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HealtHcare Finance an introduction to accounting& Financial Management sixth edition HealtHcare Finance an introduction to accounting& Financial Management sixth edition Louis C. Gapenski kristin L. reiter AUPHA/HAP Editorial Board for Graduate Studies Suzanne Babich, DrPH, Chairman University of North Carolina at Chapel Hill LTC Lee W. Bewley, PhD, FACHE Webster University Jan Clement, PhD Virginia Commonwealth University Michael Counte, PhD St. Louis University Joseph F. Crosby Jr., PhD Armstrong Atlantic State University Jonathan P. DeShazo, PhD Virginia Commonwealth University Mark L. Diana, PhD Tulane University Blair D. Gifford, PhD University of Colorado Denver Peter D. Jacobson, JD University of Michigan Nir Menachemi, PhD Indiana University Mark A. Norrell, FACHE Indiana University Mary S. O Shaughnessey, DHA University of Detroit Mercy Cynda M. Tipple, FACHE Marymount University Leah J. Vriesman, PhD University of California, Los Angeles Health Administration Press, Chicago, IllinoisAssociation of University Programs in Health Administration, Arlington, Virginia Your board, staff, or clients may also benefit from this book s insight. For more information on quantity discounts, contact the Health Administration Press Marketing Manager at (312) 424-9470.

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The statements and opinions contained in this book are strictly those of the authors and do not represent the official positions of the American College of Healthcare Executives, the Foundation of the American College of Healthcare Executives, or the Association of University Programs in Health Administration.

Copyright 2016 by the Foundation of the American College of Healthcare Executives.

Printed in the United States of America. All rights reserved. This book or parts thereof may not be reproduced in any form without written permission of the publisher.

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

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

Gapenski and Kristin L. Reiter. Sixth edition.

pages cm Includes index.

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

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

RA971.G3695 2016 362.11068’1 dc23 2015032582 The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences Permanence of Paper for Printed Library Materials, ANSI Z39.48-1984. Acquisitions editor: Janet Davis; Project manager: Joyce Dunne; Cover designer: James Slate; Layout: Cepheus Edmondson Found an error or a typo? We want to know! Please e-mail it to hapbooks@ache.org, and put Book Error in the subject line.

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

Chapter 7.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ancillary Materials for Instructors Three important teaching aids are available for instructors who adopt this book. To request access to online instructor resources, please e-mail hapbooks@ache.org.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Describe the key characteristics of a business.

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

Describe the major players in the health services industry.

List the key operational issues currently faced by healthcare managers.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2. What is the purpose of this book?

3. Briefly describe the organization of this book.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. What is meant by the term healthcare finance?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Between a business and a governmental agency?

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

In general, finance activities include the following:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2. How has this role changed over time?

3. What are the four Cs?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Proprietorships and partnerships have several disadvantages, including the following:

Selling their interest in the business is difficult for owners.

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

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

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

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

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

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

Owners of a corporation have limited liability.

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

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

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

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

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

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

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

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

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

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

2. What is the purpose of hybrid forms?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

1. The hospital must maintain its financial viability.

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

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

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

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

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

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

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