3 - 1 copyright © 1999 by the foundation of the american college of healthcare executives...

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Copyright © 1999 by the Foundation of the American College of Healthcare Executives

Principles of Financial Accounting

Introduction to financial accountingUsers of financial accounting infoThe “Big 4” financial statementsThe role of standards in financial accounting

practice

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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

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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.

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Introduction to Financial Accounting

Financial vs. managerial uses of accounting information

Principles of financial accountingThe accounting entity vs. the legal entityOrganizational resources and obligationsDuality relationship

• Total assets = total liabilities plus net worth

• Accounting examples of duality relationship

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Introduction (Cont.)

Example #1 - MD purchase of X-rayIncreased total assets (+50K)Decreased cash assets (-50K)Duality relationship holds

Example #2 - Hospital purchase of ASCIncreased total assets (+2M)Decreased cash assets (-200K)Increased total liabilities (+1.8M)Duality relationship holds

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Introduction (Cont.)

Asset Valuation MethodsDefinition/purposeReplacement cost valuationMarket valuationHistorical cost valuationAdvantages/disadvantages w/each

Application - ROI calculations w/each valuation method (capital budgeting)

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Introduction (cont’d)

ROI ApplicationMRI purchase by OP imaging facilityAsset 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

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Introduction (cont’d)

Cash vs. Accrual basis of accountingAccrual-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

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The Balance Sheet andStatement of Cash Flows

Balance sheetAccounting identityAssetsLiabilities and equity

Relationship between the income statement and the balance sheet

Statement of cash flows

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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.

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Balance Sheet Basics (Cont.)

The balance sheet is organized with a left side (or upper section) and right side (or lower section):

Assets

Current assetsLong-term assets

Total assets

Liabilities and Equity

Current liabilitiesLong-term liabilitiesEquity

Total liabilities and equity

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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 $ 39,715Long-term investments $ 42,889 $ 20,667Property 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 $ 49,099Other Assets: Goodwill $ 5,170 $ 5,620

Total assets $154,815 $115,101

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Current Assets

Assets either possess (say, cash) or create (say, buildings and equipment) economic benefit to the business.

Current assets include:CashOther assets that are expected to be

converted into cash within the next year:• Marketable securities• Net patient accounts receivable• Inventories

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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.)

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Net patient accounts receivable represents revenues owed to the business but not yet collected.


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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.

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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.

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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.

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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.

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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.

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Other Assets (cont’d)

Restricted Assets

Investment Assets

Organizational costs

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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 $ 15,315Long-term debt $ 85,322 $ 53,578 Total liabilities $100,747 $ 68,893Net assets (Equity) $ 54,068 $ 46,208

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

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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 payableCurrent maturities of long-term debtAccounts payableAccrued expenses

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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

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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.


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Accrued expenses (accruals) are payment obligations of the business, primarily to:EmployeesTaxing authoritiesDebt suppliers


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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

providedThe matching principle requires expenses

to be matched to revenuesSome businesses have a catchall

account called other current liabilities.


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Long-Term Debt

Long-term debt represents debt financing with maturities greater than one year.

Detailed information typically is provided in the footnotes.

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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.

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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.

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Equity (Cont.)

A for-profit equity section might look like this:

1998 1997Stockholders’ 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

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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.

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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.

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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 operationsStatement of activities

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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.

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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

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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

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Revenues (Cont.)

In reporting revenues, note the difference in how the following adjustments are handled:DiscountsCharity careBad debt losses

Other revenue represents revenues from sources besides patient care, including:Interest earned on investmentsContributionsRental income

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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)

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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.

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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.

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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.

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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.

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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.

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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.

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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)

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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 expensesExcess of revenues over expensesChange in net assets

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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.

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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

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Income Statements ofInvestor-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.

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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?

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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 activitiesCash flows from investing activitiesCash flows form financing activities

The bottom part reconciles the change in cash on the statement with the cash account on the balance sheet.

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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)

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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

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