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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?

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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?


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?


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.

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