Accounting Fundamentals for Health Care Management

ACCOUNTING FUNDAMENTALSFOR

HEALTH CARE MANAGEMENT

Steven A. Finkler, PhD, CPAProfessor of Public and Health Administration,

Accounting, and Financial ManagementThe Robert F. Wagner Graduate School of Public Service

New York UniversityNew York, NY

David M. Ward, PhDProfessor of Health Administration and Policy

College of Health ProfessionsMedical University of South Carolina

Charleston, SC

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Copyright © 2006 by Jones and Bartlett Publishers, Inc.

ISBN-13: 978-0-7637-2675-1

ISBN-10: 0-7637-2675-3

All rights reserved. No part of the material protected by this copyright may be reproduced or utilized inany form, electronic or mechanical, including photocopying, recording, or by any information storage andretrieval system, without written permission from the copyright owner.

Library of Congress Cataloging-in-Publication DataFinkler, Steven A.

Accounting fundamentals for health care management / Steven A.Finkler, David M. Ward.

p. cm.Includes bibliographical references and index.ISBN-13: 978-0-7637-2675-1 (pbk.)1. Integrated delivery of health care. 2. Health services adminis-

tration. 3. Public health administration. I. Ward, David M.II. Title.[DNLM: 1. Delivery of Health Care, Integrated—economics.

2. Health Services Administration—economics. 3. Public HealthAdministration—economics. 4. Financial Management—methods.W 84.1 F503a 2006]RA971.F52 2006362.1068—dc22

2005029504

6048

Production CreditsPublisher: Michael BrownAssociate Editor: Kylah Goodfellow McNeillProduction Director: Amy RoseAssociate Production Editor: Daniel StoneAssociate Marketing Manager: Marissa HedersonManufacturing Buyer: Therese ConnellComposition: Arlene AponeCover Design: Kristin E. OhlinPrinting and Binding: Malloy, Inc.Cover Printing: Malloy, Inc.

Printed in the United States of America10 09 08 07 06 10 9 8 7 6 5 4 3 2 1

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4469

In Memory of Joe and Shirley Finklerand

To Howard and Marilyn Ward

iii

Dedication

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Acknowledgments

Portions of this text have been reprinted/adapted with permissionfrom Finance and Accounting for Nonfinancial Managers, Third Edition,Steven A. Finkler, Aspen Publishers, Copyright 2003, pages 3-7, 9-10,29-34, 35-38, 40-42, 43-58, 59-69, 71-76, 78-93, 95-97, 99-102, 104-105,125-134, 167-182, 189-202, 203-235, 263-264, 266-269, 271-272, 274-277, 287, 290, and 292-309.

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Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

CHAPTER 1 Introduction to Health Care Accounting and Financial Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1Do I Really Need to Understand Accounting to Be Effective

in My Health Care Organization? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1What Is Financial Management? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1What Are the Goals of Financial Management Within Health

Care Organizations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2How Does Accounting Fit into Financial Management? . . . . . . . . . . . . . . 6Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

CHAPTER 2 The Financial Environment of Health Care Organizations . . . 7How Do We Get Paid? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7Why Do Different Patients Pay Different Amounts? . . . . . . . . . . . . . . . . . 8How Does All This Impact Financial Accounting? . . . . . . . . . . . . . . . . . . . 9Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

CHAPTER 3 Accounting Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13Owners’ Equity / Net Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13The Accounting Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14Fund Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14Generally Accepted Accounting Principles . . . . . . . . . . . . . . . . . . . . . . . 15Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

v

Contents

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CHAPTER 4 Introduction to the Key Financial Statements . . . . . . . . . . . . . 21The Balance Sheet—How Much Do We Have and What Do We Owe? . . . 21The Income or Operating Statement—How Much Did We Make? . . . . 23The Statement of Cash Flows—Where Did All Our Cash Go? . . . . . . . . 24Notes to Financial Statements—What Do the Financial Statements

Really Mean? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

CHAPTER 5 Valuation of Assets and Equities . . . . . . . . . . . . . . . . . . . . . . . . 27Asset Valuation—How Does That Old Building Show Up on the

Balance Sheet? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27Valuation of Liabilities—What Do We Really Owe? . . . . . . . . . . . . . . . . . 31Valuation of Net Assets and Owner’s Equity—Is It Really Just

What’s Left Over? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

CHAPTER 6 Recording Financial Information . . . . . . . . . . . . . . . . . . . . . . . 35Double Entry and the Accounting Equation—The Golden Rule

of Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35Debits and Credits: The Accountant’s Secret . . . . . . . . . . . . . . . . . . . . . . 36Recording the Financial Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38T-Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44Chart of Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

CHAPTER 7 Reporting Financial Information: A Closer Look at the Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47Ledgers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47Healthy Hospital’s Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . 48Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

CHAPTER 8 The Role of the Outside Auditor . . . . . . . . . . . . . . . . . . . . . . . 57The Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58Next Steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

CHAPTER 9 Depreciation: Having Your Cake and Eating it Too! . . . . . . . . 65Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65Asset Valuation for Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66Straight-Line Versus Accelerated Depreciation . . . . . . . . . . . . . . . . . . . . 69

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Comparison of the Depreciation Methods . . . . . . . . . . . . . . . . . . . . . . . . 69Modified Accelerated Cost Recovery System . . . . . . . . . . . . . . . . . . . . . . 71Depreciation and Deferred Taxes: Accounting Magic . . . . . . . . . . . . . . 73Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

CHAPTER 10 Inventory Costing: The Accountant’s World of Make-Believe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75The Inventory Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Periodic Versus Perpetual Inventory Methods . . . . . . . . . . . . . . . . . . . . . 75The Problem of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77Cost-Flow Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

CHAPTER 11 An Even Closer Look at Financial Statements . . . . . . . . . . . . . 83The Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83Statement of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92The Notes to the Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . 95Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

CHAPTER 12 Notes to the Financial Statements: The Inside Story . . . . . . . 97Significant Accounting Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97Other Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

CHAPTER 13 Ratio Analysis: How Do We Compare to Other Health Care Organizations? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103Benchmarks for Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103Common Size Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105Liquidity Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110Efficiency Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112Solvency Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115Profitability Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116Return On Investment (ROI) Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

CHAPTER 14 Working Capital Management and Banking Relationships . . 121Working Capital Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121Short-Term Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

Contents vii

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Managing the Revenue Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129Short-Term Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130Banking Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136

CHAPTER 15 Investment Analysis: What Should We Do Next? . . . . . . . . . . 137Investment Opportunities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137Data Generation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138The Payback Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138Time Value of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140The Net Present Value Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147Internal Rate of Return Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150Project Ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

CHAPTER 16 Capital Structure: Long-Term Debt and Equity Financing . . . 153Charitable Giving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155Other Elements of Capital Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158Getting Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161Test Your Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161

CHAPTER 17 Case Study: Happy Hospital . . . . . . . . . . . . . . . . . . . . . . . . . . 163Recovering from New Year’s Eve: Is it Really the Start of

Another Year? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163What Should We Do with All That Money? . . . . . . . . . . . . . . . . . . . . . . . 163What a Busy Year! Tracking Financial Events . . . . . . . . . . . . . . . . . . . . . 169Time to Close the Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170Putting Together the End-of-Year Financial Statements . . . . . . . . . . . . 172How Did We Do? Using Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 172

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

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The complexity of today’s health care system has brought with it a need forall managers and executives to have a solid understanding of accounting.This book is geared toward the student or current health care managerwho needs a basic grounding in financial accounting within health care or-ganizations. It is presented from the basic premise that knowledge of ac-counting is beneficial regardless of a person’s primary focus within thehealth care system. The operating room nurse, the compliance officer, thephysician practice manager, or the pharmaceutical sales representative,can all benefit from a better understanding of health care accounting.

This book will not make anyone a chief financial officer. It will, how-ever, provide the vocabulary and introduction to the tools and conceptsemployed by finance officers. It will help the nonfinancial manager assessfinancial information, ask the appropriate questions, and understand thejargon-laden answers.

To help enable the use of this book within the framework of a healthcare accounting course, we have posted end-of-chapter questions andproblems on the book’s Web site at www.jbpub.com/catalog/0763726753.In addition, the Web site includes a number of Excel templates that canhelp the reader use the various tools presented in the book.

We have attempted to cover the material in a thorough yet notoverwhelming manner. However, we recognize that there is always room for improvement. Readers are encouraged to use the Web page(www.jbpub.com/catalog/0763726753) to e-mail us to point out errorsor unclear passages, or to suggest additional applications or other im-provements. All contributions will be acknowledged in the next edition.Any corrections to errors in the text will be posted on the Web page.

The authors wish to thank Daniel Stone, Michael Brown, and Kylah McNeilfrom Jones and Bartlett Publishers for all their help in bringing this bookfrom conception to reality.

Steven A. FinklerDavid M. Ward

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Preface

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The companion Web site for this book contains Excel templatesavailable for download.These templates have been designed to help

the reader use various tools illustrated in the text of this book. End-of-chapter questions and problems have also been posted to this site. Toaccess the supplemental material for this text on the Web, please visit:

http://www.jbpub.com/catalog/0763726753/supplements.htm.

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DO I REALLY NEED TOUNDERSTAND ACCOUNTING TOBE EFFECTIVE IN MY HEALTHCARE ORGANIZATION?

Today’s health care system, with its many dif-ferent types of health care organizations, isextremely complex. The science of healthcare is complex, the physical maintenanceof the facilities is complex, the interactionsand human behaviors within the organiza-tions are complex, and so too are the finan-cial and accounting requirements. Thecomplexity of today’s environment has re-sulted in the spread of accounting and fi-nancial management to all areas within ahealth care organization. Accounting and fi-nancial management is no longer the solepurview of the finance department. Nurse-managers are being held responsible for thefinancial management of their units, phar-macy directors are making significant finan-cial management decisions on a daily basis,operating room (OR) managers must main-tain efficient utilization rates and keep pa-tients flowing through the OR to maintainthe financial health of the organization.

To be successful, health care managers andexecutives (regardless of what specific areawithin a health care organization they lead)must all have a firm understanding of ac-

counting and financial management. It isclear that not everyone will become the ChiefFinancial Officer, but everyone is making fi-nancial decisions and needs to be able to com-municate effectively with financial managers.

WHAT IS FINANCIAL MANAGEMENT?

This book focuses on health care account-ing and finance (Figure 1-1). Accounting is asystem for providing financial information.It is generally broken down into two princi-pal elements: financial accounting and man-agerial accounting. Finance has traditionallybeen thought of as the area of financialmanagement that supervises the acquisitionand disposition of the organization’s re-sources, especially cash.

The financial accounting aspect of account-ing is a formalized system designed to record

1

CHAPTER 1

Introduction to Health Care Accountingand Financial Management

Accountingand Finance

Accounting Finance

FinancialAccounting

ManagerialAccounting

Figure 1-1 Accounting and Finance

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2 ACCOUNTING FUNDAMENTALS FOR HEALTH CARE MANAGEMENT

the financial history of the health care or-ganization. The financial accountant is sim-ply a historian who uses dollar signs. Anintegral part of the financial accountant’sjob is to report the organization’s historyfrom time to time to interested individuals,usually through the organization’s quarterlyand annual reports.

The managerial accountant looks forward;the financial accountant looks backward.Instead of reporting on what has happened,the managerial accountant provides finan-cial information that might be used for mak-ing improved decisions regarding the future.In many organizations the same individual isresponsible for providing both financial andmanagerial accounting information.

Finance has expanded significantly fromthe functions of borrowing funds and invest-ing the excess cash resources of the firm. Inits broader sense, the finance function in-volves providing financial analyses to im-prove decisions that affect the wealth of theorganization. Whereas the managerial ac-countant provides the information for usein the analyses, the finance officer often per-forms the actual analyses.

WHAT ARE THE GOALS OFFINANCIAL MANAGEMENT WITHINHEALTH CARE ORGANIZATIONS?

At first, one might simply say that the goal offinancial management is to aid in the maxi-mization of wealth, or more simply, maxi-mization of the organization’s profits. Profitsare, after all, literally, the bottom line. That istrue, but as managers know, the health careenvironment has many other goals—improv-ing the health and well-being of the commu-nity, providing the highest quality healthcare services, and minimizing morbidity andmortality, for example. For many health careorganizations (e.g., not-for-profit hospitals)

maximization of profit may not be a goal atall, although at least some profit is usuallynecessary to ensure the financial well-beingof even these organizations.

On a more personal level, managers areconcerned with maximization of salaries andbenefits. In a for-profit organization, suchmaximization is often tied in with the maxi-mization of return on investments (ROI), re-turn on equity (ROE), return on assets(ROA), or return on net assets (RONA) (seeChapter 13). The list of goals within the or-ganization is relatively endless, and our in-tention is to narrow the range rather thanbroaden it.

From the perspective of financial man-agement there are two overriding goals:profitability and viability (Figure 1-2). Theorganization wants to be profitable and itwants to continue in business. It is possible tobe profitable and yet fail to continue in busi-ness. Both goals require some clarificationand additional discussion because they sur-face from time to time throughout this book.

Profitability

As stated, many health care organizations donot have the maximization of profit as a goal,but they must generate some level of profit inorder to achieve their other goals. Whetherfor profit or not for profit, health care organ-izations need profits to invest in expansion ofservices so there is wider access to health care.Health care organizations need profits so theycan acquire new technologies to improve the

OrganizationalGoals

Profitability Viability

Figure 1-2 Organizational Goals


quality of health care. And health care organ-izations need profits to replace old buildingsand equipment as they wear out. Generally,replacement facilities are more expensivethan the ones they replace, because of infla-tion if nothing else, and profits are used tocover some of those higher costs. Because ofthis, we continue to use the terms profit andprofitability, even when referring to not-for-profit health care organizations.

This does not mean that profits are theonly goal. They are not even always the pri-mary goal. High-quality health care oftencomes first. However, we must always bear inmind that profits are necessary to be able toachieve the goals related to providing high-quality care.

In maximizing profits, there is always atrade-off with risk (Figure 1-3). The greaterthe risk we must incur, the greater the antic-ipated profit or return on our money we de-mand. Certainly, given two equally riskyprojects that provide similar health benefitsto the community, we would always chooseto undertake one with a greater anticipatedreturn. More often than not, however, oursituation revolves around whether the re-turn on a specific investment is greatenough to justify the risk involved.

Consider keeping funds in a passbook ac-count insured by the Federal Deposit Insur-ance Corporation (FDIC). You might earn aprofit or return (in nominal terms—we’lltalk about inflation later) of about 2 percent.The return is low, but so is the risk. Alterna-tively, you could put your money in a non-

bank money market fund where the returnmight be considerably higher. However, theFDIC would not insure the investment andthe risk is clearly greater. Or you could putyour money into the stock market. In gen-eral, do we expect our stocks to do better orworse than a money market fund? Well, therisks inherent in the stock market are signifi-cantly higher than in a money market fund.If the expected return were not higher,would anyone invest in the stock market?

That does not mean that everyone willchoose to accept the same level of risk.Some people keep all their money in bankaccounts; others choose the most specula-tive of stocks. Some organizations are morewilling than others to accept a high risk toachieve a high potential profit. The keyhere is that in numerous business decisions,the organization is faced with a trade-off—risk versus return. Throughout this book,when decisions are considered, the ques-tion that will arise is, “Are the extra profitsworth the risk?” It is, we hope, a questionthat you will be somewhat more comfort-able answering before you have reached theend of this book.

As noted, profits are not the sole reasonthat health care organizations exist. Some-times profits are just a means to an end, andnot an end in itself at all. Health care organ-izations should always make decisions thatkeep their underlying mission in mind.Throughout this book, we provide manytechniques that can be used to help youmake the best financial decision, otherthings being equal. But we realize that otherthings are not always equal. If two projectsyield the same health benefit, the one withgreater profits or lower risk is usually thebetter choice. However, if the health carebenefits are not equal, then managers needto factor that into their decision-makingprocess. Sometimes you may decide that you

Chapter 1: Introduction to Health Care Accounting and Financial Management 3

ProfitabilityTrade-Off

Risk Returnversus

Figure 1-3 Profitability Trade-Off



are willing to accept a lesser profit or to takea bigger risk to hopefully achieve betterhealth outcomes.

Viability

Health care organizations have no desire togo bankrupt, so it is no surprise that one ofthe crucial goals of financial management isensuring financial viability. This goal is oftenmeasured in terms of liquidity and solvency(Figure 1-4).

Liquidity is a measure of the amount of re-sources an organization has that are cash orare convertible to cash in the near term tomeet the obligations the organization hasthat are coming due in the near term. Ac-countants use near term, short term, and currentinterchangeably. Generally the near-termmeans 1 year or less. Thus, an organization isliquid if it has enough near-term resources tomeet its near-term obligations as they be-come due for payment.

Solvency is the same concept from a long-term perspective, where long term means morethan 1 year. Will the organization have enoughcash generation potential over the next 3, 5,and 10 years to meet the major cash needs thatwill occur over those periods? An organizationmust plan for adequate solvency well in ad-vance because the potentially large amountsof cash involved may take a long period to gen-erate. The roots of liquidity crises that put or-ganizations out of business often are buried ininadequate long-term solvency planning inearlier years.

So a good strategy is maximization ofyour organization’s liquidity and solvency,right? No, wrong. Managers have a complexproblem with respect to liquidity. Every dol-lar kept in liquid form (such as cash, T-bills,or money market funds) is a dollar thatcould have been invested by the organiza-tion in some longer term, higher yieldingproject or investment. There is a trade-off inthe area of viability and profitability. Themore profitable the manager attempts tomake the organization by keeping it fully in-vested, the lower the liquidity and thegreater the possibility of a liquidity crisis andeven bankruptcy. The more liquid the or-ganization is kept, the lower the profits. Thisis essentially a special case of the trade-offbetween risk and return discussed earlier.

Similarly, there is a trade-off between pro-viding health care services and viability. Wecannot provide all the health care patientsmight want regardless of their ability to pay.Although providing charity care is often ap-propriate, there must be limits. If the organ-ization decides to provide unlimited charitycare without consideration of the financialimplications, it may threaten its viability orcontinued existence.

Health care organizations have to tempertheir desire to provide health care servicesregardless of ability to pay with their desire tocontinue in business. It does not do the com-munity any good for a health care provider toprovide so much charity care in 1 year that itgoes bankrupt and ceases operations. It isbetter for it to provide a measured amount ofcharity care so that it can remain viable. Thatway it can continue to serve the community,including the poor, on a long-term basis.

We mentioned that profitability and viabil-ity are not synonymous. An organization canbe profitable every year of its existence, yet gobankrupt anyway. How can this happen? Fre-quently it is the result of rapid growth and

ViabilityTrade-Off

Liquidity Solvencyversus

Figure 1-4 Viability


poor financial planning. Consider a privatelyheld medical supplies company, ExpandingMedical Supplies, whose sales are so goodthat it constantly needs to expand its inven-tory on hand. Such expansion requires cashpayments to manufacturers well in advanceof ultimate cash receipts from customers.

Assume that Expanding Medical Suppliesstarts the year with $40,000 in cash, $80,000of receivables, and 10,000 units of inventory.Receivables are amounts its customers owe itfor goods and services that they bought butwhich have not been paid for yet. Its inven-tory units (the medical supply items) aresold for $10 each and they have a cost of $8,yielding a profit of $2 on each unit sold. Dur-ing January, it collects all of its receivablesfrom the beginning of the year (no baddebts!), thus increasing available cash to$120,000. January sales are 10,000 units, up2,000 from the 8,000 units sold in December.

Because of increased sales, ExpandingMedical Supplies decides to expand inven-tory to 12,000 units. Of the $120,000 avail-able, it spends $96,000 on replacement andexpansion of inventory (12,000 units ac-quired at $8 each). No cash is collected yetfor sales made in January. This leaves a Janu-ary month-end cash balance of $24,000.

$ 40,000 Cash, January 1

+ 80,000 Collections during January

$ 120,000 Cash available

– 96,000 Purchases of inventory

$ 24,000 Cash balance, January 31

During February, all $100,000 of receiv-ables from January’s sales (10,000 units at$10 each) are collected, increasing the avail-able cash to $124,000. In February, the en-tire 12,000 units on hand are sold and arereplaced in stock with an expanded total in-ventory of 15,000 units.

$ 24,000 Cash, January 31

+ 100,000 Collections during February


– 120,000 Purchases of inventory(15,000 units at $8 each)

$ 4,000 Cash balance, February 28

Everyone at Expanding Medical Suppliesis overjoyed. They are making $2 on eachunit sold. They are collecting 100 percent oftheir sales on a timely basis. There appears tobe unlimited growth potential for increasingsales and profits. The reader may suspect thatwe are going to pull the rug out from underExpanding Medical Supplies by having salesdrop or customers stop paying. Not at all.

In March, Expanding Medical Suppliescollects $120,000 from its February sales. Thisis added to the $4,000 cash balance from theend of February, for an available cash balanceof $124,000 in March. During March, all15,000 units in inventory are sold and inven-tory is replaced and expanded to 20,000 units.Times have never been better, except for oneproblem. Expanding Medical Supplies hasonly $124,000, but the bill for its March pur-chases is $160,000 (20,000 units at $8 each). Itis $36,000 short in terms of cash needed tomeet current needs. Depending on the atti-tude of its supplier and its banker, ExpandingMedical Supplies may be bankrupt.

$ 4,000 Cash, February 28

+ 120,000 Collections during March


– 160,000 Purchases of inventory

$ (36,000) Cash balance, March 31

Two key factors make this kind of scenariocommon. The first is that growth implies out-lay of substantial amounts of cash for the in-creased inventory levels needed to handle a

Chapter 1: Introduction to Health Care Accounting and Financial Management 5



growing sales volume. The second is thatgrowth is often accompanied by an expansionof plant and equipment, again well in advanceof the ultimate receipt of cash from customers.

Do growing organizations have to go bank-rupt? Obviously not. But they do need to plantheir liquidity and solvency along with theirgrowth. The key is to focus on the long-termplans for cash. It is often said that banks pre-fer to lend to those who don’t need themoney. Certainly banks do not like to lend toorganizations like Expanding Medical Sup-plies, who are desperate for the money. Amore sensible approach for Expanding Med-ical Supplies than going to a bank in Marchwould be to lay out a long-term plan for howmuch it expects to grow and what the cashneeds are for that amount of growth. Themoney can then be obtained from the issuingof bonds and additional shares of stock (seeChapter 16), or orderly bank financing canbe anticipated and approved well in advance.

Apparently, even in a profitable environ-ment cash flow projections are a real con-cern. Liquidity and solvency are crucial toan organization’s viability. Throughout thebook, therefore, we return to this issue aswell as that of profitability. In fact, thereader will become aware that a substantialamount of emphasis in financial accountingis placed on providing the user of financialinformation with indications of the organi-zation’s liquidity and solvency.

HOW DOES ACCOUNTING FIT INTOFINANCIAL MANAGEMENT?

As mentioned, accounting is like history withdollar signs. As with many things in life, we canlearn a great deal from history. To that end, fi-nancial accounting (often taking the form ofbalance sheets and income statements) canhelp managers to make ongoing decisions tohelp the organization maintain both its prof-

itability and viability. In Chapter 2, we intro-duce the reader to the financial environmentof today’s health care organizations. There area number of unique aspects of health care thatrequire a solid understanding before one canstart to completely understand accountingand financial statements that are generated byaccountants. Chapter 3 introduces the basicaccounting concepts used within the broaderframework of financial management.

KEY CONCEPTS

Financial management—Management of thefinances of the organization to maximize theorganization’s wealth and the achievement ofits other goals.

Accounting—The provision of financial in-formation.

a. Financial accounting—Provision of ret-rospective information regarding thefinancial position of the organizationand the results of its operations.

b. Managerial accounting—Provision ofprospective financial information formaking improved managerial decisions.

Finance—Provision of analyses concern-ing the acquisition and disposition of theorganization’s resources.

Goals of Financial Managementa. Profitability—A trade-off always exists

between maximization of expectedprofits and the acceptable level of risk.Undertaking greater risk requiresgreater anticipated returns.

b. Viability—A trade-off always exists between viability and profitability.Greater liquidity results in more safety,but lower profits.

TEST YOUR KNOWLEDGE

See www.jbpub.com/catalog/0763726753/supplements.htm.


Health care is an enormous part of theUS economy, representing 17% of all

personal consumption expenditures annu-ally.1 It has many different components,many different types of providers, and manydifferent types of organizations all playing animportant part in the overall delivery ofhealth care. Health care is provided by for-profit organizations, not-for-profit organiza-tions, and governmental organizations;there are service providers, suppliers, and in-surers. In the end, it is a very complex mazeof different organizations with different def-initions of success and some differences intheir accounting procedures and financialmanagement techniques. This chapter high-lights some of the most significant differ-ences and issues within the financialenvironment of today’s health care system.

HOW DO WE GET PAID?

Anyone who works in a health care organiza-tion knows that getting paid for services pro-vided is never easy. The health care financing(or reimbursement) system is one of themost complex systems around. Unlike mostindustries, health care service providers are

often paid by third parties. By third party wemean someone other than the individual re-ceiving the medical care. This includes insur-ance companies, government programs, andother third-party payers. The patient is oftencaught in the middle of the maze of paymentand insurance issues that plague the currenthealth care system.

Although we cannot describe “the” pay-ment system (because there are literallyhundreds of payment systems), we can de-scribe the basic flow of the money in today’shealth care payment maze. From the healthcare provider’s point of view, the paymentsystem starts with the delivery of service to a patient and the generation of a bill (a formal claim on cash). Most health careproviders have established rates for differ-ent services called charges. In addition, how-ever, providers also have rates that they havenegotiated and agreed to with insurancecompanies as well as rates they must agree toaccept from the government (mostlyMedicare and Medicaid) if they choose toparticipate in those government programs.The difference between the provider’scharge and the negotiated rate is referred toas a contractual allowance.

7

CHAPTER 2

Financial Environment of Health Care Organizations

1Source: Derived from Economic Report of the President 2005, Table B-16—Personal consumption expendi-tures, 1959–2004.



Depending on the type of insurance andthe specific insurance company, the patientmay pay some portion of the bill at the timeof the service (a co-pay), but generally eitherthe majority of the bill or the entire bill issubmitted to the insurance company forpayment at a later date. The insurance com-pany adjusts the charges on the bill for thecontractual allowance and pays its share.Often the patient is responsible for either adeductible (e.g., the patient may have to paythe first $250 of incurred costs each year) ora co-pay (e.g., the patient may be responsi-ble for 20% of the total cost of care after ad-justment for contractual allowances). Thepayment cycle is completed when theprovider receives the negotiated rate, whichis usually a minimum of 30 days from thedate of service and is often much longer.This is an overly simplistic depiction of thepayment system. There are many variationsto this, but it suffices for our purposes.

There are many different kinds of healthcare organizations. The payment system de-scribed is most applicable to health careprovider organizations like physician prac-tices, hospitals, clinics, physical therapy

practices, and nursing homes. There arehealth care organizations that have a moretraditional business model of payment, in-cluding medical equipment and suppliescompanies (supplying directly to theproviders) and pharmaceutical companies.The more traditional payment model in-volves direct payment from the customer tothe supplier (no third-party involvement).

WHY DO DIFFERENT PATIENTS PAYDIFFERENT AMOUNTS?

As described, many health care providersnegotiate different rates with different in-surance companies. In the obstetrics depart-ment of a hospital, for instance, there maybe four women all delivering babies on thesame day. All four women give birth via ce-sarean section with no complications. Allfour babies are happy and healthy. However,each woman’s insurance company pays a dif-ferent amount (Table 2-1).

As you can see, this is very confusing.Four patients all receive the same service,but each pays a different amount. It shouldalso be noted that this is really a simplified

Table 2-1 Examples of Different Insurance Payments

Patient TwoPatient One Traditional Patient Three Patient Four

Medicaid Fee-For-Service Managed Care Private Payer

Hospital charge $1,000 $1,000 $1,000 $1,000

Contractual allowance $ 500 $ 100 $ 300 $ 0

Net charge $ 500 $ 900 $ 700 $1,000

Patient co-pay 0% 20% Often a 100%flat amount

Patient payment $ 0 $ 180 $ 100 $1,000

Insurance payment $ 500 $ 720 $ 600 $ 0

Total receivedby provider of care $ 500 $ 900 $ 700 $1,000


version of what really may exist! Sometimesit makes you wonder how any health careprovider ever gets paid.

Another problem is created by charitycare. Some patients cannot afford to pay fortheir care and have no insurance. Manyproviders offer a sliding scale, allowing thesepatients to pay the amount they can afford.Often this is below cost. It is critical to makesure that the amount collected from thecharity patients and the other patients is suf-ficient in total to cover all of the costs of all ofthe patients and also provide at least a mini-mally acceptable level of profits. Bad debtscompound the charity care problem. Not allpatients pay the amount of the obligationthat they are responsible for. As if this allwere not enough, insurers refuse to pay billsif there are significant errors. For example, ifthe patient ID number is incorrect, no insur-ance payment is collected. If the provider isunable to find the patient and get the cor-rect ID after the claim has been rejected,they may never be paid for those services.

These differences in payment by differentpayers and the complexity of the differenttypes of health care organizations all createissues for the financial accounting withinhealth care organizations.

HOW DOES ALL THIS IMPACTFINANCIAL ACCOUNTING?

The most direct impact that the payment sys-tem has on financial accounting within thehealth care environment is that charges arenot the same as revenues. Because mosthealth care organizations have no expecta-tion of getting paid full charges (they havenegotiated discounts up front), the organiza-tion is not allowed to claim the full charge asrevenue when it reports the financial resultsof its operations. Similarly, if you are givingaway care for free, you cannot include the

amount you would have charged for that careas revenue. On health care financial state-ments that show revenues and expenses,therefore, the first item listed is net patient rev-enues, which reflects the fact that contractualallowances and charity care are not includedin the revenue amount. Health care account-ing is therefore somewhat different from tra-ditional accounting. Many of the differencescan be traced to the unique manner in whichhealth care organizations get paid and theunique manner in which the industry dividesalong for-profit and not-for-profit lines.

The unique nature of the health care in-dustry does not change the basic premises andconventions of accounting (see Chapter 3). Itdoes, however, require accountants and man-agers to be aware of the uniqueness of healthcare accounting. We therefore provide a broadoverview at first and ultimately a more specificand thorough analysis of the intricacies ofhealth care accounting. Where appropriate,we point out the many different ways a particu-lar financial event can be portrayed within dif-ferent types of health care organizations.

KEY CONCEPTS

Health care reimbursement system—The com-plex system of patients and insurers that pay(reimburse) for the care provided by thevarious health care providers.

Third-party payers—Insurance companiesand governmental agencies that pay the ma-jority of the cost of treating patients.

Contractual allowance—The difference be-tween a provider’s posted charge for serviceand the amount of payment agreed to by theprovider and the third-party payer.

TEST YOUR KNOWLEDGE


Chapter 2: Financial Environment of Health Care Organizations 9



In most MBA and MHA programs, an ac-counting course is required in the first se-

mester of study. Accounting has frequentlybeen referred to as the language of business.The buzzwords you encounter in accountingare used as a normal part of the everyday lan-guage of finance, marketing, and other areasof management. Receivables, payables, jour-nal entries, ledgers, depreciation, equity,LIFO, and MACRS are a smattering of theterms that you encounter if you have anydealing with the financial officers of your or-ganization. All these terms have their rootsin accounting.

In Chapters 3 through 8, we focus on in-troducing the reader to accounting and tomany of the terms used by accountants.Specifically, these chapters emphasize the fi-nancial accounting system, that is, reportingthe financial history and current financialstatus of the organization.

BASICS

Accounting centers on the business entity.An entity is the unit for which we wish to ac-count. Entities frequently exist within alarger entity. An entity can be a department,project, or organization. For example, Joe’sFamily Medical Office is an organizationthat is an entity. However, if it is not a corpo-

ration and Joe owns it solely, the InternalRevenue Service considers it to be part ofthe larger entity Joe. That larger entity in-cludes Joe’s salary, other investments, andvarious other sources of income in additionto the Family Medical Office.

From an accounting standpoint, thereare two crucial aspects of the entity concept.First, once we have defined the entity we areinterested in, we should not commingle theresources and obligations of the entity withthose of other entities. If we are interestedin Joe’s Family Medical Office as an ac-counting entity, we must not confuse thecash that belongs to Joe’s Family Medical Of-fice with the other cash that Joe has.

Second, we should view all financialevents from the entity’s point of view. For ex-ample, consider that the Family Medical Of-fice buys tongue depressors “on account.” Atransaction on account gives rise to an obli-gation or account payable on the part of thebuyer and an account receivable on the part ofthe seller. For both the buyer and seller tokeep their financial records, or “books,”straight, each must record the event fromtheir own viewpoint. They must determinewhether they have a payable or a receivable.

We assume throughout this book that theorganization you work for is the entity. Oncewe establish the entity we want to account

11

CHAPTER 3

Accounting Concepts



for, we can begin to keep track of its finan-cial events as they happen. There is a restric-tion, however, on the way in which we keeptrack of these events. We must use a mone-tary denominator for recording all financialevents that affect the organization. Even ifno cash is involved, we describe an event interms of amounts of currency. In the UnitedStates, accounting revolves around dollars;elsewhere the local currency is used.

This restriction is an important one forpurposes of communication. The financialaccountant not only wants to keep track ofwhat has happened to the organization, butalso wants to be able to communicate the or-ganization’s history to others after it hashappened. Conveying information aboutthe financial position of the organizationand the results of its operations would becumbersome at best without this monetaryrestriction. Imagine trying to list and de-scribe each building, machine, parcel ofland, desk, chair, and so on owned by the or-ganization. The financial statement wouldbe hundreds if not thousands of pages long.

Yet, don’t be too comfortable with themonetary restriction either, because curren-cies are not stable vis-à-vis one another, norare they internally consistent over time. Dur-ing periods of inflation or deflation, the as-signment of a dollar value creates its ownproblems. For example, the values of inven-tory, buildings, and equipment constantlychange as a result of inflation or deflation.

ASSETS

The general group of resources owned bythe organization represents the organiza-tion’s assets. An asset is anything with eco-nomic value that can somehow help theorganization to provide health care to its pa-tients, either directly or indirectly. The CATscanner used in radiology is clearly an asset.

The desk in the chief executive’s office isalso an asset, however indirect it may be intreating patients.

Assets may be either tangible or intangi-ble. Tangible assets have physical form andsubstance and are generally shown on the fi-nancial statements. Intangible assets have nophysical form; they consist of such items as agood credit standing, skilled employees,and a reputation for high-quality care. It isdifficult to precisely measure the value of in-tangible assets. As a result, accountants usu-ally do not record these assets on thefinancial statements.

An exception to this rule occurs if the in-tangible asset has a clearly measurable value.For example, if we purchase that intangiblefrom someone outside of the organization,the price we pay puts a reasonable mini-mum value on the asset. It may be worthmore, but it cannot be worth less or we, asrational individuals, would not have paid asmuch as we did. Therefore, the accountantis willing to show the intangible on the fi-nancial statement for the amount we paidfor it.

If you see a financial statement that in-cludes an asset called goodwill, it is an indica-tion that a merger has occurred at sometime in the past. The organization paidmore for the company it acquired thancould be justified based on the market valueof the specific tangible assets of the acquiredorganization. The only reason an organiza-tion would pay more than the tangible assetsthemselves are worth is because the organi-zation being acquired has valuable intangi-ble assets. Otherwise, the organization wouldhave simply gone out and duplicated all ofthe specific tangible assets instead of buyingthe organization.

After the merger, the amount paid in ex-cess of the market value of the specific tangi-ble assets is called goodwill. It includes the


good credit standing the organization haswith suppliers, the reputation for quality andreliability with its patients, the skilled set ofemployees already working for the organiza-tion, and any other intangible benefitsgained by buying an ongoing organizationrather than by buying the physical assets andattempting to enter the market from scratch.

The implication of goodwill is that an or-ganization may be worth substantially morethan it is allowed to indicate on its own fi-nancial statements. Only if the organizationis sold will the value of all of its intangiblesbe shown on a financial statement. Thus weshould exercise care in evaluating how goodfinancial statements are as an indication ofthe true value of the organization.

LIABILITIES

Liabilities, from liable, represent the obliga-tions that an organization has to outsidecreditors. Although there generally is noone-on-one matching of specific assets withspecific liabilities, the assets taken as a wholerepresent a pool of resources available to paythe organization’s liabilities. The most com-mon liabilities are money owed to suppliers,employees, financial institutions, bondhold-ers, and in the case of for-profit health careorganizations, the government (taxes).

OWNERS’ EQUITY/NET ASSETS

Equity represents the value of the organiza-tion to its owners. It is the portion of the assetsavailable to the owners of the organizationafter all liabilities have been paid. For an or-ganization owned by an individual proprietor(a solo practitioner), we refer to this value asowner’s equity. For a partnership (possibly aphysician group) we speak of this value aspartners’ equity. For a corporation we talk ofthis value as shareholders’ or stockholders’ equity.

For not-for-profit health care organizations,we use net assets, given the lack of formal“ownership.” Net Assets is used to describe theleftover balance when you subtract liabilitiesfrom assets. In this book we use the term netassets whenever the equity of the owners ismeant. Except in the rare cases in which atopic is relevant only to not-for-profit healthcare organizations, the reader from a for-profit corporation, sole proprietorship, orpartnership can simply convert the term inhis or her mind to the appropriate one fortheir organization.

Net assets is often referred to as the “networth” of the organization or its “total bookvalue.” In the case of a corporation, bookvalue per share is simply the total book valuedivided by the number of shares of stockoutstanding. It is important to keep inmind, however, that a share of stock may beworth a different amount than its bookvalue for a number of reasons addressed invarious places later in this book. For now,consider just one example—goodwill. If anorganization develops a good reputationwith patients and suppliers, that reputationhelps it to generate future profits. But good-will that you develop for your organization isan intangible asset that does not appear onyour financial statements because account-ants have trouble determining exactly howmuch goodwill you have, and what thatgoodwill is worth. Rather than take a guessat it, goodwill you develop yourself is simplyignored when financial statements are pre-pared. As a result, this unreported goodwillmight result in the organization being morevaluable than the amount reported on thebooks. But stock advisors (brokers) will esti-mate the value of that goodwill and take itinto account in telling their customers thetrue value of the organization. Therefore, itsstock price per share may exceed its bookvalue per share of stock.

Chapter 3: Accounting Concepts 13



The net assets of an organization arequite similar to the equity (or ownership)that is commonly referred to with respect tohome ownership. If you were to buy a housefor $400,000 by putting down $80,000 ofyour own money and borrowing $320,000from a bank, you would say that your equity(or ownership) in the $400,000 house was$80,000.

If the house were an outpatient surgerycenter owned by a large health care organi-zation, the $400,000 purchase price could beviewed as the value of the outpatient surgerycenter asset, the $320,000 loan as the organi-zation’s liability to an outside creditor, andthe $80,000 difference as the net assets, orthe portion of the surgery center owned out-right by the organization—its net assets.

THE ACCOUNTING EQUATION

The relationship among the assets, liabili-ties, and stockholders’ equity is shown in thefollowing equation and provides a frame-work for all of financial accounting.

Assets = Liabilities + Net Assets

The left side of this equation representsthe organization’s resources. The right sideof the equation gives the sources of the re-sources. Another way to think about thisequation is that the right side represents theclaims on the resources: the liabilities repre-sent the legal claims of the organization’screditors, and the net assets represent theorganization’s claim on any resources notneeded to meet its liabilities.

This equation is true for any entity. Oncethe organization’s assets and liabilities havebeen defined, the value of its net assets ismerely a residual value. The organization orits owners own all of the value of the assetsnot needed to pay off obligations to credi-tors. Therefore, the equation need not ever

be imbalanced because there is effectivelyone term on the equation, net assets, thatchanges automatically to keep the equationin balance. We refer to this basic equation ofaccounting throughout this book.

FUND ACCOUNTING

Not-for-profit organizations, includingmany health care organizations, have aunique element of financial accounting re-ferred to as fund accounting. A fund is an ac-counting entity with its own separate set offinancial records. A single health care or-ganization can have a number of differentfunds. That is, we can think of a large healthcare provider that is an entity. But that entityis made up of many smaller subentities.

The easiest example of a distinct fundwithin a health care organization is a devel-opment fund, which is often a separate ac-counting entity that exists solely to collectcharitable gifts from donors. Donors areoften concerned that the money they givebe used in the manner they specified at thetime of the gift. In most cases, gifts are notfor general operations. The organizationtherefore creates a separate accounting en-tity called a fund to help ensure that thedonors’ funds are used in accordance withtheir wishes.

As a separate accounting entity, eachfund tracks its financial transactions andrecords separately. At the end of the fiscalyear, each fund may produce separate finan-cial statements, although the organizationmust prepare one set of financial statementsthat contains information for all of thefunds combined.

Fund accounting also brings with it yet an-other term for net assets. In this case, net as-sets is sometimes referred to as fund balance.In mathematical terms, the fund balance issimply the difference between assets and lia-bilities. If we took the funds assets and paid


off the liabilities, the amount that would beleft is the balance in the fund, or simply thefund balance. Remember, we now have anumber of different terms that represent thesame concept, but are used for different or-ganizations, namely, owner’s equity, partners’equity, stockholders’ equity, net assets, and fundbalance. Throughout this text, we predomi-nantly use the term net assets.

GENERALLY ACCEPTEDACCOUNTING PRINCIPLES

Accounting is not a physical science likechemistry or biology; there are no laws ofnature at work. In fact, accounting is moreof an art than a science. If there are no lawsof nature, then how do we know that differ-ent organizations are following the samerules with respect to how they account fortheir financial performance? One account-ant (artist) could choose to account for (orpaint) the history of his or her organizationusing one approach while another account-

ant across the street uses a different ap-proach. In many instances, strong argu-ments can be posed for alternativeaccounting treatments. Selection of oneuniform set of rules for all organizations isnot, however, a simple exercise.

For example, consider a pharmaceuticalcompany that is developing new drugs. Hy-pothetically, suppose that for every 20 drugsdeveloped and put into clinical trials, the in-dustry average is 1 drug becoming a com-mercially viable product.

The pharmaceutical company hypotheti-cally expects to spend $100 million develop-ing each new drug and expects to recover$20 billion worth of revenue from the onecommercially viable drug. After 1 year, 10drugs have been developed at a cost of $1billion, and no commercially viable drug hasbeen approved for sale. Consider how thecompany might present this on its financialstatements. Table 3-1 provides income state-ments under three alternative accountingmethods. (An income, or operating, statement


Table 3-1 Alternative Accounting Methods for New Drug Development

Year One Year Two

Actual Result If Drug Developed If No Drug

Method One

Revenue $ 0 $20,000,000,000 $ 0

Less Expense 1,000,000,000 1,000,000,000 1,000,000,000

Net Income $(1,000,000,000) $19,000,000,000 $ (1,000,000,000)

Method Two

Revenue $ 0 $20,000,000,000 $ 0

Less expense 0 2,000,000,000 2,000,000,000

Net Income $ 0 $18,000,000,000 $ (2,000,000,000)

Method Three

Revenue $ 10,000,000,000 $10,000,000,000 $(10,000,000,000)

Less expense 1,000,000,000 1,000,000,000 1,000,000,000

Net Income $ 9,000,000,000 $ 9,000,000,000 $(11,000,000,000)



is a financial statement that provides infor-mation on whether the organization hasearned a profit or loss for the year, and if so,how much. We more formally introduce in-come statements in Chapter 4). As you lookat Table 3-1, note that putting parenthesesaround a number is an accountant’s indica-tion of a negative number.

In all three methods, net income is thesame for the 2-year period. If the pharma-ceutical company develops a viable drug, itwill receive $20 billion in return for a 2-yearcost of $2 billion, leaving a profit of $18 bil-lion. If the company doesn’t discover a vi-able drug, then the combined 2 years mustindicate an expenditure of $2 billion withno revenue, or a loss of $2 billion.

Although the 2-year totals are the sameunder all three methods, viable drug or noviable drug, the profit reported in each yearvaries substantially depending on themethod chosen. Method one takes things asthey come. In year one no viable drug is de-veloped, so the $1 billion spent is all consid-ered to be gone. The company reports a lossof $1 billion for the year.

Method two argues that the $1 billion wasan investment in a 2-year project rather thanbeing a loss. On the basis of the hypotheticalpharmaceutical industry average, the com-pany will likely develop a viable drug nextyear, and it gives an unduly harsh picture ofthe company’s results to show it as a loss.This method records no revenue or expensefor year one.

Method three argues that because thecompany expects to develop a viable drug,and because half of the work is completedby the end of year one, the company shouldreport half of the profits by the end of yearone. In this method, $10 billion of revenueis recorded in year one, even though no vi-able drug has yet been developed. If nodrug is developed in year two, the year one

revenue must be eliminated by showing neg-ative revenue in year two.

Comparing the three methods at the endof year one leaves the user of financial state-ments with the information that the com-pany either lost $1 billion, or broke even, ormade a profit of $9 billion during the year.For the second year, if a drug is successfullydeveloped and approved, the profits will be$19 billion for method one, $18 billion formethod two, and $9 billion for methodthree. If no drug is successfully developed,method one shows a loss of $1 billion,method two shows a loss of $2 billion, andmethod three shows a loss of $11 billion.

You may have a favorite among the threemethods. Accountants do not allow use ofmethod three. It is considered to be overlyoptimistic, because there is a reasonablygood chance that there may well be no vi-able drug developed at all. In that case, re-porting $9 billion of profit in the first year isclearly misleading.

Methods one and two, however, eachhave strong proponents and substantial the-oretical support. Accountants frequentlyprefer a conservative approach, and methodone provides it. On the other hand, ac-countants like to “match” expense with therevenue it causes to be generated. This pref-erence supports method two. In this exam-ple, the supporters of method one havecarried the day. Amounts spent currently re-searching drugs must be treated as expensesin the year the research is being done. Wecannot defer recognition of that expense toa future period when a successful drugmight be developed.

This particular example highlights amajor controversy in accounting. It repre-sents only one of a number of situations inwhich the accounting profession has diffi-culty selecting one consistent rule and say-ing that it should be applied across the


board to all organizations in all situations.There is no true theory of accounting to re-solve these dilemmas. The only way toachieve a logical order is by agreement onan arbitrary set of rules.

Comparison of different organizationswould be simplified if the set of rules se-lected permitted very little leeway for the or-ganization. However, politically, accountantshave not always been able to accomplish thisbecause selection of one method over an-other will usually help one set of organiza-tions and hurt another set. In most instancesorganizations have no choice, but there area substantial number of situations where al-ternative rules are allowed.

However, the organization can choosefrom only a relatively narrow set of alterna-tive rules. Whenever the organization makesa choice, that choice must be explicitly statedsomewhere in the financial statements.

Who makes the rules that organizationsmust follow in their accounting practices?There is a rule-making body called the Fi-nancial Accounting Standards Board(FASB). The pronouncements of this boardcarry the weight of competent authority, ac-cording to the American Institute of Certi-fied Public Accountants (AICPA). TheAICPA is a body much like the physicians’AMA and has substantial influence with itsmembership, so much influence that allCPAs look to it to specify the rules theirclients must follow. If the CPA chooses not tofollow one of the rules, he or she is subject tostrong sanctions.

The FASB’s (pronounced faz-B) rules arecalled Generally Accepted Accounting Principles(GAAP). GAAP (pronounced gap) constitutea large number of pages of detailed techni-cal rulings. Following are just a few of themost universally applicable rules. As we gothrough the book, additional rules relevantto the discussion will be noted.

Going Concern

In valuing an organization’s assets, it is as-sumed that the organization will remain inbusiness in the foreseeable future. If it ap-pears that an organization may not remain agoing concern, the auditor is required to indi-cate that in his or her report on the financialstatements. The rationale is that if an organ-ization does go bankrupt, its resources maybe sold at forced auction. In that case, theresources may be sold for substantially lessthan their value as indicated on the organi-zation’s financial statements.

Conservatism

Conservatism requires that sufficient atten-tion and consideration be given to the riskstaken by the organization. In practice thisresults in asymmetrical accounting. There isa tendency to anticipate possible losses, butnot to anticipate potential gains.

There has been considerable argumentover whether this rule actually protects in-vestors. There is the possibility that the or-ganization’s value will be understated as aresult of the accountant’s extreme effortsnot to overstate its value. From an economicperspective, we could argue that one couldlose as much by failing to invest in a good or-ganization as by investing in a bad one.

Matching

To get a fair reflection of the results of opera-tions for a specific period of time, we shouldattempt to put expenses into the same periodas the revenues that caused them to be gener-ated. This principle of matching provides thebasis for depreciation. If we buy a machinewith an expected 10-year life, can we chargethe full amount paid for the machine as an ex-pense in the year of purchase? No, because




that would make the organization look like ithad a bad first year followed by a number ofvery good years. The machine provides serv-ice for 10 years; it allows us to make and sell aproduct or service in each of the years. There-fore, its cost should be spread out into each ofthose years for which it has helped to gener-ate revenue.

Sometimes these principles conflict. Theconservatism principle lends support tousing the first method in the earlier drugcompany example. However, the matchingprinciple lends support to the secondmethod. Some of the most difficult report-ing problems faced by CPAs arise when sev-eral of the generally accepted accountingprinciples come into conflict.

Cost

The cost of an item is what was paid to ac-quire it, or the value of what was given up toget it.

Objective Evidence

This rule requires accountants to ensurethat financial reports are based on such evi-dence as reasonable individuals could allagree on within relatively narrow bounds.

For example, if we bought a piece ofproperty for $50,000 and we could producea cancelled check and deed of conveyanceshowing that we paid $50,000 for the prop-erty, then reasonable people would proba-bly agree that the property cost $50,000.Our cost information is based on objectiveevidence. Twenty years after the property ispurchased, management calls in an ap-praiser who values the property at $500,000.The appraisal is considered to be subjectiveevidence. Different appraisers might varysubstantially as to their estimate of the prop-erty’s value. Three different appraisers

might well offer three widely different esti-mates for the same property.

In such a case, the rule of objective evi-dence requires the property to be valued onthe financial statements based on the bestavailable objective evidence. This is thecost—$50,000! Consider the implications ofthis for financial reporting. If you thoughtthat financial statements give perfectly validinformation about the organization, thisshould shake your confidence somewhat. Fi-nancial statements provide extremely lim-ited representations of the organization.Without an understanding of generally ac-cepted accounting principles (GAAP), thereader of a financial statement may welldraw unwarranted conclusions.

Materiality

The principle of materiality requires the ac-countant to correct errors that are “material”in nature. Material means large or signifi-cant. Insignificant errors may be ignored.But how does one define significance? Is it$5? $500? $5,000,000? Significance dependssubstantially on the size and particular cir-cumstances of the individual organization.

Rather than set absolute standards, ac-countants define materiality in terms of ef-fects on the users of financial statements. Ifthere exists a misstatement so significantthat reasonable, prudent users of the finan-cial statements would make a different deci-sion than they would if they had been giventhe correct information, then the misstate-ment is material and requires correction.

Thus, if an investor can say, “Had I knownthat, I never would have bought the stock,” ora banker can say, “I never would have lent themoney to them if I had known the correcttotal assets of the organization,” then we havea material misstatement. The implications ofthis are that accountants do not attempt to


uncover and correct every single error thathas occurred during the year. In fact, to do sowould be prohibitively expensive. There isonly an attempt to make sure errors that arematerial in nature are uncovered.

Consistency

In a world in which alternative accountingtreatments frequently exist, users of finan-cial statements can be seriously misled if anorganization switches back and forth amongalternative treatments. Therefore, if an or-ganization has changed its accountingmethods, the auditor must disclose thechange in his or her report. A note must beincluded along with the statements to indi-cate the impact of the change.

Full Disclosure

Accountants, being a cautious lot, feel thatperhaps there may be some relevant itemthat users of financial statements should beaware of, but for which no rule exists that ex-plicitly requires disclosure. So, to protectagainst unforeseen situations that may arise,there is a catchall generally accepted ac-counting principle called full disclosure,which requires that if there is any other in-formation that would be required for a fairrepresentation of the results and financialposition of an organization, then that infor-mation must be disclosed in a note to the fi-nancial statement.

KEY CONCEPTS

Entity—The unit for which we wish to ac-count. This unit can be a person, depart-ment, project, division, or organization.

Fund accounting—A system of accountingfound in not-for-profit and government or-ganizations that uses separate accounting

entities (funds), each with its own set of fi-nancial records and financial statements.

Fund balance—The difference between as-sets and liabilities. Another term for net as-sets or owner’s equity.

Generally accepted accounting principles(GAAP)—A set of rules used as a basis for fi-nancial reporting. Some key GAAP:

a. Going concern—Financial statementsare prepared based on the assumptionthat the organization will remain inbusiness for the foreseeable future. Ifthat is not likely to be the case, it mustbe disclosed.

b. Conservatism—In reporting the finan-cial position of the organization, suffi-cient consideration should be given tothe various risks the organization faces.

c. Matching—Expenses should berecorded in the same accounting pe-riod as the revenues that they were re-sponsible for generating.

d. Cost—The value of what was given upto acquire the item.

e. Objective evidence—Financial reportsshould be based on such evidence asreasonable individuals could all agreeupon within relatively narrow bounds.

f. Materiality—An error is material if anyindividual would make a different deci-sion based on the incorrect informationresulting from the error than if he orshe possessed the correct information.

g. Consistency—To avoid misleading usersof financial reports, organizationsshould generally use the same account-ing methods from period to period.

h. Full disclosure—Financial reportsshould disclose any informationneeded to ensure that the reports are afair presentation.

Monetary denominator—All resources areassigned values in a currency, such as dollars,to simplify communication of information




regarding the organization’s resources andobligations.

Assets—The resources owned by the or-ganization.

a. Tangible assets—Assets having physicalsubstance or form.

b. Intangible assets—Assets having no phys-ical substance or form; result in sub-stantial valuation difficulties.

Liabilities—Obligations of the organiza-tion to outside creditors.

Owners’ equity—The value of the firm toits owners, as determined by the account-

ing system. This is the residual amount leftover when liabilities are subtracted fromassets.

Net assets—The residual amount leftover when liabilities are subtracted fromassets.

Fundamental equation of accounting—Assets= Liabilities + Net assets.

TEST YOUR KNOWLEDGE



This chapter provides a brief introductionto the key financial statements contained

in annual financial reports. We discuss thebalance sheet (or statement of financial posi-tion), the income statement (or statement ofoperations), and the statement of cash flows.These statements are crucial to understand-ing the finances of an organization.

THE BALANCE SHEET—HOW MUCH DO WE HAVE AND WHAT DO WE OWE?

The statement of financial position, morecommonly referred to as the balance sheet,indicates the financial position of an organ-ization at a particular point in time. Basi-cally, it illustrates the basic accountingequation (Assets = Liabilities + Net assets)on a specific date, that date being the end ofthe accounting period. The accounting pe-riod ends at the end of the organization’syear. Most organizations also have interimaccounting periods. These periods often aremonthly for internal information purposesand quarterly for external reports.

By default, an organization ends its yearat the end of the calendar year. Alterna-tively, an organization may pick a financialor “fiscal” year end different from that ofthe calendar year. The year-end that an or-ganization chooses is generally influenced

by a desire to make things as easy and inex-pensive as possible. One factor in the deci-sion is the organization’s inventory cycle(this is especially true for medical equip-ment and supply companies). At year end,most health care organizations that have in-ventories have to physically count everyunit. If your inventory has a seasonal lowpoint, this makes a good year end because ittakes less time and money to count the in-ventory than it would at other times duringthe year.

Another factor in the selection of a fiscalyear is how busy your accounting and book-keeping staff is. At the end of the fiscal year,many things have to be taken care of by bothyour internal accountants and your externalauditor. For organizations that are requiredto have an independent audit, there aretime-consuming questions and informationdemands by the CPA. Tax returns must beprepared. Reports to the Securities and Ex-change Commission are required for pub-licly held companies.

Thus, if you can find a time when the ac-counting functions within the organizationare at a slow point, it makes for a good fiscalyear end. For example, many academicmedical centers end their fiscal year on June30 because this date gives them all of Julyand August to get things done before stu-dents return to campus for the Fall semester.

21

CHAPTER 4

Introduction to the Key Financial Statements



The basic components of a balance sheetare shown in Table 4-1, which uses the hypo-thetical Keepuwell Clinic as an example.The first asset subgroup is current assets,and the first liability subgroup is current lia-bilities. Short term, near term, and current areused interchangeably by accountants andusually refer to a period of time less than orequal to 1 year. Current assets generally arecash or will become cash within a year. Cur-rent liabilities are obligations that must bepaid within a year. These items get promi-nent attention by being at the top of the bal-ance sheet. Locating the current assets andcurrent liabilities in this way ensures that thereader can quickly get some assessment ofthe liquidity of the organization.

Long-term (greater than a year) assets arebroken into several groupings. Fixed assetsrepresent the organization’s property, plant,and equipment. Fixed assets are sometimesreferred to as capital facilities. Investments areprimarily securities purchased with the intentto hold onto them as a long-term investment.Securities purchased for short-term interestor appreciation are included in the currentasset category and are referred to as mar-

ketable securities, rather than as investments.Intangibles, although frequently not in-cluded on the balance sheet, are shown withthe assets when accounting rules allow theirpresentation on the financial statements.

In addition to current liabilities, the or-ganization also typically has obligations thatare due more than a year from the balancesheet date. Such liabilities are termed long-term liabilities.

In the case of a not-for-profit health careorganization, the last item on the balancesheet is either the Fund Balance or Net As-sets. This represents the portion of total as-sets owned outright by the organization. Inother words, it is simply the difference be-tween assets and liabilities.

On the balance sheet, net assets are fur-ther divided into three categories:

• Unrestricted net assets• Temporarily restricted net assets• Permanently restricted net assets

Restricted classifications are usually tied todonor requests and requirements for how thefunds are to be used. Donations that comewith no strings attached and profit generated

Table 4-1 Keepuwell ClinicBalance Sheet

December 31, 20XX

Assets Liabilities and Net Assets

Current assets $ 5,000 Liabilities

Fixed assets 10,000 Current liabilities $ 3,000

Investments 3,000 Long-term liabilities 4,000

Intangibles 1,000 Total liabilities $ 7,000

Net assets

Unrestricted $ 4,000

Temporarily restricted 2,000

Permanently restricted 6,000

Total net assets $12,000

Total assets $19,000 Total liabilities and net assets $19,000


from daily operations are recorded as unre-stricted net assets.

In the case of a for-profit corporation, thefinal entry on the balance sheet becomes abit more complicated. Stockholders’ or own-ers’ equity consists of contributed capital and re-tained earnings. Contributed capital (sometimesreferred to as paid-in capital) represents theamounts that individuals have paid directly tothe organization in exchange for shares ofownership such as common or preferredstock. Retained earnings are the portion of theincome that the organization has earnedover the years that has not been distributedto the owners in the form of dividends.

Retained earnings, net assets, and fundbalance, like all items on the liabilities andequity side of the balance sheet, represent aclaim on a portion of the assets and are notassets themselves. Net assets of $100,000does not imply that somewhere the organi-zation has $100,000 in cash readily availablethat could be used immediately (perhaps asa dividend in a publicly traded health carecorporation). It is far more likely that, as theorganization earned profits over the years, itinvested those profits in plant and equip-ment to generate future profits. Net assetsreally represent the organization’s (or own-ers in the for-profit sector) share of owner-ship of the plant and equipment and otherassets rather than a secret stash of cash.

THE INCOME OR OPERATING STATE-MENT—HOW MUCH DID WE MAKE?

The income or operating statement comparesthe organization’s revenues to its expenses.Revenues are the monies an organization has

Excel Template

Template 1 provides an opportunity to prepare asimple balance sheet for your organization.Thetemplate is available on the Web at www.jbpub.com.

received in exchange for the goods andservices it has provided. Expenses are thecosts incurred to generate revenues. Net in-come is the difference between revenuesand expenses. The simplest form of an in-come statement appears in Table 4-2. Unlikethe balance sheet, which is a photograph ofthe organization’s financial position at apoint in time, the income statement tellswhat happened to the organization over aperiod of time, such as a month or a year.

The income statement is frequently usedas a vehicle for the presentation of changesin net assets from year to year. By showingthe difference between revenues and ex-penses for the year, the income statementgives a clear picture of the organization’schange in wealth (or net assets). As men-tioned, it is this wealth (or change in net as-sets) that enables the organization to investin such things as buildings or equipment.

Although we use income statement at times inthis book, that is only an informal name for thestatement that reports revenues and expensesfor health care organizations. The technicalterm for this statement for most organizationsin the health care industry is the operating state-ment or statement of operations. Often, for-profitorganizations in many industries refer to thisstatement as the income statement, and most not-for-profit organizations refer to this statementas an activity statement. The accounting profes-sion considered whether for-profit health careorganizations were more like other for-profitorganizations or more like not-for-profithealth care organizations. And whether not-

Chapter 4: Introduction to the Key Financial Statements 23

Table 4-2 Keepuwell ClinicOperating Statement

For the Year Ending December 31, 20XX

Revenues $20,000

Less expenses 12,000

Net income $ 8,000



for-profit health care organizations were morelike other types of not-for-profit organizationsor more like for-profit health care organiza-tions. Ultimately, the decision was that, for themost part, health care organizations, at leasthealth care providers, were pretty similar andshould be treated as similarly to each other aspossible. Rather than officially call this state-ment an income statement (and imply not-for-profit health care organizations are likefor-profit organizations) or call it an activitystatement (and imply for-profit health care or-ganizations are like not-for-profit organiza-tions), it was decided that all health careproviders would use the term operating state-ment or statement of operations to report theirrevenues and expenses.

STATEMENT OF CASH FLOWS—WHERE DID ALL OUR CASH GO?

The third major financial statement is thecash flow statement, which provides infor-mation about the organization’s cash in-flows and outflows. The current assetssection of the balance sheet of the organiza-tion shows how much cash the organizationhas at the end of each accounting period.This can be compared from year to year tosee how much the cash balance haschanged. However, that gives little informa-tion about how or why it has changed.

Looking only at the balance sheet can re-sult in erroneous interpretations of financialstatement information. For example, an or-ganization experiencing a liquidity crisis (in-adequate cash to meet its currently dueobligations) may sell off a profitable part ofits business. The immediate cash injection

Excel Template

Template 2 provides an opportunity to prepare a simple operating statement for your organization. The template is available on the Web at www.jbpub.com.

from the sale may result in a substantial cashbalance at year end. On the balance sheetthis may make the organization appear to bequite liquid and stable. However, selling offthe profitable portion of the business mayhave pushed the organization even closer tobankruptcy. There is a need to explicitly showhow the organization obtained that cash.

The statement of cash flows details where cashresources come from and how they are used.It provides more valuable information aboutliquidity than can be obtained from the bal-ance sheet and income statements. Table 4-3presents a simplified example of what a state-ment of cash flows would look like.

Excel Template

Template 3 provides an opportunity to prepare a cash flow statement for yourorganization. The template is available on the Web at www.jbpub.com.

Table 4-3 Keepuwell ClinicStatement of Cash Flows

For the Year Ending December 31, 20XX

Cash flows from operating activities

Collections $19,000

Payments to suppliers (8,000)

Payments to employees (3,000)

Net cash from operating activities $ 8,000

Cash flow from investing activities

Purchase of new equipment ($6,000)

Net cash used for investing activities ($6,000)

Cash flow from financing activities

Borrowing from creditors $ 2,000

Debt payment (1,000)

Net cash from financing activities $ 1,000

Net increase/(decrease) in cash $ 3,000

Cash, beginning of year 1,000

Cash, end of year $ 4,000


NOTES TO FINANCIALSTATEMENTS—WHAT DO THE FINANCIAL STATEMENTSREALLY MEAN?

As you continue to read this book, you willfind that the accounting numbers don’t alwaystell the entire story. For a variety of reasons, fi-nancial statements tend to be inadequate tofully convey the results of operations and thefinancial position of the organization.

As a result, accountants require that notesbe provided to supplement the financialstatements discussed. These notes providedetailed explanations and are included inannual reports as an integral part of the over-all financial statements (see Chapter 12).

KEY CONCEPTS

Fiscal year end—The organization’s yearend should occur at a slow point in theorganization’s normal activity to reducedisruption caused in determining the or-gani-zation’s results of operations and year-end financial position.

The balance sheet—Tells the financial posi-tion of the organization at a point in time.

Asset classification—Assets are commonlyclassified on the balance sheet as current,fixed, investments, and intangibles.

Liability classification—Liabilities are gen-erally divided into current and long-termcategories.

Net assets—the portion of total assets not re-quired to repay obligations owed to creditors.

a. Unrestricted net assets result from dona-tions that are given without restrictions

and from operating profits. They areavailable to use as the organizationsees fit.

b. Temporarily restricted net assets have sometime or use restriction imposed by adonor.

c. Permanently restricted net assets are assetswith specific restrictions imposed by adonor that prevent them from everbeing consumed. However, they maybe invested, and the earnings on theinvestment can generally be used foroperating purposes.

Stockholders’ equity is divided into con-tributed capital and retained earnings.

a. Contributed or paid-in capital is theamount the organization has receivedin exchange for shares of stock that re-flect ownership of the organization.

b. Retained earnings are the profits earnedby the organization over its lifetimethat have not been distributed to itsowners in the form of dividends.

Income or operating statement—A summaryof the organization’s revenues and ex-penses for the accounting period (month,quarter, year).

Statement of cash flows—Shows the sourcesand uses of the organization’s cash.

Notes to the financial statements—Vital in-formation supplementing the key financialstatements.

TEST YOUR KNOWLEDGE


Chapter 4: Introduction to the Key Financial Statements 25



One would not expect there to be muchcontroversy over the valuation of bal-

ance sheet items. Wouldn’t they simply berecorded at what they’re worth? Unfortu-nately, it isn’t as easy as that. Consider hav-ing bought a car 3 years ago for $25,000.Today it might cost you $28,000 to buy a sim-ilar car. Is your car worth $25,000 or$28,000?

Wait, it’s more complicated than that.Your old car is no longer new and so itsvalue has gone down with age. Because thecar is 3 years old, and generally cars areexpected to have a 5-year useful life, yourcar has lost 60% of its value, so it’s onlyworth $10,000. However, because of infla-tion, you could sell the car for $15,000 andyou’d have to pay $18,000 to buy it on aused car lot.

What is the value of your car? Is it $25,000,$28,000, $10,000, $15,000, or $18,000? Obvi-ously valuation is a complex issue. This chap-ter looks at how accountants value assets,liabilities, and stockholders’ equity for in-clusion in financial statements. In addi-tion, several other valuation methods thatare not allowed for financial statement re-porting are discussed because they are use-ful to managers.

ASSET VALUATION—HOW DOESTHAT OLD BUILDING SHOW UPON THE BALANCE SHEET?

Historical or Acquisition Cost

Financial statements generally value assetsbased on their historical or acquisition cost.This is done to achieve a valuation based onthe Generally Accepted Accounting Princi-ple (GAAP) of objective evidence. If the or-ganization values all of its assets based onwhat was paid for them at the time it ac-quired them, there can be no question as tothe objectivity of the valuation.

For example, let’s suppose that somenumber of years ago a hospital bought landat a cost of $10 per acre. Suppose that 1,000acres of that land runs through the down-town area of a major city. Today, many yearsafter the acquisition, the organization has todetermine the value at which it wishes toshow that land on its current financial state-ments. The historical cost of the land is$10,000 ($10 per acre multiplied by 1,000acres). By historical cost, we mean the histori-cal cost to the organization as an entity. Theorganization may have bought the landfrom previous owners who paid $1 per acre.Their historical cost was $1 per acre, but to

27

CHAPTER 5

Valuation of Assets and Equities



our entity the historical or acquisition cost is$10 per acre.

Accountants are comfortable with theirobjective evidence. If the land cost $10,000and the organization says it cost $10,000,then everyone gets a fair picture of what theland cost. However, one might well get theimpression from the balance sheet that theproperty is currently worth only $10,000.

In fact, today that land might be worth$10,000,000 (or even $100,000,000). Thestrength of using the historical cost ap-proach is that the information is objectiveand verifiable. However, the historical costmethod also has the weakness of providingoutdated information. It does not provide aclear impression of what assets are currentlyworth. Despite this serious weakness, histor-ical or acquisition cost is the method thatgenerally must be used on audited financialstatements in order for them to be in com-pliance with GAAP.

For assets that wear out, such as buildingsand equipment, the historical cost is ad-justed each year to recognize the fact thatthe asset is being used up. Each year theasset value is reduced by an amount that isreferred to as depreciation expense. Depre-ciation is discussed in Chapter 9.

Price-Level Adjusted Historical Cost

Accountants are ready to admit that the rav-ages of inflation have played a pretty impor-tant part in causing the value of assets tochange substantially from their historical cost.The longer the time between the purchase ofthe asset and the current time, the more likelyit is that a distortion exists between the cur-rent value of an item and its historical cost.One proposed solution to the problem isprice-level adjusted historical cost (PLAHC,pronounced plack). This method is frequentlyreferred to as constant dollar valuation.

The idea behind constant dollar valua-tion is that most of the change in the valueof assets over time has been induced byprice-level inflation. Thus, if we use a priceindex such as the Consumer Price Index(CPI) to adjust the value of all assets basedon the general rate of inflation, we would re-port each asset at about its current worth. Al-though this approach may sound good, ithas some serious flaws.

Unfortunately, not everything increasesat the same rate of inflation. The land in thehospital example may have increased invalue much faster than the general inflationrate. There is no easy way to adjust eachasset for the specific impact that inflationhad on that particular asset using price in-dexes such as the CPI.

Where does that leave us? Well, PLAHCgives an objective measurement of assets.However, it might allow an asset worth$10,000,000 to be shown on the balancesheet at only $110,000. Perhaps it is better toleave the item at its cost and inform every-one that it is the cost and is not adjusted forinflation, rather than to say that it has beenadjusted for inflation when the adjustmentmay be a poor one.

Net Realizable Value

A third alternative for the valuation of assetsis to measure them at what you could get ifyou were to sell them. This concept of valua-tion makes a fair amount of sense. If youwere a potential creditor, be it banker orsupplier, you might well wonder, “If this or-ganization were to sell off all of its assets,would it be able to raise enough cash to payoff all of its creditors?”

Net is used in front of realizable value to in-dicate that we wish to find out how much wecould realize net of any additional costs thatwould have to be incurred to sell the asset.


Thus, commissions, packing costs, and thelike would be reductions in the amount wecould expect to obtain.

This method doesn’t seek to find the po-tential profit. We aren’t interested in thecomparison of what it cost to what we’re sell-ing it for. We simply want to know what wecould get for it. In the case of the hospital’sland, its net realizable value is $10,000,000less any legal fees and commissions the hos-pital would have to pay to sell it.

Is this a useful method? Certainly. Does itgive a current value for our assets? Defi-nitely. Then why not use it on financialstatements instead of historical cost? Thebig handicap of the net realizable valuemethod is that it is based on someone’s sub-jective estimate of what the asset could besold for. There is no way to determine theactual value of each of the organization’s as-sets unless they are sold. This always poses aproblem from an accountant’s point of view.Another problem occurs if an asset that isquite useful to the organization does nothave a ready buyer. In that case, the futureprofits method that follows provides a morereasonable valuation.

Future Profits

The main reason an organization acquiresmost of its assets is to use them to producethe organization’s goods and services.Therefore, a useful measure of their worthis the profits they will contribute to the or-ganization in the future. This is especiallyimportant in the case where the assets are sospecialized that there is no ready buyer. Ifthe organization owns the patent on a par-ticular process, the specialized machineryfor the process may have no realizable valueother than for scrap.

Does that mean that the specialized ma-chinery is worthless? Perhaps, yes, from the

standpoint of a creditor who wonders howmuch cash the organization could generateif needed to meet its obligations. From thestandpoint of evaluating the organization asa going concern, a creditor may well bemore interested in the ability the organiza-tion has to generate profits. Will the organi-zation be more profitable because it has themachine than it would be without it?

Under this relatively sensible approach,an asset’s value is set by the future profits theorganization can expect to generate be-cause it has the asset. However, the problemof dealing with subjective estimates arisesonce again. Here we are even worse off thanwith the previous valuation approach. Atleast we can get outside and hire independ-ent appraisers to evaluate the realizablevalue of buildings and equipment. However,under this method, estimates of futureprofit streams require the expertise of theorganization’s own management. Even withthat expertise and an honest attempt to de-termine the future profits, the estimatesoften turn out to be off by quite a bit.

Replacement Cost

The replacement cost approach is essen-tially the reverse of the net realizable valuemethod. Rather than considering howmuch we could get for an asset were we tosell it, we consider how much it would costus to replace that asset. Although this mightseem to be a difference that splits hairs, it re-ally is not.

Suppose that last year you could buy aunit of merchandise for $5 and resell it for$7. This year you can buy the unit for $6 andsell it for $8. You have one unit remainingthat you bought last year. Today, its historicalcost is $5, the amount you paid for it; its netrealizable value is $8, the amount you cansell it for; and its replacement cost is $6, the

Chapter 5: Valuation of Assets and Equities 29



amount you would have to pay to replace itin your inventory. Three different methodsresult in three different valuations.

Replacement cost (often referred to ascurrent cost) is another example of a subjec-tive valuation approach. Unless you actuallygo out and attempt to replace an asset, youcannot be absolutely sure what it would costto do so. While there might be an activemarket for inventory, and you can deter-mine exactly how much you would pay foranother unit, that is often not the case foryour buildings and equipment. It is veryhard to determine what it would cost you toreplace one of your buildings, exactly, ifsomething happened to it.

Which Valuation Is Right?

Unfortunately, none of these methods (seeFigure 5-1) is totally satisfactory for all infor-mation needs. Different problems requiredifferent valuations. The idea that there is adifferent appropriate valuation dependingon the questions being asked may not seemto be quite right. Why not simply say whatit’s worth and be consistent?

From the standpoint of financial state-ments, we have little choice. GAAP requiresthe use of historical cost information andthat restricts options substantially in provid-ing financial statements. You might say,“Okay, the financial statements must followa certain set of rules, but just among us man-agers, what is the asset’s real value?” Still werespond, “Why do you want to know?” We re-ally are not avoiding the questions. Let’sconsider a variety of possible examples.

First, assume that one of your duties is tomake sure the organization has adequatefire insurance coverage. The policy is cur-rently up for renewal and you have obtaineda copy of your organization’s annual report.According to the balance sheet, your organ-ization has $40,000,000 of plant and equip-ment. You don’t want to be caught in thecold, so you decide to insure it for the full$40 million. Nevertheless, you may well haveinadequate insurance. The $40 millionmerely measures the historical cost of yourplant and equipment.

Which valuation method is the most ap-propriate? In this case, the answer is re-placement cost. If one of the buildings wereto burn down, then our desire would be tohave enough money to replace it. Othermeasures, such as net realizable value, arenot relevant to this decision.

Suppose we are considering the acquisi-tion of a new machine. What measure of val-uation is most appropriate? We could valuethe machine at its historical cost—that is, theprice we are about to pay for it. This methodcannot possibly help us to decide if weshould buy the asset or not. Looking at anasset’s value from the point of view of its costwould lead us to believe that every possibleasset should be bought, because by defini-tion it would be worth the price we pay for it.

How about using the net realizable value?What would the net realizable value of the

PRICE-LEVELADJUSTED

HISTORICAL COSTObjective but limited

relevance

REPLACEMENT COST

Useful, but subjective

HISTORICAL COSTObjective, but limitedrelevance; basis forfinancial statements

NET REALIZABLE VALUE

Useful, but subjective

FUTURE PROFITSUseful, but subjective

Figure 5-1 Asset Valuation Alternatives


machine be the day after we purchase it?Probably less than the price we paid becauseit is now used equipment. In that case, wewouldn’t ever buy the machine. How aboutusing replacement cost? On the day we buya machine, the replacement cost is the sameas its historical cost.

Logically, why do we wish to buy the ma-chine? Because we want to use it to makeprofits. The key factor in the decision to buythe machine is whether or not the futureprofits from the machine will be enough tomore than cover its cost. So the appropriatevaluation for the acquisition of an asset isthe future profits it will generate.

Finally, consider the divestiture of awholly owned subsidiary (perhaps a physi-cian practice owned by a hospital) that hasbeen sustaining losses and is projected tosustain losses into the foreseeable future.What is the least amount that we would ac-cept in exchange for the subsidiary? Histor-ical cost information is hopelessly outdatedand cannot possibly provide an adequateanswer to the question. Replacement costinformation can’t help us. The last thing inthe world we want to do is go out and dupli-cate all of the assets of a losing venture. Ifwe base our decision on future profits, wemay wind up paying someone to take the di-vision because we anticipate future losses,not profits.

The appropriate valuation in this case isnet realizable value. Certainly we don’twant to sell the entire subsidiary for lessthan we could get by auctioning off each in-dividual asset.

As you can see, it is essential that you beflexible in the valuation of assets. As a man-ager, you must do more than simply refer tothe financial statements. To determine thevalue of assets, you must first assess why theinformation is needed. Based on that as-sessment, you can determine which of the

five methods discussed provides the mostuseful information for the specific decisionto be made.

VALUATION OF LIABILITIES—WHATDO WE REALLY OWE?

Valuation of liabilities does not cause nearlyas many problems as valuation of assets. Withliabilities, if you owe Charlie $50, it’s not allthat hard to determine exactly what your lia-bility is; it’s $50. In general, our liability is theamount we expect to pay in the future.

Suppose we purchase medical supplies ata price of $580 on open account with thenet payment due in 30 days. We have to pay$580 when the account is due. Therefore,our liability is $580. The crucial aspects arethat our obligation is to be paid in cash andit is to be paid within 1 year. Problems ariseif either of these aspects does not hold.

For instance, suppose we borrow $7,000from a bank today and have an obligation topay $10,000 to the bank 3 years from today. Isour liability $10,000? No, it isn’t. Bankscharge interest for the use of their money.The interest accumulates as time passes. Ifwe are to pay $10,000 3 years from now, thatimplies that $3,000 of interest will accumu-late over that 3-year period. We don’t owethe interest today, because we haven’t yethad the use of the bank’s money for the 3years. As time passes, each day we owe thebank a little more of the $3,000 of interest.Today, however, we owe only $7,000, fromboth a legal and an accounting point of view.

You might argue that legally we owe thebank $10,000. That really isn’t so, althoughthe bank might like you to believe that it is.Let’s suppose that you borrowed the moneyin the morning. That very same day, unfor-tunately, your rich aunt passes away. Thestate you live in happens to have rather fastprocessing of estates and around 1 o’clock




in the afternoon you receive a large inheri-tance in cash. You run down to the bank andsay that you don’t need the money after all.Do you have to pay the bank $10,000?

If you did, your interest for one day wouldbe $3,000 on a loan of $7,000. That is a rateof about 43% per day, or over 15,000% peryear. Perhaps there would be an early pay-ment penalty, but it would be much lessthan $3,000. Generally, accountants ignorepossible prepayment penalties and recordthe liability at $7,000.

Another problem occurs if the liability isnot going to be paid in cash. A health insur-ance company, for example, may receiveadvance payment for a year’s worth of cov-erage. When it receives that money, it can-not record revenue right away, because ithas not yet provided insurance coverage.Rather than revenue, when the insurancecompany receives the money it records a li-ability. What is it that the insurance com-pany owes? The obligation is to providefinancial coverage for health care needsthat may arise over the year. We don’t knowexactly how much the payments will be, butwe must make an attempt to value the liabil-ity. Take the example one step further andassume that the insurance company re-ceived $36,000 for the coverage, but hopesto only have to pay for $18,000 of healthcare. Is the liability $36,000 or $18,000?

In cases in which the obligation is non-monetary in nature, we record the obliga-tion as the amount received, not the cost ofproviding the nonmonetary item. What iffor some reason the insurance companycannot provide the coverage? Will the cus-tomer be satisfied to receive a refund of$18,000 because that’s all it would have costthe company? No, the customer needs to getthe full $36,000 back, so the insurance com-pany must show that amount as the liability.Over time, as the insurance company pro-

vides the coverage, they can reduce the lia-bility in a pro rata fashion.

VALUATION OF NET ASSETS ANDOWNER’S EQUITY—IS IT REALLYJUST WHAT’S LEFT OVER?

The valuation of net assets and owners’ equityis relatively easy. Recall that assets are equal toliabilities plus net assets. Once the value of as-sets and liabilities has been determined, thenet assets are whatever it must take to makethe equation balance. Remember that net as-sets are, by definition, a residual of whatever isleft after enough assets are set aside to cover li-abilities. Thus, given the rigid financial state-ment valuation requirements for assets andliabilities, there is little room left for inter-preting the value of net assets.

On the other hand, might there not beanother way to determine the value of theorganization to its owners? For a publiclyheld organization the answer is clearly yes.The market value of the organization’s stockis a measure of what the stock market andthe owners of the organization think it’sworth. If we aggregate the market value ofthe organization’s stock, we have a measureof the total value of the owners’ equity.

Is the market value of the organizationlikely to equal the value assigned by the fi-nancial statements? Probably not. Financialstatements tend to substantially undervalue awide variety of assets; intangible assets thatmay be quite valuable are not always includedin financial statements. Further, historicalcost asset valuation causes the tangible assetsto be understated in many cases. Thus, theorganization’s assets may be worth substan-tially more than the financial statements in-dicate. If the public can determine that to bethe case (usually with the aid of the largenumber of financial analysts in the country),the market value of the stock will probably ex-


ceed the value of stockholders’ equity indi-cated on the financial statements. Further-more, stock prices are often dictated by theorganization’s ability to earn profits. In somecases, companies with few assets can still bequite profitable and therefore have a marketvalue well in excess of the stockholders’ eq-uity shown on the balance sheet.

This discussion of valuation of assets andequities has left us in a position to better in-terpret the numbers that appear in financialstatements. Financial statements are the endproduct of the collection of informationregarding a large number of financial trans-actions. Each transaction is recorded indi-vidually into the financial history of theorganization using the valuation principlesof this chapter. Chapter 6 discusses theprocess of recording the individual transac-tions—how and why it’s done. Chapter 7demonstrates how all of the transactions,perhaps millions or even billions during theyear, can be consolidated into three 1-pagefinancial statements.

KEY CONCEPTS

Asset valuation—There are a variety ofasset valuation methods. The appropriatevalue for an asset depends on the intendeduse of the asset valuation information.

a. Historical cost—The amount an entitypaid to acquire an asset. This amountis the value used as a basis for tax re-turns and financial statements.

b. Price-level adjusted historical cost—Valua-tion method that adjusts the asset’s his-torical cost based on the general rateof inflation.

c. Net realizable value—Valuation of anasset based on the amount we wouldreceive if we sold it, net of any costs re-lated to the sale.

d. Future profits—This valuation methodrequires each asset to be valued on thebasis of the amount of additional prof-its that can be generated because wehave the asset.

e. Replacement cost—Under this methodeach asset is valued at the amount itwould cost to replace that asset.

Liability valuation—The value of liabilitiesdepends on whether they are short term orlong term and whether or not they are to bepaid in cash.

a. Short-term cash obligations—Amounts tobe paid in cash within 1 year are valuedat the amount of the cash to be paid.

b. Long-term cash obligations—Amounts tobe paid in cash more than 1 year in thefuture are valued at the amount to bepaid, less the implicit interest includedin that amount.

c. Nonmonetary obligations—Obligation toprovide goods or services rather thancash, where the liability is generally val-ued at the amount received ratherthan the cost of providing that item.

Net assets and owner’s equity valuation—Given a value for each of the assets and lia-bilities, net assets are the residual amountthat makes the fundamental equation of ac-counting balance.

TEST YOUR KNOWLEDGE





DOUBLE ENTRY AND THEACCOUNTING EQUATION—THEGOLDEN RULE OF ACCOUNTING

Financial accounting consists largely ofkeeping the financial history of the organi-zation. In performing financial accounting,the accountant attempts to keep close trackof each event that has a financial impact onthe organization. This is done to facilitate fi-nancial statement preparation. By keepingtrack of things as they happen, the account-ant can periodically summarize the organi-zation’s financial position and the results ofits operations.

To keep track of the organization’s fi-nancial history, the accountant has chosena very common historical device. In thenavy one keeps a chronological history of avoyage by daily entries into a log. For a per-sonal history, individuals make entries intheir diaries. Explorers frequently recordthe events of their trip in a journal. Ac-countants follow in the tradition of the ex-plorers, each day recording the day’sevents in a journal, often referred to as ageneral journal. The entries the accountantmakes in the journal are simply called jour-nal entries. The general journal is oftencalled the book of original entry. This term is

used because an event is first entered intothe organization’s official history via ajournal entry.

In recording a journal entry, we need ad-equate information to describe an entireevent. To be sure that all elements of a fi-nancial event (more commonly referred toas a transaction) are recorded, accountantsuse a system called double-entry bookkeeping.To understand double entry, we shouldthink in terms of the basic equation of ac-counting. That equation is:

Assets (A) = Liabilities (L) + Net assets (NA)

Any event having a financial impact on theorganization affects this equation becausethe equation summarizes the entire finan-cial position of the organization. Further-more, by definition this equation mustalways remain in balance. Absolutely noth-ing can happen (barring a mathematicalmiscalculation) that would cause this equa-tion not to be in balance, because net as-sets has been defined in such a way that itis a residual value that brings the equationinto balance.

If the equation must remain in balance,then a change of any one number in theequation must change at least one other

35

CHAPTER 6

Recording Financial Information



number. We have great latitude in whichother number changes. For example, wemight begin with the equation looking like:

A = L + NA

$300,000 = $200,000 + $100,000

If we were to borrow $40,000 from thebank, we would have more cash—assetswould increase by $40,000—and we wouldowe money to the bank. Our liabilitieswould increase by $40,000. Now the equa-tion would be:

A = L + NA

$340,000 = $240,000 + $100,000

The equation is in balance. Compare thisequation to the previous one. Two numbersin the equation have changed. Double entrysignifies that it is not possible to change onenumber in an equation without changing atleast one other number.

However, the two numbers that changeneed not be on different sides of the equa-tion. For example, what if we next boughtsome inventory for $30,000 and paid cashfor it? Our asset “cash” has decreased whileour asset “inventory” has increased. Theequation now is:

A = L + NA

$340,000 = $240,000 + $100,000

The equation appears as if it hasn’tchanged at all. That’s not quite true. Theleft side of the equation has both in-creased and decreased by $30,000. Al-though the totals on either side are thesame, our journal entry would haverecorded the specific parts of the double-entry change that took place on the leftside of the equation.

DEBITS AND CREDITS: THEACCOUNTANT’S SECRET

It wouldn’t be much fun to be an account-ant if you didn’t have a few tricks and se-crets. Later in this book we discuss a few ofthe more interesting tricks; for now you’llhave to settle for a secret, the meaning ofdebit and credit.

Earlier an accountant’s journal was com-pared to a navy logbook. That’s not the onlysimilarity. Sailors use the terms port and star-board. Many a time you’ve watched an oldseafaring movie, and in the middle of afierce storm, with the skies clouded and thewinds blowing, the seas heaving and therains pouring, someone yells out, “Hard tothe port!” The sailor at the large oakenwheel, barely able to stand erect in the gustsof wind and the torrential downpour, strug-gles hard to turn the ship in the directionordered. Perhaps you thought they wereheading for the nearest port—ergo, “Hardto the port.” Not at all. The shouted com-mand was to make a left turn.

It seems that port simply stated means leftand starboard really means right. Of course,it’s more sophisticated than that; port meansthe left-hand side as you face toward the frontof the boat or ship and starboard means theright-hand side as you face the front. Reallywhat port means is debit, and starboardmeans credit. Certainly we can drape theterms debit and credit in vague definitions andesoteric uses, but essentially debit means left(as you face the accounting document infront of you) and credit means right.

Perhaps you had figured that out on yourown, perhaps not. If you had, then you arepotentially threatening to take away the jobsof your accountants and bookkeepers. Toprevent that, some rather interesting abbre-viations have been introduced to commonaccounting usage. Rarely will the accountant


write out the words debit or credit. Instead, ab-breviations are used. The word credit is ab-breviated Cr. Got it? Then you can guess theabbreviation for debit: Dr. If you didn’t guessit’s not too surprising, given the absence ofthe letter “r” from the word debit. How didthis abbreviation come about? Accounting aswe know it today has its roots in Italy duringthe 1400s. Italy is the home of Latin, andwere we to trace the word debit back to itsLatin roots, the “r” would turn up.

Debit and credit deserve a little more clarifi-cation. Prior to actually using debit and credit,accountants perform a modification to theaccounting equation (that is, Assets (A)equal Liabilities (L) plus Net Assets (NA)).Essentially, this modification requires exami-nation of what causes net assets to change. Aspresented, the balance sheet equation is:

A = L + NA

To find out where we are at the end of a year,we need to know where we started and whatchanges occurred during the year. Thechanges in assets are equal to the change inliabilities plus the change in net assets, or:

∆A = ∆L + ∆NA

where the symbol “∆” indicates a change insome number. For example, ∆A representsthe change in assets.

Moving a step further, net assets increaseas a result of revenues (R) and decrease as aresult of expenses (E). Revenues make own-ers better off and expenses make ownersworse off. Therefore, our basic equation ofaccounting now indicates that the change inassets is equal to the change in liabilities,plus the change in revenues less expenses,or in equation form:

∆A = ∆L + ∆R - ∆E

The only problem with this equation as itnow stands is that accountants are very fondof addition, but only tolerate subtractionwhen absolutely necessary. The above equa-tion can be manipulated using algebra. Wecan add the change in expenses to bothsides of the equation. Doing so produces thefollowing equation:

∆A + ∆E = ∆L + ∆R

Having made these changes in the basicequation, we can return to our discussion ofdebits and credits. When we say that thedebit means left, we are saying that debitsare increases in anything on the left side ofthis equation. When we say that creditmeans right, we are saying that credits in-crease anything on the right side of thisequation. Of course, that leaves us with aslight problem. What do we do if somethingon either side decreases? We have to reverseour terminology. An account on the left isdecreased by a credit and an account on theright is decreased by a debit.

Debits and credits are mechanical toolsthat aid bookkeepers. Debits and creditshave no underlying theoretical or intuitivebasis. In fact, the use of debits and credits asexplained here may seem counterintuitive.Cash, which is an asset, is increased by adebit. Cash is decreased by a credit.

If you think about this, it may not quitetie in with the way you’ve been thinkingabout debits and credits until now. In fact,what we’ve said here may seem to be down-right wrong. Most individuals who are not fi-nancial officers have relatively little need touse debit and credit in a business context. Wecome upon the terms much more often intheir common lay usage.

Most of us have come into contact withthe terms debit and credit primarily from suchevents as the receipt of a debit memo from

Chapter 6: Recording Financial Information 37



the bank. Perhaps we have a checking ac-count and we are charged 30 cents for eachcheck we write. If we write twenty checks onemonth, we will receive a notice from thebank that it is debiting our account by $6.Something here doesn’t tie in with the ear-lier discussion of debits and credits.

If a debit increases items on the left, and as-sets are on the left, our assets should increasewith a debit. But when the bank debits our ac-count, it takes money away from our account.The discrepancy results from the entity con-cept of accounting discussed in Chapter 3.Under the entity concept, each entity must view financial transactions from its own pointof view. In other words, the organizationshouldn’t worry about the impact on its own-ers, managers, or customers; it should onlyconsider the impact of a transaction on itself.

When the bank debits your account, it isnot considering your cash balance at all! Thebank is considering its own set of books. Tothe bank, you are considered a liability. Yougive the bank some money and it owes thatamount of money to you. When the bankdebits your account, it is saying that it is re-ducing an item on the right; the bank is re-ducing a liability. To you as an entity, there isa mirror image. Whereas the bank is reduc-ing its liability, on your records you must re-duce your cash. Such a reduction is a credit.Therefore, receipt of a debit memo from an-other organization would cause you to recorda credit on your books or financial records.

Consider returning merchandise to astore. The store issues you a credit memo.From the store’s point of view, it now owesyou money for the returned item. The store’sliability has risen so it has a credit. From yourpoint of view, you have a receivable from thatstore; receivables are assets. Thus you havean increase in an asset, or a debit.

In other words, about the best way to insultyour accountant is to call him or her a credit(that is, liability) to the organization! You’ll

have to reflect on this new way of thinkingabout debits and credits for a while if you’renot accustomed to it, and if you wish to be-come fluent in the use of debits and credits.Unfortunately, because the items on one sideof the equation increase with debits and theitems on the other side decrease with debits,and vice versa for credits, it can take a whilebefore it becomes second nature. Imagine aproduct manager trying to explain to an ac-countant that a new product is going to gen-erate extra cash of $100,000. The accountantsays, “Okay, debit cash $100,000,” and theproduct manager says, “No, no I said it willgenerate $100,000, not use it!” Of course theaccountant replies, “That’s what I said, debitcash a hundred grand!”

If you still find debits and credits to besomewhat confusing, don’t be overly con-cerned. Trying to look at things from a mirrorimage of what you’ve been used to all your lifeisn’t easy. Fortunately, debits and credits aresimply bookkeeping tools, and you don’tneed to use them extensively to understandthe concepts of accounting and finance.

RECORDING THE FINANCIAL EVENTS

Now we are going to work through an exam-ple in which we actually record a series oftransactions for a hypothetical health careorganization, Healthy Hospital, for 2007.The purpose of this example is to give you afeel for the way that financial information isrecorded, and to show the process by whichmillions of transactions occurring during ayear can be summarized into several pagesof financial statements. At the same time, weuse the specific transactions in the exampleto highlight a number of accounting con-ventions, principles, and methods.

Table 6-1 presents the balance sheet forHealthy Hospital as of December 31, 2007.From this balance sheet, we can obtain in-formation about assets, liabilities, and net


assets for the beginning of 2008. Year-endclosing balances from the balance sheet willbe identical to opening balances for the fol-lowing year. Our basic equation at the startof 2008 is as follows:

A = L + NA

$300,000 = $134,000 + $166,000

To examine financial events during the year,we are interested in the change in this equa-tion. As explained, the change in the equa-tion may be stated as follows:

∆A + ∆E = ∆L + ∆R

Every financial event is a transaction that af-fects the basic equation of accounting. Wekeep track of whether or not each transac-tion complies with the rules of double entryby examining its effect on this equation.After a journal entry is recorded, placing anevent into the financial history of the organ-ization, this equation must be in balance orsome error has been made.

The way that accountants actually recordjournal entries ensures that the equationremains in balance at all times. Each jour-nal entry first lists all accounts that have adebit change, and then lists all accountsthat have a credit change. The accountnames for accounts with a debit change arerecorded in a column on the left and theaccount names for accounts with a creditchange are recorded on a column in-dented slightly to the right. Similarly, theactual dollar amounts appear in twocolumns, with the debit column on the leftof the credit column.

For example, suppose that we buy inven-tory and pay $12 cash for it. One asset, in-ventory, goes up by $12, and another asset,cash, goes down $12. In journal entry formthis would appear as:

Dr. Cr.

Inventory $12Cash $12

To record purchase of inventory for cash.

Notice that Inventory appears to be some-what to the left, and the dollar amount onthat line appears in the Dr. column. Asnoted, an increase in an asset is a debit. Cashis indented to the right and the dollaramount on that line is on the Cr. column. Adecrease in the asset, cash, is a credit. A briefexplanation is often recorded for each jour-nal entry. In this example the explanation isthat the purpose of the journal entry was“To record purchase of inventory for cash.”


Table 6-1 Healthy HospitalBalance Sheet

As of December 31, 2007

Assets

Current assets

Cash $104,000

Accounts receivable 36,000

Inventory 40,000

Total current assets $180,000

Fixed assets

Plant and equipment 120,000

Total assets $300,000

Liabilities

Current liabilities

Accounts payable $ 34,000

Wages payable 20,000

Total current liabilities $ 54,000

Long-term liabilities

Mortgage payable 80,000

Total liabilities $134,000

Net assets

Unrestricted net assets $146,000

Permanently restricted net assets 20,000

Total net assets $166,000

Total liabilities & net assets $300,000



The total of all numbers in the Dr. columnmust equal the total of all numbers in theCr. column, or the fundamental equation ofaccounting is not in balance.

In the example that follows, we indicatethe impact of each transaction on the fun-damental equation of accounting and thenshow how it appears in journal entry form.

Healthy Hospital 2008 Financial Events

1. January 2. Purchased a 3-year fire in-surance policy for $6,000. A check wasmailed. The starting point for making ajournal entry is to determine what has hap-pened. In this case, we have $6,000 less cashthan we used to and we have paid in advancefor 3 years worth of insurance. Any item thatwe would like to keep track of is called an ac-count, because we want to account for theamount of that item. Here, the balance inour cash account (an asset) has gone down,and our prepaid insurance (P/I) account(also an asset) has increased. This results inoffsetting changes on the left side of theequation, so there is no net effect or changeto the equation.

∆A + ∆E = ∆L + ∆R

Cash - 6,000 = No changeon right side

P/I + 6,000

Dr. Cr.Prepaid Insurance $6,000

Cash $6,000

2. January 18. The hospital mails a checkto its supplier for $30,000 of the $34,000 itowed them at the end of last year. (Refer toTable 6-1 for the accounts payable (A/P) lia-bility balance at the end of the previousyear.) This requires a journal entry showing

a decrease in the cash balance and a reduc-tion in the A/P liability to our supplier.

∆A + ∆E = ∆L + ∆R

Cash - 30,000 = A/P - 30,000

Dr. Cr.Accounts Payable $30,000

Cash $30,000

Notice that when we look at the impact onthe equation, both cash and accountspayable are negative numbers; each de-creases by $30,000. In the journal entry for-mat, negative signs are never needed orused. The decrease in cash is a credit, andappears as $30,000 in the credit column.The decrease in accounts payable results ina debit and appears in the debit column.

3. February 15. The hospital places anorder with an equipment manufacturer for anew piece of machinery. The new machinecosts $20,000 and delivery is expected earlynext year. A contract is signed by both HealthyHospital and the equipment manufacturer. Inthis case there is no journal entry, eventhough there is a legally binding contract.

For there to be a journal entry, three re-quirements must be fulfilled. The first is thatwe know how much money is involved. Inthis case, we do know the exact amount ofthe contract. Second, we must know whenthe transaction is to be fulfilled. Here, weknow that delivery will take place early thefollowing year. Finally, the accountant re-quires that there must have been some ex-change and that the transaction berecorded only to the extent that there hasbeen an exchange. From an accountingpoint of view, Healthy Hospital has not yetpaid anything nor has it received anything.There is no need to record this into the fi-nancial history of the organization via theformal process of a journal entry.


This doesn’t mean that the item must betotally ignored. If an unfilled contract in-volves an amount that is material, then theprinciple of full disclosure requires that anote to our financial statements disclose thisfuture commitment. However, the balancesheet itself may not show the machine as anasset or show a liability to pay for it.

4. March 3. Healthy Hospital purchasesinventory on account for $30,000. Healthywill use this inventory in the delivery of carefor which they will be paid $60,000. The ef-fect of this transaction is to increase theamount of inventory (Inv.) asset that wehave and to increase a liability, A/P. Do werecord the newly purchased inventory at$30,000 or the amount we will ultimately getpaid? According to the cost principle, wemust value inventory at what it cost eventhough it will be used to generate revenuesthat are greater than that amount.

∆A + ∆E = ∆L + ∆R

Inv + 30,000 = A/P + 30,000

Dr. Cr.Inventory $30,000

Accounts Payable $30,000

5. April 16. Cash of $28,000 is receivedfrom third-party payers for services providedto patients last year. This increases one asset,cash, and reduces another asset, accountsreceivables (A/R).

∆A + ∆E = ∆L + ∆R

Cash + 28,000 = No change on right side

A/R - 28,000

Dr. Cr.Cash $28,000

Accounts Receivable $28,000

6. May 3. Healthy Hospital treats and dis-charges a patient for which they used $58,000worth of inventory and have billed the pa-tient’s insurance company the agreed-uponrate of $112,000. This is an income-generatingactivity. Healthy has revenues of $112,000 fromthe service. It also has an expense of $58,000,the cost of inventory used during treatment.(There would obviously be other costs directlyrelated to treatment such as wages, but we willkeep it simple for now.) We can treat this astwo transactions. The first transaction relatesto the revenue and the second to the expense.

First, we have generated patient servicerevenue (PSR) of $112,000, so we have torecord revenue of $112,000. We haven’tbeen paid yet, so we have an account receiv-able of $112,000. This leaves the accountingequation in balance.

The second transaction concerns inven-tory and expense. To provide the service, weused some of our inventory. Thus, we haveless inventory on hand. This reduction in in-ventory is offset in the accounting equationby a corresponding inventory expense.Once again, this transaction leaves the ac-counting equation in balance.

∆A + ∆E = ∆L + ∆R

A/R = Patient + 112,000 Services

Revenue + 112,000

Inv. Inv. Exp.- 56,000 + 56,000

Dr. Cr.Accounts Receivable $112,000Inventory Expense 56,000

Inventory $56,000PSR 112,000

7. June 27. Healthy Hospital places an$18,000 order to resupply its inventory. The




goods have not yet been received. In this casethere is no formal journal entry. Our pur-chasing department undoubtedly keeps trackof open purchase orders. However, as in thecase of the equipment contract discussed ear-lier, there is no journal entry until there is anexchange by at least one party to the transac-tion. We haven’t paid for the goods and thesupplies have not yet been received.

8. November 14. Employees were paid$36,000. This payment included all balancesoutstanding from the previous year. Becausewe are paying $36,000, cash decreases by$36,000. Is this all an expense of the currentyear? No. We owed employees $20,000 fromwork done during the previous year. Thus,only $16,000 is an expense of the currentyear. Our journal entry shows that labor ex-pense (Labor) rises by $16,000 and thatwages payable (W/P) decline by $20,000.Note that three accounts have changed.Double-entry accounting requires that atleast two accounts change. The equationwould not be in balance if only one accountchanged. However, it is perfectly possible formore than two accounts to change. Here wecan see that although three accounts havechanged, in net, the equation is in balance.

∆A + ∆E = ∆L + ∆R

Cash - 36,000 Labor + 16,000 = W/P - 20,000

Dr. Cr.Labor Expense $16,000Wages Payable 20,000

Cash $36,000

9. December 31. At year end, HealthyHospital makes its annual mortgage pay-ment of $20,000. The payment reduces themortgage balance by $8,000. It doesn’t seemcorrect to pay $20,000 on a liability but onlyreduce the obligation by $8,000. Actually,

mortgage payments are not merely repay-ment of a debt. They also include interestthat is owed on the debt. If Healthy Hospitalis making mortgage payments on its plantand equipment just once a year, then thispayment includes interest on the $80,000balance outstanding at the end of last year(see Table 6-1).

If the mortgage is at a 15% annual inter-est rate, then we owe $12,000 of interest forthe use of the $80,000 over the last year(15% x $80,000 = $12,000). Thus, the trans-action lowers cash by $20,000, but increasesinterest expense (IE) (also on the left sideof the equation) by $12,000. The reductionof $8,000 on the right side to reduce themortgage payable (M/P) account leaves theequation exactly in balance.

∆A + ∆E = ∆L + ∆R

Cash - 20,000 IE + 12,000 = M/P - 8,000

Dr. Cr.Interest Expense $12,000Mortgage Payable 8,000

Cash $20,000

10. December 31. At year end, HealthyHospital makes an adjustment to its booksto indicate that 1 year’s worth of prepaid in-surance has been used up. Many financialevents happen at a specific moment in time.In those cases, we simply record the eventwhen it happens. Some events, however,happen over a period of time. Technicallyone could argue that a little insurance cov-erage was used up each and every day, so theaccountant should have recorded the expi-ration of part of the policy each day, or forthat matter, each minute.

There is no need for that degree of ac-curacy. The accountant merely wants tomake sure that the books are up to date


prior to issuing any financial reports basedon them. Therefore, a number of adjustingentries are made at the end of the account-ing period.

One might ask why the accountant both-ers to make such an entry even then. Whynot wait until the insurance is completelyexpired? The matching principle would notallow that. In each case of an adjustingentry, the overriding goal is to place ex-penses into the correct period—the periodin which revenues were generated as a re-sult of those expenses.

In the case of the insurance, we have usedup one third of the $6,000, 3-year policy, sowe must reduce our asset, prepaid insurance(P/I), by $2,000, and increase our insuranceexpense (Ins.) account by $2,000.

∆A + ∆E = ∆L + ∆R

P/I - 2,000 Ins. + 2,000 = No change onright side

Dr. Cr.Insurance Expense $2,000

Prepaid Insurance $2,000

11. December 31. Healthy Hospital alsofinds that it owes office employees $6,000 atthe end of the year. These wages will not bepaid until the following year. This requiresan adjusting entry to accrue this year’s laborexpenses. The entry increases labor expenseand, at the same time, increases the wagespayable liability account.

∆A + ∆E = ∆L + ∆R

Labor + 6,000 = W/P + 6,000

Dr. Cr.Labor Expense $6,000

Wages Payable $6,000

12. December 31. The plant and equip-ment that Healthy Hospital owns are now 1year older. To get a proper matching of rev-enues for each period with the expenses in-curred to generate those revenues, the costof this plant and equipment was notcharged to expense when it was acquired.Instead we allocate some of the cost to eachyear in which the plant and equipmenthelps the organization to provide its goodsand services. The journal entry increases anexpense account called depreciation expense(Depr.) to show that some of the cost of theasset is becoming an expense in this period.In this year, the expense amounts to$12,000. The calculation of annual depreci-ation expense is discussed in Chapter 9.

The other impact (recall that the double-entry system requires at least two changes) ison the value of the plant and equipment(P&E). Because the plant and equipment aregetting older, we must adjust their valuedownward by the amount of the depreciation.

∆A + ∆E = ∆L + ∆R

P/E - 12,000 Depr. + 12,000 = No change onright side

Dr. Cr.Depreciation Expense $12,000

Plant and Equipment $12,000

These transactions for Healthy Hospitalgive a highly consolidated view of the thou-sands, millions, or quite possibly billions oftransactions that are recorded annually byan organization. These few transactionscannot hope to have captured every indi-vidual transaction or type of transactionthat occurs in your particular organiza-tion. However, in this brief glance, you canbegin to understand that there is a system-atic approach for gathering the raw bits of




data that make up the financial history ofthe organization.

There may be an enormous number ofindividual journal entries for an organiza-tion during the year. Chapter 7 examineshow we can consolidate and summarizethese numerous individual journal entriesto provide useful summarized informationto interested users of financial statements.

T-ACCOUNTS

Accountants frequently use a device called T-accounts as a form of shorthand when they areconsidering the financial impact of transac-tions. For any account that might be affectedby a transaction, the accountant draws a largeT, and places the name of the account on thetop. For example, in the first transaction forHealthy Hospital in 2008, Healthy purchasedan insurance policy for $6,000. This affectsboth prepaid insurance and cash, and T-ac-counts would be set up as follows:

Within the T-account, any entries on theleft side of the vertical line are debits, andany entries on the right side are credits. Thepurchase of $6,000 of insurance on January2, 2008, generates a debit to prepaid insur-ance and a credit to cash as follows:

Often, T-accounts are used to assess thebalance that remains in an account after atransaction. From Table 6-1, we see that atthe end of 2007, Healthy had $104,000 incash, and no prepaid insurance. We can addthis information to the T-accounts, and thensummarize the position immediately follow-ing the transaction to purchase the insur-ance as follows:

Notice that when the beginning debit bal-ance of $104,000 of cash is combined withthe $6,000 credit transaction on January 2,the result is a $98,000 debit balance. The$6,000 credit reduces the total amount ofthe debit balance, in the same way that anegative number offsets a positive number.

The use of T-accounts by accountants forinformal discussions and analyses is quitecommon, even though T-accounts are notgenerally part of the organization’s formal ac-

Prepaid Cash Insurance

Cash

1/2/08 $6,000

Cash

12/31/07 $104,000

1/2/08 $6,000

Ending Bal. $ 98,000

Prepaid Insurance

1/2/08 $6,000

Prepaid Insurance

12/31/07 $ 0

1/2/08 6,000

Ending Bal. $ 6,000


counting system. The biggest problem T-ac-counts create for nonaccountants is that neg-ative signs are not used. Each part of atransaction, or journal entry, is recorded in aT-account on the left or right side of the T, de-pending on whether it is a debit or credit, re-spectively. When you look at a T-account, tounderstand if the account balance is increas-ing or decreasing as a result of a specific entry,the user needs to be aware of whether eachspecific account is one that increases with adebit or a credit. Simply keep in mind that as-sets and expenses increase with debits and de-crease with credits. Liabilities and revenuesincrease with credits and decrease with debits.

CHART OF ACCOUNTS

Up to this point we have always referred to ac-counts by their names, such as accounts re-ceivable or wages payable. In practice, mostorganizations find it helpful to assign codenumbers to each account. This facilitates theprocess of recording journal entries in thecomputer systems widely used for accounting.

Typically, an organization uses a fairly sys-tematic approach to assigning numbers. Allasset code numbers must begin with 1, liabili-ties with a 2, revenues with a 3, and expenseswith a 4, for example. A second and thirddigit provide more specific information. Forexample, cash might be represented by 100and accounts receivable might be repre-sented by 110. Most organizations have re-ceivables from many customers. A second setof numbers might provide that detailed infor-mation. For example, 110-12850 might referto accounts receivable from customer num-ber 12850. The organization might thereforesell $5,000 of its product to customer 12850on account. It would record a $5,000 increasein its account number 110-12850.

Charts of accounts can be quite flexible.If an organization has five divisions, it can

set aside one digit for each division. Thatdigit might come at the beginning or end ofthe entire account code used for each trans-action. Also, the organization may choose touse the chart to identify specific programs,projects, departments, or other informa-tion. Thus, an account number might looksomething like 4-110-12850-028. This mightindicate that the home health division (divi-sion 4 of the company’s five divisions) has anaccount receivable (110) from customer12850 related to hospice services (028).

Although this may appear to be compli-cated, it actually keeps things clear and sim-ple once you know how the organization’schart of accounts is set up. The official chartof accounts provides the guide to the systemof accounts used by any organization. It firstdefines the intended purpose of each digitand the meaning of each number containedin each digit. So the first thing you learn isthat the first digit represents the division ofthe organization and that the specific num-ber associated with each of the five divisionsis listed. Next you learn the meaning of thesecond digit, which in this case indicateswhether we are looking at an asset, liability,revenue, or expense. If the second digit is 1in this system, it means we are looking at anasset. The next two digits indicate the spe-cific asset, liability, revenue, or expense.Thus, the 110 after the first hyphen tells usthat we are looking at an asset, specificallyaccounts receivable. And so on.

Generally, in addition to defining themeaning of each digit and providing all dataneeded to interpret an account number, acomplete chart is also maintained. This al-lows a user to look up any specific accountnumber. Bear in mind, however, that thechart of accounts is a dynamic document.New accounts are frequently added to an ac-counting system and it is important to keepthe chart of accounts up to date.




KEY CONCEPTS

Double-entry accounting—Each financialevent affects the basic equation of account-ing. For the equation to remain in balance,the event must affect at least two items in theequation; therefore, the “double” entry.

Journal—A book (or computer memoryfile) in which all financial events arerecorded in chronological sequence.

Debits—Increases in assets and expenses;decreases in liabilities and revenues.

Credits—Increases in liabilities and rev-enues; decreases in assets and expenses.

Timing for recording transactions—Journalentries can be made only if we know withreasonable certainty the amount of money

involved and the timing of the event, and ifthere has been exchange by at least oneparty to the transaction.

Adjusting entries—Most financial eventsoccur at one specific point in time and arerecorded as they occur. Some financial eventsoccur continuously over time, such as the ex-piration of insurance or the accumulation ofinterest. Adjusting entries are made immedi-ately prior to financial statement preparationto bring these accounts up to date.

TEST YOUR KNOWLEDGE



Chapter 6 discusses how each of the nu-merous financial transactions affecting

an organization can be recorded into theorganization’s financial history through theuse of a journal and journal entries. Whenwe get to the end of an accounting period(typically a month, quarter, or year), wewant to report what has occurred. We needsome method of summarizing the massivequantity of information we have recordedinto a format concise enough to be useful tothose who desire financial informationabout the organization.

Financial statements are used to presentthe organization’s financial position and re-sults of operations to interested users of finan-cial information. As we learned in Chapter 4,financial statements are only several pageslong. How can we process our journal entryinformation in such a way as to allow for sucha substantial summarization? We do it via useof a ledger.

LEDGERS

A ledger is a book of accounts. An account isan item that we would like to keep track of.Every account that might be affected by ajournal entry is individually accounted for ina ledger.

Although today many organizations havecomputerized their bookkeeping systems sothat they no longer have a ledger book, youcan think of a ledger as if it were simply abook. Each page in the ledger book repre-sents one account. For instance, there is apage for the cash account, one for the in-ventory account, and one for patient rev-enue. Every time we make a journal entry,we are changing the amount that we have inat least two ledger accounts to keep the basicequation of accounting in balance.

An intermediate benefit of the ledger sys-tem is that it allows us to determine howmuch we have of any item at any point intime. For example, suppose that someoneasked us on May 4th how much cash we cur-rently have. One way to provide that infor-mation would be to review each and everyjournal entry that we made since the begin-ning of the year, determine which ones af-fected cash, and calculate by how much thecash total has changed. That presents anenormous amount of work.

Using a ledger approach, immediatelyafter making a journal entry, we update ourledger for each account that had changed asa result of that entry. For example, in Chap-ter 6, the first thing that happened toHealthy Hospital in 2008 was a purchase of

47

CHAPTER 7

Reporting Financial Information: A Closer Look at the Financial Statements



insurance for $6,000, which was paid for incash. This expenditure requires us to go tothe ledger account for cash and show a de-crease of $6,000, as well as go to the ledgeraccount for prepaid insurance and show anincrease of $6,000. At the same time, wecould update the balance in each account.

The ledger is, in some respects, a morecomplete picture of the organization thanthe journal is. Each year the journal indi-cates what happened or changed duringthat year. The ledger not only contains thisyear’s events, but also tells us where we werewhen we started out at the beginning of theyear. For instance, Healthy Hospital had$104,000 in cash at the end of 2007 accord-ing to Table 6-1. Our cash account in theledger shows $104,000 as the opening bal-ance at the beginning of 2008. Thus, whenwe purchased our insurance on January 2,2008, we would be able to determine thatour initial balance of $104,000 was de-creased by $6,000, and that there is a re-maining cash balance of $98,000. This givesa better overall picture of the organizationthan the $6,000 change alone does.

Essentially, the ledger combines accountbalances from the beginning of the year withthe journal entries that were recorded duringthe year. All of the beginning balances forthis year can be found by looking at last year’sending balance sheet. The balance sheet isthe statement of financial position. The orga-nization’s financial position at the beginningof the year is identical to its financial positionat the end of the previous year. Therefore,the ledger accounts start the year with bal-ances from the year-end balance sheet of theprevious year. During the year, the changesthat occur and are recorded as journal en-tries are used to update the ledger accounts.The year-end balance in each account is thesum of the opening balance plus the changesrecorded in that account during the year.

HEALTHY HOSPITAL’S FINANCIAL STATEMENTS

Table 7-1 presents the information fromwhich we can prepare a set of financial state-ments for Healthy Hospital. This table rep-resents a highly abbreviated ledger for theentire organization for the whole year. All ofthe journal entries for the year have beenrecorded. Each column represents oneledger account. That is, each column in thistable is the same as one page in a ledgerbook. The opening balance is recorded foreach account, based on information fromTable 6-1, Healthy Hospital’s December 31,2007 Balance Sheet. The horizontal linesrepresent the individual numbered journalentries from Chapter 6. A running balancein each account has not been provided inthis example.

A number of the ledger accounts in Table7-1 start with a zero balance. This occurs forone of two reasons. The first reason is simplythat there was no balance at the end of lastyear, so there is no balance at the beginningof this year. Such is the case with prepaid in-surance. The second reason is that someitems are kept track of year by year ratherthan cumulatively. The income or operatingstatement accounts relate specifically to theaccounting period. We kept track of our in-come for 2007. Once 2007 was over and itsresults reported in our financial statements,we wished to keep track of 2008’s incomeseparately from 2007’s. Therefore, all of therevenue and expense accounts start 2008with a zero balance. When we get to the endof this year and ask “What was our revenuethis year?”, we want to know the revenue ofthis year separate and apart from any rev-enue we made in earlier years. The revenueand expense accounts are called temporaryaccounts because we start them over eachyear with a zero balance.


Chapter 7: Reporting Financial Information 49Ta

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7-1

Hea

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Hos

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2008

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$104

$0$3

6$4

0$1

20$0

$0$0

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$34

$20

$80

$146

$0$2

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1-6

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20$1

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6$2

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46$0

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$112

Cash

Prepaid Insurance

Accounts Receivable

Inventory

Plant & Equipment

Inventory

Labor

Interest

Insurance

Depreciation

Accounts Payable

Wages Payable

Mortgage Payable

Unrestricted

Temporarily Restricted

Permanently Restricted

Revenue

TRANSACTION



The key to conveying financial informationis the ending balance of each ledger account.As long as we are using a system in which eachjournal entry is posted, or recorded in the indi-vidual ledger accounts involved, we are ableto determine the ending balance in each ac-count. These ending balances provide the in-formation needed to prepare a complete setof financial statements.

The Operating Statement

Table 7-2 presents the 2008 Operating State-ment for Healthy Hospital. The operatingstatement for any organization consistsmerely of a comparison of its revenues andexpenses. To prepare this statement, we lookat the ending balance in each revenue andexpense ledger account. The ending bal-ance in the revenue account at the bottom ofTable 7-1 shows revenue of $112,000, whichis exactly the same as the revenue in the op-erating statement in Table 7-2. You can com-

Excel Template

Use Template 4 to record journal entries, post themto ledger accounts, and calculate ending balancesthat can be used to prepare financial statements.This template is on the Web at www.jbpub.com.

pare each of the expenses between Tables 7-1 and 7-2 as well, and find them to be thesame. This must be so, because the way thatthe operating statement was prepared was tosimply take the ending balances from eachof the revenue and expense ledger accounts.

Notice that the last line in Table 7-2 iscalled the Increase in net assets. For-profithealth care organizations often refer to thisas Net income, whereas not-for-profit organi-zations indicate either an Increase in net assetsor a Decrease in net assets. If financial state-ments for 2 years are shown side by side, andthere was a profit 1 year and a loss the other,the heading becomes Change in net assets.

Where did the “increase in net assets” ter-minology come from? Generally, all organi-zations, whether for-profit or not-for-profit,attempt to earn a profit each year. However,many not-for-profit organizations are uncom-fortable subtracting expenses from revenueand reporting the difference as net income.They fear that would give the public an in-correct impression—the public might viewthe organization as a for-profit organizationwhen they see that it has earned income. Thiscould significantly reduce donations that theorganization might hope to receive.

So an alternative name was sought for thedifference between revenues and expenses.Revenue transactions result in an increase innet assets. For example, you provide careand get paid $100 for that care. Cash goes up$100 on the left side of the fundamentalequation and revenue goes up $100 on theright side in the net assets category. So, netassets increase by $100. Suppose that it cost$80 to provide that care. Expenses result ineither a decrease in assets or an increase in aliability, and also in a decrease in net assets.So, net assets would have declined by $80.Because net assets rose by $100 and declinedby $80, there was a $20 change in net assets.Because it was a positive net change, it canbe referred to as an increase in net assets.

Table 7-2 Healthy HospitalOperating Statement

For the Year Ending December 31, 2008

Revenue $ 112,000

Less expenses

Inventory $ 56,000

Labor 22,000

Interest 12,000

Insurance 2,000

Depreciation 12,000

Total expenses 104,000

Increase in net assets $ 8,000


The Balance Sheet

The net assets ledger accounts (unrestricted,temporarily restricted, and permanently re-stricted) in Table 7-1 have the same balance atthe end of the year as they had at the begin-ning of the year. As noted, the net assets of anorganization increase when it has revenue anddecrease when it has expense. In fact, everyrevenue increases net assets, and all expensesdecrease it. We have had both revenues andexpenses, but the net assets accounts have notchanged. The reason for this is that we havesimply been keeping track of the specificchanges in revenues and expenses separately,instead of immediately showing their impacton the net asset accounts.

By keeping track of revenues and ex-penses in detail rather than directly indicat-ing their impact on net assets, we havegenerated additional information. This in-formation has been used to derive an oper-ating statement. If we simply changed netassets directly whenever we had a revenue orexpense, we would not have had the infor-mation needed to produce that statement.

Nevertheless, we cannot produce a bal-ance sheet without updating the informa-tion in our net asset accounts. Table 7-3provides a statement that updates all of the

net asset accounts. In Table 7-3, we can seethat both of the restricted net asset accountsdid not change this year. Usually these ac-counts change as a result of gifts fromdonors. The increase in unrestricted net as-sets is a result of the difference between the$112,000 of revenues and the $104,000 ofexpenses.

All of the information used in Table 7-3comes directly or indirectly from the ledgeraccounts shown in Table 7-1. The increase innet assets figure in Table 7-3 does not ap-pear anywhere in Table 7-1. It is a summaryof the year-end revenue and expense itemsfrom the operating statement (Table 7-2).All of the Table 7-2 items came directly fromTable 7-1. We now have all of the informa-tion we need to produce a balance sheet.

The balance sheet for Healthy Hospitalfor 2008 appears in Table 7-4. The asset andliability balances came directly from Table7-1 and the net asset balances came fromour derivation in Table 7-3. The prepara-tion of this financial statement is reallyquite simple, given the ledger account bal-ances. The balances are transferred to thefinancial statement, with the main work in-volved being the determination of which ac-counts are short term and which accountsare long term.

Chapter 7: Reporting Financial Information 51

Table 7-3 Healthy HospitalAnalysis of Changes in Net Assets


Temporarily PermanentlyUnrestricted Restricted RestrictedNet Assets Net Assets Net Assets

Beginning Balance 1/1/08 $146,000 $ 0 $20,000

Donor Gifts for 2008 0 0 0

Increase in Net Assets for 2008 8,000

Ending Balance 12/31/08 $154,000 $ 0 $20,000



The Statement of Cash Flows

The one remaining financial statement thatis widely used to report the results of opera-tions is the statement of cash flows. As dis-

Excel Template

Template 5 uses the journal entry informationfrom Template 4 to derive an IncomeStatement and Balance Sheet. The template isincluded on the Web at www.jbpub.com.

cussed in Chapter 4, this statement focuseson the organization’s sources and uses ofcash. This statement also provides insightabout the organization’s liquidity, or its abil-ity to meet its current obligations as theycome due for payment.

The statement of cash flows shows wherethe organization got its cash and how it usedit over the entire period covered by the fi-nancial statement. This feature is similar tothe operating statement, which shows rev-enues and expenses for the entire account-ing period, and is different from thebalance sheet, which shows the organiza-tion’s financial position at a single point intime. The statement of cash flows is dividedinto three major sections: cash from operat-ing activities, cash from investing activities,and cash from financing activities.

The operating activities are those thatrelate to the ordinary revenue- and ex-pense-producing activities of the organiza-tion. Organizations tend to be particularlyinterested in how their day-to-day revenuesand expenses affect cash balances. Theseactivities include items such as payments toemployees and suppliers and collections ofcash from customers. A controversial ele-ment involves interest and dividends. Manypeople believe that interest and dividendsare more closely associated with investingand financing activities. However, interestand dividends received and interest paidmust be included with operating activitiesbecause of their impact on revenues andexpenses.

The investing activities of the organizationrelate to the purchase and sale of fixed assetsand securities. It is clear that the purchase ofstocks and bonds represents an investing ac-tivity. The accounting rule-making body de-termined that the purchase of property, plant,and equipment also represents an investment,and should be accounted for in this category.

Table 7-4 Healthy HospitalBalance Sheet


ASSETS

Current Assets:

Cash $ 40,000

Prepaid Insurance 4,000

Third-Party Receivables 120,000

Inventory 14,000

Total Current Assets $ 178,000

Fixed Assets:

Plant and Equipment, net 108,000

TOTAL ASSETS $ 286,000

LIABILITIES AND NET ASSETS

Liabilities

Current Liabilities:

Accounts Payable $ 34,000

Wages Payable 6,000

Total Current Liabilities $ 40,000

Long-Term Liabilities:

Mortgage Payable 72,000

TOTAL LIABILITIES $ 112,000

Net Assets

Unrestricted Net Assets $ 154,000

Permanently restricted Net Assets 20,000

TOTAL NET ASSETS $ 174,000

TOTAL LIABILITIES & NET ASSETS $ 286,000


Lending money (and receiving repayments)also represents an investing activity.

The financing activities of the organiza-tion are concerned with borrowing money(or repaying it), issuance of stock, and thepayment of dividends. Note that when an or-ganization lends money, it is investing. How-ever, borrowing money relates to getting thefinancial resources the organization needs tooperate. Thus, borrowing is included in thefinancing category, along with issuance ofstock. For-profit organizations may choose todistribute some of their profits to their stock-holders in the form of a dividend. Dividendspaid are considered to be a financing activitybecause they are a return of financial re-sources to the organization’s owners. Theyare not included in operating activities be-cause dividends paid are not classified as an

expense, but rather as a distribution to theorganization’s owners of income earned.

There are two different approaches tocalculating and presenting the statement ofcash flows. These are the direct and indirectmethods. Table 7-5 presents an example ofthe Statement of Cash Flows prepared usingthe direct method. The direct method listseach individual type of account that resultedin a change in cash.

Looking at Table 7-1, we can see that cashwas affected by transactions 1, 2, 5, 8, and 9.Review of each of those journal entries pro-vides the information needed to prepareTable 7-5. For example, transaction 1 con-sisted of a $6,000 payment for insurance.Therefore, the decrease in cash was for anoperating activity, specifically payment forinsurance.


Table 7-5 Healthy HospitalStatement of Cash Flows



Collections from third-party payers $ 28,000

Payments to employees (36,000)

Payments to suppliers (30,000)

Payments for insurance (6,000)

Payments for interest (12,000)

Net cash used for operating activities $ (56,000)

Cash flows from investing activities

None

Net cash used for investing activities 0

Cash flows from financing activities

Payment of mortgage principal $ (8,000)

Net cash used for financing activities (8,000)

NET INCREASE/(DECREASE) IN CASH $ (64,000)

CASH, DECEMBER 31, 2007 104,000

CASH, DECEMBER 31, 2008 $ 40,000



This may be a cumbersome task when thereare a large number of individual transactions.For example, how much cash was collectedfrom customers during 2008? By looking attransaction 5 from Table 7-1, we know that theanswer is $28,000. We can see the increase incash and the reduction in accounts receivable.Typically, however, there are an extremelylarge number of individual journal entries re-lated to receipts from customers.

Rather than review each transaction, ac-countants usually prepare the cash flowstatement by making general inferencesfrom the changes in the balances of variousaccounts. Note that accounts receivable atthe beginning of the year were $36,000, andpatient service revenue during the year was$112,000. Combining what was owed to us atthe beginning of the year with the amountwe billed patients and insurance companiesthis year indicates that there was a total of$148,000 that we would hope to eventuallycollect from insurers and patients. At theend of the year the accounts receivable bal-ance was $120,000. Therefore we can inferthat $28,000 must have been collected (the$148,000 total due us, less the $120,000 stilldue at the end of the year).

Let’s consider another example. Themortgage payable account started with a bal-ance of $80,000 and ended with a balance of$72,000 (see Table 7-1). Rather than review-ing all of the journal entries related to mort-gage payments, accountants infer that$8,000 was spent on the financing activity ofrepaying debt. However, this inferenceprocess requires care. It is possible, for in-stance, that $40,000 was paid on the mort-gage principal, but a new mortgage of$32,000 was taken on a new piece of equip-ment. The statement of cash flows mustshow both the source of cash from the newmortgage, as well as the payment of cash onthe old mortgage. Therefore, preparation of

the statement requires at least some in-depth knowledge about changes in the ac-counts of the organization.

An alternative approach for developingand presenting the statement of cash flows isreferred to as the indirect method. The indi-rect method starts with net income, or thechange in net assets, as a measure of cashfrom operations. It then makes adjustmentsto the extent that net income is not a truemeasure of cash flow. Table 7-6 was pre-pared using the indirect method.

One of the most common adjustments toincome is for depreciation. When buildingsand equipment are purchased, there is a cashoutflow. Each year, a portion of the cost of thebuildings or equipment is charged as a de-preciation expense. That expense lowers netincome, but it does not require a cash out-flow. Therefore, the amount of the deprecia-tion expense is added back to net income tomake net income more reflective of true cashflow. In Table 7-6 we see that the $12,000 de-preciation expense is added to net income.

There are a variety of other items thatcause net income to over- or understate thetrue cash flow. For example, if customersbuy our product or service, but do not payfor it before the end of the year, then in-come overstates cash inflow. Therefore, inTable 7-6, there is a negative adjustment forthe increase in accounts receivable.

Many of the adjustments to net incomethat are needed to determine cash flow fromoperating activities are quite complex.Therefore, many people prefer use of the di-rect method. However, because net incomeis considered essential to the process of gen-erating cash, the net income reconciliation isrequired for cash flow statements to be con-sidered to be in compliance with GenerallyAccepted Accounting Principles (GAAP). Ifthe direct method is used, the Cash Flowsfrom Operating Activities portion of the in-


direct method (Table 7-6) must be includedas a supporting schedule.

The information contained in the state-ment of cash flows is quite dramatic in thisexample. Although Table 7-2 indicated thatthere was a positive net income of $8,000,the organization is using substantially morecash than it is receiving. In some cases, thismight reflect recent spending on buildingsand equipment. A decline in cash is not nec-essarily bad. However, in this case, we notefrom the statement of cash flows (Table 7-5or 7-6) that no money was used for investingactivities. The largest decline in cash camefrom operations. What was the single largest

cause of the decline? Table 7-5 indicates thatpayments to employees were the largestitem. They caused the largest cash outflow.

However, this is an example in which thenet income reconciliation provides particu-larly useful information. Looking at the cashflows from the operating activities section ofTable 7-6, the most striking number is the$84,000 increase in receivables. A growingcompany is likely to have growing receivables.In this case, however, the growth in receiv-ables seems unusually large. What does thismean? It could mean that the organizationneeds to make a stronger effort to collect pay-ment from its customers on a timely basis. Or


Table 7-6 Healthy HospitalStatement of Cash Flows



Net income $ 8,000

Adjustments

Depreciation expense $ 12,000

Decrease in inventory 26,000

Increase in accounts receivable (84,000)

Increase in prepaid insurance (4,000)

Decreases in wages payable (14,000)

Total adjustments to net income (64,000)

Net cash used for operating activities $ (56,000)

Cash flows from investing activities

None

Net cash used for investing activities 0

Cash flows from financing activities

Payment of mortgage principal $ (8,000)

Net cash used for financing activities (8,000)

NET INCREASE/(DECREASE) IN CASH $ (64,000)

CASH, DECEMBER 31, 2007 104,000

CASH, DECEMBER 31, 2008 $ 40,000



it could mean that services were provided topatients who can’t pay. The statement of cashflows highlights the fact that if receivablescontinue to grow at this rate, the organiza-tion will run out of cash, probably before theend of the next year. Although there is no cri-sis yet, there may be unless we take this situa-tion into account in managing theorganization and in planning for cash inflowsand outflows for the coming year.

In the previous chapters we have followedthe basic course of accounting events. Trans-actions get recorded via debit and credits ina journal using a chart of accounts. In turn,the journal entries get aggregated into thefinancial statements that we reviewed in thischapter. The next step in the accountingprocess is the audit of our financial state-ments by outside independent certifiedpublic accountants.

KEY CONCEPTS

Ledger—A book (or computer memoryfile) in which we keep track of the impact offinancial events on each account. Theledger can provide us with the balance inany account at any point in time.

Operating statement preparation—The oper-ating statement is directly prepared fromthe year-end ledger balances of the revenueand expense accounts.

Balance sheet preparation—Ledger ac-count balances can be used to provide ananalysis of changes in net asset accounts.This analysis, together with other ledgeraccount balances, is used to prepare thebalance sheet.

Statement of cash flows—This statement showsthe sources and uses of the organization’scash. It specifically shows cash from operating,investing, and financing activities. It can beprepared under two alternative methods:

a. the direct method—Lists the change incash caused by each account.

b. the indirect method—Starts with net in-come as an estimate of cash flow, andmakes a series of adjustments to net in-come to determine cash flow from op-erating activities.

TEST YOUR KNOWLEDGE



The stock market crash of 1929 broughtto light substantial inadequacies in fi-

nancial reporting. Investigations of bankruptcompanies showed numerous arithmetic er-rors and cases of undetected fraud. These in-vestigations also disclosed the common useof a widely varying set of accounting prac-tices. A principal outcome of these investiga-tions was that the newly formed Securitiesand Exchange Commission (SEC) requiredthat publicly held companies annually issue areport to stockholders. The report must con-tain financial statements prepared by the or-ganization’s management and audited by acertified public accountant (CPA).

SEC rules are aimed at publicly-held for-profit companies (those with stockholders).Do not-for-profit health care organizationshave to worry about having CPA-audited fi-nancial statements? Yes. Health care organi-zations are subject to a variety of rules andregulations that lead to the need for auditedstatements. For one thing, annual cost re-ports that must be provided to third-partypayers often require that an audited set of fi-nancial statements be submitted as part ofthe report. If the health care organization is-sues bonds to raise funds for a capital proj-ect, the bondholders are entitled to auditedstatements. Banks often will not lend money

without seeing audited statements. Even sup-pliers may require audited statements beforeselling to a health care provider on credit.

Annual reports are frequently referred toas certified reports or certified statements, al-though, in fact, it is the outside auditor whohas been certified, not the statements them-selves. Each state licenses CPAs and in grant-ing the license certifies them as experts inaccounting and auditing. The CPA gives anexpert opinion regarding the financial state-ments of a company. There is no certificationof correctness of the financial statements.

What exactly is the CPA’s role in perform-ing an audit? Well, some people considerthe CPA to be the individual who walks outonto the field of battle after the fighting hasdied down and the smoke has cleared, andproceeds to shoot the wounded. CPAs havealways been respected individuals, but intheir role as auditors they tend to be seen ina rather unpleasant light, as the foregoinganalogy indicates. This is largely because ofa lack of understanding of what the CPA’srole really is. The SEC, in requiring auditedstatements, was particularly concerned witharithmetic accuracy and the use of a clear,consistent set of accounting practices.

Ultimately, the SEC’s desire is that a reli-able set of financial statements, one that

57

CHAPTER 8

The Role of the Outside Auditor



presents a “fair representation” of what hasoccurred, is given to the users of financialstatement information. Those users includestockholders, bankers, suppliers, and otherindividuals. The CPA’s focus is on the finan-cial statements rather than on individualemployees in the organization. Errors occuras long as humans are involved in the ac-counting process. The CPA has no interestin discrediting individuals. The CPA merelywants to ensure that the most significant ofthe errors are discovered and corrected.

THE AUDIT

The Management Letter and Internal Control

In performing an audit, the CPA checks forarithmetic accuracy. In performing thischeck, the external auditor focuses on thesystem rather than the individual.

Consider a system in which an individualis issuing invoices to insurance companiesbased on patients’ medical records. The in-dividual takes a copy of a medical recordfrom the in box, records the dollar amountsand issues the invoice (or bill), and placesthe medical record in the out box to bebrought back to the medical records depart-ment. Again and again, over and over, thissame mechanical process is repeated. Occa-sionally the clerk takes the medical record,sips some coffee, and puts the document inthe out box without having issued an in-voice. Errors happen.

The auditor does not try to discover everysuch error; the cost of reexamining every fi-nancial transaction is prohibitive. Instead,by sampling some fraction of the documentsprocessed, the auditor attempts to deter-mine how often errors are occurring andhow large they tend to be. The goal is to seeif a material error exists.

What if the accountant feels that the clerkis making too many errors and the potentialfor a material misstatement may exist? Theclerk must be fired and replaced with amore conscientious individual, right? No,wrong. Humans all make errors and the ac-countant wants the system to acknowledgethat fact. The focus is on what accountantscall the internal control of the accounting sys-tem. Basically, adequate internal controlmeans that the system is designed in such away as to catch and correct the majority oferrors automatically, before the auditor ar-rives on the scene.

In our example with the clerk, the solu-tion to the problem may be to have the clerkinitial each document immediately after heor she processes the invoice. A second indi-vidual then reviews the documents to seethat all have been initialed. Those thathaven’t been initialed are sent back for veri-fication of whether an invoice was issuedand for correction if need be. Errors can stilloccur—initialing the document after sip-ping the coffee, even though the invoicehasn’t been processed—but they are lesslikely and should occur less frequently.

The auditor issues an internal controlmemo, often called a management letter,which points out the internal control weak-nesses to management. Although there maybe some expense involved for the organiza-tion to follow some of the recommenda-tions, the inducement is that of reducedaudit fees. Internal control weaknesses re-quire an expanded audit so that the CPAcan ascertain whether a material misstate-ment does exist. If the internal control isimproved, the auditor feels more comfort-able relying on the client’s system and lessaudit testing is required. The managementletter is given to the organization’s top man-agement and is not ordinarily disclosed tothe public.


Fraud and Embezzlement

In an organization with good internal con-trol, fraud and embezzlement are made dif-ficult through a system of checks andbalances. The auditor does not consider itto be a part of his or her job to detect allfrauds. In fact, many cases of embezzlementare virtually impossible to uncover.

Although no statistics exist, it is likely thatdiscovered embezzlements in this countryamount to only the tip of the iceberg of whatis really occurring. It is usually the greedyembezzlers that are caught. The modest em-bezzlers have an excellent chance of goingundetected, especially if collusion amongseveral employees exists.

A common misperception is that embez-zlement leaves a hole in the bankbook. Allof a sudden we go to withdraw money fromour bank account and find that a milliondollars is missing. This sort of open embez-zlement is really the exception, not the rule.

Consider an individual whose job is to ap-prove bills for payment. Suppose he was toprint up stationary for Bill’s Roofing Repairand send an invoice for $400 to his organiza-tion. What happens? He receives the invoiceat work and approves it for payment. Largepayments may require second approval.Therefore, larger embezzlements may re-quire a partner if they are to go undetected.

Who is likely to question a small repairbill in a large organization? Or perhaps a se-ries of small bills for office supplies? Ourembezzler could be running 10 phony com-panies. One can easily conceive of an em-ployee who, upon retirement after 40 yearsof apparently faithful service, admits to hav-ing charged the firm $1,000 a year for thelast 35 years for maintenance and supply fora water cooler in the southern plant, eventhough the southern plant never had awater cooler.

Doesn’t this type of embezzlement cause acash shortage? No! We record the roofing re-pair expense or water cooler expense and re-duce the cash account by the amount of thepayment. Can the auditor issue his report onthe financial statements of this companywithout discovering the fraud? Certainly. Butthen, doesn’t that result in a material mis-statement in the financial statements? Proba-bly not, for several reasons.

First, the modest thief, not choosing todraw unwanted attention, is unlikely to steala material amount of money. Second, themoney is being correctly reported as an ex-pense. We are calling the expense a roofingrepair expense when, in fact, it should becalled miscellaneous embezzlement ex-pense. There would be no impact on thebalance sheet nor on the organization’s netincome if we were to correct this misclassifi-cation! The cash account isn’t overstatedbecause the account was appropriately re-duced when we paid the expense. The in-come isn’t overstated because we did recordan expense, even if we didn’t correctly iden-tify its cause.

How can the fraud be detected? If wesend a letter to Bill’s Roofing Repair and askif their invoice was a bona fide bill, we willlikely get an affirmative response, albeitcoming from the embezzler himself. If wedirectly ask the employee if he approved thebill for payment, he will say yes, because hedid approve it for payment to himself. To re-ally see if this type of embezzlement is goingon, we would have to trace each bill back tothe individual in the organization who orig-inally ordered the work done or the goodspurchased. Unfortunately, the cost of theaudit work involved is likely to far exceedthe amount likely to have been embezzled.

The result is that the auditor tests somedocuments in an effort to scare the timid,but it is possible for numerous small frauds

Chapter 8: The Role of the Outside Auditor 59



to go undetected. The auditor is also likelyto suggest in the management letter thatlarge payments require two approvals. Thismakes embezzlement of large amounts lesslikely unless there is collusion among atleast two employees.

The Auditor’s Report

In addition to the management letter, theauditor issues a letter to the Board of Direc-tors or Trustees of the organization. Thisopinion letter generally has three standardparagraphs that are reproduced almostverbatim in most auditors’ reports. Alterna-tively, some auditors combine the informa-tion from these three paragraphs into onelonger paragraph. You might find it interest-ing to compare the auditor’s letter from yourorganization’s financial statement in the fol-lowing sample letter.

Report of the Independent Auditors

To the Directors of Healthy Hospital:

We have audited the accompanying bal-ance sheets of Healthy Hospital as ofDecember 31, 2006 and 2007, and therelated statements of operations, net as-sets, and cash flow for the years thenended. These financial statements arethe responsibility of the Company’smanagement. Our responsibility is toexpress an opinion on these financialstatements based on our audits.

We conducted our audits in accordancewith generally accepted auditing stan-dards. Those standards require that weplan and perform the audit to obtainreasonable assurance about whether thefinancial statements are free of materialmisstatement. An audit includes exam-ining, on a test basis, evidence support-ing the amounts and disclosures in the

financial statements. An audit also in-cludes assessing the accounting princi-ples used and significant estimates madeby management, as well as evaluatingthe overall financial statement presenta-tion. We believe that our audits providea reasonable basis for our opinion.

In our opinion, the financial statementsreferred to above present fairly, in allmaterial respects, the financial positionof Healthy Hospital as of December 31,2006 and 2007, and the results of its op-erations and its cash flows for the yearsthen ended, in conformity with gener-ally accepted accounting principles.

Finkler and Ward, CPAsApril 8, 2008

These three paragraphs are the standardclean opinion report. The first paragraph isreferred to as the opening or introductoryparagraph. The second paragraph is thescope paragraph. The third paragraph is theopinion paragraph. If there are any addi-tional paragraphs, they are unusual and rep-resent circumstances that require furtherexplanation.

The opening paragraph serves to informthe users of the financial statements that anaudit was performed. In some cases, audi-tors perform consulting or other servicesaside from audits. The opening paragraphalso indicates explicitly that the organiza-tion’s management bears the ultimate re-sponsibility for the contents of the financialstatements.

The scope paragraph describes thebreadth or scope of work undertaken as abasis for forming an opinion on the finan-cial statements. This paragraph explains the type of procedures auditors follow incarrying out an audit. Note that just as or-ganizations must follow generally acceptedaccounting principles (GAAP) in preparing


their statements, CPAs must follow generallyaccepted auditing standards in auditingthose statements.

The opinion paragraph describeswhether the financial statements provide afair representation of the financial position,results of operations, and cash flows of thecompany, in the opinion of the auditor. Aclean opinion, such as this one, indicatesthat in the opinion of the auditor, exercisingdue professional care, there is sufficient evi-dence of conformity to GAAP, and there isno condition requiring further clarification.This paragraph does not contend that the fi-nancial statements are completely correct. Itdoes not even certify that there are no mate-rial misstatements. The CPA merely gives anexpert opinion.

Note that the opinion of the CPA is thatthe financial statements are a fair represen-tation of the organization’s financial posi-tion. This is a somewhat audacious remark.Considering the intangible assets that oftenare not recorded on the financial statementsdespite their potentially significant value,and considering that plant, property, andequipment are recorded on the balancesheet at their cost, even though their valuetoday may be far in excess of cost, you haveto have a lot of nerve to say the statementsare fair.

The key is that the accountant merely saysthe statements are a fair presentation in ac-cordance with GAAP. In other words, thisfairness is not meant to imply fair in any ab-solute meaning of the word fair.

Certainly this creates a problem in thatmany users of the financial statements are un-familiar with the implications of GAAP. Suchindividuals may interpret the word fair in abroader sense than is intended. This is why itis vital that in looking at an annual report anindividual read the notes to the financialstatements as well as the statements them-

selves. Later in the book we discuss the notesto the financial statements in some detail.

The auditor may issue an adverse, qualified,or disclaimer opinion, if it is not possible toissue a clean opinion. An adverse opinion is asevere statement. It indicates that the audi-tor believes that the organization’s financialstatements are not presented fairly, in accor-dance with GAAP. A qualified opinion indi-cates that the financial statements are a fairrepresentation in conformity with GAAP, ex-cept as relates to a specific particular area.

In some cases, the audit opinion letteralso contains additional paragraphs contain-ing explanations. This is generally the case ifthere is a significant uncertainty or a mate-rial change in the application of GAAP. Suchparagraphs highlight special circumstancesthat might be of particular concern to theusers of the financial statements. An exam-ple of a significant uncertainty is a lawsuit ofsuch magnitude that, if the case is lost, itmight cause the organization to become in-solvent. Also, a material change in GAAPmust be reported because it makes the cur-rent financial statement no longer com-pletely comparable to the previous ones forthe same company. The presence of morethan the standard opening, scope, and opin-ion paragraphs should alert the user to exer-cise special care in interpreting the numbersreported in the financial statements.

The Management Report

It is common practice for the annual report ofthe organization to include not only the orga-nization’s financial statements and an audi-tor’s report, but also a management report. Incontrast to the management letter written bythe CPA and given to the organization’s man-agement, the management report is writtenby the organization’s management and is ad-dressed to the readers of the annual report.




The management report explains that al-though the financial statements have beenaudited by an independent CPA, ultimatelythey are the responsibility of the organiza-tion’s management. The report also dis-cusses the organization’s system of internalcontrol and the role of its audit committee.The audit committee, consisting of mem-bers of the Board of Directors, has the re-sponsibility for supervising the accounting,auditing, and other financial reporting mat-ters of the organization.

Audit Failures

From time to time a major scandal hits thenewspapers because an audit fails to provideusers of financial statements with appro-priate or timely information. The health in-dustry financial community was finallyrecovering from the Allegheny Health Sys-tem bankruptcy when the Health Southscandal occurred. When events such asthese happen, there are four principal issuesto be considered: internal accounting sys-tems, disclosure rules, auditor oversight,and ethics.

Internal Accounting Systems

One possible cause of situations such as theAllegheny bankruptcy is that the accountingsystems at Allegheny were inadequate. Per-haps revenues that were not real were beinginappropriately recorded and the account-ing system was not designed well enough topick it up.

Disclosure Rules

A second possible problem is that the exist-ing rules for disclosure have loopholes thatdo not require all questionable practices tobe disclosed. Usually after a highly visibleevent such as the Allegheny bankruptcy, thedisclosure rules are reviewed, and the Finan-

cial Accounting Standards Board (FASB)and SEC make rule changes.

Auditor Oversight

CPAs are paid by the organization being au-dited. Desiring to keep earning their annualaudit fees, auditors are sometimes convincedby their clients to allow questionable report-ing practices. There is no doubt that thecoming years will see changes in oversight ofauditors to try to prevent future occurrencessimilar to Allegheny and Health South.

Ethics

Even with the best internal controls in place,at times auditors don’t find everything, orworse yet, may even be complicit with man-agement in perpetrating a fraud on theirstockholders, lenders, employees, and thepublic. It is necessary to bear in mind thatrules and accounting systems can’t make upfor a lack of ethical behavior on the part ofthe management or its outside auditor.

Avoiding Future Audit Failures

Clearly, to reduce the likelihood of such fail-ures occurring again, several steps areneeded. Auditors need to continue to workto help their clients improve their internalcontrol systems. Regulators need to reviewand improve their disclosure rules. A bettersystem of auditor oversight is essential. Andfinally, a culture of ethical behavior must bedeveloped, or individuals will always findways around the internal control systemsand disclosure rules.

NEXT STEPS

Audited financial statements represent thecompletion of the financial accounting cycle.Transactions have been entered into journals.Journal entries have been aggregated into fi-nancial statements, and now those statements


have been audited. So, what do all these fi-nancial statements really mean? The answerto this question lies in a thorough analysis ofthe financial statements. Unfortunately, be-fore we are able to fully analyze the financialstatements (see Chapter 13) we must first un-derstand a few more critical accounting con-cepts. In Chapter 9 we introduce and explaindepreciation and the effects this concept hason the financial statements. We then move toan explanation of inventory costing and howthe value of inventory may directly affect theorganization’s bottom line.

KEY CONCEPTS

Audited financial statements—Presentation ofthe organization’s financial position and its re-sults of operations, in accordance with GAAP.

Management letter—Report to top manage-ment that makes suggestions for the im-provement of internal control to reduce thelikelihood of errors and undetected fraudsor embezzlements.

Auditor’s report—Letter from the outsideauditor giving an opinion on whether or notthe organization’s financial statements are afair presentation of the organization’s re-sults of operations, cash flows, and financialposition in accordance with GAAP.

Management report—Letter from the orga-nization’s management that is part of theannual report.

TEST YOUR KNOWLEDGE





The matching principle of accounting re-quires that organizations use deprecia-

tion. Suppose we buy a machine with a10-year useful life. This machine helps toproduce services over its entire 10-year life-time. Therefore, it generates revenues ineach of those 10 years. The matching princi-ple holds that we would be distorting the re-sults of operations in all 10 years if weconsidered the entire cost of the machine tobe an expense in the year in which it was ac-quired. We would be understating incomein the first year and overstating it in subse-quent years.

Instead of expensing the equipment, weconsider it to be a long-term asset when it isacquired. As time passes and the equipmentbecomes used up, we allocate a portion ofthe original cost as an expense in each year.Thus, the revenue received each year re-lated to the services provided by the ma-chine is matched with some of themachine’s cost.

Okay, if we have to do it that way, there issome intuitive rationale. But where is the fi-nancial decision? It seems as if there is littlechoice left for the financial manager. In fact,that is not true. There are several complicat-ing factors. We must determine both the val-uation to be used as a basis for each year’sdepreciation as well as the depreciation

method. Although this sounds simpleenough, it really involves a number of steps;we must ensure that all costs associated withthe asset are captured, we must estimate boththe expected life of the asset and what theasset will be worth at the end of its useful life(the salvage value), and finally we must deter-mine whether the asset gets used up propor-tionally during its life. For-profit health careorganizations must also ask what the tax im-plications are of the depreciation methodsthey decide to use. These issues make up thetopic of this chapter. Figure 9-1 lays out thedepreciation process that organizations gothrough to calculate depreciation. The com-ponents of the process are discussed below.

AMORTIZATION

Amortization is the spreading out of a costover a period of time. It is a generic termused for any type of item that is being pro-rated over time. Depreciation is a specializedsubset of amortization. Depreciation refersto the wearing out of a tangible asset such asa building or piece of equipment.

Some items don’t wear out per se, and wedon’t refer to them as depreciating over time.For example, natural resources such as oil,gas, and coal are said to deplete. Depletemeans to empty out, and this is essentially

65

CHAPTER 9

Depreciation: Having Your Cake and Eating It Too!



what happens to a coal mine or oil well. Fi-nally, some items neither deplete nor depre-ciate. For example, a patent loses its valueover time. It doesn’t break down, wear out, orempty out—it simply expires with the passageof time. When neither of the terms deprecia-tion nor depletion is applicable, we refer to theitem as amortizing. Therefore, for a patent,the annual reduction in value is referred to asamortization expense. This chapter speaks ex-clusively of depreciation, even though theprinciples generally apply in a similar fashionfor assets to be depleted or amortized.

ASSET VALUATION FORDEPRECIATION

The first step in the depreciation process isthe determination of the full cost of theasset to be depreciated. As you may remem-ber from Chapter 5, accountants have ahabit of being able to look at a particularasset and come up with a number of differ-ent values for it. The process of determining“the” value that will be used in financialstatements is referred to as valuation. In the

case of depreciation, valuation of the assetbeing depreciated is critical. This first stepin the depreciation process sets the stage forall the calculations that follow.

Asset valuation for depreciation basicallyfollows the rules of historical cost. Chapter 5stated that the historical or acquisition costof an asset is simply what we paid for theitem when we acquired it. However, for de-preciation purposes, determination of assetcost is somewhat more complex.

The first problem that arises is the issueof what to do with the costs of putting anasset into productive service. For example,suppose that we purchase a machine for$40,000, and we cannot use the machinewithout modifying our electrical system. Ifwe pay an electrician $2,000 to run a heavy-duty power line to the spot where the ma-chine will be located, is that a currentperiod expense? No; according to generallyaccepted accounting principles (GAAP),the cost of the electrical work provides uswith benefits over the entire useful life ofthe machine. Therefore, matching requiresthat we spread the cost of the electrical work

Full AssetValuation

Historical cost

plus

Cost to put intoservice (deliveryinstallation, plant

modifications, etc.)

plus

Replacementsand improvements

Determinationof Depreciable Base

Full value fromprevious step

minusSalvage value

Determinationof Useful Life

Estimate

Determinationof Depreciation Method

Straight-line

or

Declining balance

orSum-of-the-years-digits

Figure 9-1 The Depreciation Process


over the same period as the life of the ma-chine. The way that is handled is by addingthe cost of the electrical work to the cost ofthe equipment. Instead of our equipmentshowing a cost of $40,000, it has a cost of$42,000 and we depreciate that amount overits lifetime.

In fact, all costs to put an item into serviceare added to the cost of that item so thatthey can be matched with the revenues overthe useful life of the asset. This includesfreight on the purchase, insurance while intransit to our facility, new fixtures, and plantmodifications. Further, although repairsand maintenance are current period ex-penses, replacements and improvements toan asset must be added to the cost and de-preciated over the life remaining at the timeof the replacement or improvement. Re-placements and improvements are simplyexpenditures that extend the useful life ofthe asset, improve its speed or quality, or re-duce its operating costs.

If a motor burns out, is its replacement aroutine repair expense charged to the cur-rent year, or is the cost of the replacementcapitalized (that is, added to the cost of along-term item shown on the balancesheet)? That depends on the circumstances.Do motors burn out quite regularly, or is it arare event? Regular replacement may wellbe a repair, but infrequent major overhaulsare capitalized. However, there is no clearright or wrong answer in many instances.

As you can see, determining the full costof the asset to be depreciated is not as sim-ple as identifying what was paid directly forthe particular asset. Ultimately, the cost ofthe asset listed on the balance sheet (andthereby depreciated over its life) is a combi-nation of the direct acquisition cost of theasset, all indirect costs associated with get-ting the asset into service, and all subse-quent replacements and improvements.

Equipment tends to have acquisition and in-stallation costs, whereas property and phy-sical plant items tend to have acquisitionand improvement costs. A roof is anothercommon example of a capital improvement.Ongoing roof maintenance (replacing ashingle or two) is a current operating ex-pense. Replacing the entire roof is an im-provement that extends the use of the assetand therefore needs to be added to thevalue of that asset and subsequently depreci-ated. Determining the full value of an assetis not only critical to the calculation of de-preciation, it is more complicated than mostpeople think.

The Depreciable Base

Our problems are not yet over. How muchof the asset’s cost do we depreciate? Yourfirst reaction may well be to say the entirecost, including the various additions to thepurchase price that we have just discussed.This is basically true, except that there is stilla matching problem. We wish to depreciateproperty that wears out over the course of itsuse to get a portion of its cost to assign toeach period in which the asset helps gener-ate revenues. However, we only want tomatch against revenues those resources thatactually get used up. We don’t necessarilyconsume 100% of most assets.

Suppose we bought a machine with a 10-year expected life at a cost of $40,000, in-cluding all of the costs to put it into service.Suppose further that after 10 years we ex-pect to be able to sell the machine for$4,000. Then we really have not used up$40,000 of resources over the 10 years. Wehave used up only $36,000 and we still havea $4,000 asset left over. This $4,000 value isreferred to as the machine’s salvage value.Therefore, from an accounting perspective,we depreciate a machine by an amount

Chapter 9: Depreciation 67



equal to its cost less its anticipated salvagevalue. That difference is referred to as its de-preciable base.

The salvage value has to be estimated—atbest, it is an educated guess. Your account-ant reviews the reasonableness of your sal-vage value estimates for financial statementpreparation.

Asset Life

The next step in the depreciation process isto determine how long an asset lasts. We at-tempt to depreciate an asset over its usefullife. If we depreciate it over a period longeror shorter than its useful life, we don’t ob-tain an accurate matching between rev-enues and the expenses incurred togenerate those revenues. However, we canonly guess an asset’s true useful life. Oftenwe see equipment that lasts well after the es-timated useful life. This is not surprising,considering the GAAP of conservatism. Bet-ter to write off an asset too quickly and un-derstate its true value than to write it off tooslowly (anticipating a longer life than ulti-mately results) and overstate its value.

What happens if we are still using theasset after its estimated useful life is over?We stop taking further depreciation. Therole of depreciation is to allocate some ofthe cost of the asset into each of a number ofyears or accounting periods. Once we haveallocated all of the cost (less the salvagevalue), we simply continue to use the assetwith no further depreciation. That meanswe have revenues without depreciation ex-pense matched against them. That is simplya result of a matching based on estimatesrather than being based on perfect fore-knowledge.

What if we sell the asset for more than itssalvage value? That presents no problem—we can record a gain for the difference be-

tween the selling price and the asset’s bookvalue. The book value of an asset is theamount paid for it, less the amount of de-preciation already taken. Thus, if we boughtour machine for $40,000, and sold it after 10years during which we had taken $36,000 ofdepreciation, its book value is $4,000. Ac-cording to our financial records, or books,its value is $4,000. If we sell it for $10,000,there is a gain of $6,000.

What if the asset becomes obsolete after 3years owing to technological change and it issold at that time for $1,000? Assuming wewere depreciating it at a rate of $3,600 a year(to arrive at $36,000 of depreciation over 10years), then we would have taken $10,800 ofdepreciation (3 years at $3,600 per year)during those first 3 years. The book value($40,000 cost less $10,800 of accumulateddepreciation) is $29,200, and at a sale priceof $1,000, we record a loss of $28,200.

Accumulated Depreciation

In Chapter 7, the balance sheet had a line forPlant and Equipment, Net. This means the costof the plant and equipment, less any depreci-ation that has been charged to that plant andequipment while we have owned it. The fullamount of depreciation that has been takenon a piece of depreciable property over allthe years you have owned it is called accumu-lated depreciation. It is important to distinguishbetween each year’s depreciation expenseand the accumulated depreciation.

Take the equipment discussed above. Theacquisition cost was $40,000, it has a $4,000salvage value, and therefore a $36,000 de-preciable base. Assuming the 10-year usefullife, for the next 10 years the operating state-ment will show a $3,600 depreciation ex-pense each year.

How does the equipment appear on thebalance sheet? At the end of the first year, it


appears as $36,400, net. This is the $40,000cost, less the first year’s depreciation ex-pense. By the end of the second year, wehave taken a total of $7,200 of depreciationexpense (i.e., $3,600 per year for 2 years).That $7,200 is referred to as the accumu-lated depreciation for that piece of equip-ment. The net value of the equipment isnow shown on the balance sheet as $32,800(i.e., the $40,000 cost, less the $7,200 of ac-cumulated depreciation).

STRAIGHT-LINE VERSUSACCELERATED DEPRECIATION

The final step in the depreciation process isthe determination of the depreciationmethod that is used to calculate the annualdepreciation expense. In the previous exam-ple we noted that $7,200 of depreciation hadbeen taken over 2 years, if we assume depre-ciation of $3,600 per year. The $3,600 figureis based on straight-line depreciation. It as-sumes that we take an equal share of the totaldepreciation each year during the asset’s life.

In fact, we have choices for how we calcu-late the depreciation. The straight-line ap-proach is just one of several methodsavailable. Not all equipment declines in pro-ductive value equally in each year of its use-ful life. Consider a machine that has acapacity of 1 million units of output over itslifetime. If it is run three shifts a day, it willbe used up substantially quicker than if it isrun only one shift a day. The units of produc-tion or units of activity method of deprecia-tion bases each year’s depreciation on theproportion of the machine’s total produc-tive capacity that has been used in that year.For instance, if the machine produces130,000 units in a year, and its estimatedtotal lifetime capacity is 1 million, we take13% (130,000 divided by 1,000,000) of thecost less salvage value as the depreciation for

that year. Of course, this method entails sub-stantial extra bookkeeping to keep track ofannual production.

Two other methods exist that are com-monly used—the declining balance method(really this is a group of similar methods asdiscussed below) and the sum-of-the-years’digits method. These are called acceleratedmethods. The basic philosophy behindthese methods is that some assets are likelyto decline in value more rapidly in the earlyyears of their life than in the later years. Acar is an excellent example. If we considerthe decline in value for a car, it is largest inits first year, not quite as large in the follow-ing year, and eventually tails off to a pointwhere there is relatively little decline peryear in the latter part of its life.

COMPARISON OF THEDEPRECIATION METHODS

We use an example to demonstrate the prin-cipal depreciation methods and to allow usto compare the results using each method.Assume that we buy a machine for $40,000and we have $8,000 of costs to put the ma-chine into service. We expect the machineto have a useful life of 6 years and a salvagevalue of $6,000.

The straight-line (SL) method first calcu-lates the depreciable base, which is the costless salvage. In this case, the cost is the$40,000 price plus the $8,000 to put the ma-chine into service. The salvage value is$6,000, so the depreciable base is $42,000($40,000 + $8,000 – $6,000). The base isthen allocated equally among the years ofthe asset’s life. For a 6-year life, the depreci-ation is 1/6 of the $42,000 each year, or$7,000 per year. The straight-line method israther straightforward.

The declining balance method acceler-ates the amount of depreciation taken in




the early years and reduces the amounttaken in the later years. When someonerefers to accelerated depreciation, he or sheis not referring to a shortening of the assetlife for depreciation purposes. The life re-mains 6 years under the accelerated meth-ods. Declining balance represents a groupof methods. We start with double decliningbalance (DDB), also referred to as 200% de-clining balance. We discuss the other declin-ing balance methods below.

The DDB approach starts out with a depre-ciable base equal to the asset cost ignoring sal-vage value. The cost is multiplied, not by 1/6as in the SL method, but by a rate that is dou-ble the SL rate. In this case we multiply thedepreciable base by 2 times 1/6, or by 2/6.Hence the word double in the name of thismethod. If we take 2/6 of $48,000 (rememberthat cost includes the various costs to get themachine into service, and that this method ig-nores salvage value), we get $16,000 of depre-ciation for the first year. At that rate, the assetwill be fully depreciated in just 3 years, andwe’ve said that accelerated methods generallydo not shorten the asset life!

Therefore, we need some device to pre-vent the depreciation from remaining atthat high level of $16,000 per year. This de-vice is the declining balance. Each year we sub-tract the previous year’s depreciation fromthe existing depreciable base to get a newdepreciable base. In this example, we startwith a base of $48,000 and take $16,000 ofdepreciation in the first year. This meansthat in the second year there is a new depre-ciable base of $32,000 ($48,000 – $16,000).In the second year, our depreciation is 2/6of $32,000, or $10,667. For year 3, we deter-mine a new base equal to $32,000 less thedepreciation of $10,667 in year 2. Thus, wehave a new base of $21,334, and so on.

However, there is one caveat to thisprocess. We cannot take more depreciationduring the asset’s life than the asset’s cost

less its salvage value. In this problem, we cantake no more than $42,000 of depreciation,regardless of the method chosen. We haveachieved our goal of having higher depreci-ation in the early years and less in each suc-ceeding year. The method, which doublesthe SL rate, does have some intuitive appealas an approach for getting the desired accel-erated effect.

The declining balance family also in-cludes 150% declining balance and 175%declining balance. In each of these meth-ods, the only difference from the 200%, orDDB, is that the SL rate is multiplied by150% or 175% instead of 200% to find theannual rate.

Sum-of-the-years’ digits (SYD) is a similaraccelerated method. SYD takes the cost lesssalvage, that is, $42,000, the same as SL, andmultiplies it by a fraction that consists of thelife of the asset divided by the sum of the dig-its in the years of the life of the asset. Thatsum consists of adding from one to the lastyear of the asset’s life, inclusive. In our exam-ple, we add 1 + 2 + 3 + 4 + 5 + 6, because theasset has a 6-year life. The sum of these digitsis 21. Therefore, we multiply $42,000 by 6/21(the life of the asset divided by the sum). Thisgives us first-year depreciation of $12,000.

In each succeeding year, we lower the nu-merator of the fraction by 1. That is, for year2, the fraction becomes 5/21 and the depre-ciation amount is $10,000 ($42,000 × 5/21).For year 3, the fraction becomes 4/21 andthe depreciation $8,000, and so on. It is hardto find any intuitive appeal to this manipula-tion. All we can say is that it does achieve thedesired result of greater depreciation in theearly years, and it does account for theproper amount of total depreciation.

Table 9-1 compares the three methods forthis piece of equipment for its entire 6-yearlife. It is especially important to note that allthree methods produce exactly the sametotal depreciation over the life of the asset.


Ideally, in choosing a depreciation methodfor your organization, you select from amongSL, declining balance, and SYD based on themethod that most closely approximates themanner in which your particular resourcesare used up and become less productive. Youneed not use the same method for all of yourdepreciable property.

Many organizations simply choose the SLapproach for reporting depreciation ontheir financial statements. The apparent rea-son for this is that it tends to cause net in-come to be higher in the early years than itwould be using the accelerated methods andtheir high charges to depreciation expense.

For not-for-profit health care organizations,the depreciation process is now complete. Thelast step of the process, considering the im-plications of depreciation on taxes, is only ap-plicable to the for-profit health careorganizations. It is to the special tax treatmentof depreciation that we now turn our attention.

Excel Template

Template 6 may be used to calculate straight-line and accelerated depreciation using yourorganization’s data. The template is on the Webat www.jbpub.com.

MODIFIED ACCELERATED COSTRECOVERY SYSTEM

The first and most important point that thereader should be aware of is that this is oneplace where you can actually have your cakeand eat it too! For-profit health care organi-zations are not required to use the samemethods of depreciation for reporting tothe Internal Revenue Service (IRS) as theyuse for reporting to their stockholders. Theimplications of that are enormous. We canuse straight-line depreciation on our finan-cial statements, thus keeping our deprecia-tion expense relatively low, and be able totell our stockholders that we had a very fineyear. Then we can use the IRS accelerateddepreciation system, called the modified ac-celerated cost recovery system (MACRS), whichaccelerates depreciation, lowering incomeand taxes in the early years of an asset’s life.

We highlight many of the important is-sues here. However, we can’t stress stronglyenough the benefits of consulting a taxexpert. Tax law is an area that requires up-to-date expertise. The tax law changes con-stantly, not only because of congressionalaction, but also as a result of IRS rulings andinterpretations and the results of courtcases. No tax decisions should be madebased solely on the information containedin this book.

The most important aspect of the IRS de-preciation system is that it assigns shorterlives to assets. Generally these shorter livesare not used in preparation of financial state-ments for reports to stockholders. The lawdoes give some leeway in extending the life ofthe asset by choosing a less accelerated ap-proach, but most organizations find that thebasic MACRS approach provides the quickestallowable deductions and lowest current taxpayments, and is therefore beneficial in mostcases. By accelerating a deduction, a prof-itable organization can push its tax payments


Table 9-1 Comparison of Depreciation Methods

Double Sum-ofDeclining the-Years’

Straight- Balance DigitsYear Line (SL) (DDB) (SYD)

1 $ 7,000 $ 16,000 $ 12,000

2 7,000 10,667 10,000

3 7,000 7,111 8,000

4 7,000 4,741 6,000

5 7,000 3,160 4,000

6 7,000 321 2,000

Total $ 42,000 $ 42,000 $ 42,000



off to the future, thus effectively getting an in-terest-free loan from the government.

Under MACRS, asset lives are substan-tially shorter than their useful life estimates,and salvage value is ignored until we actuallydispose of the asset. The government-im-posed lifetimes for depreciation underMACRS for different types of assets are 3, 5,7, 10, 15, 20, 27.5, and 39 years.

The 3-, 5-, 7-, and 10-year classes are de-preciated under the 200% or DDB systemthat substantially accelerates depreciation.The 15- and 20-year classes are depreciatedusing a 150% declining balance method.The 27.5- and 39-year classes are depreci-ated on a SL basis.

The MACRS 3-year category includesitems such as tractors, some machine tools,and racehorses over 12 years old. Leave it toCongress!

The MACRS 5-year category includesproperty with a useful life of more than 4but less than 10 years. This class specificallyincludes computers, cars, trucks, and re-search and experimental equipment.

The MACRS 7-year class includes prop-erty that has a life of 10 to 15 years. This gen-erally includes office furniture and fixturesand property that does not explicitly fallinto another category.

The MACRS 10-year class is for propertywith a life of 16 to 19 years. Included are ves-sels, barges, and tugs.

The MACRS 15-year class includes prop-erty with a life of 20 to 24 years. This cate-gory includes billboards, service stationbuildings, and land improvements.

The MACRS 20-year class is for propertywith a useful life of 25 years or more, such asutilities and sewers.

Residential rental property falls into the27.5-year class, and most nonresidential realproperty has a class period of 39 years.

Although all of this may make your headswim, the government has kindly provided

tables giving the percentage of the asset’scost to be taken as depreciation for tax pur-poses in each year of the asset’s life. For ex-ample, Table 9-2 provides a table showingthe portion of the asset to be depreciatedeach year under MACRS, for the 3- through20-year classes. Note that the table contains21 years because it is generally assumed thateach asset (except real property) is put intoservice halfway into the year. The first andlast years each contain only a half-year of de-preciation. (It should be noted as an asidethat there is a less favorable mid-quarterconvention that applies if substantial por-tions of a year’s assets are placed into servicein the last 3 months of the tax year.)

Tax law is complex and changes frequently.Do not file tax returns based on informationfrom the use of this template without firstconsulting a tax expert.

In some instances, it is possible todeduct in 1 tax year approximately$100,000 of assets, rather than depreciat-ing them under MACRS. This is an optionavailable to the taxpayer for some types ofproperty used in a trade or business. It isreferred to as a Section 179 expense. Theavailable deduction is phased out if morethan approximately $400,000 worth ofqualified property is placed into serviceduring the tax year. To the extent that youcan avail yourself of this rule, it can providean even faster tax write-off of the asset thanMACRS would generate.

Another tax issue concerns “Section 197Intangibles.” This refers to goodwill and otherpurchased intangibles. Firms may deduct the

Excel Template

Template 7 may be used to calculate MACRSdepreciation for your organization. Thetemplate is included on the web atwww.jbpub.com.


cost of such intangibles as an expense for taxpurposes on a SL basis over a 15-year period.

What’s the bottom line to all this? Essen-tially, you can base the income you report toyour stockholders on SL depreciation ex-tended over the asset’s useful life and using asalvage value, and at the same time, use theMACRS method for reporting to the IRS.Thus, you show your stockholders a net in-come that is higher than you show the IRS.You therefore report relatively high incometo the owners (your bosses), and yet pay rela-tively low taxes because of the higher depre-ciation reported to the government. Haveyou actually reduced your tax payments, orjust shifted them off to the future? That is a

very interesting question and one that is thebasis for the discussion of deferred taxes.

DEPRECIATION AND DEFERREDTAXES: ACCOUNTING MAGIC

We discussed the use of straight-line depre-ciation for financial statements and MACRSfor the tax return. The fact that we can telldifferent depreciation stories to our stock-holders and the IRS has interesting ramifi-cations for the organization and its financialstatements. It creates something called atemporary difference. Our financial recordsrecord taxes in a different year than our taxreturn does. This applies only to for-profit


Table 9-2 MACRS Schedule for Property Placed in Service after 1986

3-Year 5-Year 7-Year 10-Year 15-Year 20-YearYear Class Class Class Class Class Class

1 33.33 20.00 14.29 10.00 5.00 3.750

2 44.45 32.00 24.49 18.00 9.50 7.219

3 14.81 19.20 17.49 14.40 8.55 6.677

4 7.41 11.52 12.49 11.52 7.70 6.177

5 11.52 8.93 9.22 6.93 5.713

6 5.76 8.92 7.37 6.23 5.285

7 8.93 6.55 5.90 4.888

8 4.46 6.55 5.90 4.522

9 6.56 5.91 4.462

10 6.55 5.90 4.461

11 3.28 5.91 4.462

12 5.90 4.461

13 5.91 4.462

14 5.90 4.461

15 5.91 4.462

16 2.95 4.461

17 4.462

18 4.461

19 4.462

20 4.461

21 2.231



organizations because not-for-profit organi-zations are not subject to income taxes.

If we tell our stockholders that we had agood year, then they expect the organizationto pay a lot of taxes on the profits we are cur-rently making. Even if we don’t pay thosetaxes now, but instead defer payment to thefuture, the matching principle seems to re-quire that we record the tax expense basedon our depreciation in our financial records,rather than when the IRS calculates the de-preciation and taxes. In fact, that is exactlythe case. Taxes are recorded on the organi-zation’s financial statements as tax expenseand a liability, called a deferred tax liability.However, the implications of this deferredtax are quite unusual—almost magical.

Generally, if we can postpone payment oftaxes, with no other change in the operationof our business in any respect, we should doso. For any one asset, the deferred tax liabil-ity represents an interest-free loan that iseventually repaid to the government. How-ever, what is true for one asset is not neces-sarily true for the entire organization. Formany companies, balances in the deferredtax account do not become zero, but rathergrow continuously into the future.

This rather amazing result is simply ex-plained. If we had one depreciable asset,over its lifetime we would first defer some taxand later repay it. But if we are constantly re-placing equipment—buying new equipmentas old equipment wears out—the deferral in-crease on the new assets offsets the deferralreduction on the old assets, often causingthe deferral to effectively become a perma-nent interest-free loan. However, the magicof deferred taxes is not yet fully apparent.

Consider what happens for an organiza-tion that is growing. Such an organization isnot only offsetting higher taxes on olderequipment with deferred taxes on an equalamount of new equipment. The expansion

in fixed assets causes the deferred liability togrow each year. For growing companies, thestartling result is that deferred taxes repre-sent both a growing and permanent inter-est-free loan. A bit of accounting magic.

KEY CONCEPTS

Matching—Depreciation is an attempt tomatch the cost of resources used up over aperiod longer than 1 year with the revenuesthose resources generate over their usefullifetime.

Amortization—Generic term for thespreading out of costs over a period of time.Depreciation is a special case of amortization.

Amounts to be depreciated—Cost of an asset,less its salvage value, is depreciated over theasset’s useful life. The cost is the fair marketvalue at the time of acquisition, plus costs toput the asset into service, plus the costs ofimprovements made to the asset.

Depreciate methods—Asset may be depreci-ated on a SL basis, resulting in an equalamount of depreciation each year, or by anaccelerated method, which results in greaterdepreciation in the earlier years of theasset’s life. Two common accelerated depre-ciation methods are DDB and SYD.

Modified Accelerated Cost Recovery System(MACRS)—Depreciation method used fortax reporting.

Deferred taxes—If the pretax income re-ported to stockholders is more than that re-ported to the IRS, then a tax deferral willarise; that is, some of our current tax ex-pense becomes a liability to be paid at someunstated time in the future, rather thanbeing paid currently.

TEST YOUR KNOWLEDGE



THE INVENTORY EQUATION

Inventories are a stock of goods held for usein production, delivery of services, or forsale. Retailers and wholesalers, like drug-stores and medical supply stores, have mer-chandise inventory. They buy a productbasically in the same form as that in which itis sold. Manufacturers, like pharmaceuticalcompanies or medical device makers, haveseveral classes of inventory—raw materialsthat are used in the manufacturing processto make a final product; work in process thatconsists of goods on which production hasbegun but has not yet been finished; andfinished goods that are complete and await-ing sale.

Just as there is a basic equation of ac-counting, there is a basic equation for keep-ing track of inventory and its cost:

Beginning Units Units EndingInventory + Purchased – Sold = Inventory

(BI) (P) (S) (EI)

This equation can be understood from a rea-sonably intuitive point of view. Consider an or-ganization selling syringes. At the start of theyear, it has 2,000 syringes. During the year, itbuys 8,000 syringes. If it sells 6,000 syringes,how many are left at the end of the year?

BI + P – S = EI

2,000 + 8,000 – 6,000 = 4,000

We can readily see that there should be4,000 syringes on hand at year end.

PERIODIC VERSUS PERPETUALINVENTORY METHODS

Organizations must make a major decisionabout the way in which they intend to keeptrack of the four items in the inventoryequation. This year’s beginning inventory isalways last year’s ending inventory. All ac-counting systems are designed so as to keeptrack of purchases. A problem centers onthe cost of goods sold and ending inventory.(Because many health care organizationsuse inventory in the delivery of services, wesometimes refer to the traditional cost ofgoods sold as cost of goods used.)

If we wish, we can keep track of specificallyhow many and which items in our inventoryare used. However, this requires a fair amountof bookkeeping. And in the end, it may not beworth the cost. Consider a community clinicthat stocks hundreds (or thousands) of as-pirin. Maintaining a running count of howmany aspirin are distributed may require pay-ing a clerk just to watch and count the aspirin.

75

CHAPTER 10

Inventory Costing: The Accountant’sWorld of Make-Believe



A far simpler approach is to simply waituntil year end and then count what is left.Once we know the ending inventory, we canuse our inventory equation to determinehow many aspirin were distributed. For ex-ample, if we started with 2,000 aspirin andpurchased 8,000, then a year-end count of4,000 on hand indicates that we distributed6,000 during the year.

BI + P – S = EI

If:

2,000 + 8,000 – S = 4,000

then

S = 6,000

This method is called the periodic method ofinventory. It requires us to take a physicalcount to find out what we have on hand atany point in time. It gets this name becausewe keep track of inventory from time totime, or periodically.

A major weakness of the periodic systemis that, at any point in time, we don’t knowhow much inventory we’ve used and howmuch we have left. Therefore, our controlover our inventory is rather limited. If run-ning out of an item creates a serious prob-lem, this method is inadequate.

There are several easy solutions to thatproblem in some situations. If, for example,the aspirin are kept in a bin, we can paint astripe two thirds of the way down the bin.When we see the stripe, we know it’s time toreorder. Bookstores often solve this problemby placing a reorder card in a book near thebottom of the pile. When that book is soldan order is made to replenish the stock.

The periodic method has other weak-nesses as well. Although we calculate a figure

for units used based on the three other ele-ments of the inventory equation, we don’tknow for sure that just because a unit of in-ventory isn’t on hand, it was used. It may havebroken, spoiled, expired, or been stolen.

An alternative to periodic inventory ac-counting is the perpetual method for keepingtrack of units of inventory. Just as the nameimplies, you always, or perpetually, know howmuch inventory you have, because you specif-ically record each item. This method is ap-propriate for companies selling relatively fewhigh-priced items. In such cases, it is relativelyinexpensive to keep track of each sale relativeto the dollar value of the sale. Furthermore,control of inventory tends to be a more im-portant issue with high-priced items.

Which of the two methods is consideredmore useful? Clearly the perpetual methodgives more information and better control.However, it also adds substantially to book-keeping costs. Most firms would choose per-petual if they could get it for the samemoney as periodic, but typically they can’t.The result is a management decision as towhether the extra benefits of perpetual areworth the extra cost.

Computers have made significant inroadsin allowing organizations to switch to perpet-ual inventory without incurring prohibitivelyhigh costs. For example, supermarkets were aclassic example of the type of organizationthat couldn’t afford perpetual inventory.Imagine a checkout clerk in the supermarketmanually writing down each item as it’s sold.The clerk rings up one can of peas, and thenturns and writes down “one 6-ounce can ofGreen Midget peas.” Then the clerk rings upone can of corn, and turns and writes down,“one 4-ounce can of House Brand corn,” andso on. At the end of the day, another clerkwould tally up the manual logs of each check-out clerk. The cost of this would be enor-mous. In such a situation, an organization


would just keep track of total dollars of sales,and would take periodic inventories to seewhat is still on hand. Yet supermarkets run onextremely tight margins, so they can ill affordto run out of goods, nor can they afford thecarrying cost of excess inventory.

Supermarkets were among the leaders inadopting use of bar codes. These computer-sensitive markings allow the store to save thecost of stamping the price on goods. Thecomputer that reads the bar code knowshow much the price of each item is, so theclerk no longer needs to see a stampedprice. It also allows the clerk to ring up thegoods at a much faster pace. Finally, it auto-matically updates the inventory. In many su-permarkets using this system, the cashregister tape gives you more informationthan just the price. Not only does it tell youthat you bought a 4-ounce container of yo-gurt, but also that it was blueberry yogurt.That detailed information tells the super-market’s main computer the size, brand,and flavor of yogurt to be restocked. The po-tential time saved in stamping prices ongoods and in the checkout process can off-set much of the cost of the computer system.

Many larger health care organizations, es-pecially hospitals, have adopted bar codingand perpetual inventory systems. In healthcare, the use of bar codes has moved beyondthe tracking of inventory to the tracking ofmedical records, services provided, andeven the tracking of patients as they movethroughout the hospital.

It should be noted that even on a perpet-ual system there is a need to physically countinventory from time to time (typically atleast once a year). The perpetual methodkeeps track of what was used. If there is a pil-ferage or breakage, our inventory recordswill not be correct. However, when we use aperpetual system, we know what we shouldhave. When we count our inventory, we can

determine the extent to which goods thathave not been used are missing.

THE PROBLEM OF INFLATION

The periodic and perpetual methods of in-ventory tracking help us to determine thequantity of goods on hand and the quantityused. We must also determine which unitswere used and which units are on hand.Consider the following situation:

Quantity Cost ($)

Beginning Inventory 20,000 200 each

Purchase March 1 20,000 220 each

Purchase June 1 20,000 240 each

Purchase September 1 20,000 260 each

Use during Year 60,000

How many units are left in stock? Clearlyfrom our basic inventory equation the answerto that is 20,000. Beginning inventory of20,000 units, plus the purchases of 60,000units, less the use of 60,000 units leaves end-ing inventory of 20,000 units. What is thevalue of those 20,000 units? Here a problemarises. Which 20,000 units are left? Does itmatter? From an accounting point of view itdefinitely does matter. In Chapter 3, wenoted that generally accepted accountingprinciples require us to value items on thebalance sheet at their cost. To know the costof our remaining units, we must know whichunits we used and which are still on hand.This requires the manager to make some as-sumptions, referred to as cost-flow assumptions.

This is particularly important during pe-riods of high inflation. Recently, inflationhas been modest, but at some point in thenear future the rate of inflation may acceler-ate. Therefore managers need an under-standing of the impact of the cost-flowassumptions that they make.

Chapter 10: Inventory Costing 77



COST-FLOW ASSUMPTIONS

The methods for determining which unitswere used and which are on hand are re-ferred to as cost-flow assumptions. There arefour major alternative cost-flow assumptions.

Specific Identification

This is the accountant’s ideal. It entails phys-ically tagging each unit in some way so thatwe can specifically identify the units onhand with their cost. Then, when a periodicinventory is taken, we can determine thecost of all the units on hand and thereforededuce the cost of the units used.

As you might expect, for most organiza-tions such tagging would create a substantialadditional bookkeeping cost. Think of thecommunity clinic not just trying to keeptrack of how many aspirin are used, but alsothe specific aspirin. Can any type of businessgo to this effort? Certainly some can—typi-cally those organizations that keep closetrack of serial numbers for the items used.

For example, a drug store must keep trackof specific lot numbers for each medicationin stock. By doing so, they can keep track ofspecifically which pills from which lot weredispensed and which specific pills remain ininventory. Similarly, hospitals must trackwhich specific medical device (such as apacemaker) is implanted into each patientin case there is a recall of that device.

First-In, First-Out

The second cost-flow approach is called first-in, first-out, and is almost always referred to bythe shorthand acronym FIFO. This methodallows you to keep track of the flow of inven-tory without tagging each item. It is based onthe fact that, in most industries, inventorymoves in an orderly fashion. We can think of

a hospital that has medical supplies with anexpiration date. Imagine that hospital as abuilding with a front door and a back door.New deliveries of merchandise are receivedat the back door and put on a conveyor belt.They move along the conveyor belt and rightout the front door. We would never have oc-casion to skip 1 unit ahead of the other itemsalready on the conveyor belt ahead of it.

A good example of FIFO is a dairy. It isclear that the dairy would always prefer tosell the milk that comes out of the cowtoday, before they sell the milk that the cowproduces tomorrow. We’ve all seen in the su-permarket that the freshest milk is put onthe back of the shelf. Of course, we knowthe fresh milk is in the back so we sometimesreach back to get it. But then, they know weknow so they sometimes.... Nevertheless, thepoint is clear—the supermarket’s desire isfor us to buy the oldest milk first; they wantto sell the milk in a FIFO fashion.

In health care, the closest example to thedairy is a drug store that stocks refrigeratedmedication that has expiration dates. Clearly,like the milk, the goal is to dispense the oldestmedication first. The first medication placedin the refrigerator needs to be the first out.

In most industries there is a desire toavoid winding up with old, shopworn, obso-lete, dirty goods. Therefore, FIFO makesreasonable sense as an approach for pro-cessing inventory.

Weighted Average

The weighted average (WA) approach to in-ventory cost flows assumes that our entire in-ventory is commingled and there is no wayto determine which units were used. For ex-ample, consider the community clinic andthe aspirin again. Suppose the clinic pur-chases their first batch of aspirin for $.10 perpill and all the pills are dumped in a large


bin. A week later, when the bin is half full,they reordered the aspirin, but this time thebatch cost $.14 per pill and again, the pillsare dumped into the bin. We now dispensetwo pills to a patient; are we dispensing pillsthat cost $.10 or $.14? Because there is reallyno way to know, the WA method assumesthat all of the pills have been thoroughlymixed, and therefore the pills being dis-pensed cost $.12 per pill. This method is ap-propriate whenever inventory gets stirred ormixed together and it is physically impossi-ble to determine what has been used.

Last-In, First-Out

The last of the four methods of cost flow forinventory is last-in, first-out (LIFO), whichhas received much attention in the lastdecade. The LIFO method is just the reverseof the FIFO method. It assumes that the lastgoods we receive are the first goods we use.In the case of the dairy it would mean thatwe always would try to sell the freshest milkfirst and keep the older, souring milk in ourwarehouse.

Does the LIFO method make sense for anyindustries at all? Yes. In fact it is the logical ap-proach to use for any industry that piles theirgoods up as they arrive, and then uses fromthe top of the pile. For example, a companymining coal or making chemicals frequentlypiles them up and them simply sells from thetop of the pile. However, for most organiza-tions it doesn’t provide a very logical inven-tory movement. Nevertheless, a large numberof organizations have shifted from the FIFOmethod to the LIFO method. Why?

Comparisons of the LIFO and FIFOCost-Flow Assumptions

Financial statements are not ideally suitedfor inflationary environments. During infla-

tion, we have problems trying to report in-ventory without creating distortions in atleast one key financial statement.

Consider an example in which we buy 1unit of inventory on January 2 for $10 andanother unit of inventory on December 30for $20. On December 31, we sell a unit for$30. What happens to the financial state-ments if we are using the FIFO method of in-ventory tracking? The FIFO method meansthat the inventory that is first in is the inven-tory that is first out. The January 2 purchasewas the first one in, so the cost of the unitsold is $10 and the cost of the unit remainingon hand is $20. What would it cost to buy aunit of inventory near year end? Well, webought one on December 30 for $20, so thebalance sheet seems pretty accurate.

However, consider the income statementunder FIFO. We presumably sold the first in,which cost $10, for a selling price of $30,leaving us with a $20 profit. Is that a good in-dication of the profit we could currentlyearn from the purchase and sale of a unit ofinventory? Not really. At year end we couldhave bought a unit for $20 and sold it for$30, leaving a profit of only $10. Thus, dur-ing periods of rising prices, the FIFOmethod does not give users of financialstatements a current picture of the profit op-portunities facing the organization.

We do not have that problem with LIFO.Under LIFO, the last in is the first out, whichmeans that we sold the unit that was pur-chased on December 30. That unit had cost us$20, and by selling it for $30 we realize a profitof $10. When we tell our stockholders that ourprofit was $10, we are giving them a reason-ably current picture of the profit we can cur-rently make by buying and selling a unit.

Unfortunately this gives rise to anotherproblem. Under LIFO, we have sold the unitthat cost $20, so we must have held onto theunit that cost $10. Is it true that we could




currently go out and buy more inventory for$10 a unit? No, by year end the price we paidwas already up to $20. So, under LIFO, thevalue of inventory on the balance sheet isunderstated.

There is no readily available solution to thisproblem. The weighted average method sim-ply leaves both the balance sheet and incomestatements somewhat out of whack, instead ofcausing a somewhat bigger problem with re-spect to one or the other, as results underLIFO and FIFO. In the face of this problem,for-profit organizations have shifted to LIFOfor a very simple reason: to save taxes.

Let’s take a second to consider the implica-tion of our example. If we use a FIFO systemduring inflationary periods, we report a pre-tax profit of $20 because we have sold a unitthat cost $10 for $30. Under LIFO, we reporta pretax profit of only $10 because we havesold a unit that cost $20 for $30. Therefore, bybeing on the LIFO system, we can reduce ourtax payments. Are the tax savings worth thefact that we will be reporting lowered profitson our financial statements? Absolutely. If wecan lower our taxes by using allowable GAAP,we should take advantage of that opportunity.

However, it gets even better. Suppose wepurchase a unit on January 2 for $10. OnJuly 1 we sell that unit. On December 30 webuy a unit for $20. Which unit did we sell?You probably think we sold the unit we paid$10 for. However, you are now entering theaccountant’s world of make-believe.

Inventory accounting make-believe isplayed this way. Under FIFO we record $10 ofexpense and $20 of inventory as an asset. Butunder LIFO we record $20 of expense on theincome statement and $10 as an asset on thebalance sheet! That implies that we sold theunit we acquired on December 30, eventhough the sale took place 6 months earlier.

The accountant knows that obviously thiscan’t physically be so. But that’s okay. We’ll

just make believe that that’s what happened.Under LIFO there is no need for us to actu-ally move our inventories on a LIFO basis.We don’t have to throw our conveyor beltinto reverse, or keep milk on hand until itturns sour. If our product is dated, there isno need to feel we can’t be on a LIFO systembecause we can’t afford to keep stock onhand past the expiration date.

The organization on LIFO can continueto behave all year long as if it were on FIFO.Your managers should continue to maketheir product decisions based on the currentcost of inventory items—and that usually re-quires a FIFO-type approach. However, youraccountant at year end makes adjustments toyour financial records to calculate your in-come as if you were consuming your inven-tory on a LIFO basis.

Assume the following:

Beginning Inventory $ 0

January 3, Purchase 1 Unit @ $ 10

July 1, Sell 1 Unit @ $ 30

December 1, Purchase 1 Unit @ $ 20

Under either method, the first unit pur-chased was physically shipped and the sec-ond unit purchased was physically on handat the end of the year. From a standpoint ofphysical movement of goods, the FIFO in-come statement tells the truth. However, bymaking believe that we shipped a unit thatwe hadn’t even received by the shippingdate, we can report a higher cost of goodsused expense, and therefore report a lowerprofit and pay the government less tax.

The LIFO Conformity Rule

When we talked about depreciation inChapter 9, we noted that we could have ourcake and eat it too. We could tell our stock-


holders what a good year we had, but wecould also tell the government how miser-able things had really been. This is not truewith LIFO. The government requires thatthe organization use the same method of in-ventory reporting to stockholders as it usesto report to the government.

Who Shouldn’t Use LIFO

Many, many organizations could benefitfrom LIFO, but there are some that wouldnot. LIFO is not necessarily advantageous ifthe cost of your inventory is highly uncer-tain, and veers downward as often as upward.For organizations dealing in commodities,WA remains a better bet. Organizationswhose inventory costs are actually falling(computer chips, for example) will havelower taxes by staying on FIFO.

What if your inventory contains someitems with rising cost and some items withfalling cost? If you segment the inventoryadequately, it is possible to report some ofyour inventory using one method and someof it based on another method.

LIFO Liquidations

The lower tax paid by an organization onLIFO is caused by reporting to the govern-ment that the most recent, high-priced pur-chases were sold while the old, low-cost itemswere kept. If we ever liquidate our inventoryand sell everything we have, we incur a highprofit on the sale of those low-cost items andhave to pay back the taxes we would havepaid had we been on FIFO all along. How-ever, in the meantime we have had an inter-est-free loan from the government. If ouryear-end inventory is always at least as big asthe beginning inventory, we will never havethat problem and we will never have to repaythose extra taxes to the government.

How about not-for-profit health care or-ganizations? Can we assume that taxes makeLIFO beneficial to for-profit organizations,but that not-for-profit health care organiza-tions will stick with FIFO? No. If it turns outthat any of your revenue results from a re-imbursement of your costs, LIFO will helpyou. Suppose that a foundation offers to payfor the care for some group of disadvan-taged patients. However, since they don’tfeel you should profit from treating thosepatients, the foundation agrees to just reim-burse the cost of care. If you are using FIFO,the inventory you consume in treating thosepatients will be reported at a lower cost thanif you use LIFO. So it turns out that revenuemaximization would lead even not-for-profithealth care organizations to use LIFO fortheir inventory cost-flow assumptions.

KEY CONCEPTS

The Inventory EquationBeginning Units Units EndingInventory + Purchased – Sold = Inventory

(BI) (P) (S) (EI)Periodic versus perpetual inventory—Differ-

ent methods for keeping track of how manyunits have been used and how many unitsare on hand.

Periodic—Goods are counted periodi-cally to determine the ending inventory.The number of units used is calculatedusing the inventory equation.Perpetual—The inventory balance is ad-justed as each unit is used so that a per-petual record of how many units havebeen used and how many are on handis maintained at all times.

Cost-flow assumptions—Inventory is valuedat its cost. Therefore, it is necessary to knownot only how many units were used and howmany are left on hand, but specificallywhich were used and which are left. This




determination is made via one of four dif-ferent approaches.

Specific identification—We record andidentify each unit as it is acquired orused.First-in, First-out (FIFO)—We assumethat the units acquired earlier are usedbefore units acquired later.Weighted average (WA)—We assume thatall units are indistinguishable and assigna weighted average cost to each unit.

Last-in, First-out (LIFO)—We assumethat the last units acquired are the firstones used, even if this implies use of aunit prior to its acquisition. During pe-riods of inflation there are tax savingsassociated with LIFO.

TEST YOUR KNOWLEDGE



Earlier, we examined the source of finan-cial statements. We discussed the basic

definitions of assets, liabilities, net assets, rev-enues, and expenses. We traced through avariety of journal entries, and saw how ledgerbalances can be used to derive key financialstatements. To understand financial infor-mation, it is vital to have an understanding ofwhere this information comes from.

We now turn our attention to trying to getas much useful information as possible froma set of financial statements. There are a va-riety of reasons for wanting to be able to dothis. First and foremost is to enable us tomanage our organization better. Second, wewant to be able to review the financial state-ments of close competitors to evaluate ourperformance as compared to theirs. Third,we may want to evaluate the financial state-ments of an organization in which we wishto invest. Fourth, we want to evaluate the fi-nancial statements of organizations we areconsidering extending credit to.

We may be looking for different types ofinformation in each case. Before investingin an organization, we wish to know about itspotential profitability; before extendingcredit, we want to assess an organization’sliquidity and solvency. The goal of financialstatement analysis is to derive from financial

statements the information needed to makeinformed decisions.

We do this primarily through examina-tion of the notes that accompany the finan-cial statements and through the use of atechnique called ratio analysis. Generally ac-cepted accounting principles (GAAP), inrecognition of many of the limitations of fi-nancial numbers generated by accountingsystems, require that clarifying notes accom-pany financial statements. The informationcontained in these notes may be more rele-vant and important than the basic state-ments themselves. Ratio analysis is a methodfor examining the numbers contained in fi-nancial statements to see if there are rela-tionships among the numbers that canprovide us with useful information.

Chapter 12 focuses on the notes to the fi-nancial statements and Chapter 13 discussesratio analysis. In the remainder of this chap-ter, we present a hypothetical set of financialstatements to use as a basis for discussion.

THE BALANCE SHEET

Table 11-1 presents the balance sheet for thehypothetical Community Hospital (CH) thatis the subject of our analysis. Information isprovided for 2 years. In recognition of the

83

CHAPTER 11

An Even Closer Look at Financial Statements


84 ACCOUNTING FUNDAMENTALS FOR HEALTH CARE MANAGEMENTTa

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fact that information in a vacuum is not veryuseful, accountants generally provide com-parative data. In the case of CH, the financialstatements present the current fiscal yearending December 31, 2007, and the previousfiscal year ended December 31, 2006. Manyfinancial reports contain the current yearand the 2 previous years for comparison.

All the numbers on the CH statementsare rounded to the nearest million dollars.You should be very careful to note that thetitle of the financial statement includes anote telling the reader that the figures arepresented without three zeros or in thou-sands. This is what is meant at the end of thetitle by the words “in ‘000.” In other words,the $16,000 listed for cash is really$16,000,000. This is common practice forlarge organizations, and accountants oftenround numbers to thousands or in somecases millions. Although this may seem likethe accountant is not being very accurate,you must remember accounting and espe-cially audited accounting statements are notexpected to be perfectly accurate. Round-ing the figures is a result of the the material-ity principle discussed earlier in this book.Additionally, rounding makes the state-ments much easier to read.

Current Assets

The first assets listed on the balance sheetare the current assets. These are the most liq-uid of the organization’s resources. The cur-rent assets are presented on the balancesheet in order of liquidity. Cash, the mostreadily available asset for use in meeting ob-ligations as they become due, is listed first.Cash includes amounts on deposit in check-ing and savings accounts as well as cash onhand. The next item is marketable securitiesthat are intended to be liquidated in thenear term. They can be converted to cash in

a matter of a few days. Marketable securitiesthat the organization intends to hold as long-term investments shouldn’t be listed withcurrent assets, but instead under a long-terminvestment category, after fixed assets.

The next current asset listed is accountsreceivable, net. It is usually the case that we do not expect to collect all of the money that is due us from all of our patients and in-surers. Some of it will become bad debts. As discussed in Chapter 2, there are manydifferent third-party payers and paymentmechanisms. “Accounts receivables, net”represents gross charges less an allowancefor bad debts and also less the various con-tractual allowances established with thosethird-party payers. For example, supposethat CH delivered health care services dur-ing the year for which the charges were$100,000. CH had $20,000 of contractual al-lowances, bringing the receivable down to$80,000. In addition, there was $20,000worth of patient co-payments. Historically,10% of all co-payments are never collectedfor a variety of reasons. Sometimes the pa-tient moves away. Sometimes the patient justdecides not to pay his or her bill. SometimesCH hasn’t recorded the correct address in-formation and can’t find the patient. CHtherefore takes a bad debt allowance of$2,000 (10% of $20,000), bringing the netreceivable down to $78,000.

Charges $ 100,000

Contractual Allowance (20,000)

Allowance for Bad Debt (2,000)

Accounts Receivable, net $ 78,000

Inventory is generally listed on the balancesheet after receivables. This is because it isless liquid than receivables. The reason forthis is that inventory is used to provide pa-tient care services. Once those services have

Chapter 11: An Even Closer Look at Financial Statements 85



been provided, we can issue bills to patients,and accounts receivables arise. So clearly, in-ventory takes longer to convert to cash thanreceivables, because it has not yet been usedto provide services. Prepaid expenses aregrouped with current assets even thoughthey do not usually generate any cash to usefor paying current liabilities. Rather we ex-pect them to be used up within the comingyear. Prepaid expenses generally includeitems such as prepaid rent or insurance.

Health insurance companies often haveprepaid expenses on their balance sheets.Typically, these represent capitated arrange-ments with providers. The insurance com-pany pays a provider up-front for a certain setof services to be provided to a specific groupof patients. When the insurance companypays the provider it has two entries on itsledger; cash goes down and the asset calledprepaid insurance goes up. Conceptually, thehealth insurance company is trading oneasset (cash) for another (the claim to serv-ices). As time goes by, the claim on servicesgoes down and the insurance company mustrecognize the expense of these services.

In this example, the provider’s balancesheet records mirror image entries. Theprovider receives the cash and has an obli-gation to provide health care services. Inthis case, cash goes up and the provider cre-ates a liability called unearned or deferred rev-enue. As time goes by, and the provider hasearned the revenue, the liability (unearnedrevenue) is reduced and insurance revenueis recognized.

Long-Term Assets

All assets the organization has that are notcurrent assets fall into the general category oflong-term assets. Prominent among the long-term assets are fixed assets, which include theproperty, plant, and equipment used to

process or produce the organization’s prod-uct or service. A variety of other long-term as-sets may also appear on the balance sheet.There would be a category for investments ifwe had marketable securities that we antici-pated keeping for longer than 1 year.

In the case of CH, there is an asset calledgoodwill, an intangible asset that may arisethrough the acquisition of another organi-zation (perhaps a physician practice). Mostorganizations have some goodwill: they havecustomer loyalty and a good relationshipwith their suppliers. However, goodwill is anintangible asset that accountants usuallyleave off the balance sheet because of thedifficulty in measuring it. When one organi-zation takes over another, if it pays more forthe organization it is acquiring than can rea-sonably be assigned as the fair market valueof the specific identifiable assets that it isbuying, then the excess is recorded on thebalance sheet of the acquiring organizationas goodwill. This follows the accountant’sphilosophy that people are not fools. If wepay more for an organization than its otherassets are worth, then there is a presump-tion that the various intangibles we are ac-quiring that can’t be directly valued must beworth at least the excess amount we paid.

Liabilities

The organization’s current liabilities are thosethat exist at the balance sheet date, whichhave to be paid in the next operating cycle—usually considered to be 1 year. Common cur-rent liabilities include wages payable, accountspayable, and in for-profit organizations, taxespayable. The taxes payable include only theportion to be paid in the near term, not thetaxes that have been deferred more than 1year beyond the balance sheet date.

Long-term liabilities include any recordedliabilities that are not current liabilities.


There may be a variety of commitments thatthe organization has made that will not beincluded with the liabilities. For example, ifthe organization has operating leases, theydo not appear on the balance sheet, eventhough they may legally obligate the organi-zation to make large payments into the fu-ture. The notes to the financial statementsare especially important in disclosing mate-rial commitments.

Net Assets and Stockholders’ Equity

As discussed earlier, Net Assets represents thedifference between assets and liabilities. Innot-for-profit organizations this can bethought of as the community’s claim on theassets of the organization. This is conceptu-ally similar to stockholders’ equity in for-profit organizations. Stockholders’ equityrepresents the outstanding claim that stock-holders have on the organization. In most in-stances, the organization does not have anamount of cash equivalent to net assets orstockholders’ equity. Rather, profits thathave been earned over time, and that belongto the community or to the stockholders,have been reinvested in the organization inthe form of equipment or other items tohelp the organization meet its mission andearn additional profits in the future.

In our CH example, net assets has threecomponents: unrestricted, temporarily re-stricted, and permanently restricted. Unre-stricted net assets represent an unfetteredclaim on a share of the organization’s assets.To the extent that there are unrestricted netassets, the organization has an ability tomake decisions about how to use an equiva-lent amount of the organization’s assets.

Temporarily restricted net assets are typicallyrestricted for a certain period of time oruntil a certain event occurs. These net assetsusually arise as the result of either a grant or

donation that comes with strings attached.Suppose that a foundation offers CH a$100,000 research grant to participate in anational research study. However, themoney must all be used on expenses relatedto that study. When CH receives the money,cash goes up. Liabilities don’t change be-cause the money is a grant; it is not owedback to the Foundation. On the other hand,CH is not free to do whatever they wouldlike with that money. By treating the$100,000 as a temporarily restricted netasset, it ensures that everyone knows thatthe organization is not free to use thatmoney however it would like. Similarly,when donors restrict their donations to aspecific purpose or a specific time period foruse, temporarily restricted net assets help tokeep everything clear. Once the restrictionshave been met, the temporarily restrictednet assets become unrestricted.

Permanently restricted net assets are just that,permanently restricted as to their use. Gen-erally they arise when donors are trying toprovide for an endowment. Such endow-ments are invested and their earnings canbe used by the organization. If the donordoesn’t give specific conditions on a perma-nently restricted gift, beyond the permanentrestriction, then the earnings can be usedfor any reasonable purpose such as opera-tions or capital asset acquisitions. However,sometimes donors specify that the earningsfrom the endowment must be used for aparticular purpose. In that case, as money isearned on the endowment investment,those earnings immediately become tem-porarily restricted net assets. They remaintemporarily restricted until they are used inthe manner specified by the donor.

If CH were a publicly traded for-profithealth care organization, the balance sheetwould contain a stockholders’ equity section(instead of net assets) similar to Table 11-2.




The stockholders’ equity section of the bal-ance sheet contains a number of elements.Instead of simply having contributed capitaland retained earnings, there are a number ofseparate items that comprise contributedcapital. In addition, there is a distinction be-tween amounts paid representing par valueand amounts in excess of par. Par value is a newterm that is discussed in this section.

In our example, there are two generalclasses of stock. There is common stock andpreferred stock. Common stock is a traditionalmeans of obtaining capital in many for-profit organizations. Investors purchaseshares of the organization’s assets in theform of stock. As stockholders, the investorsbecome the owners of the organization andhave the right to elect a board of directorsand have a right to a share of any profit dis-tributions. Preferred stock is a bit different. Inthis case, the organization generates capitalby selling ownership rights (stock) with pre-determined dividend payments. Thespecifics of common and preferred stock arediscussed in more detail in Chapter 16.

Par value is a legal concept. In manystates, organizations are required to set anarbitrary amount as the par value of theirstock. One of the primary reasons many or-ganizations incorporate is to achieve a lim-ited liability for their owners. Limited liability

assumes that the corporation’s stock wasoriginally issued for at least its par value. Ifstock is issued below the par value—let’s saythat $10 par value stock is issued for $7—then the owner could be liable for the dif-ference between the issue price and the parvalue should the organization go bankrupt.Given that situation, the par value of the cor-poration’s stock is generally set low enoughso that all stock is issued for at least the parvalue. Par value is an arbitrary value set bythe organization.

There is no connection between the parvalue and any underlying value of the or-ganization. There is no reason to believethat the arbitrarily selected par value is agood measure of what a share of stock isworth. In fact, because most organizationsare very careful to set par low enough so thatthere is no extra liability for the corpora-tion’s owners, par value has become almostmeaningless. Therefore, some states nowallow corporations to issue stock without as-signing a par value (called no par stock).

From an accounting perspective, we wishto be able to show the user of financial state-ments whether there is some potential addi-tional liability to the stockholders. Toaccomplish this, the accountant has one ac-count to show amounts received for stockup to the par value amount. Anything paid

Table 11-2 Stockholders’ Equity Component of Statement of Financial PositionAs of December 31, 2007 and December 31, 2006 (in ’000)

2007 2006

Stockholders’ Equity

Common Stock, $1 Par, 1000 Shares $ 1,000 $ 1,000

Common Stock-Excess over Par 24,000 24,000

Preferred Stock, 10%, $100 Par, 100 Shares 10,000 10,000

Retained Earnings 101,000 73,000

Total Stockholders’ Equity $ 136,000 $ 108,000


above par for any share goes into a separateaccount with a name such as “excess paidover par” or “additional paid-in capital.”

In our example, we see that CH has 1,000shares of $1 par value common stock. Thebalance in the common stock par account is$1,000, meaning that all 1,000 shares were is-sued for at least $1 each, the par value. Thereare 100 shares of $100 par value preferredstock and the balance in the preferred stockpar account is $10,000, indicating that eachof the 100 shares was issued for at least $100.Therefore, we know that the stockholdershave limited liability. They can lose every-thing they’ve paid for their stock, but if theorganization goes bankrupt, creditors cannotattempt to collect additional amounts fromthe stockholders personally.

As is quite commonly the case, the stock-holders in our example have paid more thanthe par value for at least some of the stock is-sued by the corporation. The common stockexcess over par account has a balance of$24,000. Together with the $1,000 in thecommon stock par account, this indicatesthe investors paid $25,000 (or gave the firmresources worth $25,000) for 1,000 shares ofstock. On average, investors paid $25 pershare for the common stock. There is no ex-cess over par account for the preferred stock.Therefore, we know that the preferred stock-holders each paid exactly $100 per share forthe preferred stock at the time it was issued.

The preferred stock is referred to as 10%,$100 par stock, indicating that the annualdividend rate on the preferred stock is 10%of the $100 par value. Each preferred sharemust receive a $10 dividend before the or-ganization can pay any dividend to the com-mon stock shareholders.

The retained earnings, as discussed previ-ously, represent the profits that the organiza-tion earned during its existence that have not been distributed to the stockholders as

dividends, and therefore have been retainedin the organization. Remember that thiscategory, like the others on the liability andowners’ equity side of the balance sheet, rep-resents claims on assets. There is no pool ofmoney making up the retained earnings.Rather, the profits earned over the years andretained in the organization have likely beeninvested in a variety of fixed and current assets.

STATEMENT OF OPERATIONS

As discussed earlier, the statement of operations(often referred to as the income statement) is aflow statement. Its primary purpose is to showthe flow of revenues (increases in wealth) andexpenses (decreases in wealth) for the organ-ization over a given period of time. Table 11-3shows the statement of operations for CH. Asis the case with most health care organiza-tions, CH derives the vast majority of its rev-enues from patient services. As you can see,they also have a reasonable amount of pre-mium revenue (this is often based on capi-tated per member per month charges). Thestatement of operations is divided into twomain sections. On top, revenues and ex-penses are listed and together yield the netgain or loss from operations (often listed asExcess of Revenues over Expenses). Belowthe operating section are changes in net as-sets that are not from operating activities.These “below-the-line” changes must beshown to be able to link the beginning netasset value with the ending net asset value onthe balance sheet. The below-the-line changesmay include items such as contributions,

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You may use Template 8 to prepare a balancesheet for your organization. The template is onthe Web at www.jbpub.com.




transfers to or from a parent organization, orother non-operating transactions.

To understand the link between the state-ment of operations and the balance sheet allone has to do is look at the ending unre-stricted net asset balance from Table 11-1.For the year ended 2006, CH had unre-stricted net assets of $38,000. The followingyear, CH ended with unrestricted net assetson the balance sheet of $66,000. This repre-sents a change of $28,000 for the 2007 fiscalyear. This change is shown on the bottom ofthe statement of operations (Table 11-3). Inreality, the statement of operations is noth-ing more than a listing of all the changesthat affect the net assets. It is organized intoan operating section that includes the or-

ganizations revenues and expenses and anon-operating section that captures otherchanges to net assets.

In publicly traded for-profit health careorganizations, the statement of operationsmust also include earnings per share data.The earnings per share data is shown belowall the information described above. Table11-4 shows an example of this portion of astatement of operations. In Table 11-4, weuse a Net Income number that is differentfrom the Increase in Unrestricted Net Assetsthat we saw in Table 11-3. These numbersare normally the same, but in this examplewe changed the net income number so thatwe can demonstrate the impact of dividendson the retained earnings balance. The num-

Table 11-3 Community HospitalStatement of Operations

For the Years Ended December 31, 2007 and December 31, 2006 (in ’000)

2007 2006

Revenues

Net Patient Services Revenue $ 180,000 $ 159,000

Premium Revenue 29,000 20,000

Other Operating Revenue 15,000 12,000

Total Revenues From Operations $ 224,000 $ 191,000

Expenses

Salaries and Benefits $ 75,000 $ 68,000

Medical Supplies and Drugs 95,000 87,000

Insurance 15,000 12,000

Depreciation 20,000 16,000

Interest 2,000 3,000

Provision for Bad Debts 5,000 3,000

Total Expenses From Operations $ 212,000 $ 189,000

Excess of Revenues over Expenses $ 12,000 $ 2,000

Unrestricted Contributions 56,000 40,000

Transfers to Parent (40,000) (35,000)

Increase/(Decrease) in Unrestricted Net Assets $ 28,000 $ 7,000


bers presented in Table 11-4 match the re-tained earnings and stockholder’s equityshown in Table 11-2.

The line following Net Income in Table11-4 contains earnings per share data. GAAPrequire inclusion of information on a per-share basis for common stock. It is felt thatthis type of information may be more rele-vant than net income for many users of fi-nancial information. Consider an individualwho owns 100 shares of common stock of alarge corporation. The corporation reportsthat its profits have risen from $25,000,000to $30,000,000. On the surface, we wouldpresume that the stockholder is better offthis year. What if, however, during the yearthe corporation issued additional shares ofstock, thereby creating additional owners.Although total profits have risen $5,000,000or 20%, because of the additional share ofstock outstanding, investors find that theirshare of earnings increased by less than20%. In fact, it is quite possible that the prof-its attributable to each individual share mayhave fallen, even though the total profit forthe corporation has increased.

Table 11-4 begins with Net Income. Notethat for-profit organizations use Net Income

on their operating statement rather than in-crease or decrease in net assets, which isused by not-for-profit organizations; concep-tually they are the same. One of the mainreasons for the difference in terminology isthat not-for-profit organizations are reluc-tant to give the image of earning profits orincome. They feel the public, and donors es-pecially, won’t understand that even not-for-profit organizations need to be profitable tobe able to meet their mission.

Using the same stock information weused in Table 11-2, we see that althoughthere are 1,000 shares of common stock andthe net income was $33,000, the earnings orincome (the two terms are used inter-changeably) per share is $32.00, rather thanthe expected $33.00. This is because $1,000has to be paid as a 10% dividend to the pre-ferred shareholders. This portion of the in-come of the organization doesn’t belong tothe common shareholders. The remaining$32,000 does.

Looking at Table 11-2, we see that the bal-ance in the common and preferred stock ac-counts didn’t change during the year.However, the balance in retained earningsdid change. The change in retained earnings


Table 11-4 Earnings Per Share Component ofStatement of Operations


2007 2006

Net Income $ 33,000 $ 10,000

Earnings Per Share Common $ 32.00 $ 9.00

Less Dividends 2007 and 2006 5,000 3,000

Addition to Retained Earnings $ 28,000 $ 7,000

Retained Earnings January 1,2006 and 2005 73,000 66,000

Retained Earnings December 31,2007 and 2006 $ 101,000 $ 73,000



on the balance sheet is mapped out at thebottom of Table 11-4. The beginning balancein Retained Earnings is combined with thisyear’s addition to retained earnings to yieldthe end of year Retained Earnings listed onthe balance sheet. This is the same tie be-tween the balance sheet and statement of op-erations we discussed earlier with respect tounrestricted net assets.

STATEMENT OF CASH FLOWS

The statement of cash flows focuses on fi-nancial rather than operating aspects of theorganization. Where did the money comefrom and how did the organization spend it?Whereas the major concern of the incomestatement is profitability, the statement ofcash flows is very concerned with viability. Isthe organization generating and will it gen-erate enough cash to meet both short-termand long-term obligations?

There are two methods currently used forpresenting the statement of cash flows: thedirect method and the indirect method. InChapter 4 we presented a simple directmethod layout of the cash flow statement(see Table 4-3). As you may recall, the state-ment lists all the sources and uses of cashand organizes these into three categories:operating activities, investing activities, andfinancing activities. The main difference be-tween the direct and indirect methods oflaying out the statement is in the operatingactivities section of the statement.

Cash flow from operations is a focal pointbecause it provides information on whether

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You may use Template 9 to prepare aStatement of Operations for your organization.The template is on the Web at www.jbpub.com

the routine operating activities of the organi-zation generate cash, or require a cash infu-sion. If the operating activities generate asurplus of cash, the organization is more fi-nancially stable and viable than if they con-sume more cash than they generate. Thisdoes not mean that negative cash from oper-ating activities is bad. It may be indicative of agrowing, profitable organization that is ex-panding inventories and receivables as itgrows. However, it does provide a note of cau-tion. Overly rapid expansion, without otheradequate cash sources, can cause some finan-cial failure. Table 11-5 shows the Statement ofCash Flows for CH using the direct method.

Table 11-6 shows the same information as itwould be displayed using the indirect method.Instead of a straight listing of cash flow trans-actions, the indirect method starts with the in-crease in unrestricted net assets from the lastline of the operating statement and makes ad-justments to reconcile to actual cash flow. It isimportant to remember that under accrual ac-counting revenues and expenses are not thesame thing as cash inflows and cash outflows.The operating statement reports revenuesand expenses. The cash flow statement re-ports cash inflows and cash outflows.

The cash flows from operating activitiesare first approximated by the net income orchange in unrestricted net assets of the or-ganization. Revenue activities are generallygenerators of cash, and expenses generallyconsume cash. That is not always the case,however, and a number of adjustments areneeded. First of all, there are certain ex-penses that do not consume cash. In Table11-6, note that several expenses are added tothe increase in net assets. Depreciation re-flects a current year expense for a portion offixed assets that are being used up duringthe year. These assets were mostly purchasedin earlier years, and paid for at that time.The operating statement charges part of


their cost as an expense in the current year.However, that does not require any cash.Similarly, a reduction in the value of good-will (called impairment of goodwill) oftenoccurs only years after payment was made toacquire that goodwill. Therefore, the changein net assets or net income is an imperfectmeasure of cash flow. It treats all expenses asif they consumed cash. Because depreciationand impairment do not consume cash, theyare added back. To the extent that cash wasactually spent this year on fixed asset pur-

chases, it shows up in the investing activityportion of the statement of cash flows.

In addition to these expense items, thereare a variety of other activities related to op-erations that consume or provide cash, butare not adequately approximated by thechange in net assets. For example, when theorganization purchases more inventory thanit uses, the extra inventory is not an expense.Nevertheless, we must pay for it, so there is acash flow. Increases in inventory must there-fore be subtracted to show that they consume


Table 11-5 Community HospitalStatement of Cash Flows (Direct Method)


2007 2006

Cash Flows From Operating Activities

Collections $ 237,000 $ 198,000

Payments to Suppliers (105,000) (96,000)

Payments to Employees (60,000) (75,000)

Insurance Payments (16,000) (14,000)

Interest Payments (2,000) (3,000)

Net Cash From Operating Activities $ 54,000 $ 10,000

Cash Flow From Investing Activities

Increase in Marketable Securities $ (6,000)

Sale of Fixed Assets 0 $ 2,000

Purchase of New Equipment (60,000)

Net Cash (Used for)/From Investing Activities $ (66,000) $ 2,000

Cash Flow From Financing Activities

Payment of Mortgage Principal $ (10,000) $ (10,000)


Additional Long-term Debt 8,000 6,000


Net Cash (Used for)/From Financing Activities $ 14,000 $ (4,000)

Net Increase/(Decrease) in Cash $ 2,000 $ 8,000

Cash, Beginning of Year 14,000 6,000

Cash, End of Year $ 16,000 $ 14,000



cash. On the other hand, if wages payable in-crease, that indicates that less cash was cur-rently paid than we would expect based onthe labor expenses we had for the year.

These adjustments can become compli-cated. However, for the nonfinancial man-ager it is not necessary to be able to make thevarious adjustments. Nonfinancial managers

Table 11-6 Community HospitalStatement of Cash Flows (In-Direct Method)


2007 2006

Cash Flows From Operating Activities

Increase in Unrestricted Net Assets $ 12,000 $ 2,000

Add Expenses Not Requiring Cash:


Impairment of Goodwill 10,000 0

Other Adjustments:

Add Reduction in Accounts Receivable 16,000 $ 2,000

Add Increase in Wages Payable 2,000 0

Add Increase in Accounts Payable 8,000 3,000

Add Increase in Unearned Revenue 6,000 0

Subtract Decrease in Accounts Payable 0 (6,000)

Subtract Increase in Inventory (18,000) (7,000)

Subtract Increase in Prepaid Expenses (2,000) 0

Net Cash (Used for)/From Investing Activities $ 54,000 $ 10,000

Cash Flows From Investing Activties

Increase in Marketable Securities $ (6,000)

Sale of Fixed Assets 0 $ 2,000

Purchase of New Equipment (60,000)

Net Cash (Used for)/From Investing Activities $ (66,000) $ 2,000

Cash Flows From Financing Activities

Payment of Mortgage Principal $ (10,000) $ (10,000)


Additional Long-term Debt 8,000 6,000


Net Cash From/(Used for) Financing Activities $ 14,000 $ (4,000)

Net Increase/(Decrease) in Cash $ 2,000 $ 8,000

Cash, Beginning of Year 14,000 6,000

Cash, End of Year $ 16,000 $ 14,000


should focus on interpretation of the num-bers. It is more important to be aware of thefact that these components show us what isaffecting cash from operating activities. Forinstance, increases in accounts receivable re-quire a subtraction from the increase in netassets. This is because net income assumesthat all revenues have been received. If ac-counts receivable are rising, the organiza-tion is not collecting all of its revenues fromthe current year. If we note a large increasein accounts receivable, it warns the man-agers that perhaps greater collections effortsare in order.

The second part of the statement of cashflows is cash from investing activities. Wenote here that CH increased its marketablesecurities, using $6,000 of cash, and pur-chased new equipment for $60,000. In theprior year, some equipment was sold.

The third section of the statement of cashflows is from financing activities. CH hadone cash inflow during the year in the formof $8,000 worth of additional long-termdebt. The other financing activities includepayment of principal on an existing mort-gage in the amount of $10,000 and a$40,000 transfer of cash to CH’s parent or-ganization. Many health care organizationsare part of larger health care systems (orcorporations). As part of the “system”arrangement, funds often flow to the parentas well as flowing from the parent.

Combining the cash flows from operat-ing, investing, and financing activities yieldsthe net increase or decrease in cash for theyear. Added to the cash balance at the be-ginning of the year, this provides the cashbalance at the end of the year. This is thesame balance as that appearing on the bal-ance sheet (Table 11-1).

For CH the final cash balance has notbeen varying substantially. At the end of2007 the balance is $16,000. The prior year

it was $14,000. More important than the sta-bility in the closing balance each year is thefact that the investments made by CH arebeing financed from operating activities.Not only are operations generating a posi-tive cash flow, but further this cash flow isgenerally sufficient, or nearly sufficient, tocover the organization’s investing and fi-nancing needs.

Right now, CH is relatively stable. It isgrowing and profitable, has twice as much incurrent assets as current liabilities, and hassustained its cash balance. On the otherhand, as growth continues it must carefullymonitor this statement. Increases in fixedassets, inventory, and receivables that nor-mally accompany growth may prevent theorganization from remaining in balance.Managers should consider whether the cashbeing generated from activities is sufficientto sustain planned growth. If not, theyshould start to plan for additional increasesin long-term debt. A specific focus on thestatement of cash flows can be a tremendousaid to management in preparing an orderlyapproach to meeting the financial needs ofthe organization.

THE NOTES TO THE FINANCIALSTATEMENTS

This chapter introduces you to the financialstatements of CH. We discuss these statementsin somewhat more detail than the statementswe looked at in earlier chapters. However, nomatter how closely you read the numbers in

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You may use Template 10 to prepare aStatement of Cash Flows for your organization. The template is on the Web at www.jbpub.com.




the financial statements nor how well you un-derstand the detail presented on the financialstatements, in themselves they are an inade-quate picture of the organization.

The balance sheet, statement of opera-tions, and statement of cash flows of an au-dited set of financial statements all refer thereader to the “notes” that follow or accom-pany the financial statements. Accounting isnot a science. It is a set of rules containingnumerous exceptions and complications. Fi-nancial analysis requires an understandingof what the organization’s financial positionreally is and what the results of its operationsand cash flows really were. It is vital that theuser of financials not simply look to the totalassets and net income to determine howwell the organization has done. The notesthat accompany the financial statements re-ally are an integral part of the annual re-port. It is to those notes for CH that we turnin Chapter 12.

KEY CONCEPTS

Financial statement analysis—Techniques ofanalyzing financial statement information tofind out as much about the organization’s fi-nancial position and the results of its opera-tions and its cash flows as possible. The focusis on the financial statements, the notes tothe financial statements, and ratio analysis.

Par value—Legal concept related to lim-ited liability of stockholders. There is no re-lationship between par value and a fair orcorrect value of the organization’s stock.

Earnings per share—Rather than focus sim-ply on net income or total earnings, GAAP re-quire disclosure of the earnings available tocommon shareholders on a per-share basis.

TEST YOUR KNOWLEDGE



The financial statements for CommunityHospital (CH) tell a great deal about the

organization. We have information about theorganization’s resources, obligations, networth (net assets), profitability, and cashflows. Yet financial statements are extremelylimited in their ability to convey information.Therefore, audited financial statements mustbe accompanied by a set of notes. These notesexplain the organization’s significant ac-counting policies and provide disclosure ofother information not contained in the bal-ance sheet, statement of operations, andstatement of cash flows, but that is necessaryfor the statements to be a fair representationof the organization’s financial position andthe results of its operations.

This chapter presents a hypothetical setof notes for the financial statements of CH.We first present each note and then discussit before moving on to the next note. Thisdiscussion is not exhaustive. Each organiza-tion has notes that apply to its own uniquecircumstances.

SIGNIFICANT ACCOUNTINGPOLICIES

The notes section generally begins with astatement of accounting policies. This is particularly important because of the

alternative choices of accounting methodsallowed, even within the constraints ofgenerally accepted accounting principles(GAAP). In cases in which the organizationhas a choice of methods, that choice likelyhas an impact on both the balance sheetand the statement of operations and pos-sibly on the statement of cash flows. Thefinancial statement figures are not mean-ingful unless we know what choices the or-ganization has made.

NOTE A: Significant Accounting Policies

1. Net Patient Services Revenue—The Hos-pital has arrangements with third-partypayers that provide for payments to theHospital at amounts different from estab-lished rates. Net patient services rev-enue is recorded at the estimated netrealizable amounts from patients andthird-party payers.

This note makes it clear that CH does notclaim full charges as revenue. As describedearlier in this book, health care organiza-tions have a variety of payment systems. Netpatient service revenue represents the actualamount that the hospital is entitled to collectfor the services it has provided, after sub-tracting charity care, negotiated discounts,and other contractual allowances.

97

CHAPTER 12

Notes to the Financial Statements: The Inside Story



2. Short-term investments—Short-term invest-ments are stated at their fair market value.

CH has $24,000 of marketable securitiesat the end of fiscal year 2007 (see Table 11-1). Your expectation might well be thatthese securities cost CH $24,000 becausethat would correspond with the cost princi-ple of accounting. However, objective mar-ket prices for stocks and bonds are availablefrom many sources. We can determine theprice at which identical securities were actu-ally sold. Therefore, marketable securitiesare generally shown on the balance sheet attheir fair market value.

3. Inventories—Inventories are stated at cost,not to exceed market. Cost is calculatedusing the last-in, first-out (LIFO) method.

Here the principle of recording at cost(based on objective evidence) conflicts withthat of conservatism (adequate considera-tion of relevant risks). In this case, GAAP re-quires use of lower of cost or market value(LCM). If the market value exceeds cost, weuse the cost. If the cost exceeds marketvalue, we use the market value. Essentially,we are willing to value inventory below itscost, but not above it.

So inventories are stated using LCM be-cause of the GAAP of conservatism. But howdoes CH measure the cost of its inventory?This note tells us that CH uses the LIFOmethod to determine inventory cost.LIFO/FIFO is a choice the organization isallowed under GAAP.

4. Property, plant, and equipment—Property,plant, and equipment are recorded at cost,less depreciation. Depreciation taken overthe useful lives of plant and equipment iscalculated on the straight-line basis.

For financial reporting, we have a fair de-gree of latitude in choosing a depreciationmethod. We could use a declining balance or

sum-of-the-years’ digits approach as an alter-native to straight-line depreciation. For CHin 2007, operating costs included $20,000 ofdepreciation calculated on a straight-linebasis. Suppose that the double-declining bal-ance depreciation would have been $32,000,and that the sum-of-the-years’ digits depreci-ation would have been $26,000.

The organization’s reported net incomecan be greatly affected by the choice of ac-counting methods. Disclosure of choices,such as the inventory and depreciationmethods used, provides users with a greaterability to understand the organization’s fi-nancial situation.

5. Income Taxes—Community Hospital is anot-for-profit organization as described inInternal Revenue Code 501(c)(3) and re-lated income is exempt from federal in-come tax under Code Section 501(a).

Like many health care organizations, CH is anot-for-profit organization and thereforedoes not pay income tax. This note identifiesthe specific sections of the IRS code underwhich CH is claiming its tax-exempt status.

6. Charity Care—The Hospital provides carewithout charge to patients who meet cer-tain criteria under its charity care policy.Because the Hospital has no expectationor claim on payment in such cases, no rev-enue related to charity care is reported.

Many health care organizations providecharity care. In fact, the IRS code specificallyspeaks to the issue of not-for-profits givingback to the community as a justification fortheir favorable tax-exempt status. Becausethe organization has no up-front expecta-tion of being paid for the services renderedunder its charity care policy, it cannot claimany revenues related to these services.Often, readers of health care financial state-ments expect to see expenses related tocharity care specifically highlighted on the


statement of operations. In reality, the ex-penses related to providing charity care areincluded in the operating statement in theform of expenses such as wages and sup-plies. They are not, however, listed as a sepa-rate expense, nor are they listed as revenue.

7. Temporarily and Permanently RestrictedNet Assets—Temporarily restricted net as-sets have been limited by donors to a spe-cific time period or until a specific event.Permanently restricted net assets have re-strictions set by donors that must be main-tained in perpetuity.

As described earlier, the net assets of not-for-profit health care organizations like CHhave three categories: unrestricted, tem-porarily restricted, and permanently re-stricted. This note outlines the definitionsbeing used for temporarily restricted andpermanently restricted net assets.

OTHER NOTES

In addition to a summary of accountingpolicies, the annual report contains othernotes that provide additional disclosure ofinformation needed for the financial state-ments to provide a fair representation of thefinancial position of the organization andthe results of its operations.

NOTE B: Receivables

Receivables at December 31, 2007, including ap-plicable allowances, were as follows:

Patient accounts $ 72,000

Less allowances for:

Contractual adjustments (22,000)

Uncollectibles (6,000)

Receivables, Net $ 44,000

The note on receivables provides the readerwith additional information on the relation-

ship between charges and actual payments.Based on the information provided here, it isclear that the big difference between chargesand net receivables is the contractual al-lowance. This note also allows the reader totrack changes in uncollectables to see if thisis becoming a larger problem over time.

NOTE C: Bonds Payable

At December 31, 2007, the schedule of requiredpayments on Community Hospital’s outstandingbonds consisted of the following:

Year EndingDecember 31 Principal Interest Total

2007 $ — $ 2,000 $ 2,000

2008 — 2,000 2,000

2009 — 2,000 2,000

2010 — 2,000 2,000

2011 — 2,000 2,000

2012–2016 68,000 14,000 82,000

2017–2021 45,000 12,000 57,000

2022–2026 46,000 11,500 57,500

2027–2031 41,000 12,700 53,700

Total $ 200,000 $ 60,200 $ 260,200

The balance sheet of CH lists three classes oflong-term debt: mortgages, bonds, andother. The long-term debt schedule in-cluded in the notes provides detailed infor-mation on the upcoming bond paymentobligations. As can be seen, CH has obliga-tions that are stable for the next 5 years,through 2011. In the period 2012 to 2016,they have $68,000 in bonds that come dueand cause their total payments for thoseyears to jump from $2,000 to $82,000. Inmost cases, health care industry bonds re-quire that only interest be paid during thelife of the bond with a full principal paymentat maturity. The large principal payment at

Chapter 12: Notes to the Financial Statements 99



maturity causes spikes in an organization’sdebt payment schedule. In many cases,bonds or portions of them are refinanced asthey reach maturity.

NOTE D: Commitments, Contingencies,and Litigation

Community Hospital is involved in a num-ber of legal proceedings and claims with var-ious parties that arose in the normal courseof business. In the opinion of management,the outcome of the legal proceedings andclaims is not expected to have a material ad-verse affect on the financial position of theentity.

The organization is required to disclose anymaterial obligations or other possible liabili-ties or litigations that are significant. Recallthat a financial transaction is not recordedunless there has been exchange. The organi-zation may have recently settled a mal-practice suit, but not had any accountingtransactions. If the settlement is material, dis-closure is required.

NOTE E: Goodwill

The goodwill recorded on the balance sheetarose as a result of the acquisition of anotherorganization for more than fair market valueof the identifiable assets of the organization.It has been determined that due to permanentchanges in market conditions, the goodwillhas lost 10% of its value during 2007.Therefore, goodwill has been reduced from$100,000 to $90,000 on the balance sheetand a $10,000 expense has been charged.

When one organization acquires anotherfor more than the value of the specific iden-tifiable resources, the excess is groupedunder the category of goodwill. It is very com-mon for goodwill to arise when acquisitionsoccur. If the ongoing organization being ac-

quired was not worth more than its specificassets, the purchaser might simply buy simi-lar assets rather than acquiring the organi-zation. Many intangibles arise over anorganization’s life, such as reputation forquality products and creditworthiness.Goodwill remains as an asset on the balancesheet indefinitely under current GAAP.Goodwill is only reduced when there is aclear impairment to its value. At such time,the entire impairment is treated as a one-time reduction in the value of goodwill. Thisdiffers from tax treatment that allows for-profit organizations to deduct the cost ofgoodwill as an expense over a 15-year pe-riod.

SUMMARY

This chapter does not present an all-inclu-sive listing of required notes to the financialstatements. Depending on the exact circum-stance of different organizations, a wide va-riety of disclosures are required by GAAPand by requirements of the Securities andExchange Commission. The most importantlearning issue in this chapter is not the in-formation contained in the notes discussed.Rather, it is that the reader should have anawareness of the importance of the informa-tion that is contained in the notes to the fi-nancial statements.

The notes to the financial statements mayat first seem both overwhelming and boring.They certainly do not make for light reading.You have to work through them slowly andcarefully to understand the information thateach note is trying to convey. Exactly whichchoices has the organization made, and whatare the implications of each choice? Is the or-ganization reliant on one key customer? If so,that fact would have to be disclosed some-where in the notes. Can the organization useall of its cash, or does it have a “compensating


balance” agreement with its bank that requiresit to maintain a minimum balance? If the lat-ter, the organization’s liquidity is somewhatoverstated in the balance sheet. Compensat-ing balance arrangements must be disclosed.Are there securities outstanding, such as con-vertible bonds that can be converted intocommon stock? If so, then the organization’snet income might have to be shared amongmore stockholders. Such potential dilution, ifsignificant, is discussed in the notes.

We could continue with examples of thetypes of information relevant to creditors, in-vestors, and internal management containedonly in the notes to the financials. Not allnotes are relevant to all readers. Some itemsare of more concern to employees than tostockholders. Some items help creditorsmore than internal managers. Whateveryour purpose in using a financial report, thekey is that the financial statements by them-selves are incapable of telling the full story.To avoid being misled by the numbers, it isnecessary to supplement the information inthe statements with the information in thenotes that accompany the statements.

KEY CONCEPTS

Significant accounting policies—WheneverGAAP allow an organization a choice in ac-counting methods, the organization mustdisclose the choice that it made. This allowsthe user of financial statements to better in-terpret the numbers, such as net income,contained in the financial statements.

Other notes—The organization must dis-close any information that a user of the fi-nancial statements might need to have a fairrepresentation of the organization’s finan-cial position and the results of its operationsin accordance with GAAP. This informationshould be included in either the financialstatements themselves or the notes that ac-company the financial statements.

TEST YOUR KNOWLEDGE


Chapter 12: Notes to the Financial Statements 101



So, we have generated the financial state-ments, had them audited, and have fully

read the notes that accompany the state-ments. With a full understanding of thefinancial statements and the types of trans-actions that generated them, we can beginto use the information to help assess the fi-nancial health of the organization.

One of the most widely used forms of fi-nancial analysis is the use of ratios. Ratios canprovide information that is useful for com-paring one health care organization to an-other (benchmarking). Ratios can provide theinformation that banks and lenders use todetermine if our organization can take onmore debt. They can also help internal man-agement of an organization gain an aware-ness of their company’s strengths andweaknesses. And, if we can find weaknesses,we can move to correct them before irrepara-ble damage is done.

What is a ratio? Basically, a ratio is a com-parison of any two numbers. In financialstatement analysis, we compare numberstaken from the financial statements. For in-stance, if we want to know how muchCommunity Hospital (CH) had in currentassets as compared to current liabilities atthe end of fiscal 2007, we could compare its

$188,000 in current assets (Table 13-1) to its$94,000 in current liabilities. Mathemati-cally, we could state this as $188,000 dividedby $94,000, which is equal to 2. This meansthat there are 2 dollars of current assets forevery 1 dollar of current liabilities. This is re-ferred to either as a ratio of 2 or a ratio of 2to 1. This particular ratio is called the cur-rent ratio. In this chapter, we discuss manywidely used ratios, but the discussion is notall inclusive.

Different sectors of the health care sys-tem may have different ratios that are com-monly used. It is important to rememberthat a ratio is merely the combination of twonumbers that together show a relationshipthat often provides more useful informationthan the two numbers separately. Youshould feel free to create your own ratiosthat help to show meaningful relationshipsfor your organization.

BENCHMARKS FOR COMPARISON

Is the CH current ratio of 2 good or bad? Isit high enough? Is it too high? We don’twant to have too little in the way of currentassets, or we may have a liquidity crisis(thatis, insufficient cash to pay our obligations as

103

CHAPTER 13

Ratio Analysis: How Do We Compareto Other Health Care Organizations?



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they become due. We don’t want to have toomuch in the way of current assets becausethis implies that we are passing up profitablelong-term investment opportunities. Butthere is no correct number for the currentratio. We can only assess the appropriate-ness of our ratios on the basis of somebenchmark or other basis for comparison.

There are three principal benchmarks.The first is the organization’s history. We al-ways want to review the ratios for the organ-ization this year, compared to what theywere in the several previous years. This en-ables us to discover favorable or unfavorabletrends that are developing gradually overtime, as well as pointing up any numbersthat have changed sharply in the space oftime of just 1 year.

The second type of benchmark is to com-pare the organization to specific competi-tors. If the competitors are publicly heldcompanies, we can obtain copies of their an-nual reports and compare each of our ratioswith each of theirs. This approach is espe-cially valuable for helping to pinpoint whyyour organization is doing particularly bet-ter or worse than a specific competitor. Byfinding where your ratios differ, you may de-termine what you are doing better or worsethan the competition.

The third type of benchmark is industry-wide comparison. Many consulting firmsand benchmarking specialists, such as Solu-cient, collect financial data, compute ratios,and publish the results. Not only are indus-try averages available, but the information isoften broken down both by size of the or-ganization and in a way that allows determi-nation of relatively how far away from thenorm you are.

For example, if your current ratio is 2,and the industry average is 2.4, is that a sub-stantial discrepancy? Published industrydata may show that 25% of the organizations

in the industry have a current ratio below1.5. In this case, we may not be overly con-cerned that our ratio of 2.0 is too low. Weare still well above the bottom quartile. Onthe other hand, what if only 25% of thehealth care organizations have a currentratio of less than 2.1? In this case, over threequarters of the organizations have a highercurrent ratio than we do. This might be acause for some concern. At the very least, wemight want to investigate why our ratio isparticularly low, compared to others. Table13-2 presents one page from the SourceBookby Solucient. This page provides informa-tion about hospital profit margins over a pe-riod of 5 years. In addition, it breaks theinformation down by size of hospital (num-ber of beds), urban/rural status, and othermajor classifications.

There are five principal types of ratiosthat we examine in this chapter. They are(1) common size ratios; (2) liquidity ratios;(3) efficiency ratios; (4) solvency ratios;and (5) profitability ratios.

COMMON SIZE RATIOS

Common size ratios are used as a startingpoint in financial statement analysis. Sup-pose that we wished to compare our organi-zation to another. We look to our cashbalance and see that it is $10,000, whereasthe other firm has cash of $5,000. Does thismean we have too much cash? Does theother organization have too little cash? Be-fore we can even begin to consider suchquestions, we need more general informa-tion about the two organizations. Are wetwice as big as the other organization? Arewe smaller than the other organization? Theamount of cash we need depends on the sizeof our operations compared to theirs. Com-paring our cash to their cash does not createa very useful ratio.

Chapter 13: Ratio Analysis 105



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However, we can “common size” cash bycomparing it to total assets. If our cash of$10,000 is one tenth of our total assets andtheir cash of $5,000 is one tenth of theirtotal assets, then relative to asset size, bothorganizations are keeping a like amount ofcash. This is much more informative. There-fore, the first step in ratio analysis is to cre-ate a set of common size ratios. Usuallycommon size ratios are converted to per-centages. Thus, rather than referring tocash as being one tenth of total assets, wewould refer to it as being 10% of total assets.

To find our common size ratios, we needa key number for comparison. On the bal-ance sheet, the key number is total assets ortotal equities (i.e., liabilities plus net assets).We calculate the ratio of each asset on thebalance sheet as compared to total assets.We calculate the ratio of each liability andnet asset account as compared to the total li-abilities and net assets. For the statement ofoperations, all numbers are compared tototal revenue. Once we have calculated thecommon size ratios, we can use them tocompare our organization to itself overtime, to specific competitors, and to indus-try-wide statistics.

The common size ratios for CH’s balancesheet and statement of operations are pre-sented in Tables 13-1 and 13-3.

The Balance Sheet: Assets

Looking at the balance sheet (see Table 13-1), we can begin to get a general feelingabout CH by comparing the common size ra-tios for 2 years. Note that there is typicallysome rounding errors in ratio analysis. Wecould eliminate them by being more precise.For example, in 2007 the ratio of cash to totalassets really is 2.6756%. We generally don’tbother with such precision. Ratios can’t givetheir users a precise picture of the organiza-

tion. They are meant to serve as general con-veyors of broad information. Our concern isif a number is particularly out of line—eitherunusually high or low. It is virtually impossi-ble to interpret minor changes.

For CH, current assets have remained rel-atively stable, falling from 31.7% to 31.4% oftotal assets. Note, however, that accounts re-ceivable have fallen while inventory hasrisen. Is this good or bad? If accounts receiv-able have fallen because we are seeing fewerpatients or because there are more baddebts, and inventory has risen because CHhas not adjusted their purchasing patternsto match the lower patient numbers, thenthis is bad. It implies that we are accumulat-ing inventory we can’t use and are failing togenerate revenues from providing patientcare. On the other hand, if accounts receiv-able are down because the organization hasbeen successful in its efforts to collect morepromptly and inventory is up because it isneeded to support growing patient num-bers, then this is a good sign.

Clearly, ratios can’t be interpreted in avacuum. The ratio merely points out whatneeds to be investigated. The ratio doesn’tprovide answers in and of itself. In the caseof CH, the statement of operations (Table13-3) shows us that revenue did indeed riseduring the fiscal year ending June 30, 2007.It would appear that the changes in ac-counts receivable and inventory represent afavorable trend.

It is interesting to note that not only isCH increasing its total revenue over time, it appears to be increasing its reliance onpremium revenue and other sources ofrevenue. Both of these categories are in-creasing in real dollar amounts as well astheir respective proportions of total rev-enue. Once again, there is no easy answer towhether or not this is good or bad. If thepremium revenue represents some form of




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managed care carve-out, CH may be in-creasing its risk with respect to growing ex-penses to care for patients covered underthe carve-out. There may, however, be a spe-cific and well-thought-out plan on the partof management to diversify its revenuesources, and these changes simply make itclear that CH is achieving its goals. As men-tioned, ratios are a guide, not an answer.Often they just help us to understand thequestions that we need to ask to learn aboutthe financial health of the organization.

Fixed assets (Table 13-1) for CH have in-creased, not only in absolute terms, but alsoas a percentage of total assets. After ac-counting for depreciation that has accumu-lated on buildings and equipment overtheir lifetime, we see a rise in net buildingsand equipment from 32.4% to 36.8% oftotal assets.

The Balance Sheet: Liabilities and Net Assets

The current liability common size ratioshave remained fairly constant over time (seeTable 13-1). Each has risen slightly, whichmight well have been anticipated given therise in revenue and inventory noted. As ouroperations grow and become more prof-itable, we might expect some growth in cur-rent liabilities to match the increases ininventory. In any case, the changes here ap-pear to be modest.

Long-term liabilities (see Table 13-1)have fallen as a percentage of total equities.This is primarily because the organizationhas not needed to raise funds from the debtmarket to finance its fixed asset growth. Theonly caveat is the growth in “Other” long-term debt from $70 to $78 million almostcompletely offsets the decline in the mort-gage payable. In all likelihood, the notes to

the financial statements help to explain thiscategory and its growth.

The common size ratio for total net assets(see Table 13-1) has risen from 19.4% for2006 to 22.7% for 2007. This is not surprisingconsidering the absolute growth in the excessof revenue over expenses (see Table 13-3). Itis also important to note the shift that hastaken place within net assets. The growth innet assets is limited to the unrestricted cate-gory. Unrestricted net assets have increasedfrom 6.8% in 2006 to 11.0% in 2007. Tem-porarily and permanently restricted net assetshave fallen as a percentage of the total owingto the fact that they have remained constantin dollar terms. Is this good or bad? Ask any fi-nance officer and they will indicate thatwhereas growth in unrestricted net assets isdesirable, the lack of growth in the other twocategories may be a problem. It is indicative ofa failure on the part of development activities(fundraising). There were no donations to in-crease endowment in 2007 (permanently re-stricted net assets), nor even any increases indonations earmarked for specific projects.

The Statement of Operations

For the statement of operations (Table 13-3),total revenue is the key figure around whichall common size ratios are calculated. Thisyear total expenses have fallen in relation torevenue. Assuming that quality has beenmaintained, this is a favorable trend. Bykeeping expenses down relative to revenue,surpluses should rise. If we look closer at the

Excel Template

Template 11 may be used to calculate commonsize ratios for your organization’s balancesheet. The template is on the Web atwww.jbpub.com.




changes within expenses for CH, we can seethat both salaries and supplies fell as a pro-portion of total revenues. It would appearthis is where CH has gained some efficiency.Although this looks good, internal manage-ment should, nevertheless, be very inter-ested in determining why this occurred. Ifthe causes were related to improved effi-ciency, we want to know that so we can re-ward the individuals responsible andmaintain a higher level of efficiency. On theother hand, if the apparent improvementwas due to increased turnover and staff va-cancies, the long-run impact may be to hurtour reputation and potentially reduce oursurpluses or profits in the longer term.

Therefore, even favorable trends such asreduced expenses should be viewed withcaution. Investigation is needed to deter-mine why that change occurred.

For CH, other operating expenses haveremained fairly stable, increasing in relativeproportion to the dollar increase in totalrevenue. The excess revenues over ex-penses, sometimes called the operating profit,have increased from 1.0% in 2006 to 5.4%in 2007. This increase is due to the fact thattotal revenues increased at a faster rate thantotal expenses.

There are two other changes worthy ofnote for CH. First, the increase in unre-stricted donations from 20.9% of total rev-enues in 2006 to 25.0% in 2007. This is arather large increase that in turn helps to in-crease the overall change in unrestricted netassets at the bottom of the statement. Sec-ond, the transfer to parent has actually fallenfrom 2006 to 2007. Although CH has trans-ferred more dollars in absolute terms ($40million compared to $35 million the year be-fore), this year’s transfer was only 17.9% oftotal revenue compared to a last year’s trans-fer that was 18.3% of total revenue.

Common Size Ratios: Additional Notes

The common size ratios give a startingpoint. You can quickly get a feel for any un-usual changes that have occurred, adjustedfor the overall size of assets and the relativeamount of revenue. Comparison with spe-cific and industry-wide competition wouldpoint out other similarities and differences.For example, our organization has 31.4% ofits assets in the current category (see Table13-1). Is that greater or less than the indus-try average? If it’s substantially greater orless, then you might want to investigate why.Are we in a peculiarly different situation rel-ative to other organizations in our industry?

As mentioned, the key to interpretationof ratios is benchmarks. Without a basis forcomparison, it is impossible to reasonablyinterpret the meaning of a ratio.

LIQUIDITY RATIOS

Liquidity ratios attempt to assess whether anorganization is maintaining an appropriatelevel of liquidity. Too little liquidity raisesthe possibility of default and bankruptcy.Too much liquidity implies that long-terminvestments with greater profitability havebeen missed. Financial officers have to walka tightrope to maintain enough, but not toomuch, liquidity.

The most common of the liquidity ratiosis the current ratio (Table 13-4), discussedpreviously. This ratio compares all of theorganization’s current assets to all of its cur-

Excel Template

Template 12 may be used to calculate commonsize ratios for your organization’s incomestatement. The template is on the Web atwww.jbpub.com.


rent liabilities. A common rule of thumb isthat the current ratio should be 2.

A second liquidity ratio exists that placeseven more emphasis on the organization’sshort-term viability—its ability to continueoperations. This ratio is called the quickratio. It compares current assets quickly con-vertible into cash to current liabilities (seeTable 13-4). The concept here is that al-though not all current assets become cash inthe very near term, most current liabilitieshave to be paid in the very near term. Forexample, prepaid rent is a current asset, butit is unlikely that we could cash in that pre-payment to use to pay our debts. Inventory,although salable, takes time to sell.

The quick ratio compares the organiza-tion’s cash plus marketable securities plusaccounts receivable to its current liabilities.Accounts receivable are considered to be“quick” assets because there are factoringfirms that specialize in lending money on re-ceivables or actually buying them outright,so they can be used to generate cash almostimmediately. For CH, the quick ratio fellfrom 1.2 in 2006 to .9 in 2007.

The third liquidity ratio is the days cash onhand. Although this ratio looks more compli-cated than the first two, conceptually it is rel-atively simple. The numerator of the ratio(cash + marketable securities) is a represen-tation of how much cash or cash equivalents

the organization has on hand. The denomi-nator can be best understood by breaking itdown into its elements. First, operating ex-penses less bad debts and depreciation is arepresentation of the cash operating costs forthe year. Bad debts and depreciation are non-cash expenses, so we subtract them out of theannual expenses to get closer to the cash op-erating costs. Now that we have the cash op-erating costs for the year we divide by 365 toget a daily operating cost. In other words, thedenominator is an estimate of the daily oper-ating cash costs for the organization. Whenthe cash on hand (numerator) is divided bydaily operating cash costs (denominator) wehave an estimate of the number of days theorganization could continue to operate with-out any additional cash inflows.

For CH, the days cash on hand increasedfrom 69 days in 2006 to 78 days in 2007. Onceagain, although increasing the number ofdays cash on hand may be a good thing, toohigh a value may be an indicator that CH isnot using its cash wisely and missing potentialreturns and investment opportunities.

All of the liquidity ratios have commonlybeen used as measures of the organization’srisk—how likely it is to get into financial dif-ficulty. However, you should be extremelycautious in using these ratios. Three ratiosalone do not tell the entire story of an or-ganization. They should be used like clues or


Table 13-4 Liquidity Ratios

Current Ratio = Current AssetsCurrent Liabilities

Quick Ratio = Cash + Marketable Securities + ReceivablesCurrent Liabilities

Days Cash on Hand = Cash + Marketable Securities(Operating Expenses – Bad Debts – Depreciation) / 365



pieces of evidence for the financial analystwho is really acting as a detective. Any oneclue can point in the wrong direction.

For example, suppose a hospital has largebalances in cash and marketable securities,and its current ratio is 4 or 5. Is this an ex-tremely safe organization? The current ratioby itself leads us to believe that the hospital isvery safe. However, what if the hospital is los-ing money at a rapid rate, and the only thingthat staved off bankruptcy was the sale of amajor physical asset or investment? The salegenerated enough cash to meet immediateneeds and left an excess, resulting in the highcurrent and quick ratios. How long will this ex-cess last? If the cash and securities are largerelative to current liabilities, but small relativeto operating costs or long-term liabilities, thenthe hospital may still be extremely risky. In thisscenario, the days cash on hand may providebetter information about the true relationshipbetween cash and the high operating costs.

On the other hand, a very profitable hos-pital may be in the process of substantiallyexpanding its physical facilities. Because ofcash payments related to the expansion,perhaps the current ratio falls to 1.5 and thequick ratio to .6 at year end. Those ratiosseem to imply financial weakness. However,within a month or two after the year end,the hospital may be expecting to receivecash from operating its profitable operatingactivities or perhaps it has already arrangedto borrow money for the expansion. Thishospital is probably stable. The point is thatall of the ratios, when taken together, cansupplement the financial statements andthe notes to the financial statements. Theycan point out areas for specific additionalinvestigation. However, no one or two ratiosby themselves can, in any way, replace the in-formation in the financial statements, thenotes to the financial statements, and otherinformation possessed by management.

EFFICIENCY RATIOS

Whether health care organizations want tomaximize their profit/surplus or the quantityand quality of services provided, the organiza-tion must operate efficiently. A number of ra-tios exist that can help an organization toassess how efficiently it is operating and allowfor comparison between organizations andover time. These ratios are sometimes referredto as activity ratios. The principal efficiency or ac-tivity ratios measure the efficient handling ofreceivables, payables, and total assets.

Receivables Ratios

One problem faced by most health care or-ganizations is the timely collection of receiv-ables. Once receivables are collected, themoney received can be used to pay off loansor it can be invested. This means that oncemoney is received, either we would be pay-ing less interest or we would be earningmore interest. Therefore, we want to collectour receivables promptly.

We often think of receivables in terms ofhow long it takes from billing to collection.A useful aid in analysis is to convert our re-ceivables and our patient revenue into ameasure that represents the number of daysin accounts receivable (Table 13-5). Days inaccounts receivable is an easy ratio to calculateand understand once you break it down toits component parts. The numerator—netaccounts receivable—is used as a proxy forthe amount of money that our patients andtheir insurers owe us at any point in time,

Excel Template

Template 13 may be used to calculate liquidityratios for your organization. The template is onthe Web at www.jbpub.com.


which we ultimately expect to collect. It isimportant to note that because this figurecomes from the balance sheet it technicallyis the value of accounts receivable on a spe-cific day. We are therefore assuming that thelast day of the fiscal year is a good represen-tation of accounts receivable on any givenday. If this is not a valid assumption, we canalso calculate the average accounts receiv-able balance by taking the beginning of theyear value plus the ending receivables valueand dividing by two. This yields the “aver-age” accounts receivable. Alternatively, wecan find the average value of receivables atthe end of each of the 12 months of the year.

The denominator in the days in accountsreceivable ratio is simply the annual patientrevenue divided by 365 to yield the averagepatient revenue per day. Average receivablesdivided by the average revenue per day yieldsthe number of days the average bill stays a re-ceivable. For CH, the days in accounts receiv-ables is 72 (44,000,000/[224,000,000/365]).

In other words, it is taking CH 72 days toconvert a bill into a cash collection. At firstthought, you would think that we wouldwant to have this ratio be as low as possible.However, much like the current ratio, wewant the days in accounts receivables ratioto be neither too high nor too low. We are

really striving for a middle ground, ratherthan far to one extreme as possible. This isbecause of the fact that if we try to keep thedays in accounts receivables extremely low,our credit manager may attempt to denycredit to anyone that typically pays slowly.This is not necessarily in the best interest ofthe organization. The services (that thecredit manager is denying) may createenough revenue that we benefit even if thecustomer or insurer is slow to pay.

We therefore want to not only calculatethe days in accounts receivables, but we alsoneed to investigate that ratio to see if a shortaverage days in accounts receivables indi-cates too restrictive a credit policy or if along days in accounts receivables indicatestoo loose a credit policy or a lack of suffi-cient efforts to collect in a timely manner.

One final caution with respect to days inaccounts receivable: many health care or-ganizations are dominated by one or twopayers such as Medicare or Medicaid. Long-term care facilities, for example, may haveas much as 90% of their revenue comingfrom a state Medicaid program. Programslike Medicaid have been known to skip pay-ments to providers if the annual budget fortheir state is not passed on a timely basis.The providers typically have no recourse


Table 13-5 Efficiency Ratios

Days in Accounts Receivable = Net Accounts Receivable(Net Patient Revenue) / 365

Days in Accounts Payable = Accounts Payable(Operating Expenses – Depreciation) / 365

Average Payment Period = Current Liabilities(Operating Expenses – Depreciation) / 365

Total Asset Turnover = Total RevenueTotal Assets



and the state ultimately catches up. But, atthe time of the skipped payment, the daysin accounts receivable rises dramatically(the organization is carrying twice the nor-mal receivables). Once again, this points tothe fact that all ratios need to be taken witha grain of salt and the analyst must look atthe context within which the specific nu-merical value exists. It also shows the im-portance of ratios such as days cash onhand. Can the organization sustain a periodwithout cash collections?

Payables Ratios

The same type of ratio calculated for receiv-ables can be calculated with respect topayables (Table 13-5). The days in accountspayable ratio gives us a measure of how manydays it takes our organization to pay its bills.Like the receivables ratio, a middle positionis desired. Pay your bills too quickly and youforgo the opportunity to earn more intereston your cash. Take too long to pay your billsand you run the risk of payment penalties(additional costs) or being denied credit byyour suppliers in the future.

The calculation of days in accounts payabletakes the same form as the receivables ratio.The numerator is the accounts payable bal-ance from the balance sheet. The denomina-tor is an estimate of the daily operating costs.This estimate is obtained by taking the annualoperating expenses, less depreciation, and di-viding by 365. When combined, the numera-tor and denominator yield the number ofdays it takes our organization to pay its bills.

For CH, the days in accounts payable was110 days in 2007 up from 105 days in 2006.These values are above what most healthcare organizations run, and the fact that it isincreasing is not a good sign.

An additional measure of an organiza-tion’s payment pattern is the average payment

period ratio. This ratio is similar to the days inaccounts receivables described above, butincludes all current liabilities in the numer-ator. By including all current liabilities, thisratio is a broader measure of an organiza-tion’s payment record. Average payment pe-riod incorporates the fact that there areshort-term creditors not included in ac-counts payable. In the case of CH, their av-erage payment period was 179 days! Onedoesn’t need an advanced degree in financeto know that this is higher than what mostorganizations want.

CH would have to take a very close lookat why it appears to be taking so long to payits bills. They may be making their cash po-sition look favorable by holding on to cashtoo long and not paying bills. This could ul-timately threaten their ability to get sup-plies in a timely manner. On the otherhand, this ratio may be artificially inflatedby inclusion of items such as deferred rev-enues. Deferred revenues represent amountsthat customers (such as health mainte-nance organizations) have prepaid for care.Until we provide patient care, we show theamount as a liability. Once we provide care,we eliminate the liability from our balancesheet and record revenue. Because wenever really intend to repay these advances(we intend to provide care), it is not as crit-ical if these amounts remain on the balancesheet for a number of days.

Total Asset Turnover

A final efficiency ratio is the total asset turnoverratio. This ratio compares total operating rev-enue to total assets. The more revenues anorganization can generate per dollar of as-sets, the more efficient it is, other thingsbeing equal. If we divide 2007 revenue of$224 million (from Table 13-3) by total assetsof $598 million (from Table 13-1), the ratio


of 0.37 indicates that CH generates $0.37 ofrevenue for every $1 in assets. Relative tomost health care organizations that generateapproximately $1 of revenue for every $1 in-vested in assets, this is very low. This is an-other piece of the financial puzzle that CHwould need to investigate to determine thecause and to see if there are ways to use theirassets more efficiently and thereby generateadditional revenue.

SOLVENCY RATIOS

One of the primary focuses on the organiza-tion’s riskiness occurs through examinationof its solvency ratios. Unlike the liquidity ra-tios that are concerned with the organiza-tion’s ability to meet its obligations in thevery near future, solvency ratios take more ofa long-term view. They attempt to determineif the organization has overextended itselfthrough the use of financial leverage. Thatis, does the organization have principal andinterest payment obligations exceeding itsability to pay, not only now, but into the fu-ture as well? These ratios are sometimes re-ferred to as leverage or capital structure ratios.

Excel Template

Template 14 may be used to calculateefficiency ratios for your organization. Thetemplate is on the Web at www.jbpub.com.

Three of the most common of the solvencyratios are the interest coverage ratio (also re-ferred to as the times interest earned ratio),the debt service coverage ratio, and the debt to netassets ratio or debt to equity ratio in for-profitorganizations (Table 13-6). The interest anddebt service coverage ratios focus on the abil-ity to meet interest and principal paymentsarising from liabilities. The debt to net assetsratio focuses on the protective cushion thatnet assets (or owner’s equity) provides forcreditors. If a bankruptcy does occur, credi-tors can share in the organization’s assets be-fore the owners can claim any of their equity.The more equity (or net assets) that the or-ganization has, the greater likelihood that theorganization’s assets will be great enough toprotect the claims of all the creditors.

The interest coverage ratio comparesfunds available to pay interest to the totalamount of interest that has to be paid. Thefunds available for interest are the organiza-tion’s profits (excess of revenues over ex-penses) before paying interest (in for-profitorganizations, you would also want to addback in taxes that were paid). As long as theprofit before interest is greater than theamount of interest, the organization willhave enough money to pay the interestowed. Therefore, excess of revenue over ex-penses plus interest is divided by interest ex-pense to calculate this ratio. The higher thisratio is, the more comfortable creditors feel.


Table 13-6 Solvency Ratios

Interest Coverage = Excess of Revenues Over Expenses + Interest ExpenseInterest Expense

Debt Service Coverage = Excess of Revenues Over Expenses + Interest Expense + Depreciation ExpenseInterest + Principal Payments

Long-Term = Long-Term DebtDebt to Net Assets Net Assets



For CH in 2007, the excess of revenues overexpenses was $12 million with $2 million ininterest expense (Table 13-3). The interestcoverage ratio therefore is 7.0, or (12 +2)/2. This is a significant improvementfrom 2006, when the excess of revenues overexpenses was $2 million and the interest was$3 million. In that year, the interest cover-age was 1.7.

However, we should be careful in our useof the term improvement. From a creditor’spoint of view, this is an improvement be-cause profits are up relative to interest, cre-ating a greater cushion of safety. From theorganization’s point of view, whether this isan improvement or not depends on its atti-tude toward risk and profits. For example, ifthe organization doesn’t mind risk, it couldhave provided more charity care, increasingexpenses and lowering profits. The interestcoverage ratio would be lower, but morefree care would have been provided.

The debt service coverage ratio builds onthe interest coverage ratio and provides abroader and more comprehensive look atthe organization’s ability to pay its long-termdebt. In the case of the debt service cover-age ratio, the numerator is the same as inthe interest coverage ratio but we add thedepreciation expense so that we get an ap-proximation for the available cash flow. Thedenominator is then both the interest andthe principal payments.

In the case of CH we get a debt service cov-erage ratio of 2.8 for 2007. To calculate thisratio, we need to pull information from boththe statement of operations and the state-ment of cash flows. The excess of revenuesover expenses of $12 million along with theinterest expense of $2 million and the depre-ciation expense of $20 million comes fromthe statement of operations (Table 13-3). Theprincipal payment of $10 million comes fromthe statement of cash flows (Table 11-5).

The final solvency ratio is the long-termdebt to net assets ratio. This ratio measures theproportion of debt to net assets and gives agood sense of the overall debt burden theorganization has. In the case of CH, thelong-term debt to net assets ratio is 2.7. Thismeans that there is $2.70 of long-term debtfor every $1 in net assets. CH would certainlybe considered highly leveraged. On the pos-itive side, the debt to net assets ratio has im-proved for CH from 3.4 in 2006.

PROFITABILITY RATIOS

When all is said and done, the key focus ofaccounting and finance tends to be on prof-its. Profitability ratios attempt to show howwell the organization did, given the level ofrisk and types of risk it actually assumed dur-ing the year.

If we compare net income to that of thecompetition, it is an inadequate measure.Suppose that the chief competitor of CHhad earnings of $57 million this year, andCH made only $19 million. Did the com-petitor have a better year? Not necessarily. Itearned three times as much money, but per-haps it required four times as much in re-sources to do it. Therefore, a number ofprofitability ratios exist to help in evaluatingthe organization’s performance.

Margin Ratios

Margin ratios are one common class of prof-itability ratios. Health care organizationscommonly compute their total margin and

Excel Template

Template 15 may be used to calculate solvencyratios for your organizations. The template isincluded on the Web at www.jbpub.com.


their operating margin as a percentage ofrevenues. These ratios (Table 13-7) arenothing more than common size ratios wecalculated previously. For CH in 2007, thetotal margin was 10% (total increase in netassets $28 million divided by total revenue of$280 million, which is the combination ofoperating revenue and nonoperating rev-enue). The operating margin for CH in2007 was 5.4% ($12 million divided by $224million). These margins are often watchedclosely, as changes can be early warning sig-nals of serious problems.

RETURN ON INVESTMENT (ROI)RATIOS

Another broad category of profitabilitymeasures falls under the heading of returnon investment (ROI). There are many defi-nitions for ROI, although individual organi-zations usually select one definition and usethat as a measure of both individual and or-ganization performance. Because we cannotknow the specific definition an organizationhas chosen, we discuss a variety of ROI meas-ures in this section. Even if none of the onesdiscussed here is exactly the same as thatchosen by your organization, you shouldgain enough from the discussion to under-

stand the strengths and weaknesses of what-ever ROI measure(s) your organization uses.

Return on assets (ROA) is an ROI meas-ure that evaluates the organization’s returnor net income relative to the asset base usedto generate the income. If we could invest$100 in each of two different investments,and one generated twice as much income asthe other, we would prefer the investmentgenerating twice as much income (assumingthe levels of risk had been the same).

Therefore, the organization that gener-ates more income, relative to the amount ofinvestment, is doing a better job, otherthings equal. If we divide the profit earnedby the amount of assets employed to gener-ate that profit, we get the ROA. A high ROAis better than a small one. The ROA meas-ure is particularly good for evaluating divi-sion managers. It focuses on how well theyused the assets entrusted to them.

Return on net assets (RONA) is anothermeasure of profitability that allows the ana-lyst to focus on how well the organization didin earning a RONA (see Table 13-7). In thecase of CH, the 2007 ROA was 2% ($12 mil-lion excess of revenue over expenses dividedby $598 million in assets) and the RONA was9% ($12 million excess of revenue over ex-penses divided by $136 million in net assets).


Table 13-7 Profitability Ratios

Total Margin = Total Net Income or Total Increase in Net AssetsTotal Revenue

Operating Margin = Excess of Revenue Over ExpensesOperating Revenue

Return on Assets = Excess of Revenues Over ExpensesTotal Assets

Return on Net Assets = Excess of Revenues Over ExpensesNet Assets



Although ROA is good for evaluatingmanagers but inadequate for evaluating theoverall organization, RONA is good for eval-uating overall organization performancebut not for manager evaluation. Except forvery top officers of the organization, man-agers do not control whether the organiza-tion borrows money to maintain or expandoperations. Most managers are simply tryingto use the funds that the finance officershave provided them most efficiently. If twomanagers operated their organizations ex-actly the same, except that one was financedsubstantially with debt and the other was fi-nanced almost exclusively with donations,the organizations would have substantiallydifferent RONAs for two reasons. First, thenet assets are different for the two organiza-tions; because one organization had moredonations than the other, the denominatorof the ratio will be different. Second, the in-terest expense differs because one organiza-tion borrowed less than the other, so theexcess of revenues over expenses are not thesame. Therefore, the numerator of the ratiois different. How can we evaluate what partof the organization’s results was caused byreasons other than the leverage decision,and what part was caused by the specific de-cision regarding financial leverage?

So, the manager who makes a decision toborrow rather than to go the more difficultroute of raising donations may be held ac-countable on a RONA basis. But if theBoard makes the decision to not bother witha fundraising campaign and instructs themanager to borrow money, then the man-ager should not be held accountable for theimpact of that decision.

RONA is a useful measure of the incomethat the organization was able to generate rel-ative to the amount of net assets and contri-butions in the organization. RONA includesthe effect caused by the organization’s degree

of leverage (i.e., how much it borrowed). Toremove the impact of leverage from our eval-uation, we should use ROA. This eliminatesthe problem with respect to the denominatorof the RONA ratio. The asset base or denomi-nator of the ROA ratio is the same whetherthe source of the money used to acquire theassets is debt or equity. However, ROA leaves aproblem with the numerator. The return, ornumerator (the net income), is affected bythe amount of interest the organization pays.For this reason, the measure of ROA oftenused for evaluation abstracting from the lever-age decision is calculated using somethingcalled delevered net income.

Delevered net income means recalculat-ing the organization’s income by assumingthat it had no interest expense at all. Indoing this, we can put organizations withdifferent decisions regarding the use of bor-rowed money all on a comparable basis. Wecan see how profitable each organizationwas relative to the assets it used regardless oftheir source. We have completely separatedany profitability (or loss) created by havingused borrowed money instead of con-tributed capital. The way we delever net in-come is to take the organization’s operatingmargin (income before interest and taxes)and calculate taxes directly on that amount,ignoring interest. The result is a net incomebased on the assumption that there was nointerest expense.

This should not lead the reader to believethat all organizations calculate ROA in ex-actly the same way. Some organizations useassets net of depreciation as the basis forcomparison. This is how the assets appear onthe balance sheet. Some organizations ig-nore depreciation and use gross assets as abase. The reason for this is to avoid causingan organization or division to appear to havea very high return on assets simply becauseits assets are very old and fully depreciated.


Such fully depreciated assets cause the baseof the ratio to be very low and, therefore, theresulting ratio to be very large. Along thesame lines, some organizations use replace-ment cost instead of historical cost to placedivisions in an equal position.

Despite any of these adjustments, use ofany of the ROA measures for evaluation ofmanagers creates undesired incentives. Sup-pose the organization is happy to accept anyproject with an after-tax rate of return of20%. One division of the organization cur-rently has an ROA of 30%, and a proposedproject that would have a 25% ROA is beingevaluated. The manager of the divisionwants to reject the project entirely if he orshe is evaluated based on ROA. The 25%project, even though profitable, and perhapsbetter than anything else the organizationcould do with their money, will bring downthat division’s weighted average ROA, whichis currently 30%. Even though the project isgood for the organization, it would hurt themanager’s performance evaluation.

For this reason we recommend an ROIconcept called residual income (RI). Underthis approach, the organization specifies aminimum required ROA rate, using one ofthe various approaches discussed. For eachproject being evaluated, we multiply theamount of asset investment required for theproject by the required ROA rate. The resultis subtracted from the profits anticipatedfrom the project. If the project is expectedto earn more than the proposed investmentmultiplied by the required rate, then therewill be a residual left over after the subtrac-tion. A division manager would be evaluatedon the residual left over from all his or herprojects combined.

For example, suppose that 20% was con-sidered to be an acceptable rate to the or-ganization. Currently all projects for thedivision earn 30%. Suppose further that a

project requiring an investment of $100,000of assets was proposed. If this new projectwould earn a profit of $25,000, or 25% ROA,it would be rejected by a manager evaluatedon an ROA basis. From an ROA basis, the25% would lower the currently achieved30% average. For RI, we would multiply the$100,000 investment by the 20% ROA re-quired rate, getting a result of $20,000.When the $20,000 is subtracted from theprofit of $25,000, there is a $5,000 RI. Themanager is considered to have increased hisor her RI by $5,000.

The advantage of this method is that ifthe organization would like to undertakeany project earning a return of more than20%, division managers will have an incen-tive to accept all such projects. This is be-cause all projects earning more than 20%will cover the minimum desired 20% ROAand have some excess left over. This excessadds to the manager’s total RI. Thus, RI mo-tivates the manager to do what is also in thebest interests of the organization.

The reader can readily see that ROI is nota simple topic. The finance officers of mostorganizations spend a fair amount of timeconsidering the implications of variousforms of ROI for both motivation and evalu-ation. Unfortunately, many organizationsuse just one ROI measure for the organiza-tion and its managers. In attempting to makethe measure serve multiple roles, the ROImeasures used often are so complex thatthey are difficult to understand. The net re-sult often is that ROI measures do not moti-vate the way they are intended to and do notprovide fair measures of performance.

Excel Template

Template 16 may be used to calculate profitabilityratios for your organization.The template isincluded on the Web at www.jbpub.com.




KEY CONCEPTS

Ratio—Any number compared to anothernumber. Ratios are calculated by dividingone number into another.

Benchmarks—An organization’s ratios canbe compared to ratios for the same organi-zation from prior years and to ratios of a spe-cific competitor and to ratios for the entireindustry.

Common size ratios—All numbers on thebalance sheet are compared to total assets ortotal liabilities plus net assets, and all num-bers on the income statement are comparedto total revenue. This makes interorganiza-tion or interperiod comparison of specificnumbers such as cash more meaningful.

Liquidity ratios—Assess the organization’sability to meet its current obligations as theybecome due.

Efficiency ratios—Assess the efficiency withwhich the organization manages its re-sources, such as inventory and receivables.

Solvency ratios—Assess the organization’sability to meet its interest payments andlong-term obligations as they become due.

Profitability ratios—Assess how profitablethe organization was and how well it was man-aged by comparing profits to the amount ofresources invested in the organization andused to generate the profits earned.

TEST YOUR KNOWLEDGE



WORKING CAPITAL MANAGEMENT

An organization’s net working capital, orworking capital, is its current assets less itscurrent liabilities. This chapter focuses onworking capital management: techniques andapproaches designed to maximize the bene-fit of short-term resources and minimize thecost of short-term obligations.

Working capital is based on a cycle of out-flows and inflows. For example, KeepuwellClinic might use cash to buy supplies. Thesupplies are used to treat patients. The em-ployees providing the health care must alsobe paid. When the patient is treated and aservice is delivered, the clinic can bill the pa-tient or insurer and thereby create a receiv-able. Once those receivables are collected,the cycle starts over and that money can beused to buy more supplies and pay workersto treat more patients.

The cycle may be delicately balanced. Atthe beginning of the cycle, Keepuwell Clinicmay have just enough to pay for suppliesand wages if it received payments promptlyfrom its patients. If Keepuwell issues billsonce a month instead of weekly or daily, itmay be more convenient for the book-keeper, but it postpones the collection of

cash. That cash is needed as soon as possibleso that Keepuwell can cover its expenses.

In performing working capital manage-ment, it is the role of the manager to ensurethat there is adequate cash on hand to meetthe organization’s needs and also to mini-mize the cost of that cash. To do this, themanager must carefully monitor and con-trol cash inflows and outflows. Cash not im-mediately needed should be invested,earning a return for the organization. Anorganization should not keep excess inven-tory. The money spent to pay for inventorythat is not yet needed could be better usedby the organization for some other purpose.At a minimum, the money could be earninginterest. Similarly, if the organization pays itsbills before they are due, it also loses interestit could have earned if it had left the cash inits savings account for a little longer.

SHORT-TERM RESOURCES

The most essential element of working capitalis cash. When accountants refer to cash theymean both currency on hand as well asamounts that can be withdrawn from bank ac-counts. A second type of short-term resource

121

CHAPTER 14

Working Capital Management and Banking Relationships



is marketable securities. These are investments,such as stock and debt, that can be boughtand sold in financial markets, such as theNew York Stock Exchange. In most organiza-tions, accounts receivables and inventory arealso important parts of working capital.These short-term resources are discussed inthis section.

Cash

There are three principal reasons that organ-izations want to keep some cash on hand orin their bank accounts. First, cash is neededfor the normal daily transactions of any activ-ity. For example, cash is needed to pay em-ployees and suppliers. Second, althoughmany activities can be anticipated, managerscan never foresee everything that might hap-pen. Experience has shown that it makessense for organizations to have a safety cush-ion available for emergencies. A third reasonfor holding cash is to have it available if an at-tractive investment opportunity arises.

Given these three reasons to hold cash,one might think that the more cash we have,the better. That is not the case. Cash earns avery low rate of return (e.g., bank savings ac-count interest) at best. If we use our cash tobuy buildings and equipment we can proba-bly earn higher profits. But then we wouldn’thave cash for transactions and emergencies.At the other extreme, we can keep all our re-sources in cash, but then we wouldn’t earnmuch of a profit. In practice, managers mustfind a middle ground, trying to keep enoughcash available, but not too much.

Short-Term Cash Investments andMarketable Securities

Cash should be earning a return wheneverpossible. Organizations should have specificpolicies that result in cash and checks re-ceived being deposited promptly into inter-

est-bearing accounts. In fact, even after acheck is written to make a payment, it is pos-sible to continue to earn interest on themoney. The period from when you write acheck until it clears your bank account iscalled the float. Many banks have arrange-ments that allow money to be automaticallytransferred from an interest-bearing ac-count to a checking account as checks arereceived for payment.

Although interest-bearing accounts arebetter than noninterest-bearing accounts,they pay relatively low rates of interest.There are a variety of alternative short-terminvestments that have the potential to earn ahigher rate of return. In a world of no freelunches, however, there is generally a tradeoff when one obtains a higher rate of return.The two most common trade offs are de-creased liquidity and increased risk. De-creased liquidity means that the money isnot immediately accessible. For example,certificates of deposit (CDs) pay higher interestrates than savings accounts, but there isoften a penalty for early withdrawal.

Although CDs may tie up money for a pe-riod of time, they are generally quite safe.Other investments hold promise of evenhigher rates of return, but entail greaterrisks. Marketable securities can be sold al-most immediately and cash from the salecan be received within a few days. However,such investments are subject to market fluc-tuations. The prices of stocks and bondsmay go up and down significantly, even on adaily basis.

Other Short-Term Investment Options

Other options exist for short-term invest-ments of cash. A Treasury bill (often called aT-bill) is a debt security issued by the U.S.government. Maturities range from 4 weeksto 1 year. If the bill is held until it matures,


the federal government guarantees to paythe maturity value. T-bills can be purchaseddirectly from the federal government with-out a fee through the Treasury Direct systemonline at www.publicdebt.treas.gov. It is pos-sible to sell a T-bill prior to its maturity date.Most stock brokerage firms will buy or sell T-bills for a fee of about $50.

Another alternative is money marketfunds. These investments tend to pay a ratebelow that of CDs, but competitive with T-bills and higher than the rate paid on a banksavings account. Interest is earned daily andmoney can be deposited or withdrawn at anytime. Although the investment has no guar-antee, money market funds are generallyconsidered to be reasonably safe invest-ments and they are very convenient to use.

The next type of money market instru-ment is a negotiable certificate of deposit issued bya U.S. bank. A negotiable CD can be sold tosomeone else, just as a bond can be sold.Sales commissions are incurred and the valueof the CD at the time of sale depends on whathas happened to market interest rates andthe creditworthiness of the lender during thetime since the investment was made.

Another type of money market instru-ment is commercial paper. Commercial papergenerally represents a note payable issuedby a corporation. Typical maturities are lessthan 1 year, and the interest rate is higherthan a T-bill. The buyer of the paper is lend-ing money to a corporation. There is a risk,albeit small, that the corporation will notrepay the loan.

Repurchase agreements, or repos, are types ofshort-term investments that are collateral-ized by securities. Repos may be for as shorta period of time as overnight. The organiza-tion with idle cash provides it to the bor-rower at an agreed-upon interest rate, whichmay fluctuate daily. Although repos arequite liquid, they do have a variety of risks.

For example, if the borrower defaults, thecollateral may turn out to be insufficient tocover the full investment.

Commercial paper, negotiable CDs, andrepos would generally be suitable only fororganizations that have substantial amountsof cash (perhaps over a million dollars)available for short-term investment. Theseinvestments can be quite complicated andshould be used only by organizations thatemploy competent advisors knowledgeablein their intricacies and potential risks.

Accounts Receivable

One should always attempt to collect ac-counts receivable as quickly as possible. Thesooner we collect all of our receivables, thesooner the organization has the cash for itsuse, at least for investment in an interest-bearing bank account. Also, the longer weallow an account receivable to be outstand-ing, the lower the chances that it will ever becollected.

As discussed in Chapter 2, the health carereimbursement system is very complex. Inmost cases, the patient does not simply comein, receive services, and pay the bill. Thecombination of direct patient payments andthird-party insurance payments requires sig-nificant management attention. Next, wediscuss specific accounts receivables man-agement practices, followed by a broader dis-cussion of how health care managers mustmanage the entire revenue cycle. Thisbroader revenue cycle management encom-passes the entire process from initial patientscheduling to collection of receivables. Ac-counts receivable are collected as a result ofa cycle of activities as depicted in Figure 14-1.

As you can see, there are a number of po-tential bottlenecks that delay the full con-version of a bill to cash. The faster and moreaccurately we compile the information

Chapter 14: Working Capital Management and Banking Relationships 123



needed to issue an invoice, and the soonerwe actually issue the invoice, the faster pay-ment can be expected to be received.

Management of accounts receivable doesnot stop when we issue an invoice. We needto establish credit policies that reduce theamount of money lost because patients failto pay the amounts they owe us. We alsoneed to monitor unpaid receivables to mini-mize such losses. An aging schedule, show-ing how long our receivables have beenoutstanding, is a very helpful device. Whenreceivables are collected, there should bespecific procedures to safeguard the cashuntil its ultimate deposit in the bank.

Credit Policies

Credit policies relate to deciding which cus-tomers or patients are allowed to make pur-chases on account. Organizations requiresome (or all) customers to pay cash at thetime of purchase if there is a high risk thatpayment would not be received later. How-ever, by excluding individuals or organiza-tions from buying goods or services onaccount, we may lose their business. You wantto give credit terms that are as good as thecompetition, but don’t want to give credit tocustomers or patients who wind up never pay-ing their bills. This requires a skillful creditmanager to weigh the risks versus the bene-fits of extending credit to specific customers.

Of course, it should also be noted thatemergency patients must always be provided

with care prior to collecting payment. In factcare must be provided before you even re-quest insurance information. Hospitals withemergency rooms are not allowed to pickand choose their patients. Until it is med-ically determined that a situation is not anemergency, care must be provided withoutconsideration of whether payment will becollected. On the other hand, once emer-gency care is provided and the patient is inthe system, the health care provider must besure to go back and collect the informationneeded for accurate and timely billing.

The Billing Process

The activities concentrated around issuingbills are critical. They must be done quickly,but also correctly. Although this basic pointis true for all health care organizations, it isespecially true for hospitals. The complexityof the reimbursement system makes both ac-curacy and timeliness more difficult. In re-cent years, however, there have beenenormous strides made in the automationof data collection (the electronic medicalrecord) and the subsequent patient classifi-cation and billing systems deployed by hos-pitals. Inaccurate data for a hospital stay canoften result in a claims denial and ultimatelya complete failure to collect any paymentfor service. Some health care organizationsnow have systems in place that enable thegeneration of a bill almost immediatelyupon discharge. For any one bill, it might

Invoice/BillIssued

Invoice/BillReceived by

Insurer

Invoice/BillReceived by

Patient

Invoice/BillPaid byInsurer

Invoice/BillPaid byPatient

PaymentReceived

Payment IsDeposited

PaymentClears Bank

Figure 14-1 The Receivables Cycle


not seem to matter if there are a few delays.However, when all bills are considered, theimpact of prompt billing is significant.

Electronic Billing and Collections

One method to speed collection is elec-tronic billing. In addition to allowing fastercollection, electronic billing may prove tobe less expensive to process than paperbilling because it uses less labor. Electronicbilling also allows for quicker communica-tion of problems.

The vast majority of health care providersprocess their billing and collections withthird-party payers electronically. Althoughthere are many different insurers, there hasbeen a great deal of standardization ofclaims forms, easing some of the burden onproviders. Yet it remains a complex andsometimes slow process.

Direct electronic collections from patientscan also be used to help reduce the time be-

tween billing and cash collections. Elec-tronic collections from patients can takemany forms such as credit or debit cards atthe time of service, credit or debit cards viathe phone after billing, or online paymentsafter billing. Clearly, if your organization candraw money directly from patients’ bank ac-counts, it can increase the speed of collec-tions and reduce the amount of bad debts.

Aging of Receivables

Once bills have been issued, it is importantfor the organization to monitor receivablesand to follow up on unpaid bills. A usefultool for this process is an accounts receiv-able aging schedule. An aging schedule showshow long it has been between the currentdate and the date when uncollected billswere issued. For example, at the end of July,a summary aging schedule for the Keep-uwell Clinic might appear as the example inTable 14-1.


Table 14-1 Keepuwell ClinicReceivables Aging Schedule


1–30 31–60 61–90 >90PAYER Days Days Days Days Total

By Total Dollars

Various Insurance Companies $175,463 $25,674 $14,562 $2,567 $218,266

Keepuwell County School District 115,935 11,327 1,674 273 129,209

Prevention First Insurance Company 31,732 10,378 4,389 1,936 48,435

Individual Patients 22,419 15,478 7,321 3,197 48,415

Total $345,549 $62,857 $27,946 $7,973 $444,325

By Percentage

Various Insurance Companies 80.4% 11.8% 6.7% 1.2% 100.0%

Keepuwell County School District 89.7% 8.8% 1.3% 0.2% 100.0%

Prevention First Insurance Company 65.5% 21.4% 9.1% 4.0% 100.0%

Individual Patients 46.3% 32.0% 15.1% 6.6% 100.0%

Total 77.8% 14.1% 6.3% 1.8% 100.0%



In Table 14-1, we notice that the largestshare of Keepuwell’s receivables is from var-ious insurance companies. Keepuwell alsohas a couple of large receivables outstand-ing with the Keepuwell County School Dis-trict and a specific insurance company(Prevention First). Finally, Keepuwellgroups all of the individual patients withoutstanding receivables together for this re-port. We can see from the bottom half of theaging schedule that 78% of Keepuwell’s re-ceivables have been outstanding for lessthan 1 month. Less than 2% of its receiv-ables are outstanding for more than 90 days.In the period shortly after bills are issued, ingeneral individual patients are the slowest topay, with only 46% collected in the firstmonth. Prevention First Insurance Com-pany also appears to be a slow payer, withonly 66% collected in the first month, 9%collected in the 61- to 90-day period, and 4%still outstanding after 90 days.

The aging schedule is a valuable tool be-cause problem areas can be quickly identi-fied. Efforts to collect payment should beginas soon as the invoice is issued. If anythinggoes beyond the current column (i.e., 1 to30 days), there should be a formal proce-dure, such as the issuance of a reminderstatement. If an account exceeds 60 days,there should be procedures such as mailinganother statement, often colored pink to getgreater attention. The “over-90-day”categoryin an aging schedule is a particular concern,even though it may be a small part of thetotal. Amounts in that category probably re-flect problems encountered in processing

Excel Template

You may use Template 17 to prepare an agingschedule for your organization. The template ison the Web at www.jbpub.com.

the bills or else an inability or unwillingnessto pay. All organizations should have specificfollow-up procedures for accounts that fallinto this category. These procedures shouldinclude not only monthly statements, butalso late charges and telephone calls to de-termine why payment has not been made.The longer an invoice goes unpaid, the lesslikely it will ever be paid.

In some cases, it is necessary to use a col-lection agency if other efforts have failed.This is a costly approach, since collectionagencies retain as much as half of all amountsthat they are successful in collecting.

Lockboxes

Some organizations have payments sent di-rectly to a lockbox rather than to the organi-zation itself. Lockboxes are usually postoffice boxes that are emptied by the bankrather than the organization. The bankopens the envelopes with the payments anddeposits them directly into the organiza-tion’s account.

One advantage of this approach is thatthe bank empties the box and deposits themoney at least once a day. This gets themoney into interest-bearing accounts fasterthan if it had to go through the organiza-tion. Second, use of a lockbox tends to sub-stantially decrease the risk that receipts willbe lost or stolen.

Inventory Management

Careful management of inventory can alsosave money for the organization. The lowerthe level of inventory kept on hand, the lessyou have paid out to suppliers, and thegreater the amount of money kept in yourown interest-bearing savings accounts. Onthe other hand, for many organizations,there are uncertainties that require inven-tory both for current use and as a safety


measure. Management must develop sys-tems to ensure adequate availability of in-ventory when needed while keeping overalllevels as low as possible.

Centralized storing of inventory shouldbe used if possible. If separate locations forinventory are created, convenience rises butso do costs. The more separate storage sites,the greater the amount of each inventoryitem the organization is likely to have. Theordering process should also be as central-ized as possible to minimize employee timespent processing orders and maximize thepossibility of volume discounts.

Economic Order Quantity

There are a variety of costs related to inven-tory in addition to the purchase price. Wemust have physical space to store it, we mayneed to pay to insure it, and there are costsrelated to placing an order and having itshipped. A method called the economic orderquantity (EOQ) considers all of these factorsin calculating the optimum amount of in-ventory to order at one time.

The more inventory ordered at one time,the sooner we pay for inventory (takingmoney out of our investments or interest-bearing accounts) and the greater the costsfor things such as inventory storage. Theseare called carrying or holding costs. On theother hand, if we keep relatively little inven-tory on hand to keep carrying costs low, wewill have to order inventory more often.That drives ordering costs up. EOQ balancesthese two factors to find the optimal amountto order at one time.

There are two categories of carrying costs.These are capital cost and out-of-pocket costs.The capital cost is the cost related to havingpaid for inventory, as opposed to using thoseresources for other alternative uses. At a min-imum this is the foregone interest that couldhave been earned on the money paid for in-

ventory. Out-of-pocket costs are other costs re-lated to holding inventory, including rent onspace where inventory is kept, insurance andtaxes on the value of inventory, the cost of an-nual inventory counts, the losses due to obso-lescence and date-related expirations, andthe costs of damage, loss, and theft.

Ordering costs include the cost of havingan employee spend time placing orders, theshipping and handling charges for the or-ders, and the cost of correcting errors whenorders are placed. The more orders, themore errors.

There is an offsetting dynamic in inven-tory management. The more orders peryear, the less inventory that needs to be onhand at any given time, and therefore thelower the carrying cost. However, the moreorders per year, the greater the amount theorganization spends on placing orders, ship-ping and handling costs, and error correc-tion. The total costs of inventory are the sumof the amount paid for inventory plus thecarrying costs plus the ordering costs.

Total Inventory Cost = Purchase Cost + Carrying Cost + Ordering Cost

The goal of inventory management is tominimize this total without reducing thequality of services the organization provides.

We use N for the total number of units ofinventory ordered per year, C for the annualcost to carry one unit of inventory, and O forthe costs related to placing one order. TheEOQ represents the optimal number ofunits to order at one time.

Suppose that Keepuwell Clinic pays $20per box of tongue depressors. They buy 200boxes per year. Each time they place anorder, it takes a paid clerk $5 worth of time toprocess the order. The delivery cost is $10 perorder. Thus, $15 is the total ordering cost.Keepuwell earns an average of 6% interest on




invested money. Therefore, the capital partof the carrying cost is $1.20 per box per year(6% × $20 price = $1.20). Other carryingcosts (such as storage and insurance) are esti-mated to be $2.40 per box per year. There-fore the total carrying costs are $3.60 per boxper year.

The formula to determine the optimalnumber to order at one time is:

where EOQ is the optimal amount to ordereach time.

This result indicates that we should order 41boxes at a time to minimize costs related toacquiring and holding inventory.

The basic EOQ model as presented heremakes a number of assumptions that areoften not true. For example, it assumes thatany number of units can be purchased. Insome cases an item might only be sold in cer-tain quantities, such as hundreds or dozens.Another assumption is that the price perunit does not change if we order differingnumbers of units with each order. It is possi-ble that we might get a quantity discount forlarge orders. Such a discount could offsetsome of the higher carrying cost related tolarge orders. Managers should adjust theEOQ based on the impact of these issues.

Excel Template

Template 18 may be used to calculate the EOQfor your organization. The template is on theWeb at www.jbpub.com.

Another assumption is that we use up ourlast unit of an item just when the next ship-ment arrives. A delay in processing, however,could cause inventory to arrive late, and wemight run out of certain items. To avoid neg-ative consequences of such stock outs, wemight want to keep a safety stock on hand.How large should that safety stock be? Thatdepends on how long it takes to get more in-ventory if we start to run out, and how criti-cal the consequences of running out are.

Clearly, certain health care providers(like emergency departments) can’t affordto run out of certain life-saving inventories.It is useful for organizations to categorize in-ventory by the potential threat to a patient’slife to help determine the need and subse-quent size of a safety stock.

Just-in-Time Inventory

One aggressive approach to inventory man-agement is called just-in-time (JIT) inventory.This method argues that carrying costsshould be driven to an absolute minimum.This is accomplished by having inventory ar-rive just as it is needed for use. The advan-tages are obvious: no storage costs, reducedhandling costs, minimum breakage, and noneed to pay for inventory before you need it.However, there are clear disadvantages aswell: increased ordering and shipping costs,and the risk that it will be necessary to stopproviding service if inventory doesn’t arriveas it is needed.

The application of JIT really centers onhow close one can come to the ideal. Thereare invariably problems when implementinga JIT system. For any organization, workflowdoes not necessarily proceed in an orderlymanner. There are peaks and valleys in de-mand. Such variability creates major chal-lenges for the implementation of a JIT system.

Once again, the key piece for health careorganizations is the risk associated for fail-

$3.602

41

$15 200EOQ

EOQ =2 ON

C


ing to have a specific piece of inventory onhand when needed. Health care organiza-tions may want to apply JIT concepts and ap-proaches to certain categories of inventorythat carry less risk.

MANAGING THE REVENUE CYCLE

We mentioned the concept of revenue cyclemanagement. Today’s health care system isso complex, both in the delivery of servicesas well as the billing and collection of pay-ments, that managers need to be focused onmore than just accounts receivables man-agement as reviewed. Managing receivablesis only part of the revenue cycle. In fact, formany health care providers, the revenuecycle begins when an appointment is sched-uled. Next is a brief description of each ofthe main steps within the revenue cycle.Each step needs attention and often pro-vides opportunities for improvement andthereby reduction in the revenue cycle andfaster cash in the bank.

Scheduling

The registration information collected ei-ther at the time of scheduling or after sched-uling via a pre-registration mechanism issome of the most critical information the or-ganization needs to guarantee smooth andtimely payment after services have been pro-vided. This information includes demo-graphics and insurance information and canset the stage for the rest of the revenue cycle.

Point of Service

The next step in the revenue cycle is often atthe time of service when the patient showsup for care. The patient “check-in” and/or“check-out” provides a unique opportunityto collect data that were not collected as part

of scheduling or pre-registration. This stepalso provides the opportunity for direct collection of any patient co-pays and/orbalances that greatly reduce/eliminate the receivables.

Coding

As mentioned, the ability to accurately code atthe time of service is critical to the timely col-lection of payment. Coding represents thetranslation of services provided into billablecharges. The requirements for coding mayvary by payer; therefore, compliance is critical.A well-organized system of coding is essentialin today’s health care system. Automated sys-tems help to streamline the process of coding,but ultimately there are many opportunitiesfor human error and delay. In some cases,coding systems are imposed on the provider.Medicare uses diagnosis-related group (DRG)codes for inpatients. Current protocol termi-nology (CPT) codes are commonly used bymany payers for outpatient care. Other cod-ing systems exist as well.

Billing and Claims

The major issues in this step of the revenuecycle were discussed previously. The mainissue is the timely filing of claims and subse-quent tracking of denials and prompt resolu-tion of problems. Once again, automation,such as electronic filing of claims, can greatlyimprove the efficiency of this step in the cycle.

Third-Party and Patient Collections

This step in the revenue cycle is really thesolid management of receivables. This in-cludes development of aging schedules andfollow-up on slow payers. It is also critical atthis stage to match insurance and patientpayments to make sure that what may have




been denied by the insurance company andcan be passed on to the patient (such ascharges that have not reached the patient’sdeductible) are included in the patient’s billand collection efforts.

Customer Service

The final step in the revenue cycle is the cus-tomer service efforts of an organization. Thekey point here is that this function serves toresolve any errors or issues that may havehappened in the previous steps. If, for exam-ple, a patient does not understand his or herbill, a good customer service system can helpto reduce the delay in collection that thisconfusion can cause. Taking a day or two toreturn a patient’s phone call may result in asignificant delay in the collection process.

SHORT-TERM OBLIGATIONS

To this point, this chapter has focused onshort-term resources. We now turn our attention to management of short-term obligations, or current liabilities. Carefulmanagement of such obligations can save asubstantial amount of money. Some short-term obligations that need management at-tention are accounts payable, payroll payable,notes payable, and taxes payable.

Accounts payable represents amounts thatthe organization owes to its suppliers. Pay-roll payable is an amount owed to employees.Notes payable represents an obligation torepay money that has been borrowed. Taxespayable includes income, sales, real estate,payroll, and other taxes.

As a general rule, managers should try todelay payment of short-term obligations tokeep resources in the organization availableto earn interest, or to avoid unnecessaryshort-term borrowing and related interestexpenses. However, this must be balanced

against any negative consequences relatedto delayed payments.

Accounts Payable

Accounts payable is often called trade credit.In most cases, there is no interest charge fortrade credit, assuming that payment is madewhen due. For example, Keepuwell mightorder and receive a shipment of syringes.Shortly afterward, it receives an invoicefrom the supplier. The invoice generally hasa due date.

Some suppliers charge interest for pay-ments received after the due date. Others donot. A common practice in many industries isto offer a discount for prompt payment. Onan invoice, under a heading called terms,there may be an indication such as: 2/10N/30. This would be read as “two ten, netthirty.” A discount of 2/10 N/30 means thatif payment is received within 10 days of the in-voice date, the payer can take a 2% discountoff the total. If payment is not made within 10days, then the full amount of the bill is due 30days from the invoice date. Some companiesstate their terms in relation to the end of themonth. Terms of 2/10 EOM (two ten, end ofmonth) mean that the buyer can take a 2%discount for payments received by the com-pany no later than 10 days after the end ofthe month in which the invoice is issued.

One confusing element is that if youdon’t take the early payment discount, youpay the “net” amount, which is the fullamount on the invoice. Usually, net refers toa number after a subtraction has beenmade. The reason for this strange terminol-ogy is that many times organizations negoti-ate a discount from the full price at the timean order is placed. For example, supposethat the regular wholesale price for tonguedepressors is $24.00 per box. However,Keepuwell successfully negotiated a 20% dis-


count off the official or “list” price. Perhapsthis is a volume discount. Alternatively, itmay be a discount that the manufacturer of-fers to meet a competitor’s price. From theseller’s viewpoint, $24.00 is the list or grossprice, $20.00 is the invoice or net price, and$19.60 is the net price less a discount forprompt payment (the $20.00 negotiatedprice less the 2% discount = $19.60).

Does it make sense to take advantage ofdiscounts for prompt payment? A formulacan be used to determine the annual inter-est rate implicit in trade credit discounts:

Implicit Discount 365 DaysInterest = Discounted × Days × 100%Rate Price Sooner

For example, suppose that Keepuwellpurchased $10,000 of pharmaceutical sup-plies with payment terms of 2/10 N/30. A2% discount on a $10,000 purchase is $200.This means that if the discount is taken, only$9,800 has to be paid. By taking the dis-count, Keepuwell must make payment bythe 10th day rather than the 30th day. Thismeans that payment is made 20 days soonerthan would otherwise be the case.

Implicit $200 365 DaysInterest = $9,800 × 20 Days × 100% = 37.2%

Rate

Although the stated discount rate of 2%seems to be rather small, it is actually quitelarge on an annualized basis. Gaining a 2%discount in exchange for paying just twentydays sooner represents a high annual rate ofreturn. Suppose that the organization had$9,800 of cash available to pay the billpromptly and take the discount. In order forit to make sense not to pay the bill promptlyand take the discount, it would have to investthe money for the next 20 days in an invest-

ment that would earn at least $200 over thatperiod. Any investment that could give usthat return would be earning profits at a rateof at least 37.2% per year. Because most or-ganizations do not have access to short-terminvestments that are assured of earning sucha high rate, it pays to take the discount andpay promptly. Even if you have to borrowmoney to take the discount you should, aslong as you can borrow at an interest rate ofless than 37.2% per year.

This assumes, of course, that the invoicewill be paid on time if the discount is nottaken. Suppose, however, that Keepuwelloften pays its bills late. Sometimes, it paysafter 3 months. Would it make sense to takethe discount and pay in 10 days, or to waitand pay the bill after 90 days? Paying after 10days is 80 days earlier than if we normallywait for 90 days before making our payment.

Implicit Discount 365 DaysInterest = Discounted × Days × 100%Rate Price Sooner

Implicit $200 365 DaysInterest = $9,800 × 80 Days × 100% = 9.3%

Rate

If Keepuwell can earn more than 9.3% onits investments, or if Keepuwell does nothave enough money to pay the bill and abank would charge more than 9.3% to lendthe money, then Keepuwell is better off wait-ing. However, that assumes its suppliers arewilling to wait and will not charge interestfor late payments. Otherwise, Keepuwellshould pay promptly and take the discount.

Excel Template

Use Template 19 to calculate the implicit interestrate for any discount for prompt payment.Thetemplate is on the Web at www.jbpub.com.




Payroll Payable

Each organization must decide upon anumber of general policies, such as howmany holidays, vacation days, and sick daysemployees get. Most new organizations arewell advised to be fairly conservative to start.It is much easier to later decide that you canafford to give employees more vacation thanit is to reduce the vacation allowance. Thebenefits of employee morale from a moreliberal policy must be weighed against thecost of paying for days not worked.

Another policy decision relates to whetheremployees will receive pay for sick days incash if they do not use them. If employees areallowed to accumulate sick days and knowthey will get paid eventually whether theytake them or not, then they are more likely toaccumulate a substantial bank of sick leavefor a serious illness. When sick leave is losteach year if it is not used, employees aremore likely to take sick days when they arenot sick. This encourages a culture wherebyemployees lie to the organization.

Although it is costly to pay employees foraccumulated sick leave, it is important tobear in mind that for many employees it willbe years or decades before that payment ismade. In the intervening time, the em-ployer has had the benefit of earning inter-est on the money. If sick leave can’t beaccumulated, most of it will be used andpaid for currently. So it may actually turnout to be less costly to allow accumulationthan to enforce a “use it or lose it” policy.

Each organization must also decide onthe length of the payroll period, and howsoon payment is made to employees oncethe payroll period ends. Employees could bepaid daily, weekly, biweekly, or monthly.They could be paid on the last day of thepayroll period, or a few days or a week later.The less frequently you pay, the fewer

checks that must be written, reducing book-keeping costs. Further, paying less fre-quently and later means that the employerholds onto the cash for a longer period,earning more interest. On the other hand,employees obviously prefer to be paid moreoften and sooner. Poor morale can turn outto be more costly than the benefits that theorganization may have accrued in the formof extra interest.

Payroll policy must also focus on otherfringe benefits. The organization must decidewhat benefits to offer, and how much will bepaid by the employer versus the portionpaid by the employee. Other fringes (in ad-dition to vacation, holidays, and sick leave)include items such as health and dental in-surance, life insurance, child care, car al-lowances, parking, and pensions.

Accounting and Compliance Issues

Payroll accounting is complicated by the var-ious deductions that must be made fromwages. The most prominent reason for pay-roll deductions relates to tax compliance is-sues. It is necessary to withhold incometaxes, Social Security (FICA) taxes, unem-ployment insurance, and disability insur-ance. Most states also have state incometaxes that must be withheld, and some local-ities have payroll or income taxes.

Calculating taxes can be complicated. Attimes the government changes the tax ratesor the amount of income subject to tax. It isalso critical to submit payments to the vari-ous governments on a timely basis. We don’twant to pay early, because we are better offholding the money in our interest-bearingaccount for as long as possible. On the otherhand, there are costly penalties for late pay-ment that should be avoided.

In addition to taxes and other government-required deductions, there are a number ofother types of deductions from payroll. These


include amounts for health and dental insur-ance, pensions, life insurance, and other sim-ilar items. Often the employer pays for part ormost of these benefits, and the employeemakes a lesser contribution. Payroll can befurther complicated if your organization paysbonuses, overtime, or piecework pay.

It is probably inadvisable for nonfinancialmanagers to attempt to take on too much ofthe payroll process themselves. Either theorganization needs to have a payroll depart-ment that can specialize in this process, oran outside payroll vendor should be used.Each organization must determine whetherit is best to prepare the payroll in house orto use a service. At least part of this analysismust rest on:

• the relative cost of preparing the pay-roll internally versus using a service;

• a determination of whether the com-pany has the expertise to be able toprepare payroll internally; and

• whether the organization’s employeeshave the time to prepare the payrollinternally.

Suppose that you decide to use an outsideservice. That doesn’t mean that your com-pany will have nothing left to do. First, allpayroll changes, such as newly hired em-ployees or raises, must be carefully recorded.Second, employees need to be clearly classi-fied between professional staff, hourlyemployees, commission-based, and piece-work employees. Finally, your company mustaccurately record hours worked, sales, orother key information needed to calculatewages earned.

Notes Payable

Notes payable are short-term loans evidencedby a written document signed by all partiesthat specifies the amount borrowed, the in-

terest rate, and the due date for repayment.Often such notes are demand notes. Thismeans that the lender has the right to callfor immediate payment of the full amountborrowed, plus accrued interest, at any time.

The interest on a note or loan is equal tothe amount of the loan, multiplied by theannual interest rate, multiplied by the frac-tion of the year that the loan is outstanding:

Interest = Loan Amount × Interest Rate per Year × Fraction of Year

For example, the interest on a 6%, 6-monthnote for $25,000 is:

Interest = $25,000 × 6% × 1⁄2 = $750

Typically, organizations obtain short-termdebt by borrowing money from banks usingunsecured notes. An unsecured note has nospecific asset that will be delivered to thelender if the borrower fails to make re-quired payments (collateral). A secured noteis one that has collateral. If the borrowerfails to repay an unsecured loan, the lenderjoins with all other creditors in making ageneral claim on the resources of the organ-ization. This is riskier than having collateral;unsecured loans, therefore, often havehigher interest rates to offset the lender’shigher risk.

For organizations that have limited finan-cial resources, another approach for obtain-ing short-term financing is to borrow moneyfrom an organization that specializes in fi-nancing and factoring receivables. A factoringarrangement is one in which we sell our re-ceivables. The buyer is called a factor. Theright to collect those receivables then belongsto the factor. In most cases, if receivables arefactored, the organization receives less than itwould have received, but gets the cash sooner.Alternatively, a financing arrangement is one




whereby money is borrowed with the receiv-ables being used as collateral in case we can-not repay the loan.

Taxes Payable

Taxes payable represents a short-term obli-gation. As with other short-term obligations,these should not be paid before they aredue. However, because there are oftenpenalties in addition to interest for the latepayment, managers must have a system inplace to ensure that taxes are paid on time.

BANKING RELATIONSHIPS

Working capital management often requiresa good working relationship with one ormore banks. A system of checking and sav-ings accounts is required by most organiza-tions. Many short-term investments aremade with one of the organization’s banks.And, of course, money is often borrowedfrom banks.

Many people think of banks as a place togo when you need a loan. However, you aremuch more likely to get a loan if you estab-lish a long-term relationship with a bank.Let the bank get to know your organization.Use the bank for some of your investmentneeds. Teach the bank about the cyclicalpatterns in your organization that are likelyto generate cash surpluses at some times ofthe year and cash deficits at other times.

It is important to be able to show banksthat your organization has thought throughits working capital situation. How muchmoney do you expect to borrow over thenext year? When? What for? How long willyou need the money? Banks are more likelyto lend to organizations that can anticipatetemporary cash needs long before the cashis needed, especially if you can show whenyou expect to be able to repay the loan.

Some organizations borrow specificamounts on short-term commercial loans.Such loans, often called commercial paper,were discussed in the short-term investmentsection of this chapter. If your needs are in-termediate-term, then a term loan, typicallyfrom 1 to 5 years, can be arranged. Suchcommercial loans and term loans can bearranged at the time the money is needed.However, many organizations arrange for aline of bank credit at a time when they cur-rently have more than adequate cash.

For example, Keepuwell Clinic mightarrange for a $1 million line of credit at thebank where it handles most of its routine fi-nancial transactions. The arrangement typi-cally includes repayment terms and interestrates tied to some benchmark rate that mayvary over time. The prime rate is the interestrate banks charge their most creditworthyclients. Keepuwell Clinic might negotiatefor a loan at 2% over prime (referred to as 2OP) at a time when the prime rate is 6%.Suppose that Keepuwell doesn’t need toborrow any of its $1 million credit line for 6months. At the time the prime has fallen to5.5%. The interest rate on money borrowedagainst the line of credit would be 7.5%,which is 2% over the then-current prime. Ifthe prime rate changes again, the interestrate on the outstanding portion of the loanchanges as well. A common alternative tothe prime rate, especially for companieswith international operations, is the LondonInterbank Offered Rate (LIBOR). TheLIBOR rate represents the rate that bankscharge each other in the London Eurocur-rency market. Having a credit line allows theorganization to hold lower cash reservesthan it might otherwise need.

In exchange for credit arrangements,many times banks require an organizationto keep compensating balances in the bank.That is, the organization must always keep a


certain amount of money in the bank. Whyagree to a compensating balance arrange-ment? Because the line of credit greatly ex-ceeds the compensating balance andprovides a level of cash safety that the or-ganization might not otherwise have. Willthe bank make a loan to your organization,or offer it a line of credit? The bank looksfor things such as positive cash flow fromyour operations, a strong managementteam, and adequate collateral. The weakeryour position in these areas, the higher therate of interest charged. If you are too weak,the bank will not make the loan.

However, this is a two-way street. Youdon’t want to borrow from just any bank.You need to pick the right bank for you. Youneed a big enough bank to meet all yourneeds, but not such a big bank that you areirrelevant to them. You need a bank that hasexperience serving health care organiza-tions. Such a bank better understands yourproblems and needs. Does your organiza-tion have international operations? If so,you may want to chose a bank that has an in-ternational department. You need a bankwith a range of services to meet your needsnow and as your organization grows. Bankscan be useful in many ways, sometimes of-fering advice on how to run your organiza-tion better, or even linking you withpotential customers.

Concentration Banking

Although many organizations deal withmore than one bank, they often maintain asignificant presence at one or more banks,which are referred to as concentration banks.Arrangements can be made with the con-centration bank to sweep or transfer moneyinto and out of accounts automatically.

For example, suppose that a nationwidechain of drugstores has many individual lo-

cations around the country that collect cashfrom customers and deposit that cash inlocal banks. The company wants to have ac-cess to those deposits to make disbursementsfor various purposes. An arrangement maybe made in which the concentration banktransfers balances from these other feederaccounts to a master account at the concen-tration bank. There could be daily, weekly, ormonthly transfers, depending on the ex-pected balances in the accounts.

The process can also be reversed withzero-balance accounts. An organization canwrite checks on an account that has a zerobalance. When the checks are presented forpayment, the bank keeps a tally of the totalamount disbursed. That amount is then au-tomatically transferred from one central ac-count at the concentration bank into thezero-balance account.

This type of automatic transferring offunds back and forth allows the organiza-tion to have quicker access to its cash re-sources for payment needs. It also allows itto maintain less cash in total than it would ifit had cash balances in many different ac-counts. The excess cash can be invested andmay enable the organization to earn ahigher yield on investments by purchasingsecurities in larger denominations.

KEY CONCEPTS

Working capital management—Managementof short-term resources and short-term obli-gations to maximize financial results.

Short-term resource management:Cash is kept for transactions, safety, andinvestment opportunities.Short-term investments—Bank deposits,CDs, money market funds, T-bills, un-secured notes, commercial paper, re-purchase agreements (repos), andsimilar securities.




Accounts receivable aging schedule—Man-agement report that shows how longreceivables have been outstanding.Inventory management—Inventory levelsshould be kept as low as possible, whileallowing for adequate inventory forcurrent use and as a safety measure.a. Economic order quantity (EOQ)—

Technique used to calculate the op-timal amount of inventory topurchase at one time.

b. Just-in-time (JIT)—Inventory man-agement approach that calls forthe arrival of inventory just as it is needed, resulting in zero inven-tory levels.

Revenue Cycle Management—Managementof the all processes associated with generat-ing revenue and converting to cash. Beginswith data gathering at time of schedulingand runs through customer care servicesand problem resolution.

Short-term obligation management:Trade credit and terms—Payables to sup-pliers. Terms represent the paymentagreement, sometimes including a dis-count for prompt payment.

Payroll payable—Amount owed to em-ployees. Payroll policy must considerpayroll benefits as well as when andhow often payroll is paid.Notes payable—Short-term loans that maybe unsecured or secured by collateral.Banking relationships—Needed fortransactions (e.g., checking), short-term investments, and borrowing.Concentration bank—Bank where an or-ganization keeps a significant presence.Short-term loans—Commercial loans,term loans, and lines of credit. The in-terest rate may be a specific set rate, ormay vary with a benchmark such as theprime rate.Compensating balances—Balances thatmust be maintained on deposit at alltimes in exchange for a line of credit(prearranged loan to be made whenand if needed in an amount up to anagreed upon limit).

TEST YOUR KNOWLEDGE



Analysis of investments in long-termprojects is referred to as capital budget-

ing. Long-term projects are worthy of specialattention because they frequently requirelarge initial investments and because thecash outlay to start projects often precedesthe receipt of cash inflows by a significantperiod of time. In such cases, we are inter-ested in being able to predict the profitabil-ity of the project. We want to be sure that theprofits from the project are greater thanwhat we could have received from alterna-tive investments or uses of our money.

This chapter focuses on how managers canevaluate long-term projects and determinewhether the expected return from the proj-ects is great enough to justify taking the risksthat are inherent in long-term investments.Several different approaches to capital budg-eting are discussed: the payback method, thenet present value method, and the internalrate of return method. The latter two of thesemethods require us to acknowledge the im-plication of the “time value of money.”

The time value of money refers to the factthat money received at different points intime is not equally valuable. To give a ratherelementary example, suppose that you arein pharmaceutical sales and someone of-fered to buy your product for $250, and they

are willing to pay you either today or 1 yearfrom today. You will certainly prefer to re-ceive the $250 today. At the very least, youcould put the $250 in a bank and earn inter-est in the intervening year.

Suppose, however, that the buyer offeredyou $250 today or $330 in 22 months. Nowyour decision is much more difficult. Howsure are you that the individual will pay you22 months from now? Perhaps he or she willbe bankrupt by then. What could we do withthe money if we received it today? Would weput the $250 in some investment that wouldyield us more than $330 22 months fromtoday? These are questions that we have tobe able to answer to evaluate long-term in-vestment opportunities. But first let’s discusssome basic issues of investment analysis.

INVESTMENT OPPORTUNITIES

The first step that must be taken in invest-ment analysis is to identify the investment op-portunity. Such opportunities fall into twomajor classes: new project investments and re-placement or reinvestment in existing proj-ects. New project ideas can come from avariety of sources. They may be the result ofresearch and development activity or explo-ration. Some health care organizations, like

137

CHAPTER 15

Investment Analysis: What Should We Do Next?



pharmaceutical companies, have departmentssolely devoted to new product development.Ideas may come from outside of the organiza-tion. Reinvestment is often the result of man-agers pointing out that certain equipmentneeds to be replaced. Such replacementshould not be automatic. If a substantial out-lay is required, it may be an appropriate timeto reevaluate the product or project to deter-mine if the profits being generated and serv-ices being provided are adequate to justifycontinued additional investment.

DATA GENERATION

The data needed to evaluate an investmentopportunity are the expected cash flows re-lated to the investment. Many projects havea large initial cash outflow as we acquireplant and equipment and incur start-upcosts prior to actual production and sale ofour new product or delivery of our new serv-ice. In the years that follow, there will be re-ceipt of cash from the sale of our product(or service) and there will be cash expendi-tures related to the expenses of production.The difference between the cash inflowsand cash outflows each year represent thenet cash flows for the year.

You’re probably wondering why we havestarted this discussion with cash flow insteadof net income for each year. There are sev-eral important reasons. First, net income orthe increase in net assets, even if it were aperfect measure of profitability, doesn’t con-sider the time value of money. For instance,suppose that we have two alternative proj-ects. The first project requires that we pur-chase a machine for $20,000 in cash. Themachine has a 10-year useful life. Deprecia-tion expense is $2,000 per year.

A totally different project requires that welease a machine for $2,000 a year for 10years, with lease payments at the start of each

year. Are the two alternative projects equal?No, they aren’t. Even though they both havean expense of $2,000 per year for 10 years,one project requires us to spend $20,000 atthe beginning. The other project requires anoutlay of only $2,000 in the first year. In thissecond project, we could hold on to $18,000that had been spent right away in the firstproject. That $18,000 can be invested andcan earn additional profits for the firm be-fore the next lease payment is due.

The data needed for investment or projectanalysis includes cash flow information foreach of the years of the investment’s life. Nat-urally, we cannot be 100% certain about howmuch the project will cost and how much wewill eventually receive. There is no perfect so-lution for the fact that we have to make esti-mates. However, we must be aware at all timesthat, because our estimates may not be fullycorrect, there is an element of risk. Projectanalysis must be able to assess whether the ex-pected return can compensate for the riskswe are taking. It should also include consid-eration of any taxes that will have to be paid.

THE PAYBACK METHOD

The payback method of analysis evaluatesprojects based on how long it takes to re-cover the amount of money put into theproject. The shorter the payback period, thebetter. Certainly there is some intuitive ap-peal to this method. The sooner we get ourmoney out of the project, the lower the risk.If we have to wait a number of years for aproject to “pay off,” all kinds of things cango wrong. Furthermore, given high interestrates, the longer we have our initial invest-ment tied up, the more costly it is for us.

Table 15-1 presents an example of the pay-back method: four alternative projects arecompared. In each project, the initial outlayis $8,000. By the end of 2009, projects one


and two have recovered the initial $8,000 in-vestment. Therefore they have a payback pe-riod of 3 years. Projects three and four donot recover the initial investment until theend of 2010. Their payback period is 4 years,and they are therefore considered to be infe-rior to the other two projects.

It is not difficult at this point to see one ofthe principal weaknesses of the paybackmethod. It ignores what happens after thepayback period. The total cash flow for projectfour is much greater than the cash receivedfrom any of the other projects. In a situationin which cash flows extend for 20 or 30 years,this problem might not be as obvious, but itcould cause us to choose incorrectly.

Is that the only problem with thismethod? No. Another obvious problemstems from the fact that according to thismethod, projects one and two are equally at-tractive because they both have a 3-year pay-back period. Although their total cash flowsare the same, the timing is different. Projectone provides $1 in 2008, and then $7,999 in2009. Project two generates $7,999 in 2008and only $1 in 2009. Are these two projectsequally as good because their total cashflows are the same? No. The extra $7,998 re-ceived in 2008 from project two is available

for investment in other profitable opportu-nities for 1 extra year as compared to projectone. Therefore, project two is clearly supe-rior to project one. The problem is that thepayback method doesn’t formally take intoaccount the time value of money.

This deficiency is obvious when lookingat project three as well. Project three ap-pears to be less valuable than projects one ortwo on two counts. First, its payback is 4years rather than 3, and second, its totalcash flow is less than either project one ortwo. But if we consider the time value ofmoney, then project three is better than ei-ther project one or two. With project three,we get the $7,999 right away. The earningson that $7,999 during 2008 and 2009 willmore than offset the shorter payback andlarger cash flow of projects one and two.

Although payback is commonly used for aquick and dirty project evaluation, problemsassociated with the payback method are quiteserious. There are several methods, com-monly referred to as discounted cash flow models,that overcome these problems. Elsewhere inthis chapter, we discuss the more commonlyused of these methods, namely, net presentvalue and internal rate of return. However, be-fore we discuss them, we need to specifically

Chapter 15: Investment Analysis 139

Table 15-1 Payback Method—Alternative Projects

Project Cash Flows

One Two Three Four

January 2007 $ (8,000) $ (8,000) $ (8,000) $ (8,000)

January 1, 2007–December 31, 2007 0 0 7,999 7,000

January 1, 2008–December 31, 2008 1 7,999 0 999

January 1, 2009–December 31, 2009 7,999 1 0 0

January 1, 2010–December 31, 2010 10,000 10,000 10,000 100,000

Total $10,000 $10,000 $ 9,999 $ 99,999

Payback Period 3 Years 3 Years 4 Years 4 Years



consider the issues and mechanics surround-ing time value of money calculations.

TIME VALUE OF MONEY

It is very easy to think of projects in terms oftotal dollars of cash received. Unfortunately,this tends to be misleading. Consider a proj-ect in which we invest $8,000 and in returnwe receive $10,400 after 3 years. We havemade a cash profit of $2,400. Because theprofit was earned over a 3-year period, it is aprofit of $800 per year. Because $800 is 10%of the initial $8,000 investment, we have ap-parently earned a 10% return on ourmoney. Although this is true, that 10% is cal-culated based on simple interest.

Consider putting money into a bank thatpays a 10% return “compounded annually.”Compounded annually means that the bankcalculates interest at the end of each yearand adds the interest to the entire amounton deposit. In future years, interest isearned not only on the initial deposit, butalso on interest earned in prior years.

If we put $8,000 in the bank at 10% com-pounded annually we would earn $800 of in-terest in the first year. At the beginning ofthe second year our principal plus interest is$8,800. For the second year, the interest onthe $8,800 is $880. At the beginning of the

third year, we have $9,680 (the $8,000 initialdeposit plus the $800 interest from the firstyear, plus the $880 interest from the secondyear). The interest for the third year is $968.We, therefore, have a total of $10,648 at theend of the 3 years.

Table 15-2 lays out the interest earningsfrom our hypothetical investment usingboth the simple interest calculations and thecompound interest calculations. The 10%interest compounded annually gives a dif-ferent result from the 10% simple interest.We have $10,648 instead of $10,400 fromthe project. The reason for this difference isthe fact that with compound interest weearn interest on our interest.

In our example above, we have not feltthe full power of compound interest. Take aslightly different example: In 1624 theDutch purchased New York from the NativeAmericans who inhabited Manhattan Islandfor $24 in gold medallions. If the NativeAmericans had invested the $24 worth ofgold in a venture that earned 10% simple in-terest for the last 383 years (from 1624 to2007) they would now have an investmentworth $943.20 ($24 plus $2.40 of interestper year for 383 years). On the other hand,if they had invested the $24 in a venture thatearned 10% compounded annually, theywould now have an investment worth

Table 15-2 Comparison of Simple Interest and Compound Interest

Simple Interest Compound Interest

Principal Interest Cumulative Principal Interest CumulativeBalance Earned Balance Balance Earned Balance

Year 1 $ 8,000 $ 800 $ 8,800 $ 8,000 $ 800 $ 8,800

Year 2 8,000 800 9,600 8,800 880 9,680

Year 3 8,000 800 10,400 9,680 968 10,648

TOTAL $ 2,400 $ 2,648


$171,241,749,947,654,000! That is anamount well in excess of the annual UnitedStates’ Gross Domestic Product. And the re-sult is substantially greater if earnings arecompounded quarterly or monthly! Obvi-ously, this example is a bit extreme, but thepoint is that compounding and the timevalue of money is an extremely important as-pect of the analysis of long-term projects,particularly if they have monthly com-pounding, which is often the case.

There are some standard terms and ap-proaches to calculating compound interest.Consider a cash amount of $100 today. Werefer to it as a present value (PV or P). Howmuch could this cash amount accumulate toif we invested it at an interest rate (i) or rate ofreturn (r) of 10% for a period of time (N) of2 years? Assuming that we compound annu-ally, the $100 earns $10 in the first year (10%of $100). This $10 is added to the $100. In thesecond year our $110 earns $11 (that is, 10%of $110). The future value (FV or F) is $121.That is, 2 years into the future we have $121.

Mechanically this is a simple process—multiply the interest rate times the initial in-vestment to find the interest for the firstperiod. Add the interest to the initial invest-ment. Then multiply the interest rate timesthe initial investment. Then multiply the in-terest rate times the initial investment plusall interest already accumulated to find theinterest for the second year.

Although this is not complicated, it canbe rather tedious. To simplify this process,mathematical formulas have been devel-oped to solve a variety of “time value ofmoney” problems. The most basic of theseformulas states that:

FV = PV(1 + i)N

This formula and the others that follow havebeen built into both business calculators

and computer spreadsheet programs. If wesupply the appropriate raw data, the calcula-tor or spreadsheet software performs all ofthe necessary interest computations.

For instance, if we wanted to know what$100 would grow to in 2 years at 10%, wewould simply tell our calculator that thepresent value, P or PV (depending on thebrand of calculator you use), equals $100;the interest rate, %i or r, equals 10%; andthe number of periods, N, equals 2. Then wewould ask the calculator to compute F or FV,the future value.

Can we use this method if compoundingoccurs more frequently than once a year?Bonds often pay interest twice a year. Banksoften compound monthly to calculate mort-gage payments. Using our example of $100invested for 2 years at 10%, we could easily ad-just the calculation for semiannual, quarterly,or monthly compounding. For example, forsemiannual compounding, N becomes 4 be-cause there are two semiannual periods peryear for 2 years. The rate of return, or interestrate, becomes 5%. If the rate earned is 10%for a full year, then it is half of that, or 5%, foreach half year.

For quarterly compounding, N equals 8(four quarters per year for 2 years) and iequals 2.5% (10% per year divided by fourquarters per year). For monthly compound-ing, N equals 24 and i equals 10%/12. Thus,for monthly compounding, we tell the cal-culator that PV = $100, i = 10%/12, and N =24. Then we tell the calculator to computeFV. We need a calculator designed to per-form present value functions to do this.

If we expect to receive $121 in 2 years, canwe calculate how much that is worth today?This question calls for a reversal of the com-pounding process. Suppose we expect toearn a return on our money of 10%. Whatwe are really asking here is, “How muchwould we have to invest today at 10% to get




$121 in 2 years?” The answer requires unrav-eling compound interest. If we calculate howmuch of the $121 to be received in 2 years isinterest earned on our original investment,then we know the present value of that $121.This process of removing or unraveling theinterest is called discounting. The 10% rate isreferred to as a discount rate. Using the calcu-lator, this is a simple process. We again sup-ply the i and the N, but instead of telling thecalculator the PV and asking for the FV, wetell it the FV and ask it to calculate the PV.

We posited a problem of whether to ac-cept $250 today or $330 in 22 months. As-sume that we can invest money in a projectwith a 10% return and monthly compound-ing. Which choice is better? We can tell ourcalculator (by the way, if you have access to abusiness-oriented calculator, you can workout these calculations as we go) that FV =$330, N = 22, and i = 10%/12. If we then askit to compute PV, we find that the presentvalue is $275. This means that if we invest$275 today at 10% compounded monthly for22 months, it accumulates to $330. That is,receiving $330 in 22 months is equivalent tohaving $275 today. Because this amount isgreater than $250, our preference is to waitfor the money, assuming there is no risk ofdefault. Looking at this problem anotherway, how much would our $250 grow to if weinvested it for 22 months at 10%? Here wehave PV = $250, N = 22, and i = 10%/12. Ourcalculation indicates that the FV = $300. If wewait, we have $330 22 months from now. Ifwe take $250 today and invest it at 10%, weonly have $300 22 months from now. We findthat we are better off waiting for the $330, as-suming we are sure that we will receive it.

Are we limited to solving for only the pres-ent or future value? No, this methodology isquite flexible. Assume, for example, that wewish to put $100,000 aside today to pay off a$1,000,000 loan in 15 years. What rate of re-

turn must be earned, compounded annually,for our $100,000 to grow to $1,000,000? Herewe have the present value, or $100,000; thenumber of periods, 15 years; and the futurevalue, or $1,000,000. It is a simple process todetermine the required rate of return. If wesimply supply our calculator with the PV, FV,and N, the calculator readily supplies the i,which is 16.6% in this case.

Or, for that matter, if we had $100,000today and knew that we could earn a 13% re-turn, we could calculate how long it wouldtake to accumulate $1,000,000. Here weknow PV, FV, and i, and we wish to find N. Inthis case, N = 18.8 years. Given any three ofour four basic components, PV, FV, N, and i,we can solve for the fourth. This is becausethe calculator is simply using our basic for-mula stated earlier and solving for the miss-ing variable.

So, far, however, we have considered onlya single payment. Suppose that we don’thave $100,000 today, but we are willing toput $10,000 aside every year for 15 years. Ifwe earn 12%, will we have enough to repay$1,000,000 at the end of the 15 years? Thereare two ways to solve this problem. We candetermine the future value, 15 years fromnow, of each of the individual payments. Wewould have to do 15 separate calculationsbecause each succeeding payment earns in-terest for 1 year less. We then have to sumthe future value of each of the payments.This is rather tedious. A second way to solvethis problem is by using a formula that accu-mulates the payments for us. The formula is:

In this formula, PMT represents the pay-ment made each period, or annuity pay-ment. Although you may think of annuitiesas payments made once a year, an annuity

[ ]iFV = PMT


simply means payments that are exactly thesame in amount, and are made at equallyspaced intervals of time, such as monthly,quarterly, or annually. For example, mort-gage payments of $321.48 per month repre-sent an annuity.

To solve problems with a series of identicalpayments, we have five variables instead offour. We now have FV, PV, N, i, and PMT. How-ever, PV doesn’t appear in our formula. Thereis a separate formula that relates present valueto a series of payments. This formula is:

Annuity formulas are built into business cal-culators and computer spreadsheet pro-grams such as Excel or Lotus 123. With thespreadsheet program or calculator, you caneasily solve for PV, i, N, or PMT, if you havethe other three variables. Similarly, you cansolve for FV, i, N, or PMT given the otherthree. For instance, how much would we paymonthly on a 20-year mortgage at 12% if weborrowed $50,000? The PV is $50,000, theinterest rate (%i) is 1% per month, and thenumber of months (N) is 240. Given thesethree factors, we can solve for the annuitypayment (PMT). It is $551 per month.

Annuity formulas provide you with a basicframework for solving many problems con-cerning receipt or payment of cash in differ-ent time periods. Keep in mind that theannuity method can be used only if theamount of the payment is the same each pe-riod. If that isn’t the case, each paymentmust be evaluated separately.

Using Microsoft Excel

Most computer spreadsheet programs havethe capability to do time value of money cal-culations built right into the program. To

make use of these features, the user onlyneeds to understand the basics of time valueof money and to know how to access thebuilt-in functions of the spreadsheet. Mi-crosoft Excel has become the most widelyused computer spreadsheet program, so wedemonstrate some standard time value ofmoney calculations using Microsoft Excel asan example. Other spreadsheet applicationsmay differ slightly, but should function inmuch the same way as Excel.

Step 1: Identify the Components of theCalculation

Like any time value of money problem, thefirst step to finding the solution is to clearlyidentify what you are solving for and all the in-formation, such as interest rate and numberof periods, that you already know. Take ourexample from earlier in the chapter. We have$100 today (the PV) and we want to know howmuch it will accumulate to (FV) over 2 years(the number of periods or N or nper) at 10%(the interest rate, or i or rate). As you may re-call, the accumulation, or future value, whenwe did this example earlier came out to be$121. In this example we have identified whatwe are solving for—the FV. We have also iden-tified all the other information we alreadyknow: PV = $100, N = 2, and i = 10%.

Step 2: Use the Appropriate Excel Functionto Solve

The next step in using Excel to solve thisproblem is to “call” the appropriate func-tion and insert the information we gatheredin step 1. Calling the appropriate function isa simple matter of clicking on the FunctionWizard button “fx” located on the tool bar.Figure 15-1 shows the location of the func-tion wizard.

Our example is a future value problem.After clicking on the Function Wizard fx, an“Insert Function” window opens. We now


i[ ]1

FV = PMT



need to specify that we are interested in theFV function. The time value of money func-tions are categorized as “financial” functions.Selecting the financial functions “category”opens a list of functions that includes FV asone of the choices. Figure 15-2 shows theopen function wizard and the selection ofthe financial category and FV function.

After clicking “OK” at the bottom of theInsert Function window, the future value“Function Arguments” window opens. Theinformation gathered as step one can nowbe entered directly into each of the appro-priate cells. Figure 15-3 shows the futurevalue function window, which has beencompleted with the information from ourexample. You should note that the “Pmt”cell has a 0. This cell is the amount of annu-ity payments made in each of the periods.In our example we do not have any pay-ments in the two periods, but rather havean upfront payment of $100 (the PV). Itshould also be noted that payments, or cash

outflows, are listed as negative numbers.Also, it is essential that the interest rate beshown either as .10 or as 10%. If you simplyuse 10 for the rate, you get an incorrect re-sult. Finally, the window displays the resultof the calculation near the bottom of thefunction window.

In our example, we entered the data forthe calculation directly into the functionwizard. The data can also be entered intothe wizard by linking to data already in thespreadsheet. Figure 15-4 shows the sameproblem using data in the spreadsheet topopulate the function wizard.

The use of Excel is not limited to futurevalue calculations. Figure 15-5 shows thepresent value function for another problempresented earlier in the chapter. In this ex-ample, the future value is $330, the numberof periods is 22 months, and the interestrate is 10% per month (.10/12). The solu-tion of $275 is the present value of $330 22months from now.

Figure 15-1 Location of the Function Wizard



Figure 15-2 Category and Function Selection

Figure 15-3 Future Value Function



Figure 15-4 Using Cell References

Figure 15-5 Present Value Calculation


With a solid understanding of how to cal-culate the changing value of money overtime, we can now turn our attention to thedifferent analytic methods used for evaluat-ing long-term projects. Taken together,these approaches are called discounted cashflow methods. They are all premised on thefact that the time value of money has a sig-nificant impact on the evaluation of differ-ent project cash flows.

THE NET PRESENT VALUE METHOD

The net present value (NPV) method ofanalysis determines whether a project earnsmore or less than a stated desired rate of re-turn. The starting point of the analysis is de-termination of this rate.

The Hurdle Rate

The rate of return required for a project tobe acceptable is called the required rate of re-turn or the hurdle rate. An acceptable projectshould be able to hurdle over—that is, behigher than—this rate.

The rate must take into account two keyfactors. First, we require a base profit to com-pensate for investing money in the project.We have a variety of opportunities for whichwe could use our money. We need to be paida profit for foregoing the use of our moneyin some alternative venture. The second ele-ment concerns risk. Any time we enter a newinvestment, there is an element of risk. Per-haps the project won’t work out exactly as ex-pected. The project may turn out to be afailure. We have to be paid for being willingto undertake these risks. The two elementstaken together determine our hurdle rate.

Although it is true that not-for-profithealth care organizations often focus on theprovision of service rather than profits, it isstill critical that new ventures and new proj-

ects generate profits/surpluses. As dis-cussed, profits generate the resourcesneeded for replacement and reinvestment.In addition, when taking on a new ventureor project, we do not want this activity to bea drain on the existing services of the organ-ization. Therefore, we still need new proj-ects to generate a certain level of profit so asnot to harm the financial health of the or-ganization. At a minimum, if a project isgoing to lose money, we must know that ex-plicitly. Then we can make a choice: If wefeel the services from the project are so im-portant that we should do the project even ifit loses money, then we must determinewhere the money will come from to subsi-dize the project.

There is no unique, standard requiredrate of return that is used by all health careorganizations. Different sectors of thehealth care industry tend to have differentbase rates of return. For-profit pharmaceuti-cal companies have very different requiredrates of return than community clinics. Fur-ther, within the various sectors of the healthcare system, one organization may havesome advantage over other organizations(e.g., economies of scale) that allow it tohave a higher base return. On top of that,different organizations, and even differentprojects within the same organization, havedifferent types and degrees of risk. For ex-ample, for most hospitals, replacing old hos-pital beds with new updated models involvesmuch less risk than opening a new outpa-tient surgery center.

One of the most prevalent risks that or-ganizations take is the loss of purchasingpower. That is, price-level inflation makesour money less valuable over time. Supposewe could buy a TV for $100, but instead weinvest that money in a new product or serv-ice. If the new product or service generatesa surplus of $4 in a year when the inflation




rate is 5%, we actually lost purchasing powerduring the year. It now costs us $105 to buy anew TV. In for-profit organizations, after-taxprofits must be compared to the inflationrate. The $4 noted would actually be evenless after taxes, resulting in additional loss ofpurchasing power. This means that in decid-ing if a project is worthwhile, we have to con-sider whether the rate of return is highenough to cover our after-tax loss of pur-chasing power due to inflation. In otherwords, if our $100 allows us to buy a TV settoday, and we invest that money instead for1 year at 4%, even though we may have $104after 1 year, we have actually lost rather thanmade money if at that point in time we donot have enough to buy a TV set.

We must also consider a variety of risks as-sociated with any new venture or project.What if the demand for outpatient surgeryfails to materialize? What if those who comein for service are all low-income patients with-out health insurance? What if state or federallaws change regarding the specific reim-bursements for our new service? In the caseof pharmaceuticals or medical equipmentmanufacturers, what if no one buys our prod-uct? The specific types of risks faced by an or-ganization depend on the sector of thehealth care system and the specific circum-stance of the organization. If 1 out of every 10projects is a complete failure, but the other 9are successful, then the rate of return earnedon the 9 successful products must be highenough to not only provide a return on theirown investment, but also to allow us to re-cover the losses from the project that failed.The organization’s past experience with proj-ects like the one being evaluated should be aguide in determining the risk portion of thehurdle rate.

When we add the desired return to all ofthe risk factors, the total is the organiza-tion’s hurdle rate. In most organizations,

the top financial officers determine an ap-propriate hurdle rate or rates and informnonfinancial managers that this hurdle ratemust be anticipated for a project to receiveapproval. Therefore, you usually do nothave to go through a calculation of the hur-dle rate yourself.

NPV Calculations

Once we know our hurdle rate, we can usethe NPV method to assess whether a projectis acceptable. The NPV method comparesthe present value of a project’s cash inflowsto the present value of its cash outflows. Ifthe present value of the inflows is greaterthan the outflows, then the project is prof-itable because it is earning a rate of returnthat is greater than the hurdle rate.

For example, suppose that a potentialproject for our organization requires an ini-tial outlay of $100,000. We expect the proj-ect to produce a net cash flow (cash inflowsless cash outflows) of $65,000 in each of the2 years of the project’s life. Suppose our hur-dle rate is 18%. Is this project worthwhile?

The cash receipts total $130,000, which isa profit of $30,000 overall, or $15,000 peryear on our $100,000 investment. Is that acompounded return of at least 18%? At firstglance it would appear that the answer is “no”because $15,000 is only 15% of $100,000.However, we haven’t left our full $100,000 in-vested for the full 2 years. Our positive cashflow at the end of the first year is $65,000. Weare not only making $15,000 profit, but weare also getting back half ($50,000) of ouroriginal investment. During the second year,we earn $15,000 profit on a remaining invest-ment of only $50,000. It is not simply howmuch money you get from the project, butwhen you get it that is important. In Table 15-3, the top half of the table lays out the cashflows associated with this project.


The bottom half of Table 15-3 (theshaded portion) shows the calculation ofthe NPV. The present value of an annuity of$65,000 per year for 2 years at 18% is$101,767 (PV = ?; PMT = $65,000; N = 2; i =18%). The present value of the initial$100,000 outflow is simply $100,000 becauseit is paid at the start of the project. The NPVis the present value of the inflows, $101,767,less the present value of the outflows,$100,000, which is $1,767. This number isgreater than zero, so the project does in-deed yield a return greater than 18%, on anannually compounded basis.

It may not be intuitively clear why thismethod works, or indeed, that it works at all.However, consider making a deal with yourfriend who is a banker. You agree that you willput a sum of money into the bank. At the endof the first year, the banker adds 18% to youraccount and you then withdraw $65,000. Atthe end of year 2, the banker credits interestto the balance in your account at an 18%rate. You then withdraw $65,000, which is ex-actly the total in the account at that time. Theaccount has a zero balance. You ask yourfriend how much you must deposit today tobe able to make the two future withdrawalsoutlined above. He replies, “$101,767.”

If we deposit $101,767, at an 18% rate, itearns $18,318 during the first year. Thisleaves a balance of $120,085 in the account.We then withdraw $65,000, leaving a bal-ance of $55,085 for the start of the secondyear. During the second year, $55,085 earnsinterest of $9,915 at a rate of 18%. Thismeans that the balance in the account is$65,000 at the end of the second year. Wethen withdraw that amount.

The point of this bank deposit example isthat when we earlier solved for the presentvalue of the two $65,000 inflows using a hur-dle rate of 18%, we found PV to be $101,767.We were finding exactly the amount of moneywe would have to pay today to get two pay-ments of $65,000 if we were to earn exactly18%. If we can invest a smaller amount than$101,767, but still get $65,000 per year foreach of the 2 years, we must be earning morethan 18% because we are putting in less thanwould be needed to earn 18%, but are gettingjust as much out. Here, we invest $100,000,which is less than $101,767, so we are earninga rate of return greater than 18%.

Conversely, if the banker had told us toinvest less than $100,000 (i.e., if the presentvalue of the two payments of $65,000 each at18% was less than $100,000), then it means


Table 15-3 Project Cash Flow and Net Present Value Calculation

Initial Outlay Year 1 Year 2 Total

Initial Outlay $ (100,000) $ (100,000)

Annual Net Cash Flow $65,000 $65,000 130,000

Total Project Cash Flow $ (100,000) $65,000 $65,000 $ 30,000

Net Present Value Calculations $ (100,000)

101,767

Net Present Value $ 1,767

Discounting



that by paying $100,000 we were putting inmore money than we would have to in orderto earn 18%; therefore, we must be earningless than 18%.

The NPV method gets around the prob-lems of the payback method. It considers thefull project life and considers the time valueof money. Clearly, however, you can see thatit is more difficult than the payback method.Another problem with it is that you must de-termine the hurdle rate before you can doany project analysis. The next method welook at eliminates the need to have a hurdlerate before performing the analysis.

INTERNAL RATE OF RETURNMETHOD

One of the objections to the NPV method isthat it never indicates what rate of return aproject is earning. We simply find out whetherit is earning more or less than a specified hur-dle rate. This creates problems when compar-ing projects, all of which have positive NPVs.

One conclusion that can be drawn fromour NPV discussion is that when the NPV isgreater than zero, we are earning more thanour required rate of return. If the NPV is lessthan zero, then we are earning less than ourrequired rate of return. If the NPV is zero,we must be earning exactly the hurdle rate.Therefore, if we want to determine the exactrate that a project earns, all we need to do isto set the NPV equal to zero. Because theNPV is the PV of the inflows less the PV ofthe outflows, or:

NPV = PV Inflows – PV Outflows

then when we set the NPV equal to zero,

0 = PV Inflows – PV Outflows

that is equivalent to:

PV Inflows = PV Outflows.

All we have to do to find the rate of returnthat the project actually earns, or the “inter-nal rate of return” (IRR), is to find the inter-est rate at which this equation is true.

For example, consider our NPV projectdiscussed earlier that requires a cash outlayof $100,000 and produces a net cash inflowof $65,000 per year for 2 years. The presentvalue of the outflow is simply the $100,000(PV = $100,000) we pay today. The inflowsrepresent a 2-year (N = 2) annuity of $65,000(PMT = $65,000) per year. By supplying ourcalculator with the PV, N, and PMT, we cansimply find the i or r (IRR). In this case, wefind that the IRR is 19.4%.

Variable Cash Flow

This calculation is simple for any businesscalculator that can handle time value ofmoney, frequently called discounted cash flow(DCF) analysis. However, this problem issomewhat simplistic because it assumed thatwe would receive exactly the same cash in-flow each year. In most capital budgetingproblems, it is much more likely that thecash inflows from a project will change eachyear. Many business calculators are not so-phisticated enough to determine the IRR ifthe cash flows are not the same each year.However, computer spreadsheet programsare able to do the calculation.

PROJECT RANKING

Often, we are faced with a situation in whichthere are more acceptable projects than thenumber that we can afford to finance. Inthis case, we wish to choose the best proj-ects. A simple way to do this is to determinethe IRR on each project and then to rankthe projects from the project with the high-


est IRR to the one with the lowest. We thensimply start by accepting projects with thehighest IRR and go down the list until we ei-ther run out of money or reach our mini-mum acceptable rate of return.

In general, this approach allows an organ-ization to optimize its overall rate of return.However, it is possible for this approach tohave an undesired result. Suppose that oneof our very highest yielding projects is a park-ing lot. For a total investment of $100,000,we expect to earn a return of $40,000 a yearfor the next 40 years. The IRR on that proj-ect is 40%. Alternatively, we can build a med-ical office building on the same site. For aninvestment of $20,000,000 we expect to earn$6,000,000 a year for 40 years, or an IRR of30%. We can either use the site for the park-ing lot or the building, but not both. Ourother projects have an IRR of 20%.

If we build the parking lot because of itshigh IRR, and therefore bypass the building,we wind up investing $100,000 at 40% and$19,900,000 at 20% instead of $20,000,000at 30%. This is not an optimal result. Wewould be better off to bypass the high-yield-ing parking lot and invest the entire$20,000,000 at 30%. Our decision should bebased on calculating our weighted averageIRR for all projects that we accept.

SUMMARY

Capital budgeting represents one of themost important areas of financial manage-ment. In essence, the entire future of the or-

Excel Template

Templates 20–23 may be used to calculatepresent values, future values, NPVs, andinternal rates of return, respectively, using yourdata. These templates are on the Web atwww.jbpub.com.

ganization is on the line. If projects are un-dertaken that don’t yield adequate rates ofreturn, they will have serious long-term con-sequences for the organization’s profitabil-ity—and even for its viability.

To adequately evaluate projects, dis-counted cash flow techniques should be em-ployed. The two most common of thesemethods are NPV and IRR. The essential in-gredient of both of these methods is thatthey consider the time value of money. Anonfinancial manager doesn’t necessarilyhave to be able to compute present values. Itis vital, however, that all managers under-stand that when money is received or paidcan have just as dramatic an impact on theorganization as the amount received or paid.

KEY CONCEPTS

Capital budgeting—Analysis of long-termprojects with respect to risk and profitability.

Net cash flow—The difference betweencash receipts and cash disbursements. Cashflow is more useful than net income for proj-ect evaluation because net income fails toconsider the time value of money.

Time value of money—Other things beingequal, we would always prefer to receivecash sooner and pay cash later. This is be-cause cash can be invested and earn a returnin exchange for its use.

Compounding—Calculation of the re-turn on a project, including the returnearned on cash flows generated dur-ing the life of the project.Discounting—A reversal of the com-pounding process. Discounting allowsus to determine what a future cash flowis worth today.Annuities—Cash flows of equalamounts, paid or received at evenlyspaced periods of time, such as weekly,monthly, or annually.




Project EvaluationPayback—A method that assesses howlong it will take to receive enough cashfrom a project to recover the cash in-vested in that project.Discounted cash flow (DCF) analysis—Methods that consider the time valueof money in evaluating projects.a. Net present value—Method determin-ing whether a project earns more thana particular desired rate of return, also called the hurdle or required rate

of return. The hurdle rate is based ona return for the use of money overtime, plus a return for risks inherentin the project.b. Internal rate of return (IRR)—Methodthat finds the specific rate of return ona project is expected to earn.

TEST YOUR KNOWLEDGE



Organizations need resources to be ableto buy land, buildings, equipment, and

supplies. The money needed to acquire theseassets is referred to as the organization’s capi-tal. Where does an organization get the capi-tal it needs to operate? Once the organizationis well established, capital can come at leastpartly from profits. But reinvestment of prof-its may not provide enough resources foreverything the organization wants to do. Andduring the early life of any organization,other sources of capital are essential.

The dominant sources of capital arestock issuance or charitable donations, re-ferred to as equity financing, or loans, re-ferred to as debt financing. The choicesmade with respect to obtaining resourcesdetermine the capital structure of the organi-zation. The capital structure of the organi-zation, therefore, represents the right-handside of the balance sheet: liabilities (thedebt financing) and net assets or stock-holder’s equity (the equity financing).Clearly, charitable giving and stock issuancedon’t often go together. In the case of thefor-profit health care organizations theyhave access to the stock markets, but in alllikelihood very little or no access to fundsvia charitable gifts. On the other hand, not-

for-profit health care organizations may notissue stock, but do have access to contribu-tions and charitable giving.

CHARITABLE GIVING

For many not-for-profit health care organi-zations, charitable giving is a major sourceof capital. In fact, some health care organi-zations would not exist without charitablegiving. It is important to note, however, thatcharitable giving does not come free. Theold saying, “There is no such thing as a freelunch” comes to mind. Organizations mustdevote resources (often in the form of astaffed development office) to secure chari-table gifts. Often, gifts come with donor re-strictions. These restrictions may tie thehands of management in ways that do notnecessarily make the most financial sense.The point of all of this is simply to note thatwhen thinking about sources of capital,charitable gifts are an option for not-for-profit health care organizations, but re-quire management to make carefullycalculated decisions about pros and cons,just as they would do when seeking financ-ing from the stock market or from loans, asdiscussed below.

153

CHAPTER 16

Capital Structure: Long-Term Debtand Equity Financing



COMMON STOCK

A dominant source of capital in the early lifeof many for-profit organizations is the is-suance of common stock. Common stockhold-ers own a share of the corporation’s assets,have the right to vote to elect the board ofdirectors, are entitled to a proportionateshare of distributions (such as dividends),and can freely sell their ownership interest.Common stockholders invest their money,hoping to benefit from dividends and/or in-creases in the value of the stock.

Once a company is well established, com-mon stock is often issued as a result of merg-ers (where we pay for the acquired companywith stock) or to managers as a result of var-ious compensation arrangements. However,common stock is generally not used to raisecapital at that point because of the potentialto dilute the share of the company owned bythe current owners.

Dividends are paid to shareholders ofcommon stock if the corporation decides todistribute some of its profits directly to itsowners. Alternatively, the corporation mayretain some or all of its profits for reinvest-ment in other potentially profitable oppor-tunities. Hopefully this results in evengreater future profits. If so, the value of eachshare of stock may rise, and the stockholderwill be able to sell the stock for a higherprice, resulting in a profit referred to as acapital gain.

A significant advantage the corporationgains by issuing common stock is that thereare no requirements to make payments tothe stockholders. If the corporation has abad year, at least it doesn’t have to worryabout getting cash to make required pay-ments to the common stockholders. A sec-ond significant advantage gained by issuingcommon stock is that it creates an equitybase. This provides a safety cushion for

lenders and makes it possible for the com-pany to incur debt.

The issuance of common stock is not anavailable option for not-for-profit healthcare organizations. The premise of the IRScode granting tax-exempt status is the factthat these organizations are formed with the“community” as the owner with no provisionfor individual ownership nor any provisionfor the distribution of profits.

DEBT

Debt is a second major source of financing.Debt represents a loan. The borrower mustpay interest and repay the amount bor-rowed. For an organization to be stable, asubstantial portion of the organization’sdebt is generally in the form of long-termdebt. This avoids the potential problemscreated if, for example, a building is fi-nanced with a 1-year loan that it intends torenew each year. What if the lender decidesnot to renew the loan when it comes duefor payment? Long-term debt also elimi-nates the risk of interest rates being sub-stantially higher when it is time to renewthe loan.

Long-term debt is often issued in theform of a bond. A bond is a debt instrumentin which investors (bondholders) lendmoney to the organization in exchange forthe right to receive periodic (usually semi-annual) interest payments of a set amounton set dates, plus repayment of principal ata maturity date. Bondholders can sell theirbonds to other investors in the same waythat stock may be sold. Failure to meet theseobligations puts the organization at peril ofbankruptcy. For-profit health care organiza-tions have the added benefit that interestpayments on debt are tax deductible. Thistax treatment lessens the effective cost ofdebt to the organization.


PREFERRED STOCK

For-profit health care organizations have athird potential source of capital—preferredstock. Preferred stock is a hybrid with char-acteristics of both stock and debt. It is partof stockholders’ equity. However, in mostrespects it is like a bond. The dividends topreferred stockholders are paid at a prede-termined rate, much like the interest rateon a bond. Unlike interest on a bond, thedividends are not tax deductible to the cor-poration. Why include preferred stock in acorporation’s capital structure if the pay-ments are not deductible? The dividendpayments may be deferred. When a corpo-ration falls on hard times, it still must paythe interest due on bonds. It does not haveto pay the dividends due on the preferredstock. However, dividends on preferredstock must be paid before any dividendsmay be paid to common shareholders.Some preferred stock is cumulative andsome is not. With cumulative preferredstock, any dividends that have been skippedin prior years must be paid to the preferredstockholders before dividends may be paidto common shareholders. Preferred stock isoften used as part of complex financingarrangements.

COST OF CAPITAL

The choice of the relative mix of capital isan important one. For-profit health care or-ganizations must choose between stock anddebt, and not-for-profit health care organi-zations must choose between debt and char-itable giving. In a for-profit setting, if theorganization is making healthy profits,greater amounts of debt result in higherearnings per share of common stock (earn-ings are high and the amount of stock out-standing is low). And although this may be

seen as positive, greater amounts of debtsubstantially increase the risk if profits startto decline. This is because interest paymentsmust be made in good years and in badyears. If an organization doesn’t haveenough money to pay the interest that is duein bad years, it may be forced into bank-ruptcy, and may cease to exist.

Managers should try to strive for a capitalstructure that keeps the organization’s costof capital low. The cost of capital is theweighted average of the cost of commonstock, preferred stock, debt, and charitablegiving. The cost of debt is the interest ratethat we have to pay on that debt. The cost ofpreferred stock is the required dividend pay-ment. The cost of common stock is the divi-dend plus the growth in the value of thestock. Many organizations assume that chari-table giving has no cost. But in reality, unlessa donor simply walks up and hands overcash, there is always a cost associated withcharitable giving. The resources used to so-licit, accept, and account for charitable giv-ing are resources that could have goneelsewhere within the organization or beeninvested in an interest-bearing account.Table 16-1 shows the weighted average costof capital for Keepuwell Clinic.

The unrestricted net assets category rep-resents a combination of unrestricted dona-tions and also the retained earnings that theorganization has that can be used for newprojects. That is, as the organization earnsprofits over time, assets rise, and unrestrictednet assets rise. Those unrestricted net assets,which represent the earnings that have beenretained in the organization, become part ofits capital structure. The restricted net assetsrepresent charitable giving that is either tem-porarily or permanently restricted in how itmay be used. The costs of these categories ofcapital are often estimated as the cost of whatthe organization could earn with an outside

Chapter 16: Capital Structure 155



investment. The weighted average cost ofcapital can ultimately be used by the organi-zation to determine the hurdle rates for newproject analysis (discussed in Chapter 15).By using the cost of capital as the hurdle rate,the organization isolates the financing deci-sion from the decision to undertake a partic-ular project relative to another project.

In for-profit health care organizations, areasonable level of debt tends to reduce thecost of capital.

Not only does it provide the opportunityfor increased profits for common share-holders, but the interest payments, as notedabove, are tax deductible. This tax benefitsubstantially reduces the cost of debt relativeto equity financing. On the other hand, onemust always keep in mind the increase in fi-nancial risk caused by having debt. Further,if debt levels rise too high, lenders will be re-luctant to provide further financing and thecost of debt will rise.

Table 16-2 shows two cost of capital scenar-ios in a for-profit version of the KeepuwellClinic. Notice that equity capital brings withit a higher cost due to the higher risk and lessfavorable tax treatment relative to debt. Asthe level of debt increases, the cost of capitaltherefore goes down.

OTHER ELEMENTS OF CAPITALSTRUCTURE

In addition to common stock, preferredstock, and debt, there are several other in-struments that have a place in the capitalstructure of for-profit health care organiza-tions. These include stock options, stockrights, warrants, and convertibles.

Stock Options

Stock options give option holders the right,but not the obligation, to purchase shares ofstock at some predetermined price over somespecified period of time. Such options areoften issued to key employees in an organiza-tion to motivate them to help the organiza-tion achieve or exceed its goals. For example,suppose that the corporation’s common stockis currently selling for $100 a share. The own-ers of the stock would certainly like that valueto increase. Employees may be given optionsto buy shares of stock at $120 per share. Theoptions might expire in 3 years.

These options give the employees avested interest in seeing the price of thestock go up. If the stock price fails to exceed$120, the employees will just let the optionsexpire. However, if the stock price rises to

Table 16-1 Weighted Average Cost of Capital

Proportion of Estimated Cost Weighted Cost Capital Total Capital of Capital of Capital

Long-Term Debt 70% 8% 5.6%

Net Assets

Unrestricted 10% 6% 0.6%

Restricted 20% 6% 1.2%

Weighted Average Cost of Capital 7.4%


stock in XYZ Corporation, which has 20,000shares outstanding in total. That means youcurrently own 10% of the corporation. Thecorporation now plans to use stock rights toissue another 4,000 shares to raise additionalcapital. You would be entitled to 400 rights,or 10% of the total offering. If the corpora-tion’s stock is currently selling for $100 ashare, and the rights allow you to buy stock at$94 a share, you would either exercise therights, buying the 400 shares, or you couldsell your rights to someone else.

Warrants and Convertibles

Warrants are similar to stock rights, but theygenerally have an exercise price above the

$140, they can then pay just $120 to buy ashare of stock that is worth $140.

Stock Rights

At times a corporation will want to raisemoney through an equity offering, but avoidthe high costs of hiring an underwritingfirm to sell the stock to the public. They canachieve this through a rights offering. Astock right gives the holder the right to buya share of stock at a stated price. Usually thestated price is somewhat less than the cur-rent market price.

Stock rights are usually offered in propor-tion to a stockholder’s current holdings. Forexample, suppose you owned 2,000 shares of

Table 16-2 Weighted Average Cost of Capital in a For-Profit Organization

High Equity–Low Debt



Preferred Stock 40% 10% 4.0%

Common Stock 30% 14% 4.2%


Low Equity–High Debt



Preferred Stock 20% 10% 2.0%

Common Stock 10% 14% 1.4%





level of the current market. Warrants areoften given as an inducement to investors toget them to do something the organizationwants. For example, a corporation may havetrouble raising debt. As an inducement tolend money to the corporation, warrantsmay be given to the lender.

Suppose that the corporation’s stock cur-rently sells for $10 per share. Warrants maybe issued to a lender allowing it to buy a cer-tain number of shares anytime in the next 5years for $20 a share. Lenders do not gener-ally share in the extreme successes of thecompanies they lend to. They just get earnedinterest and repayment of the loan. However,if this corporation’s stock shoots up to $100 ashare, the lender could use the warrants tobuy shares for $20 and join in the success ithelped cause by financing the company.

Similarly, convertible debt or convertiblepreferred stock is debt or preferred stockthat can literally be converted into shares ofcommon stock. This convertible featuregenerally allows the corporation to borrowat a lower interest rate or issue preferredstock with a lower dividend rate. Thelenders or purchasers of the preferred stockwill take a lower interest or dividend rate be-cause they have the potential for large prof-its if the common stock rises in value.

DIVIDENDS

Some for-profit companies hold themselvesout as growth companies. Growth compa-nies generally retain all or most of theirprofits to use for additional, hopefullyhighly profitable ventures. Other companieshave a policy of paying dividends to their in-vestors on a regular basis.

Some investors prefer growth companies.By holding stock without receiving dividends,they don’t have to pay tax on the dividends.Later they sell the stock, hopefully at a higher

price, and pay tax at a lower capital gains rate.And in the meantime, the company has in-vested the entire amount of retained earn-ings in ventures that are potentially morelucrative than might be available to the in-vestor. If the investor had received dividends,some of them would have been paid in tax,leaving less for reinvestment.

Other investors, however, need dividendsto pay for current living expenses. Althoughthey could sell off a little bit of stock fromtime to time to raise money for such ex-penses, they like to receive a steady, depend-able flow of income. As a result, managersmust decide on the dividend policy theywish to adopt. The choice affects the poten-tial buyers of the company’s stock.

At times, a corporation issues a stock divi-dend. For example, there might be a 10%dividend, giving the investor 1 share for every10 shares currently owned. Or there night bea stock split such as a two-for-one split, inwhich case the investor gets two new shares inexchange for each old share owned. Suchdividends and splits are not substantive. Ifyou own 1,000 out of 10,000 shares, you own10% of the company. After a two-for-one split,you own 2,000 out of 20,000 shares. You stillown exactly 10% of the company.

Stock dividends and splits are generallydone for psychological purposes. First, theymake you feel like you have more, even ifyou don’t. Second, they may bring thestock price down to a more reasonabletrading range. For example, if a growthcompany keeps growing, its shares becomemore and more expensive. Some individu-als might be tempted to buy a stock, butmight decide that its price is so high, theycould only afford to buy a few shares. In-stead, they buy a less expensive stock sothat they own more shares.

This is illogical. They should purchase thestock of the company with the greatest per-


centage appreciation potential. Fifty sharesof a $100 stock are more valuable than 100shares of a $50 stock, if the $100 stock hasthe potential to increase by a greater per-centage because of the underlying profit po-tential of the firm. The key should not be thenumber of shares, but the likely percent in-crease in the $5,000 investment.

Nevertheless, some companies believe thatif their stock is selling for $120 per share, athree-for-one split will be beneficial. It willbring the price per share down to $40 a share.That is, a value that seems substantial, but notprohibitively expensive. These companies be-lieve that this may attract more investors, caus-ing the stock to rise by a greater percentagethan it would have without the split.

Reverse splits are also possible. If a stock isselling for a very low price, investors mightbe skeptical of the value of the company. Areverse split will bring the price back up to arespectable level. For example, a stock sell-ing at $2 a share might have a one-for-tensplit that would reduce the number of sharesoutstanding by 90%, but raise the price pershare to $20. This latter price might be morelikely to attract investor interest.

Some stock exchanges also have mini-mum dollar prices for the stock on their ex-change. Without a reverse split, a stockmight be delisted, substantially reducing theability of owners of the stock to find a liquidmarket when they wish to sell their stock.

GETTING CAPITAL

Understanding your desired capital struc-ture is one thing. Getting the money is an-other. The capital to run a business isobtained by a variety of means. These in-clude capital campaigns, venture capital,public stock offerings, private stock place-ments, debt offerings, and leasing. Each ofthese is discussed briefly below.

Capital Campaigns

Besides on-going development activities,many not-for-profit health care organiza-tions engage in focused fundraising activi-ties, usually referred to as capital campaigns.These campaigns are typically gearedaround a certain theme, such as a new build-ing or the launching of a major new service.Often capital campaigns have extendedtime frames (5 years is fairly typical) andpublicly announced goals. To be effective,capital campaigns need a great deal of at-tention and the full support of senior man-agement. Many donors require a lot of handholding and relationship building beforethey are willing to part with their money. Or-ganizations must be willing to commit sig-nificant resources (both time and money) tohave a successful capital campaign.

Venture Capital

Start-up businesses must prove that theyhave a potentially viable business before thegeneral public will be willing to invest inthem. However, some investors, called ven-ture capitalists, will put up money called ven-ture capital or risk capital to help a newbusiness get started. The use of venture cap-ital in health care has increased significantlyin recent years. Nashville, Tennessee (thecorporate home of HCA, the nation’s largestinvestor-owned health care corporation) hasbecome a hot-bed of health care venturecapital and start-up firms.

If you can convince these investors thatthey can make a lot of money by financingyour start, they can get money into your firmquickly, without the lengthy and costlyprocess of an initial public offering of stock.In return, they generally expect that an ini-tial public offering will take place within ap-proximately 5 years.




Businesses often begin with seed capitalneeded to do market research and productdevelopment. Seed money is often pro-vided by the entrepreneurs starting thebusiness themselves, or their friends andfamilies. Businesses may raise up to $5 mil-lion this way with minimal government reg-istration requirements. After this point,venture capitalists are called upon to pro-vide the working capital needed to acquiresupplies and hire workers to start produc-ing the product, and in some cases the ac-quisition capital to acquire plant andequipment or a going business.

Venture capitalists rely heavily on thefirm’s business plan in determining whetherto invest in the business. Therefore, thebusiness plan may be a critical element indetermining if the venture ever gets the ini-tial capital it needs to get off the ground.

Be aware that many liken venture capital-ists to the devil. The business may be some-thing that you have conceived of anddeveloped. It is your baby. However, not onlywill the venture capitalists take a substantial fi-nancial share of your business in exchangefor their investment, but they will take a majorshare of the control of the business as well.

Public Stock Offerings

A public stock offering is one in whichshares of the company are sold to a broadrange of investors to secure capital for theorganization. Issuing stock to the public iscostly, time consuming, and complicated. Attimes, general economic conditions or stockmarket conditions will have a bigger impacton the success or failure of your offeringthan the underlying worth of your companywill have. On the other hand, to raise signif-icant amounts of capital without incurringan unreasonable level of debt, a public stockoffering may be required.

The first time a public stock offeringtakes place for a company, it is referred to asan initial public offering. Subsequent offeringsof stock to raise additional capital are re-ferred to as secondary issues. Whether you areconsidering an initial public offering or asecondary offering, stock offerings to thepublic are expensive. The costs include pay-ments to lawyers, accountants, printers, andunderwriters.

Underwriters are firms that act as generalcontractors. They coordinate with all of theaccountants, lawyers, and brokerage firmsthat will initially sell the stock to investors.They help to prepare all of the documentsthat are legally required before stock can besold, including a prospectus and registra-tion statement.

Once you have “gone public,” your or-ganization has an equity base that makes iteasier to borrow, broader public recogni-tion, and increased personal net worth forthe original owners of the business. On theother hand, there are ongoing reporting ex-penses, loss of control, and potential liabilityof officers for failure to comply with a com-plicated set of rules and regulations.

Private Placements

Given some of the complexities of public of-ferings, sometimes businesses issue stockthrough a private placement. The money re-ceived from venture capitalists is one type ofprivate placement. Even when the amountsof capital to be raised are substantiallyhigher—perhaps hundreds of millions ofdollars or even several billion dollars—a pri-vate placement is sometime possible. Sellingstock directly to a few large investors avoidsmuch of the cost of a public offering andavoids the need to file certain elaborate doc-uments with the government. Large insur-ance companies often participate in such


placements, putting perhaps $50 or $100 mil-lion into a company in exchange for stock.

Private placements can also raise fundsmuch more quickly than a public offeringcan. However, in most cases the amount ofmoney that can be raised from a privateplacement may be substantially less than thebusiness might raise from a public offering.It should also be noted that, because of therisks involved to the investor, governmentregulations tend to prohibit all but sophisti-cated investors from participating in suchplacements.

Bond Offerings

Bonds can be issued through private place-ments or public offerings in the same way asstocks are. As with stocks, private place-ments are simpler and less expensive, butdon’t have the ability to raise as muchmoney as a public offering.

Bonds are a particularly good alternativeto bank financing because they can be forlarge amounts of money, they can extendfor long periods of time (typically 30 years),providing stability, and they eliminate theintermediary. For example, a bank mightpay 4% to a depositor and then lend the de-positor’s money to a corporation for 9%.The 5% difference represents the bank’scosts and profits. If the corporation issues abond at an interest rate of 6.5%, it will pay2.5% less than the bank charges, and the ul-timate investors will receive 2.5% more thanthey would have received from the bank.The investors have more risk than theywould if they deposited their money in thebank. The corporation has greater costs andlegal compliance issues than it would if itborrowed the money from a bank. For a

large loan, it is worth paying these highercosts to get a lower interest rate.

Leasing

Another source of financing is leasing.Someone buys an asset, such as a building,and rents it to a business that wants to usethat asset. The business using the asset is alessee, and the owner of the asset is a lessor.Leasing is very similar to having borrowedmoney and purchased the asset directly.Therefore, leases are generally consideredto be a form of debt financing.

KEY CONCEPTS

Capital—The money needed by the firmto acquire resources.

Capital structure—Mix of debt and equityused to finance the firm.

Equity financing—Capital provided inexchange for an ownership interest,typically through the issuance of stock.Debt financing—Capital provided in theform of loans.

Stock option—Security that gives theholder the right to purchase shares of stockat some predetermined price, usually abovemarket value.

Stock right—Security that gives the holderthe right to buy a share of stock at a statedprice, usually below market value.

Sources of capital—Charitable giving, ven-ture capital, public stock offerings, privatestock placements, debt offerings, and leasing.

TEST YOUR KNOWLEDGE





In this chapter we trace through theevents and financial decisions of a ficti-

tious hospital—Happy Hospital. This casestudy is designed to review much of the ma-terial presented in previous chapters. Obvi-ously, no case study can cover every type ofaccounting event or issue. This case studydoes, however, provide a good overview ofmany of the issues faced by health care fi-nancial managers.

RECOVERING FROM NEW YEAR’SEVE: IS IT REALLY THE START OFANOTHER YEAR?

Wow, what a night. Now that the celebrationsare over, it is time to start another year atHappy Hospital. Today is January 1, 2008.Happy is a medium sized community hospi-tal with 115 beds. We are part of a loose affil-iation of six hospitals and two long-term carefacilities. Happy is recognized by the IRS as a501(c)3 Corporation and is therefore ex-empt from paying income taxes. Happy has along and proud tradition of providing high-quality care, meeting the needs of the com-munity, and serving all individuals withrespect and dignity regardless of ability topay. Tables 17-1 through 17-3 present theend of year financial statements for 2007 and

2006. (Magically, they have been prepared,audited, and certified overnight.)

WHAT SHOULD WE DO WITH ALLTHAT MONEY?

In looking over the financial statements youfirst notice that Happy Hospital is sitting ona sizeable amount of current assets. In fact,Happy Hospital is going into the currentyear with approximately $12.5 million incurrent assets compared to $4.3 million incurrent liabilities. (A current ratio of 2.9!)The vast majority of the $12.5 million is inaccounts receivable, but we do have just over$800,000 in cash.

The CEO of Happy Hospital, Mr. HarmO. Knee, has long been talking about theneed to automate some of the medicalrecords and move toward an electronicmedical record. Given the 2007 operatingloss of $829,000 (Table 17-2), he is pushingharder than ever. Perhaps it’s time to investin new technologies that can improve effi-ciency and help reduce medical errors. Re-cently two different vendors have been by topresent their medical records systems. Bothsystems are highly regarded for automatingmuch of the medical records process andthereby improving efficiency and reducing

163

CHAPTER 17

Case Study: Happy Hospital



Table 17-1 Happy HospitalStatement of Financial Position

As of December 31, 2007 and December 31, 2006

December 312007 2006

Assets

Current Assets

Cash and Cash Equivalents $ 804,331 $ 105,331

Accounts Receivable

Patients, Less Allowances for Uncollectible Accounts 8,957,621 9,608,145

Other 980,311 803,025

Total Accounts Receivable 9,937,932 10,411,170

Inventory 1,234,344 498,100

Prepaid Expenses and Other Assets 504,329 971,917

Total Current Assets 12,480,936 11,986,518

Assets Limited as to Use 55,732,204 52,233,340

Investments 1,639,529 1,464,780

Property and Equipment, Net 16,347,859 16,886,005

Prepaid Pension Asset 296,797 1,298,170

Total Assets $ 86,497,325 $ 83,868,813

Liabilities and Net Assets

Current Liabilities

Accounts Payable and Accrued Expenses $ 1,601,308 $ 1,586,144

Accrued Compensation and Amounts Withheld 2,399,365 2,491,736

Current Portion of Estimated Third-Party Payor Settlements 322,161 1,400,000

Total Current Liabilities 4,322,834 5,477,880

Estimated Third-Party Payor Settlements, Less Current Portion 3,697,939 3,530,000

Total Liabilities 8,020,773 9,007,880

Net Assets

Unrestricted 77,478,008 73,967,293

Temporarily Restricted 798,544 693,640

Permanently Restricted 200,000 200,000

Total Net Assets 78,476,552 74,860,933

Total Liabilities and Net Assets $ 86,497,325 $ 83,868,813


Chapter 17: Case Study 165

Table 17-2 Happy HospitalStatement of Operations


Year Ended December 312007 2006

Unrestricted Revenues

Net Patient Service Revenue $ 51,119,826 $ 48,659,436

Other Operating Revenue 2,989,626 3,136,716

Total Unrestricted Revenues 54,109,452 51,796,152

Expenses

Wages 49,606,566 47,076,683

Insurance 1,005,783 1,024,889

Inventory 1,275,524 1,053,367


Provision for Uncollectible Accounts 2,607,828 2,237,701

Total Expenses 54,938,592 51,814,237

(Loss) From Operations Before Adjustments to Prior Year Third-Party Payer Settlements and Pension Expense in Excess of Plan Contribution (829,140) (18,085)

Pension Expense in Excess of Plan Contribution (1,001,373) (451,432)

Adjustments to Prior Year Third-Party Payer Settlements 329,626 1,360,937

Operating (Loss) Income (1,500,887) 891,420

Nonoperating Gains

Investment Income 3,815,629 96,280

Unrestricted Gifts and Bequests 33,654 334,067

Other Miscellaneous Income 195,363 12,300

Nonoperating Gains 4,044,646 442,647

Excess of Revenues and Gains Over Expenses 2,543,759 1,334,067

Other Changes in Unrestricted Net Assets

Changes in Net Unrealized Gain on Investments 966,956 6,431,704

Increase in Unrestricted Net Assets $ 3,510,715 $ 7,765,771



Table 17-3 Happy HospitalStatement of Cash Flows



Operating Activities

Increase in Net Assets $ 3,510,715 $ 7,765,771

Adjustments to Reconcile Increase in NetAssets to Net Cash Provided by OperatingActivities

Depreciation 2,561,982 2,421,597

Net Realized and Unrealized Gains on Investments (3,208,808) (5,086,230)

Restricted Investment Income (34,000) (42,839)


Loss on Disposal of Property and Equipment (23,185) (24,888)

Changes in Operating Assets and Liabilities

Patient Accounts Receivable (2,119,520) (4,845,803)

Other Receivables (177,286) (360,806)

Inventory (736,244) (14,589)

Prepaid Expenses and Other Assets 467,588 (225,660)

Prepaid Pension Asset 1,001,373 451,432

Accounts Payable and Accrued Expenses 15,164 (284,615)

Accrued Compensation and Amounts Withheld (92,371) 779,623

Estimated Third-Party Payer Settlements (909,900) —

Net Cash Provided by Operating Activities 3,025,552 2,770,694

Investing Activities

Expenditures for Property and Equipment (2,028,551) (2,360,317)

Proceeds from Sales of Property and Equipment 27,900 55,728

Purchases of Investments, Net (464,805) (1,090,947)

Net Cash Used in Investing Activities (2,465,456) (3,395,536)

Financing Activity

Restricted Investment Income 34,000 42,839

Net Cash Provided by Financing Activity 34,000 42,839

Increase (Decrease) in Cash and Cash Equivalents 699,000 (453,257)

Cash and Cash Equivalents at Beginning of Year 105,331 558,588

Cash and Cash Equivalents at End of Year $ 804,331 $ 105,331


errors. The two systems have very differentcash flow and investment requirements.Table 17-4 presents the expected cash flowfor each of the two options.

As you can see, Option 1 has a lower up-front purchase price, but a higher annualmaintenance cost and doesn’t seem to yieldas much savings down the road. From a fi-nancial standpoint, which of these options isbetter? It is impossible to tell at this point.Given what we learned about the time valueof money, we must first find the presentvalue of the cash flows of the two options inorder to appropriately analyze them. Table17-5 presents the net present value calcula-tions for the two options assuming a dis-count rate of 10%.

It’s clear from the net present value calcu-lations that Option 2 is a better choice de-spite its higher up-front purchase price. Thenet present value for Option 2 is almost$25,000 higher than Option 1. Although Op-tion 2 may be the “better” choice, we have tobe careful. A close inspection of the compo-nents of the net present value calculationsreveals that Option 2 covers its large up-frontcost with projected savings from reduced er-rors that is almost twice as much as Option 1.The concern here might be that sometimesprojected savings never materialize. The netpresent value calculation is only as good asthe data that we put into the calculation.However, the vendor assures us that we willin fact realize those savings, so let’s go ahead


Table 17-4 Expected Cash Flow for Two Medical Records Systems

Option 1Up-Front Year 1 Year 2 Year 3 Year 4 Year 5

Purchase Price $ (475,000)

Maintenance Cost $ (10,000) $ (10,300) $ (10,609) $ (10,927) $ (11,255)

Personnel Savings 47,500 49,400 51,376 53,431 55,568

Savings Due to Reduced Errors 75,000 86,250 99,188 114,066 131,175

Total $ (475,000) $ 112,500 $ 125,350 $ 139,955 $ 156,569 $ 175,489


Purchase Price $ (700,000)




Total $ (700,000) $ 159,500 $ 181,330 $ 206,345 $ 235,018 $ 267,895



Table 17-5 Net Present Value Calculations for Two Medical Records Systems


Purchase Price $(475,000)




Total $(475,000) $ 112,500 $ 125,350 $ 139,955 $ 156,569 $ 175,489

$ 102,273

103,595

105,150

106,939

108,965

Total Present Value Years 1–5 $ 526,921



Purchase Price $(700,000)




Total $(700,000) $ 159,500 $ 181,330 $ 206,345 $ 235,018 $ 267,895

$ 145,000

149,860

155,030

160,520

166,342

Total Present Value Years 1–5 $ 776,751



and commit to the Option 2 system. Thepurchase of this system will in fact be our firstfinancial transaction for this fiscal year. As-sume that sufficient money was budgeted forthis purchase when our budgets for this yearwere approved late last year. Let’s take a lookat what else we are going to do this year.

WHAT A BUSY YEAR! TRACKINGFINANCIAL EVENTS

Not all of our decisions and transactions in-volve large sums of money like our new elec-tronic medical record system. In fact, thevast majority of financial events are relativelysmall routine events that must be trackedthroughout the year. Below is a list of all thetransactions recorded on our books duringthe year. As you can see, our new electronicmedical record system from above is thevery first transaction.

1. Happy Hospital purchased a new elec-tronic medical record system. Thispurchase was made with $700,000 incash.

2. Happy Hospital took out a long-termloan in the amount of $1,500,000.

3. Happy Hospital purchased inventoryon account costing $766,700.

4. Happy Hospital billed patients a totalof $20,756,800 (net of contractual al-lowances and charity care). Of thisamount, they assume that 3% will bebad debt.

5. Happy Hospital purchased a newpiece of equipment for $84,000 cash.

6. Happy Hospital paid $347,210 of theiraccounts payable.

7. Happy Hospital’s workers earned$27,567,126 in wages. Happy paid$25,167,761 and owed the balance.

8. Inventory previously purchased for$954,000 was used.

9. Happy Hospital purchased a 1-year mal-practice policy for $1,398,755 in cash.

10. Happy Hospital received a gift in theform of property from their inde-pendently wealthy founder Mrs. R.U.Happy. The property is valued at$550,000 and has no restrictions.

11. Six months into the year, Happy Hos-pital contracted with a managed careorganization to provide services to apool of 90,000 covered lives for 1 year.The managed care company has paidin advance the full annual premiumof $3,900,000.

12. Happy Hospital charged and billedthe non-managed care patients an-other $32,378,900. Of this amount,they assume that 3% will be bad debt.

13. Happy Hospital paid $614,532 of theiraccounts payable.

14. Happy Hospital accrued wagespayable in the amount of $24,567,555.Of this amount Happy Hospital paid$19,542,765.

15. Cash collections from patient ac-counts were $46,756,321.

16. Happy Hospital made a payment ontheir long-term loan in the amount of$72,200. This included $62,700 of in-terest and $9,500 of principal.

Table 17-6 shows how each of the listed trans-actions impacts the balance sheet equation.(Table 17-6 is also available as an Excel file atwww.jbpub.com.) The first line of figureswithin the table is the beginning balance foreach account (see Table 17-1). Each subse-quent line demonstrates how each specifictransaction impacts the balance sheet equa-tion. For example, in transaction 6, HappyHospital paid its suppliers $347,210. Cashgoes down by this amount and in addition, ac-counts payable goes down. Remember, assetsmust always equal liabilities plus net assets.




TIME TO CLOSE THE BOOKS

Now that all the transactions have beenrecorded is it time to take the balance ofeach account and create the financial state-ments? No. There are still a number of fi-nancial adjustments that must be made tothe books before we can create the financialstatements. Happy Hospital has a number ofcommon adjustments to be made at thistime. First, Happy Hospital must take theannual depreciation expense associatedwith its property, plant, and equipment(PPE). Let’s assume that the PPE that wason the books prior to this year has a currentdepreciation of $457,654. In addition, how-ever, we must remember that we purchased

two pieces of equipment this year. The elec-tronic medical record system for $700,000has a useful life of 10 years and no salvagevalue. The hospital plans on using thestraight-line method for calculating depreci-ation. Therefore, this year’s depreciationamount for this equipment is $70,000.

The second piece of equipment was$84,000. It has a useful life of 4 years and asalvage value of $2,500. This asset, however,will be used up in a very different rate andtherefore, Happy Hospital will use the Dou-ble Declining Balance Method for calculat-ing depreciation. Based on this approach,the current depreciation is $42,000 (Depre-ciable Base × 2/n = $84,000 × 2/4 = $42,000,where n is the number of years we expect to

Table 17-6 Tracking the Financial Transactions

Property,Plant and Prepaid

Accounts Prepaid Assets— Invest- Equipment, PensionCash Receivable Other Inventory Expenses Limited Use ments Net Asset

Beginning Balance $ 804,331 $ 8,957,621 $980,311 $1,234,344 $ 504,329 $55,732,204 $1,639,529 $16,347,859 $296,797

1 New Equipment (700,000) 700,000

2 New Long-Term Debt 1,500,000

3 Inventory on Account 766,700

4 Patient Services 20,756,800

Provision for Bad Debt (622,704)

5 New Equipment (84,000) 84,000

6 Payments (347,210)

7 Paid Wages (25,167,761)

8 Inventory Expense (954,000)

9 Malpractice Insurance (1,398,755) 1,398,755

10 Gift 550,000

11 Managed Care Contract 3,900,000



13 Payments (614,532)

14 Accrued Wages

Paid Wages (19,542,765)

15 Collections 46,756,321 (46,756,321)

16 Loan Payment—Interest (62,700)

Loan Payment—Principal (9,500)

Ending Balance $ 5,033,429 $13,742,929 $980,311 $1,047,044 $1,903,084 $55,732,204 $1,639,529 $17,681,859 $296,797


use the equipment). The three deprecia-tions (for PPE owned prior to this year andthe two acquisitions made this year) must becombined to come up with the annual de-preciation expense. In this case, the depreci-ation expense is $569,654. This transaction islisted as number 17 in Table 17-7.

Remember that managed care contractthat Happy Hospital received in the middleof the year? The next adjustment is to rec-ognize the fact that 6 months have gone bysince we received the annual payment fromthe managed care company. In this case, wereceived the cash, but had yet to deliver anyservice, so we created a $3,900,000 un-earned revenue liability. To recognize that 6months of the contract has expired, we must

reduce the liability (we no longer are obli-gated to provide 6 months worth of care)and recognize the revenue. This adjustmentis listed as number 18 in Table 17-7.

Once we have recognized any unearnedrevenue we must turn our attention to ad-justing any prepaid expenses that we madeduring the year. If you recall, we purchased 1year’s worth of malpractice insurance duringthe year. This insurance reduced cash (wepaid for the full year up-front) and added tothe prepaid expenses balance. (The insur-ance policy is an asset until we use it up, atwhich point it will become an expense.)Let’s assume that we purchased the policy onMarch 1. The adjustment is therefore to rec-ognize that we have used up 10 months of


Table 17-6 Tracking the Financial Transactions (continued)

Current Estimated Portion of 3rd-party Temporarily Permanently 3rd-party Payer Unrestricted Restricted Restricted

= Accounts Accrued Unearned Payer Settlements Long-Term + Net Net Net Payable Compensation Revenue Settlements —Noncurrent Debt Assets Assets Assets

$ 1,601,308 $ 2,399,365 $ 0 $322,161 $3,697,939 $ 0 $77,478,008 $798,544 $200,000

1,500,000

766,700

20,756,800

(622,704)

(347,210)

2,399,365 (27,567,126)

(954,000)

550,000

3,900,000

32,378,900

(971,367)

(614,532)

24,567,555 (24,567,555)

(19,542,765)

(62,700)

(9,500)

$1,406,$266 $ 9,823,520 $3,900,000 $322,161 $3,697,939 $1,490,500 $76,418,256 $798,544 $200,000



the 12-month policy. The annual cost was$1,398,755 so 10/12 of this is $1,165,629.The adjustment to recognize the expense isshown in Table 17-7 as transaction 19.

PUTTING TOGETHER THE END-OF-YEAR FINANCIAL STATEMENTS

Now that all the transactions have beenrecorded and the year-end adjustments havebeen made, it is time to put together theend-of-year financial statements. Given thebalance sheet equation we have maintainedover the course of the year, creating thestatement of financial position (the balancesheet) will be relatively straightforward.

The bottom line of Table 17-7 is in fact theend-of-year statement of financial position.Table 17-8 presents the formal statement forHappy Hospital at the end of 2008. Usingthe changes to net assets during the yearfrom Table 17-7, Table 17-9 presents theStatement of Operations. In Table 17-10, wepresent the Statement of Cash Flows usingthe indirect method.

HOW DID WE DO? USING RATIOANALYSIS

Well, it is almost time for another New Year’sEve party. But before we leave for the holiday,we should probably look at how we did dur-

Table 17-7 Final Adjustments

Property,Plant and Prepaid

Accounts Prepaid Assets— Invest- Equipment, PensionCash Receivable Other Inventory Expenses Limited Use ments Net Asset

Beginning Balance $ 804,331 $ 8,957,621 $980,311 $1,234,344 $ 504,329 $55,732,204 $1,639,529 $16,347,859 $296,797

1 New Equipment (700,000) 700,000

2 New Long-Term Debt 1,500,000

3 Inventory on Account 766,700



5 New Equipment (84,000) 84,000

6 Payments (347,210)

7 Paid Wages (25,167,761)

8 Inventory Expense (954,000)

9 Malpractice Insurance (1,398,755) 1,398,755

10 Gift 550,000

11 Managed Care Contract 3,900,000



13 Payments (614,532)

14 Accrued Wages

Paid Wages (19,542,765)

15 Collections 46,756,321 (46,756,321)

16 Loan Payment—Interest (62,700)

Loan Payment—Principal (9,500)

17 Depreciation (569,654)

18 Revenue Recognition

19 Expense Recognition (1,165,629)

Ending Balance $ 5,033,429 $13,742,929 $980,311 $1,047,044 $ 737,455 $55,732,204 $1,639,529 $17,112,205 $296,797


ing the past year. Using our financial state-ments, we can now prepare a complete set offinancial ratios and assess our performanceand our current position. Table 17-11 showsthe major ratios presented in Chapter 13.

As you can see, our days cash on hand hasincreased from 5.66 days in 2007 to 33.82days in 2008. However, that doesn’t meanthat we can assume our liquidity position isbetter. Note that our current ratio fell from2.89 to 1.60 and our quick ratio fell from2.49 to 1.46. Here we have clearly conflict-ing evidence about our liquidity. This pointsout the need to review a lot of informationabout an organization before drawing a con-clusion about its financial position.

The efficiency ratios raise a number ofcautions. The days in accounts payable isonly 9.18 for 2008, but that doesn’t tell thewhole story. Look at the difference betweenour average payment period and our days inaccounts payables. This difference must bedue to the large accrued compensation fig-ures that are included in the average pay-ment period ratio, but not in the days inaccounts payable figure. Happy Hospital iskeeping current on their payment to suppli-ers, but appears to be keeping employeeswaiting. This could be a sign of trouble. Theother interesting figure is the days in ac-counts receivables. Over the past year, wehave taken an additional 30 days to collect


Table 17-7 Final Adjustments (continued)

Current Estimated Portion of 3rd-party Temporarily Permanently 3rd-party Payer Unrestricted Restricted Restricted

= Accounts Accrued Unearned Payer Settlements Long-Term + Net Net Net Payable Compensation Revenue Settlements —Noncurrent Debt Assets Assets Assets

$ 1,601,308 $ 2,399,365 $ 0 $322,161 $3,697,939 $ 0 $77,478,008 $798,544 $200,000

1,500,000

766,700

20,756,800

(622,704)

(347,210)

2,399,365 (27,567,126)

(954,000)

550,000

3,900,000

32,378,900

(971,367)

(614,532)

24,567,555 (24,567,555)

(19,542,765)

(62,700)

(9,500)

(569,654)

(1,950,000) 1,950,000

(1,165,629)

$1,406,$266 $ 9,823,520 $1,950,000 $322,161 $3,697,939 $1,490,500 $76,632,973 $798,544 $200,000



Table 17-8 Happy HospitalStatement of Financial Position


December 312008 2007

Assets

Current Assets

Cash and Cash Equivalents $ 5,033,429 $ 804,331

Accounts Receivable

Patients, Less Allowances for Uncollectible Accounts 13,742,929 8,957,621

Other 980,311 980,311

Total Accounts Receivable 14,723,240 9,937,932

Inventory 1,047,044 1,234,344

Prepaid Expenses and Other Assets 737,455 504,329

Total Current Assets 21,541,168 12,480,936

Assets Limited as to Use 55,732,204 55,732,204

Investments 1,639,529 1,639,529

Property and Equipment, Net 17,112,205 16,347,859

Prepaid Pension Asset 296,797 296,797

Total Assets $ 96,321,903 $ 86,497,325

Liabilities and Net Assets

Current Liabilities

Accounts Payable and Accrued Expenses $ 1,406,266 $ 1,601,308

Accrued Compensation and Amounts Withheld 9,823,520 2,399,365

Unearned Revenue 1,950,000 0

Current Portion of Estimated Third-Party Payer Settlements 322,161 322,161

Total Current Liabilities 13,501,947 4,322,834

Estimated Third-Party Payor Settlements, Less Current Portion 3,697,93 3,697,939

Long-Term Debt 1,490,500 0

Total Liabilities 5,188,439 8,020,773

Net Assets

Unrestricted 76,632,973 77,478,008

Temporarily Restricted 798,544 798,544

Permanently Restricted 200,000 200,000

Total Net Assets 77,631,517 78,476,552

Total Liabilities and Net Assets $ 96,321,903 $ 86,497,325



Table 17-9 Happy HospitalStatement of Operations



Unrestricted Revenues

Net Patient Service Revenue $ 53,135,700 $ 51,119,826

Other Operating Revenue 1,950,000 2,989,626

Total Unrestricted Revenues 55,085,700 54,109,452

Expenses

Wages 52,134,681 49,606,566

Insurance 1,165,629 1,005,783

Inventory 954,000 1,275,524

Interest 62,700 0



Total Expenses 56,480,735 54,938,592

Gain/(Loss) from Operations Before Adjustments to Prior Year Third-Party Payer Settlements and Pension Expense in Excess of Plan Contribution (1,395,035) (829,140)

Pension Expense in Excess of Plan Contribution 0 (1,001,373)

Adjustments to Prior Year Third-Party Payer Settlements 0 329,626

Operating (Loss) Income (1,395,035) (1,500,887)

Nonoperating Gains

Investment Income 0 3,815,629

Unrestricted Gifts and Bequests 550,000 33,654

Other Miscellaneous Income 0 195,363

Nonoperating Gains 550,000 4,044,646

Excess of Revenues and Gains Over Expenses (845,035) 2,543,759

Other Changes in Unrestricted Net Assets

Changes in Net Unrealized Gain on Investments 0 966,956

Increase in Unrestricted Net Assets $ (845,035) $ 3,510,715



Table 17-10 Happy HospitalStatement of Cash Flows



Operating Activities

Increase/(Decrease) in Net Assets $ (845,035) $ 3,510,715

Adjustments to Reconcile Increase (Decrease) in Net Assets to Net Cash Provided by Operating Activities

Depreciation 569,654 2,561,982

Net Realized and Unrealized Gains on Investments — (3,208,808)

Restricted Investment Income — (34,000)


Loss on Disposal of Property and Equipment — (23,185)

Gain on Capital Gift (550,000) —

Changes in Operating Assets and Liabilities

Patient Accounts Receivable (6,379,379) (2,119,520)

Other Receivables — (177,286)

Inventory 187,300 (736,244)

Prepaid Expenses and Other Assets (233,126) 467,588

Prepaid Pension Asset — 1,001,373

Accounts Payable and Accrued Expenses (195,042) 15,164

Accrued Compensation and Amounts Withheld 7,424,155 (92,371)

Unearned Revenue 1,950,000 —

Estimated Third-Party Payer Settlements — (909,900)

Net Cash Provided by Operating Activities 3,522,598 3,025,552

Investing Activities

Expenditures for Property and Equipment (784,000) (2,028,551)

Proceeds from Sales of Property and Equipment — 27,900

Purchases of Investments, Net — (464,805)

Net Cash Used in Investing Activities (784,000) (2,465,456)

Financing Activity

Loan Proceeds 1,500,000 —

Loan Repayment (9,500) —

Restricted Investment Income — 34,000

Net Cash Provided by Financing Activity 1,490,500 34,000

Increase (Decrease) in Cash and Cash Equivalents 4,229,098 699,000

Cash and Cash Equivalents at Beginning of Year 804,331 105,331

Cash and Cash Equivalents at End of Year $ 5,033,429 $ 804,331


payment from our customers! This is cer-tainly worthy of our attention (after the NewYear’s Eve party).

The solvency and profitability numbers allreflect the fact that we have had 2 difficult in-come years. As you may have noticed, HappyHospital did not have any debt coming into2008. They did take on some long-term debt

this year. Because the hospital lost money,they have negative interest and debt servicecoverage ratios. Also, all of the profitabilityratios are negative as Happy Hospital hadboth operating and total losses for the year.Clearly there are serious signs of financialstress, and we have our work cut out for us toturn around the 2 years of operating losses.


Table 7-11 Happy HospitalFinancial Ratios

For the Years 2008 and 2007

2008 2007

Liquidity

Current Ratio 1.60 2.89

Quick ratio 1.46 2.49

Days Cash on Hand 33.82 5.66

Efficiency

Days in Accounts Receivables 97.56 67.04

Days in Accounts Payable 9.18 10.73

Average Payment Period 88.14 28.95

Total Asset Turnover 0.57 0.63

Solvency

Interest Coverage –12.48 NA

Debt Service Coverage –2.95 NA

Long-Term Debt to Net Assets 0.02 0.00

Profitability

Total Margin –0.02 0.06

Operating Margin –0.03 –0.02

Return on Assets –0.01 –0.01

Return on Net Assets –0.02 –0.01



Aaccelerated depreciation

methods for, 69–71, 74straight-line vs., 69

accountantscertified. See certified Public Accoun-

tants (CPAs)financial, 2

accountingconcepts of, 1, 11–20financial. See financial accountingfund, 14, 19fundamental equation for, 14, 20,

35–37, 46golden rule of, 35–36, 46health care. See health care accountingmanagerial. See managerial accountingtraditional, 9

accounting concepts, 11–20assets as, 12–13, 20equation of, 14, 20of funds, 14–15, 19generally accepted accounting

principles (GAAP), 15–19key concepts, 11–12, 19–20liabilities as, 13, 20monetary denominator as, 12, 19–20of net assets, 13–14, 20of owners’ equity, 13–14, 15, 20

accounting cycleaudit completion of, 21, 57–58, 62–63.

See also annual reports

for financial statements, 21–22accounting equation, 14, 20

in double-entry bookkeeping, 35–36, 46

modification for debit/credit recordings, 37

accounting methods, alternative examplesof, 15–17

accounting policies, significant, notes re-garding, 97–99, 101

accounting systems, internal, in audit fail-ures, 62

accountschart of, for general journals, 45for ledgers, 47–48temporary, 48

accounts payable (A/P), 5as current liability, 86Healthy Hospital example, 39–44in working capital management,

130–131, 136accounts receivable (A/R), 5, 38

aging schedule for, 125–126, 136billing process for, 124–125credit policies for, 124cycle of activities for, 123–124electronic collections, 125Healthy Hospital example, 38–44increases in, 95net, 85in working capital management,

123–126, 136

179

Index

26753_INDX_FINAL.qxd 2/6/06 9:54 AM Page 179


accumulated depreciation, 68–69acquisition capital, 160activity ratios, 112activity statement, 23, 24adverse opinion, of independent auditor, 61aging schedule, for accounts receivables,

125–126, 136AICPA (American Institute of Certified

Public Accountants), 17algebra, 37Allegheny Health System, bankruptcy ex-

ample, 62American Institute of Certified Public Ac-

countants (AICPA), 17amortization, 74

depreciation vs., 65–66amortization expense, 66analysis techniques

comparative between organizations,103–120. See also ratio analysis

for financial statements, 83, 96for investments, 137–152. See also invest-

ment analysisannual reports

accounting cycle sequelae of, 62–63audit failures and, 62components of, 60–61fraud and embezzlement detection,

59–60independent audit for, 57–63independent auditor role, 21, 57–58internal control focus of, 58key concepts, 63management letter as, 58management report as, 61–62opinion letter as, 60–61SEC requirements for, 21, 57–58

annuities, 142–143, 151A/P. See accounts payable (A/P)appreciation, of short-term interest, 22A/R. See accounts receivable (A/R)asset(s)

in accounting equation, 14, 20amortizing, 65–66

balance sheet subgroups of, 22, 24, 25, 85in bank accounts, 38book value of, 68capital. See capital assetsin common size ratios, 104, 107, 109concept of, 12–13, 20depletion of, 65–66in double-entry bookkeeping, 35–36Healthy Hospital example, 38–44intangible, 12, 20MACRS for, 71–73, 74net, 13–14, 20return on, 2, 117–118, 119salvage value of, 65, 66, 67–68tangible, 12, 20useful life of, 65, 66, 68, 72, 74. See also

depreciationasset classification, for balance sheet, 22,

24, 25, 85asset valuation, 27–33

appropriate method considerations,30–31

for depreciation, 28, 66–69key concepts, 33liabilities valuation vs., 31–32market value in, 32–33methods for, 27–30

auditor’s report, annual, 60–61, 63audits, independent, 21, 57–63. See also in-

dependent audit/auditorautomatic transfers, between bank ac-

counts, 135average payment period ratio, 114

Bbad debts, 9, 85balance sheet, 21–23

basic components of, 22common size ratios for, 104, 107, 109Community Hospital example, 83–89,

107, 108financial year for, 21–22


for for-profit companies, 23Happy Hospital example, 164, 174Healthy Hospital example, 39–44,

51–52inventory cycle for, 21key concepts, 25, 56ledger reflection of, 48for not-for-profit companies, 23preparation from ledger, 48, 56reflection of ownership share, 23statement of operations link to, 90–92template for, 22, 23useful information from, 83–89valuation controversy regarding, 27

bank accountsdebit vs. credit of, 38for working capital management,

134, 135bank financing, 134

alternatives to, 161viability and, 5–6

banking relationships, for working capitalmanagement, 134–135, 136

bankruptcyAllegheny Health System example, 62cash flows and, 24liquidity ratio and, 110, 112stock value and, 88–89viability vs., 4–6

bar codes, 77beginning inventory (BI), in inventory

costing, 75–76, 77, 81“below-the-line” changes, in income state-

ment, 89–90benchmarks

Community Hospital example of,103–104

competitors as, 105, 107industry data as, 105–106, 107, 110organizational history as, 105, 107for ratio analysis, 103, 105, 120

benefit(s), maximization of, 2BI (beginning inventory), in inventory

costing, 75–76, 77, 81

billing process, 124–125coding for, 129electronic, 125in revenue cycle, 129

bonds, 6, 154, 161bonds payable, notes regarding, 99–100bonuses, 133bookkeeping, double-entry, 35–36, 46book of original entry, 35book value, of asset, 68book value per share, 13borrowing, in statement of cash flows, 53buyers, obligations of, 11

Ccalendar year

audit completion of, 62–63. See also an-nual reports

for financial statements, 21capital

acquisition, 160cost of, 127, 155–156dominant sources of, 153, 161key concepts, 153, 161net working, 121, 135. See also working

capital managementseed, 160venture, 159–160weighted average cost of, 156–157working, 160

capital assets, 12MACRS for, 72, 74

capital budgeting, 137–138, 151capital campaigns, 159capital costs, 127, 155–156capital facilities, in balance sheet, 22capital gain, 154capitalization, of replacement costs, 67capital purchases

profits for acquiring, 2–3in statement of cash flows, 52

capital structure, 153–161

Index 181



charitable giving in, 153common stock in, 154convertibles in, 158cost of capital and, 155–156debt in, 154dividends in, 158–159key concepts, 153, 161preferred stock in, 155ratios of, 115stock options in, 156–157, 161stock rights in, 157, 161strategies for obtaining, 159–161warrants in, 157–158

capital structure ratio, 115capitated insurance

Happy Hospital example, 171ledger accounting of, 86ratio analysis and, 109

carrying costs, 127case studies

Allegheny Health System as, 62Community Hospital as. See Commu-

nity HospitalHappy Hospital as, 163–177. See also

Happy HospitalHealthy Hospital as, 48–56Keepuwell Clinic as, 121, 125–128, 130,

131, 134, 155cash

in common size ratios, 105, 107currency vs., 12as current asset, 85Healthy Hospital example, 38–44journal recording of, 39in liquidity ratio, 111–112for unused sick leave, 132viability based on, 4–6in working capital management, 121,

122, 135cash flow

bankruptcy and, 24data on, for investment analysis, 138,

149–150statement of. See statement of cash flows

variable, 150cash obligations, short- vs. long-term in li-

abilities valuation, 31–32, 33certificates of deposit (CDs), 122, 123

negotiable, 123Certified Public Accountants (CPAs)

rules for, 17year end audit role of, 21, 57–58. See

also annual reportscertified reports, annual, 57certified statements, annual, 57change in net assets, in operating state-

ment, 50charitable donations, 14, 153charity care, 4, 9

notes regarding, 98–99chart of accounts

for general journals, 45for ledgers, 47–48

checking accounts, for working capitalmanagement, 134

Chief Financial Officer, 1claims processing, in revenue cycle, 129clean opinion

of independent auditor, 60–61, 63standard letter paragraphs of, 60–61

coding, for billable charges, 129collections process

aging schedule for, 125–126customer service for, 130electronic, 125lockboxes for, 126revenue cycle and, 129–130

commercial paper, 123, 134, 135commissions, 133commitments

material, as liability, 87notes regarding, 100

common size ratios, 104, 105, 107–110, 120for balance sheet, 104, 107, 109Community Hospital example of, 104,

107–110for statement of operations, 107–108,

109–110


common stock, 88, 89, 91in capital structure, 154

community, well-being of, 2Community Hospital, financial state-

ments forbalance sheet, 83–89, 107, 108notes to, 95–96, 97–101ratio analysis of, 103, 104–110, 111,

113, 114, 116–117statement of cash flows, 92–95statement of operations, 89–92, 104, 110

compensating balances, in banks,134–135, 136

competitors, as benchmark, 105, 107compounding, annual, of interest,

140–142, 151computer technology

for inventory tracking, 76–77for time value of money calculations,

143–147concentration banking, 135, 136conformity rule, for last-in, last-out, 80–81conservatism, 17, 19consistency, 19constant dollar valuation, 28, 33Consumer Price Index (CPI), 28contingencies, notes regarding, 100contractual allowance, 9

in reimbursement systems, 8–9contributed capital, 23, 25convertibles, in capital structure, 158co-pays, 8, 129cost(s)

capital, 127carrying, 127concept of, 18, 19full, in depreciation process, 66–67, 74holding, 127inventory-related, 127–128operating. See expensesordering, 127out-of-pocket, 127storage, 128

cost-flow assumptions

comparisons of, 79–80first-in, first-out, 78, 82for inventory costing, 77, 78–82last-in, last-out, 79, 80–81, 82specific identification, 78, 82weighted average, 78–79, 82

cost of capital, 155–156weighted average, 156–157

cost of goods sold, 75cost of goods used, 75CPAs. See Certified Public Accountants

(CPAs)CPI (Consumer Price Index), 28credit cards, 125credit line, securing from banks, 134–135credit policies, for accounts receivable, 124credits

in bank accounts, 38in double-entry bookkeeping, 36–38, 46

currency, as monetary denominator, 12,19–20

current assetsin balance sheet, 22, 24, 85in common size ratios, 107 104in net working capital, 121, 135

current cost, in asset valuation, 30, 33current liabilities

in balance sheet, 22, 86in liquidity ratio, 110–112in net working capital, 121, 135

current liquidity, 4current ratio, of liquidity, 110–111, 112customer service, revenue cycle and, 130

Ddata generation, for investment

analysis, 138days cash on hand, as liquidity ratio, 111days in accounts payable ratio, 113, 114days in accounts receivable ratio, 112–113DCF (discounted cash flow) method, of

analysis, 139–140, 147, 150, 152

Index 183



DDB (double declining balance), as de-preciation method, 69, 71, 72, 74

debit cards, 125debits

in bank accounts, 38in double-entry bookkeeping, 36–38, 46

debt(s)bad, in liquidity ratio, 111–112in common size ratios, 109convertible, 158short-term, management of, 133–134, 136viability and, 5–6

debt financing, 153, 154, 156, 161. Seealso loans

debt service coverage ratio, 115, 116debt to net assets ratio, 115, 116declining balance depreciation, 69–70decrease in net assets, in operating state-

ment, 50deductibles, in revenue management, 130deductions, payroll, 132–133deferred revenue, 86, 114deferred taxes, depreciation methods for,

72–73, 74deferred tax liability, 74deflation, dollar value and, 12delevered net income, 118demand notes, 133depletion, of assets, 65–66depreciable base, 67–68depreciation, 65–74

accelerated, 69accumulated, 68–69amortization vs., 65–66asset life in, 65, 66, 68, 72, 74asset valuation for, 28, 66–69in common size ratios, 109comparison of methods, 69–71declining balance, 69–70deferred taxes and, 72–73, 74depreciable base in, 67–68double declining balance, 69, 71, 72, 74Happy Hospital accounts example,

170–173

key concepts, 65, 74MACRS, 71–73matching principle and, 65process of, 65, 66in statement of cash flow, 92–93straight-line, 69, 71sum-of-the-years’ digits, 69,

70–71, 74depreciation expense, recording of, 42direct method, in statement of cash flow,

53–54, 56, 92–93disability insurance, 132disclaimer opinion, of independent audi-

tor, 61disclosure, full

in audit failures, 62concept of, 19, 91, 96

discounted cash flow (DCF) method, ofanalysis, 139–140, 147, 150, 152

discounting, of interest, 142, 151discount rate, for interest, 142, 151discounts

in rate negotiation, 9trade credit, 130–131, 136

dividends, in capital structure, 158–159dividends paid

on common vs. preferred stock, 89, 91in statement of cash flows, 52, 53

dividends rate, for convertibles, 158dividends received, in statement of cash

flows, 52documentation systems, improvement in-

vestments for, 163, 167–171dollar value, as monetary restriction, 12donations

charitable, 14, 153in common size ratios, 109, 110as restricted net assets, 87as unrestricted net assets, 22–23, 87

donors, of charitable gifts, 14double declining balance (DDB), as de-

preciation method, 69, 71, 72, 74double-entry accounting/bookkeeping,

35–36, 46


Eearnings, retained, 25

in balance sheet, 23, 89in statement of operations, 91–92

earnings per shareon common vs. preferred stock,

88–89, 91for publicly traded companies,

90–91, 96economic order quantity (EOQ), for in-

ventory management, 127–128, 136efficiency ratios, 112–115, 120

Happy Hospital example, 173, 177key concepts, 112, 120payables ratios, 113, 114receivables ratios, 112–113total asset turnover, 113, 114–115

embezzlement detection, by independentauditor, 59–60

ending inventory (EI), in inventory cost-ing, 75–76, 81

endowments, 87entity

accounting importance of, 11–12concept of, 11, 19, 38

EOQ (economic order quantity), for in-ventory management, 127–128, 136

equipment, 12. See also plant and equip-ment (P&E)

MACRS for, 72, 74new, profits for acquiring, 2–3replacement planning for, 138salvage value of, 65, 66, 67–68

equities valuation, 33asset valuation vs., 27–31liabilities valuation vs., 31–32market value in, 32–33

equityowners’, 13–14, 15, 20, 31–33partners’, 13, 15return on, 2in solvency ratios, 115stockholders’, 13, 15, 25, 87–89, 91

total, in common size ratios, 104,107–108

equity financingin capital structure, 153–154, 155–158key concepts, 153, 161strategies for obtaining, 159–161

ethics, of independent auditors, 62expenses, 23

in common size ratios, 107, 109–110in double-entry bookkeeping, 37equipment allocation for, 65Healthy Hospital example, 39–44in income/operating statement,

23, 94in liquidity ratio, 111–112prepaid, 40, 43, 86revenue excess over, 110

Ffactor/factoring, of notes payable,

133–134“fair representation,” in financial state-

ments, 58, 61FASB (Financial Accounting Standards

Board), GAAP rules of, 17, 62Federal Deposit Insurance Corporation

(FDIC), 3FICA (Social Security) taxes, 132FIFO. See first-in, first-out (FIFO)finance, 6

description of, 1–2financial accountant, 2

certified. See Certified Public Accoun-tants (CPAs)

financial accountingdescription of, 1–2double-entry, 35–36, 46fit into financial management, 6Happy Hospital example, 170–173payment system impact on, 9

Financial Accounting Standards Board(FASB), GAAP rules of, 17, 62

Index 185



financial environment, of health care or-ganizations, 7–9

financial events, recording of, 38–40adjusting over time, 40–44, 46Healthy Hospital example, 38, 40–44T-accounts for, 44–45timing for, 35, 46

financial history, of organizations, 35as benchmark, 105, 107

financial information, recording of, 35–46accounting equation for, 35–36adjusting entries in, 40–44, 46chart of accounts for, 45debits and credits in, 36–38double-entry accounting for, 35–36events as, 38–44key concepts, 46T-accounts for, 44–45

financial management, 6description of, 1–2financial accounting fit into, 6introduction to, 1–6organizational goals of, 2, 4

financial managers, effective communica-tion with, 1

financial position, statement of. See bal-ance sheet

financial statements, 21–25analysis techniques for, 83, 96audited, 57–63. See also independent

audit/auditorbalance sheet, 21–23, 83–89cash flow statement, 24, 92–95closer look at, 47–56even closer look at, 83–96function of, 21, 47generally accepted accounting princi-

ples for, 17–19goodwill reflected on, 12–13Happy Hospital examples, 163–166,

172, 174–177Healthy Hospital examples, 48–56income statement, 23–24key concepts, 25, 56, 96

ledgers for, 47–48monetary denominator for, 12, 19–20notes to, 25, 95–96, 97–101recording financial information for, 35–46statement of operations, 23–24, 89–92useful information from, 83–96valuation methods for, 27–33

financial year. See fiscal yearfinancing

activities, in statement of cash flows, 53,92–95

bank. See bank financingdebt, 153, 154, 156, 161. See also loansequity. See equity financing

first-in, first-out (FIFO)as cost-flow assumption, 78, 82last-in, last-out vs., 79–80

fiscal yearaudit completion of, 62–63for financial statements, 21–22

fixed assetsin balance sheet, 22, 86in common size ratios, 109

float, 122for-profit hospitals

balance sheet equity for, 23, 87cost of capital in, 156–157current tax liabilities of, 86depreciation and tax implications, 71,

73–74depreciation process for, 69–71, 73–74earnings per share data on, 90–91, 96financial environment of, 7, 9financial management goals for, 2income/operating statement for, 23–24independent audit requirements for,

21, 57sources of capital for, 153, 156

fraud detection, by independent auditor,59–60

fringe benefits, 132full cost, in depreciation process, 66–67, 74full disclosure

in audit failures, 62


concept of, 19, 91, 96fund(s), 14

automatic transfers between bank ac-counts, 135

fund accounting, 14, 19fund balance

in balance sheet, 22, 23concept of, 14–15, 19

future profits, in asset valuation, 29, 33future value (FV), of money, 141–143

computer program for calculating,143–147

FV. See future value (FV)

GGAAP, generally accepted accounting

principles, 15–19general journal

chart of accounts for, 45for financial information, 35, 46

generally accepted accounting principles(GAAP), 15–19

in alternative accounting methods, 15–17for asset valuation, 27–28conservatism as, 17, 19consistency as, 19cost as, 18, 19full disclosure as, 19, 62, 91, 96going concern as, 17, 19independent audit of, 60–61key concepts, 19, 83matching as, 17–18, 19materiality as, 18–19objective evidence as, 18, 19source of, 17

gifts, charitable, 14in capital structure, 153

going concern, 17, 19golden rule, of accounting, 35–36, 46goods, cost of, sold vs. used, 75goodwill

book value per share and, 13

concept of, 12–13as long-term asset, 86reduction in value of, 93in statement of cash flow, 93

governmental organizations, reimburse-ment programs of, 7

gross price, 131

HHappy Hospital, 163–177

2007 end of year financial statementsfor, 163–166

2008 end of year financial statementsfor, 172, 174–177

2008 financial accounts adjustmentsfor, 170–173

medical records systems financial trans-actions, 166–171

medical records systems proposals, 163,167–169

ratio analysis for, 172–173, 177health care accounting, 6

introduction to, 1–6payment system impact on, 9

health care managers, financial responsi-bility of, 1

health care organizations, financial envi-ronment of, 7–9

health care reimbursement systems, 9complex nature of, 7–9in revenue management, 129–130

health care servicespayment systems for, 7–9viability trade-off for, 4

health insuranceclaim payments. See reimbursementas payroll deduction, 133

Healthy Hospital financial statements,48–56

balance sheet, 51–52cash flow statement, 52–56key concepts, 47–48, 56

Index 187



ledger accounts, 48–50operating statement, 50

historical costin asset valuation, 27–28, 33price-level adjusted, 28, 33

holding costs, 127holiday pay, 132hurdle rate, 147–148

cost of capital as, 156

Iimpairment of goodwill, 93income

net. See net incomeresidual, 119

income statement. See also statement ofoperations

for for-profit companies, 23key concepts, 23, 25for not-for-profit companies, 23–24template for, 23, 24useful information from, 89–92

income taxesnotes regarding, 98as payroll payable, 132

increase in net assets, in operating state-ment, 50

independent audit/auditor, 57–63accounting cycle sequelae and, 62–63annual role of, 21, 57–58ethics of, 62failures of, 62fraud and embezzlement detection by,

59–60internal control focus of, 58key concepts, 63management letter issued by, 58management report and, 61–62opinion letter generated by, 60–61oversight by, 62report of, 60–61

indirect method, in statement of cash

flow, 53, 54–55, 92, 94industry data, as benchmark, 105–106,

107, 110inflation

dollar value and, 12inventory costing and, 77price-level, 147

initial public offering, 160insurance expense, prepaid

capitated arrangements, 86Happy Hospital example, 171–172recording of, 40, 43

insurance payments. See reimbursementinsurances, as payroll deduction, 132, 133insurers

financial environment of, 7payment systems of, 8–9

intangible assetin balance sheet, 22, 86concept of, 12, 20

interestcompounded annually, 140–142, 151discounting, 142, 151simple, 140

interest coverage ratio, 115–116interest expense

recording of, 42in solvency ratios, 115–116

interest paid, in statement of cash flows, 52

interest rate (i), 141–143for convertibles, 158

interest received, in statement of cashflows, 52

internal accounting systems, inadequate,in audit failures, 62

internal control, as independent auditfocus, 58

internal rate of return (IRR) methodof analysis, 139, 150, 152project ranking in, 150–151

Internal Revenue Service (IRS)depreciation reporting to, 71–74tax-exempt status code, 154


inventory(ies), 75as current asset, 85–86equation for, 75Healthy Hospital example, 38–44journal recording of, 39notes regarding, 98

inventory costing, 75–82cost-flow assumptions for, 78–81inflation problem with, 77key concepts, 75, 81–82periodic vs. perpetual, 75–77

inventory cycle, for balance sheet, 21inventory equation, 75inventory management

economic order quantity as, 127–128, 136

just-in-time as, 128–129, 136key concepts, 126–127, 136in working capital management,

126–129, 136investment activities, in statement of cash

flows, 52–53, 92–95investment analysis, 137–152

data generation for, 138discounted cash flow method, 139–140,

147, 150, 152Happy Hospital example, 163, 167–171internal rate of return method, 139,

150, 152key concepts, 137, 151–152net present value method, 139,

147–150, 152opportunity identification in, 137–138payback method, 138–140, 152project ranking in, 150–151time value of money in, 137, 138,

140–147, 151investments

analysis of, 137–152identification of opportunities for,

137–138long-term, 22, 137return on, 2, 117–119short-term. See short-term investments

investment securities, in balance sheet, 22investors, as capital source, 159–160IRR method. See internal rate of return

(IRR) methodIRS. See Internal Revenue Service (IRS)

J

JIT (just-in-time) inventory, 128–129, 136journal, general

chart of accounts for, 45for financial information, 35, 46

journal entry(ies)adjusting over time, 40–44, 46capitated insurance and, 86Healthy Hospital example, 38, 40–44key concepts, 35, 46ledger vs., 47, 48posting of, 50recording of, 38–40T-accounts for, 44–45timing for, 35, 46

just-in-time (JIT) inventory, 128–129, 136

KKeepuwell Clinic

capital structure example, 155working capital example, 121, 125–128,

130, 131, 134

Llabor expense, recording of, 42–43last-in, last-out (LIFO)

conformity rule for, 80–81as cost-flow assumption, 79, 82first-in, first-out vs., 79–80inappropriate use of, 81liquidations and, 81

Index 189



leasing, 161ledger, 56

balances combined in, 48capitated insurance and, 86intermediate benefit of, 47journal entry vs., 47, 48

lending money, as investing activity, 53leverage ratio, 115liabilities

in accounting equation, 14, 20balance sheet subgroups of, 22, 25,

86–87in bank accounts, 38in common size ratios, 104, 109concept of, 13, 20in double-entry bookkeeping, 35–36Healthy Hospital example, 38–44limited, 88–89unearned, 86

liabilities valuation, 33asset valuation vs., 27–31equities valuation vs., 32–33

liability classification, for balance sheet,22, 25, 86–87

LIBOR (London Interbank OfferedRate), 134

life insurance, as payroll deduction, 133LIFO. See last-in, last-out (LIFO)limited liability, of stock value, 8–89liquidations, inventory and, 81liquidity

financial statements reflection of, 24ratios of, 110–112, 120as viability component, 4, 6

liquidity ratiosbankruptcy and, 110, 112Community Hospital example of,

111–112current, 110–111, 112days cash on hand, 111Happy Hospital example, 173, 177key concepts, 110, 120quick, 111, 112

litigation, notes regarding, 100

loansbanking relationships for, 134–135in capital structure, 153, 154, 161in liquidity ratio, 111–112commercial paper, 123, 134, 135in common size ratios, 109short-term, management of, 133–134,

136term, 134viability and, 5–6

London Interbank Offered Rate(LIBOR), 134

long-term assets, in balance sheet, 22, 86long-term cash obligations, in liabilities

valuation, 31–32, 33long-term debt

in capital structure, 154, 161in cost of capital, 155–156

long-term investments, 22analysis of, 137–152. See also investment

analysislong-term liabilities

in balance sheet, 22, 86–87in common size ratios, 104, 109

long term liquidity, 4

MMACRS (modified accelerated cost recov-

ery system), 71–73, 74malpractice insurance, 171–172managed care

accounting and, 86Happy Hospital example, 171ratio analysis and, 109

management letter, independent auditorgeneration of, 58, 63

management report, annual generationof, 61–62, 63

managerial accountant, 2managerial accounting

description of, 1–2, 6pertinent applications of, 2–6


marketable securities, 22, 85in liquidity ratio, 111–112in working capital management, 122, 135

market valuein net asset valuation, 32–33owner’s equity and, 32–33

matchingconcept of, 17–18, 19as depreciation principle, 65, 74

material commitments, as liability, 87materiality, 18–19MBA programs, 11Medicaid, reimbursement program, 8medical records systems improvement,

investments for, 163, 167–171medical supplies, in viability example, 5–6Medicare, 8merger(s), goodwill associated with, 12–13MHA programs, 11Microsoft Excel, for time value of money

calculations, 143–147modified accelerated cost recovery system

(MACRS), 71–73, 74monetary denominator, 12, 19–20money

future value of, 141–143lending, as investing activity, 53present value of, 141–143time value of. See time value of money

money market funds, 3, 123, 135mortgage payable (M/P), recording of, 42

Nnear term assets, in balance sheet, 22near term liquidity, 4negotiable certificate of deposit, 123negotiated rate, 8–9net assets

in accounting equation, 14, 20in balance sheet, 22, 23, 25, 87categories of, 22–23change in, 50

in common size ratios, 104, 109concept of, 13–14, 20, 87in cost of capital, 155–156decrease in, 50in double-entry bookkeeping, 35–36as fund balance, 14–15, 19Healthy Hospital example, 38–44income/operating statement reflection

of changes in, 23increase in, 50notes regarding, 99restricted vs. unrestricted, 22–23, 25,

87, 90return on, 117–119in solvency ratios, 115useful information regarding, 87–89valuation of, 32, 33

“net due,” 130net income

delevered, 118in investment analysis, 138in operating statement, 50, 90–91

net patient revenue, 9net present value (NPV) method

of analysis, 139, 147–150, 152internal rate of return and, 150

net price, 131net realizable value, in asset valuation,

28–29, 33net working capital, 121, 135. See also

working capital management“net worth,” 13nonmonetary obligations, in liabilities val-

uation, 31–32, 33nonresidential property, MACRS for, 72, 74no par stock, 88notes, to financial statements, 97–101

on bonds payable, 99–100on charity care, 98–99on commitments, 100Community Hospital example, 95–96on contingencies, 100on goodwill, 100importance of, 97, 100–101

Index 191



on income taxes, 98on inventories, 98key concepts, 25, 101on litigation, 100on net patient services revenue, 97on property, plant, and equipment, 98on receivables, 99on restricted net assets, 99on short-term investments, 98on significant accounting policies, 97–99useful information from, 95–96

notes payable, in working capital manage-ment, 130, 133–134, 136

not-for-profit hospitalsbalance sheet assets for, 22, 87depreciation process for, 69–71, 74financial environment of, 7, 9financial management goals for, 2income/operating statement for, 23–24independent audit requirements for, 57sources of capital for, 153

NPV method. See net present value (NPV)method

nurse-managers, financial managementby, 1

Oobjective evidence, 18, 19obligations

of buyer vs. seller, 11cash vs. nonmonetary, in liabilities valu-

ation, 31–32, 33operating activities, cash flows from, 92–95operating margin ratio, 117operating profit

in common size ratios, 110as unrestricted net assets, 23, 25

operating room (OR) managers, 1operating statement. See statement of op-

erationsopinion letter

adverse, 61

clean, standard paragraphs of, 60–61disclaimer, 61independent auditor generation of,

60–61, 63qualified, 61

ordering costs, 127organizational comparisons. See ratio

analysisorganizational history, 35

as benchmark, 105, 107organizational year, for financial state-

ments, 21OR (operating room) managers, 1out-of-pocket costs, 127outside audit/auditor. See independent

audit/auditoroversight, of independent auditors, 62overtime, 133owners’ equity

concept of, 13–14, 15, 20liability valuation vs., 31–32market value in, 32–33

ownership share, balance sheet reflectionof, 23

Ppaid-in capital, 25

in balance sheet, 23partners’ equity, 13, 15par value, of stocks, 88–89, 96patient payments, 8–9

revenue cycle and, 129–130patient service revenue (PSR), recording

of, 41payables, 5

recording of. See accounts payable (A/P)payables ratios, as efficiency ratios, 113, 114payback method

of analysis, 138–140, 152of project evaluation, 138–140, 152

payment(s)collections process for, 125, 126


discounts for, 130–131, 136by insurers. See reimbursementlockboxes for, 126organizational models of, 8–9by patients, 8–9sliding scale for, 9

payroll payableaccounting issues, 132–133compliance issues, 132–133key concepts, 130, 136policies for, 132

P&E. See plant and equipment (P&E)periodic method of inventory, 75–76, 81period of time (N), in value of money,

141–143permanently restricted net assets, 22–23,

25, 87notes regarding, 99

perpetual method of inventory, 76–77, 81P/I (prepaid insurance) account, 40, 43, 86piecework pay, 133PLAHC (price-level adjusted historical

cost), in asset valuation, 28, 33plant and equipment (P&E). See also

equipmentdepreciation adjustment for, 43Happy Hospital accounts example,

170–173as long-term asset, 86notes regarding, 98

point of serviceelectronic billing for, 125in revenue management, 129

posting, of journal entries, 50PPE (property, plant, and equipment), ac-

counts example, 170–173preferred stock, 88, 89, 91

in capital structure, 155convertible, 158

prepaid expenses, 86, 111prepaid insurance (P/I) account, 40, 43, 86pre-registration mechanism, for revenue

management, 129present value (PV), of money, 141–143

computer program for calculating,143–147

internal rate of return and, 150previous-year balance, ledger reflection

of, 48price

gross, 131net, 131

price-level adjusted historical cost(PLAHC), in asset valuation, 28, 33

price-level inflation, 147prime rate, 134private placements, in capital structure,

160–161profit(s)

for acquiring capital assets, 2–3from common stock sale, 154future, in asset valuation, 29, 33operational. See operating profitreinvestment of, 87

profitabilityfinancial statements reflection of, 24key concepts, 2, 6need for, 2–3ratios of, 116–117, 120risk trade-off for, 3–4viability trade-off for, 4–5

profitability ratiosHappy Hospital example, 173, 177key concepts, 116, 120margin, 116–117return on investment, 117–119

project evaluationcapital budgeting in, 137–138, 151discounted cash flow analysis for,

139–140, 147, 150, 152Happy Hospital example, 163,

167–171internal rate of return in, 139, 152net present value in, 139, 152payback method of, 138–140, 152project ranking in, 150–151risk analysis, 147–148

property

Index 193



Happy Hospital accounts example,170–173

as long-term asset, 86MACRS for, 72–73, 74notes regarding, 98plant, and equipment (PPE), accounts

example, 170–173PSR (patient service revenue), recording

of, 41publicly held companies. See also stocks

earnings per share data on, 90–91, 96year end audit requirements, 21, 57

public stock offersin capital structure, 160initial, 160secondary, 160underwriters for, 157, 160

purchasing power, risk related to, 147–148PV. See present value (PV)

Q

qualified opinion, of independent audi-tor, 61

quick ratio, of liquidity, 111, 112

Rraises, 133rate of return (r), 141

internal, 150, 152required, 147–148

ratesfor different services, 8negotiated, 8–9

ratio(s)activity, 112average payment period, 114capital structure, 115common size, 104, 105, 107–110, 120debt service coverage, 115, 116

debt to net assets, 115, 116definitions of, 103, 120efficiency, 112–115, 120interest coverage, 115–116leverage, 115liquidity, 110–112, 120margin, 116–117payables, 113, 114receivables, 112–113return on investment, 117–119solvency, 115–116, 120total asset turnover, 113, 114–115

ratio analysis, 103–120benchmarks for, 103, 105–106, 120common size starting point for, 105,

107–110efficiency basis of, 112–115, 120for financial statements, 83, 96Happy Hospital example,

172–173, 177investment return basis of, 117–119key concepts, 103, 120liquidity basis of, 110–112, 120profitability basis of, 116–117, 120solvency basis of, 115–116, 120

realizable value, net, in asset valuation,28–29, 33

receivables, 5as assets, 38notes regarding, 99recording of. See accounts receivable

(A/R)receivables ratios, as efficiency ratios,

112–113recording

of financial information, 35–46. See alsojournal entry(ies)

of medical information, system im-provements for, 163, 167–171

registration information, for revenuemanagement, 129

reimbursementcomplex systems for, 7–9government programs for, 8


in revenue cycle management, 129–130third party, 8

reinvestment, of profits, 87rent, prepaid, 86reorder cards, 76replacement cost

in asset valuation, 29–30, 33, 67depreciation and, 67

reports, year end. See annual reportsrepos, 123, 135repurchase agreements, 123, 135residential property, MACRS for, 72, 74residual income (RI), 119restricted net assets

notes regarding, 99temporarily vs. permanently, 22–23,

25, 87retained earnings, 25

in balance sheet, 23, 89in statement of operations, 91–92

return on assets (ROA), 2as profitability ratio, 117–118, 119

return on equity (ROE), 2return on investment (ROI), 2

ratios of, 117–119return on net assets (RONA), as prof-

itability ratio, 117–119returns. See also profitability

risk trade-off for, 3–4revenue cycle

accounts receivables in, 123–124billing and claims in, 129coding and, 129key concepts, 129, 136management of, 129–130, 136point of service and, 129scheduling in, 129

revenuesin common size ratios, 107, 109–110deferred, 86, 114in double-entry bookkeeping, 37equipment allocation for, 65excess over expenses, 110Healthy Hospital example, 41

in income/operating statement, 23, 89,90–91

net patient, 9RI (residual income), 119risk

with debt financing, 156inventory-related, 127, 128–129of new projects, 148profitability trade-off for, 3–4in rate of return, 147–148

ROA. See return on assets (ROA)ROE (return on equity), 2ROI. See return on investment (ROI)RONA (return on net assets), as prof-

itability ratio, 117–119

Ssalary(ies)

in common size ratios, 110maximization of, 2as payroll payable, 132, 133

salvage value, of assets, 65, 66, 67–68saving accounts, for working capital man-

agement, 134scheduling, in revenue cycle, 129secondary issues, of public stock, 160Section 197 expense, 72Section 197 Intangibles, 72–73securities

for long-term investments, 22marketable, 22for short-term interest, 22in statement of cash flows, 52–53

Securities and Exchange Commission,year end reports to, 21, 57

seed capital, 160sellers, obligations of, 11service charges, 8service providers, financial environment

of, 7shareholders. See stockholdersshareholders’ equity, 13, 15

Index 195



of venture capitalists, 160short term assets, in balance sheet, 22short-term interest, securities for, 22short-term investments

notes regarding, 98in working capital management,

121–123, 135short term liquidity, 4short-term loans, management of,

133–134, 136short-term obligations

accounts payable, 130–131, 136cash, in liabilities valuation, 31–32, 33key concepts, 130, 136trade credit, 130–131, 136in working capital management,

130–134, 136short-term resources, in working capital

management, 121–129, 135–136sick leave, 132SL (straight-line) depreciation, 69, 71, 74sliding scale, for payment, 9Social Security (FICA) taxes, 132solvency

ratios of, 115–116, 120as viability component, 4, 6

solvency ratiosdebt service coverage ratio, 115, 116debt to net assets ratio, 115Happy Hospital example, 173, 177interest coverage ratio, 115–116key concepts, 115, 120

specific identification, as cost-flow as-sumption, 78, 82

spreadsheet programs, for time value ofmoney calculations, 143–147

statement of cash flowsCommunity Hospital example, 92–95direct calculation approach to,

53–54, 56Happy Hospital example, 166, 176Healthy Hospital example, 52–56indirect calculation approach to, 53,

54–56

for investment analysis, 138, 148–150key concepts, 24, 25, 56preparation from ledger, 47–48, 56template for, 24useful information from, 92–95

statement of operationsbalance sheet link to, 90–92common size ratios for, 107–108, 109–110Community Hospital example, 89–92,

104, 110for for-profit companies, 23Happy Hospital example, 165, 175Healthy Hospital example, 50key concepts, 23, 25, 56for not-for-profit companies, 23–24preparation from ledger, 56template for, 23, 24useful information from, 89–92

stockholderscommon, 88, 89, 91, 154preferred, 88, 89, 91, 155public, 160year end reports for, 21, 57–58

stockholders’ equityin balance sheet, 87–89, 91concept of, 13, 15, 25

stock issuance, 153in capital structure, 153, 154, 161initial vs. secondary, 160private placements, 160–161public, 157, 160

stock market, 3stock options, in capital structure,

156–157, 161stock purchases, in statement of cash

flows, 52stock rights, in capital structure, 157, 161stocks

book value per share, 13classes of, 88par value of, 88–89, 96prices, dividends impact on, 158–159value of, bankruptcy and, 88–89viability and, 6


stock splits, in capital structure, 158, 159storage costs, 128straight-line (SL) depreciation, 69, 71, 74sum-of-the-years’ digits (SYD), as depreci-

ation method, 69, 70–71, 74suppliers

financial environment of, 7viability example of, 5–6

TT-accounts, 44–45tangible asset, 12, 20tax(es)

deferred, depreciation methods for,71–73, 74

income, 132notes regarding, 98

MACRS and, 71–73, 74payable, as current liability, 86payroll, 132

taxes payablepayroll-related, 132in working capital management, 130,

134, 136tax-exempt status, IRS code for, 154tax returns, 21T-bill, 122–123, 135technology(ies)

computer. See computer technologynew, profits for acquiring, 2–3

temporarily restricted net assets, 22–23,25, 87

notes regarding, 99temporary accounts, 48temporary difference, 73–74term loan, 134terms, for accounts payable, 130, 136third-party payers, 9

reimbursements by, 8revenue cycle and, 129–130

time value of moneyannuities and, 142–143, 151

compounding interest and, 140–142, 151discounting interest and, 142, 151in investment analysis, 139, 140–147key concepts, 137, 138, 140, 151spreadsheet program for, 143–147

timing for recording transactions, 35, 46total assets, in common size ratios, 104,

107–108, 109total asset turnover ratio, 113, 114–115“total book value,” 13total equities, in common size ratios, 104,

107–108total margin ratio, 116–117trade credit, 130–131, 136transactions, recording of, 38–40

adjusting over time, 40–44, 46Healthy Hospital example, 38, 40–44T-accounts for, 44–45timing for, 35, 46

transfers, automatic, between bank ac-counts, 135

Treasury bill, 122–123, 135

Uunderwriters, for public stock offers,

157, 160unearned liability, 86unemployment insurance, 132units purchased (P), in inventory costing,

75–76, 81units sold (S), in inventory costing,

75–76, 81unrestricted net assets, 22–23, 25, 87, 90unsecured notes, 133useful life, of asset, 65, 66, 68, 72, 74

Vvacation days, 132valuation, 66

of assets, 27–33. See also asset valuation

Index 197



of stocks, 13, 88–89, 96venture capital, in capital structure,

159–160venture capitalists, 159, 160viability

bankruptcy vs., 4–6cash flows and, 92–95key concepts, 2, 4, 6profitability trade-off for, 4–5service trade-off for, 4

WWA. See weighted average (WA)wages payable (W/P)

as current liability, 86increase in, 94recording of, 42, 43

warrants, in capital structure, 157–158wealth, maximization of, 2weighted average (WA)

as cost-flow assumption, 78–79, 82cost of capital, 156–157

well-being, of community, 2working capital, 160working capital management

accounts receivable in, 123–126, 136

banking relationships and, 134–135, 136cash in, 121, 122, 135inventory management in, 126–129, 136Keepuwell Clinic example, 121,

125–128, 130, 131, 134key concepts, 121, 135–136marketable securities in, 122, 135revenue cycle in, 129–130, 136short-term investments in, 121,

122–123, 135–136short-term obligations in, 130–134, 136short-term resources in, 121–129,

135–136W/P. See wages payable (W/P)

Yyear-end balance, ledger reflection of, 48year end reports, SEC requirements for,

21, 57–58

Zzero-balance accounts, 135


Documents

Accounting Fundamentals for Health Care Management