

Changing to a More Effective Cost Driver The Kensington Hospital example illustrated the direct method of cost allocation. In this section, we illustrate the benefits of moving from a poor cost driver to a better one.

Kensington historically has allocated the $1,500,000 in financial services costs on the basis of the dollar volume of patient services provided. However, it was widely recognized that this driver was not highly correlated with the actual amount of overhead services provided by the financial services department to each patient services department, and hence it was not perceived by the patient services department heads as being fair. More important, it did not create an incentive for overhead cost reduction because patient services department heads would not reduce the amount of services provided (and hence reduce revenues) just to lower their overhead allocations.

A thorough analysis of the work done by the financial services department indicated that its primary task in support of the patient services departments is generating third-party payer billings and collecting the payments on those bills. Thus, Kensington s managers concluded that the cost of providing financial services is more highly correlated with the number of bills generated than with patient services revenues, so number of bills was chosen as the new cost driver.

Exhibit 6.9 contains the new cost allocations for financial services as well as a comparison with the allocations under the old (patient services revenue) driver. Note that the allocations have changed substantially. Because For Your Consideration Profitability and Bonuses As shown in Exhibit 6.8, the profitability of Kensington Hospital s three patient services departments is forecasted for 2016 on the basis of direct costs and full (total) costs, which include indirect costs. When only direct costs are considered, the ranking of departmental profitability (from high to low) is routine care, radiology, and laboratory.

Furthermore, all departments are profitable. However, when indirect costs are added to the mix, the order stays the same but one of the departments (laboratory) becomes unprofitable.

Now assume that Kensington compensates its department heads using a base salary plus bonus system, with the bonus tied to department profitability as measured by profit margin. If the departm