1. 3 - 1 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Principles of Financial Accounting Introduction to financial accounting Users of financial accounting info The “Big 4” financial statements The role of standards in financial accounting practice

2. 3 - 2 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The Securities and Exchange Commission (SEC) has the legal authority to regulate the form and content of financial statements. But, the SEC relies on the following organizations for implementation: Financial Accounting Standards Board (FASB) Industry Committees of the American Institute of Certified Public Accountants (AICPA) Principles and Practices Board of the Healthcare Financial Management Association (HFMA) Regulation and Standards

3. 3 - 3 Copyright © 1999 by the Foundation of the American College of Healthcare Executives GAAP The conventions that have evolved over time from the pronouncements and rulings of the implementing organizations constitute a widely accepted set of guidelines for the preparation of financial statements. These guidelines are called generally accepted accounting principles (GAAP). The GAAP applies only to financial accounting statements.

4. 3 - 4 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Introduction to Financial Accounting Financial vs. managerial uses of accounting information Principles of financial accounting The accounting entity vs. the legal entity Organizational resources and obligations Duality relationship Total assets = total liabilities plus net worth Accounting examples of duality relationship

5. 3 - 5 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Introduction (Cont.) Example #1 - MD purchase of X-ray Increased total assets (+50K) Decreased cash assets (-50K) Duality relationship holds Example #2 - Hospital purchase of ASC Increased total assets (+2M) Decreased cash assets (-200K) Increased total liabilities (+1.8M) Duality relationship holds

6. 3 - 6 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Introduction (Cont.) Asset Valuation Methods Definition/purpose Replacement cost valuation Market valuation Historical cost valuation Advantages/disadvantages w/each Application - ROI calculations w/each valuation method (capital budgeting)

7. 3 - 7 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Introduction (cont’d) ROI Application MRI purchase by OP imaging facility Asset valuations: Historical cost -- $1M Market Value -- $800K Replacement cost -- $1.5M ROI estimates: ROI(H) -- 10% ROI(M) -- 12.5% ROI(R) -- 6.7% Comparison to cost of capital

8. 3 - 8 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Introduction (cont’d) Cash vs. Accrual basis of accounting Accrual-based accounting “Booking” of financial transactions GAAP accepted accounting basis Examples Cash-based accounting Advantages/disadvantages compared with accrual-based accounting Use(s) in financial statement preparation

9. 3 - 9 Copyright © 1999 by the Foundation of the American College of Healthcare Executives The Balance Sheet and Statement of Cash Flows Balance sheet Accounting identity Assets Liabilities and equity Relationship between the income statement and the balance sheet Statement of cash flows

10. 3 - 10 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Balance Sheet Basics Whereas the income statement contains information about a business’ operations, the balance sheet contains information about: The assets of an organization. The liabilities and equity of the business, or how the assets were financed. The balance sheet presents a business’ position at a given point in time.

11. 3 - 11 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Balance Sheet Basics (Cont.) The balance sheet is organized with a left side (or upper section) and right side (or lower section): Assets Current assets Long-term assets Total assets Liabilities and Equity Current liabilities Long-term liabilities Equity Total liabilities and equity

12. 3 - 12 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Sunnyvale Clinic: Assets (in thousands) 1998 1997 Current Assets: Cash $ 12,102 $ 6,486 Marketable securities 10,000 5,000 Net patient accounts receivable 28,509 25,927 Inventories 3,695 2,302 Total current assets $ 54,306 $ 39,715 Long-term investments $ 42,889 $ 20,667 Property and Equipment: Land $ 2,954 $ 2,035 Buildings and equipment 85,595 77,208 Gross fixed assets $ 88,549 $ 79,243 Less: Accumulated dep. 36,099 30,144 Net fixed assets $ 52,450 $ 49,099 Other Assets: Goodwill $ 5,170 $ 5,620 Total assets $154,815 $115,101

13. 3 - 13 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Assets Assets either possess (say, cash) or create (say, buildings and equipment) economic benefit to the business. Current assets include: Cash Other assets that are expected to be converted into cash within the next year: Marketable securities Net patient accounts receivable Inventories

14. 3 - 14 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Cash represents actual cash in hand and money held in commercial checking accounts. Marketable securities (MS) are short- term investments in highly liquid, typically low-risk securities: One example is Treasury bills (T-bills). MS are reported at cost, but their current market value is given in the footnotes. Current Assets (Cont.)

15. 3 - 15 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net patient accounts receivable represents revenues owed to the business but not yet collected. Current Assets (Cont.)

16. 3 - 16 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Assets (Cont.) Inventories represent the dollar amount of expendable supplies on hand. For providers, inventories are primarily medical supplies. Only supplies actually consumed in treating patients are expensed on the income statement. Providers with very small inventory accounts often group inventories in with another account.

17. 3 - 17 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Assets (Cont.) Other current assets is a catchall account to hold short-term assets not listed separately. Note that current assets are listed in order of liquidity, or nearness to cash. Current assets are necessary to support operations, but they provide no explicit monetary return.

18. 3 - 18 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Long-Term Investments Long-term investments are investments in securities (financial assets) as opposed to buildings and equipment (real assets). Unlike marketable securities, these assets have maturities greater than one year. Long-term investments are carried on the balance sheet at fair market value.

19. 3 - 19 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Property and Equipment Property and equipment, or fixed assets, represent real assets having useful lives greater than one year. Gross fixed assets are listed at historical cost. Net fixed assets reflect an adjustment for accumulated depreciation. Note that each year’s income statement depreciation expense increases the accumulated depreciation account.

20. 3 - 20 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Other Assets: Goodwill Other assets is a catchall account for long-term assets that do not belong in another category. Goodwill is an intangible, as opposed to tangible, asset. It stems from buying businesses at prices that exceed their book value of equity. Presumably, such “excess” value is due to intangible factors.

21. 3 - 21 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Other Assets (cont’d) Restricted Assets Investment Assets Organizational costs

22. 3 - 22 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Sunnyvale Clinic: Liabilities and Equity (in thousands) 1998 1997 Current Liabilities: Current maturities of LT debt $ 2,834 $ 2,345 Accounts payable 6,522 7,933 Accrued Expenses: Wages and benefits 4,344 3,523 Taxes 844 996 Interest payable 881 518 Total current liabilities $ 15,425 $ 15,315 Long-term debt $ 85,322 $ 53,578 Total liabilities $100,747 $ 68,893 Net assets (Equity) $ 54,068 $ 46,208 Total liabilities and equity $154,815 $115,101

23. 3 - 23 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Liabilities Liabilities represent claims against assets that are fixed by contract. Failure to meet these claims can result in bankruptcy and potential closure. Current liabilities include those claims that must be paid within one year: Notes payable Current maturities of long-term debt Accounts payable Accrued expenses

24. 3 - 24 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Current Liabilities (Cont.) Notes payable are short-term debt obligations, typically bank loans. Sunnyvale has no bank loans in use. Current maturities of long-term debt represents principal payments coming due on long-term debt obligations: Serial bond issues

25. 3 - 25 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Accounts payable stems from buying goods (typically medical supplies) from vendors on credit called trade credit. Vendors often have payment terms such as 2/10, net 30. Here, the buyer can obtain a 2% discount if it pays in 10 days. If not, the full purchase price is due in 30 days. The amount purchased, but not yet paid, is carried as an accounts payable. Current Liabilities (Cont.)

26. 3 - 26 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Accrued expenses (accruals) are payment obligations of the business, primarily to: Employees Taxing authorities Debt suppliers Current Liabilities (Cont.)

27. 3 - 27 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Incurred but not reported (IBNR) expenses is an important current liability account for providers with a high percentage of capitated revenues. Payment is received before services are provided The matching principle requires expenses to be matched to revenues Some businesses have a catchall account called other current liabilities. Current Liabilities (Cont.)

28. 3 - 28 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Long-Term Debt Long-term debt represents debt financing with maturities greater than one year. Detailed information typically is provided in the footnotes.

29. 3 - 29 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity Equity represents the non-liability claims against a business’ assets. For investor-owned businesses, equity is the amount of owner-supplied financing. For not-for-profit businesses, equity is the amount of capital supplied “by the community.” The equity account is really a residual: Equity = Total assets - Total liabilities.

30. 3 - 30 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity (Cont.) The equity section of the balance sheet, more than anything else, distinguishes an investor-owned business from a not-for-profit business. In not-for-profit corporations, the equity account is called net assets--it is the dollar value of assets net of liabilities.

31. 3 - 31 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity (Cont.) A for-profit equity section might look like this: 1998 1997 Stockholders’ Equity: Common stock ($1 par value, $ 1,000 $ 1,000 1,500,000 shares authorized, 1,000,000 shares outstanding) Capital in excess of par 9,000 9,000 Retained earnings 44,068 36,208 Total equity $54,068 $46,208

32. 3 - 32 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity (Cont.) Note that retained earnings, or the entire net equity account for not-for- profit organizations, is influenced by the amount of net income shown on the income statement.

33. 3 - 33 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Equity (Cont.) The right side of the balance sheet gives the mix of debt and equity financing, which is called a business’ capital structure. Capital structure is a key financing decision because it affects the business’: Cost of financing. Overall risk.

34. 3 - 34 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Income Statement Basics Perhaps the most important question about a business’ financial status is whether or not it is making money. The income statement provides information about the operations and economic profitability of a business. The income statement is often called by other names: Statement of operations Statement of activities

35. 3 - 35 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Income Statement Basics (Cont.) The income statement reports the results of operations over a some period of time, say, a year. It has three key elements: Revenues, which represent both cash received as well as payor obligations. Expenses, which are the resource expenditures required to produce the revenues. Operating expenses Financial expenses Net income (profit) = Revenues - Expenses.

36. 3 - 36 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Sunnyvale Clinic: Revenues (in thousands) 1998 1997 Revenues: Net patient service revenue $169,013 $140,896 Other revenue 7,079 5,704 Total revenues $176,092 $146,600

37. 3 - 37 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Revenues Revenues are shown in several different formats depending on the type of provider. Sunnyvale has two revenue categories. Net patient service revenue. The key definitions here are: Net Patient service revenue

38. 3 - 38 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Revenues (Cont.) In reporting revenues, note the difference in how the following adjustments are handled: Discounts Charity care Bad debt losses Other revenue represents revenues from sources besides patient care, including: Interest earned on investments Contributions Rental income

39. 3 - 39 Copyright © 1999 by the Foundation of the American College of Healthcare Executives 1998 1997 Expenses: Salaries and benefits $109,693 $ 89,953 Medical supplies 20,568 18,673 Purchased medical services 9,863 7,448 Research and education 4,518 3,710 Lease expense 3,189 2,603 Depreciation and amortization 6,405 5,798 Provision for bad debts 2,000 1,800 Interest 5,329 3,476 Other 6,667 4,933 Total expenses $168,232 $138,394 Sunnyvale Clinic: Expenses (in thousands)

40. 3 - 40 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses Expenses represent the resources used to create revenues--they are the costs of doing business. Like revenues, expenses do not necessarily reflect cash outlays. Expenses may be categorizes by: Natural classification, such as salaries, supplies, research, and so on. Functional classification, such as inpatient services, outpatient services, and so on.

41. 3 - 41 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses (Cont.) Salaries and benefits represents labor costs. Typically, this is the largest expense category for health services organizations. Although only summary information is given on the income statement, details are available from the managerial accounting system. Medical supplies represents the cost of expendable materials. The amount shown represents the amount consumed, not the amount purchased. Supply stocks are reported on the balance sheet.

42. 3 - 42 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses (Cont.) Sunnyvale bills patients for some services performed by other providers. Such expenses are reported as purchased medical services. The clinic conducts a small medical research and education program. Related expenses are reported in the research and education category.

43. 3 - 43 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses (Cont.) Sunnyvale owns its land and buildings, but it leases much of its diagnostic equipment. Lease expense reports the cost of its leases. Some leased assets are reported directly on the balance sheet while others appear only in the footnotes. Regardless, all lease expense is reported here. A footnote contains the expected future expenses associated with operating (non- balance sheet) leases.

44. 3 - 44 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses (Cont.) Depreciation expense recognizes that buildings and equipment typically lose value as they are used to provide services. Acquisition costs are not shown on the income statement. Rather, the “cost” of long-term (fixed) assets is pro-rated, or depreciated, over the life of the asset. For financial accounting purposes, depreciation is calculated by the straight-line method. Amortization expense is associated with business acquisitions. Both tie to the balance sheet.

45. 3 - 45 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Expenses (Cont.) Provision for bad debts reports the amount of net patient service revenue that is expected to remain uncollected. Interest expense reports the amount of interest paid on debt financing. Other expenses is a catchall category for expenses not otherwise listed.

46. 3 - 46 Copyright © 1999 by the Foundation of the American College of Healthcare Executives 1998 1997 Revenues: Total revenues $176,092 $146,600 Expenses: Total expenses $168,232 $138,394 Net income $ 7,860 $ 8,206 Sunnyvale Clinic: Net Income (in thousands)

47. 3 - 47 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net Income Although the reporting of revenue and expenses is important, the most important single line on the income statement is the “bottom line,” which is net income. Net income measures economic profitability as defined by GAAP. In not-for-profit businesses, net income is called: Revenues over expenses Excess of revenues over expenses Change in net assets

48. 3 - 48 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net Income (Cont.) In a not-for-profit corporation, the entire amount of net income belongs to and is reinvested in the business. In a for-profit business, net income, which constitutes the residual earnings of the business, belongs to the owners. Some portion of a corporation’s net income often is returned to stockholders as dividends. The remainder is reinvested in the business. The reinvested amount flows to the balance sheet.

49. 3 - 49 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net Income Versus Cash Flow Because of accrual accounting, net income does not represent cash flow. Some income statement items represent cash flows, others do not. Some, such as revenues, represent partial cash flows. With only income statement data, cash flow (CF) can be approximated by: CF = Net income + Noncash expenses = Net income + Depreciation/Amortization

50. 3 - 50 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Income Statements of Investor-Owned Businesses The income statements of investor- owned and not-for-profit businesses are very similar. The revenues and costs to organizations in the same core business are similar, regardless of ownership. However, some transactions, such as tax payments, clearly are applicable only to one form of ownership.

51. 3 - 51 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Statement of Cash Flows The statement of cash flows combines both income statement and balance sheet data to create an income statement-like report that focuses on cash flows. It is designed to answer three questions: Where did the business get cash? (sources) What did it do with the cash? (uses) How did its cash position change?

52. 3 - 52 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Statement of Cash Flows (Cont.) Like the income statement, it reports transactions over some time period. The top part of the statement is divided into three sections: Cash flows from operating activities Cash flows from investing activities Cash flows form financing activities The bottom part reconciles the change in cash on the statement with the cash account on the balance sheet.

53. 3 - 53 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Sunnyvale Clinic: Statement of CFs (1) (in thousands) 1998 1997 Cash Flows from Operating Activities: Net income $ 7,860 $ 8,206 Adjustments: Depreciation and amortization 6,405 5,798 Change in accounts receivable (2,582) (1,423) Change in inventories (1,393) (673) Change in accounts payable (1,411) (966) Change in accruals 1,032 865 Net cash from operations $ 9,911 $11,807 Cash Flows from Investing Activities: Capital expenditures ($ 9,306) ($ 1,953)

54. 3 - 54 Copyright © 1999 by the Foundation of the American College of Healthcare Executives Sunnyvale Clinic: Statement of CFs (2) (in thousands) 1998 1997 Cash Flows from Financing Activities: Change in marketable securities ($ 5,000) $ 0 Change in long-term investments (22,222) (20,667) Change in long-term debt 32,233 0 Net cash from financing $ 5,011 ($20,667) Net increase (decrease) in cash $ 5,616 ($10,813) Cash, beginning of year $ 6,486 $17,299 Cash, end of year $12,102 $ 6,486