Discussion 4-1: Healthcare economics

RESOURCE ARTICLE>>>>

A health care entity’s financial information reaches several distinct audiences, some internal to the organization, including the organization’s managers, officers, and directors, and some external to the organization, including creditors, investors, and governmental entities. Financial accounting, the subject of the next two lessons, provides information primarily for external audiences. This is not to say that internal decision-makers have no interest in the information contained in financial reporting. Often, the career of a manager, officer, or director depends upon the information contained in the financial statements described below. However, the focus of financial accounting information is on the external user, who is presumed to lack privity to the company’s operations. As a result, uniform reporting standards have been developed for the external user’s protection. Financial reporting standards seek to assure the external audience that information presented will be relevant and reliable and will enhance the user’s ability to compare the results of two or more entities in the same industry so that informed decisions and assessments can be made. Relevance means that the information is significant enough to make a difference in the decision at hand. Reliability refers to the ability of the user to verify that the information presented is accurate and free of bias.

Modern financial reporting has been shaped by major financial disasters, including the Stock Market Crash of 1929 and the Enron/Worldcom scandals. These disasters have demonstrated the need for full and fair disclosure of an entity’s financial position and operations. Therefore, new guidelines have been established, based upon the perceived weaknesses in reporting that created the disasters in the first place.

Financial Statements. There are four primary financial statements:

The balance sheet
The income statement
The statement of retained earnings
The statement of cash flows

The balance sheet represents a company’s financial position at one point in time. It consists of assets, the things of value the company owns; liabilities, the amounts owed to third parties or those entities or individuals not having an ownership interest in the company for goods and services provided to the company; and owner’s equity, representing the owner’s residual interest in the company (i.e., claim to company assets). The balance sheet incorporates the accounting equation (i.e., assets = liabilities + owner’s equity). This equation provides the basis for all accounting analysis and makes sense from an economic standpoint. Assets can come from only one of two sources: 1) the owners, as represented in the owner’s equity section of the balance sheet, or 2) third parties, as represented by the liability section of the balance sheet.

A balance sheet can be further divided between current assets and noncurrent assets, as well as between current liabilities and non-current liabilities; this type of sheet is known as a classified balance sheet. Current assets, which will be either consumed or realized as cash in the next operating cycle (generally a year), include cash, inventory, supplies, accounts receivable, marketable securities, and prepaid assets. Noncurrent assets, which are not expected to be sold or used up in the next operating cycle, include property, plant and equipment, long-term investments, and intangibles, such as patents, goodwill, and copyrights. Accounts payable, certain notes payable, and the current portion of a bonds payable are included in the current liabilities’ section. Long-term notes payable and the long-term portion of bonds payable are a part of the non-current liabilities’ section. While current liabilities are expected to be paid off in the next year or operating cycle, non-current liabilities are paid off sometime beyond the next operating cycle.

Income Statement. Revealing the results of a health care entity’s operations over a given period of time, the income statement has four basic elements, which were defined during our discussion of the budgeting process:

Revenues, which are inflows of assets that result from the company’s primary activities, generally sales or services
Expenses, which are outflows of assets that result from activities which generate revenue
Gains, which are net inflows of assets from peripheral, or non-primary, activities
Losses, which are net outflows of assets from peripheral or non-primary activities

Income statements contain a bottom line figure indicating whether the company experienced net income or net loss. To the extent that a company’s revenues and gains exceed its expenses and losses, it will have net income. To the extent that a company’s expenses and losses exceed its revenues and gains, it will have a net loss.

The elements of the statement of owner’s equity section vary according to whether the entity involved is a for-profit or a nonprofit organization. Generally, in a corporate nonprofit organization (for which you will be accounting in Activity 4), there are two components of owner’s equity: a capital section, representing the investments made by the owners, and a retained earnings section, representing all the earnings of a company from its origin, which have not been distributed to the shareholders or been used for reinvestment in the company (distributions of earnings in a corporate setting are dividends). The capital section contains such accounts as Common Stock, Preferred Stock, and Additional Paid-in Capital.

Cash Flow. The statement of cash flows provides, in detail, all sources of a company’s inflows and outflows. There are three primary sources of cash flows:

From operating activities
From investing activities
From financing activities

To determine cash flows from operating activities, the accountant must analyze such items as net income, depreciation, current assets, and current liabilities. However, to obtain the cash flows from investing activities, the accountant must review long-term assets. Finally, cash flows from financing activities are determined by analyzing stockholder equity accounts, such as the capital accounts and dividends, and by reviewing long-term liabilities. To develop a statement of cash flows, health care accountants usually analyze comparative balance sheets (i.e., balance sheets from the most recent two year period). The various accounts are analyzed to determine the cash flow effect. As a part of this lesson, you are asked to develop a cash flow statement. The two different methods used to develop cash flow analysis are the direct method and the indirect method. Because the indirect method is preferred, you will be using it in your statement.

The statement of cash flows can be thought of as a reconciliation of accrual basis accounting with cash basis accounting (see the discussion below). The starting point for cash flow analysis under the indirect method is net income. Items such as depreciation and losses are added to net income. To complete the operating activities section, the accountant must analyze changes in current assets and current liabilities. The rules applicable to the analysis of current liabilities and assets are as follows:

Any increase in current assets must be subtracted from Net Income on the Statement of Cash Flows
Any decrease in current assets must be added to Net Income
Any decrease in current liabilities must be subtracted from Net Income
Any increase in current liabilities must be added to Net Income

For investing activities, the rules are more straightforward. An increase in a long-term asset must mean that a purchase was made and, therefore, that a cash outflow took place. A decrease in a long-term asset must mean that a sale took place and, therefore, that a cash inflow took place. Finally, for financing activities, if a long-term liability increases, it means that a cash inflow has taken place (e.g., When a note payable is issued, it means that the health care facility has borrowed money. If a long-term liability decreases, it indicates the facility has paid it off or reduced it, so a cash outflow has taken place). Dividends are always a cash outflow. Increases in common stock indicate investment in the company by owners and thus represent a cash inflow.

To prepare three of the four financial statements, you must understand the articulation or relationship between the balance sheet, the statement of retained earnings, and the income statement. Statements must be prepared in the following order:

Income Statement
Statement of Retained Earnings
Balance Sheet.

This is due to the fact that in order to complete the Statement of Retained Earnings, a final net income (loss) figure is needed, and to complete the Balance Sheet, a final Statement of Retained Earnings figure is needed. To understand the link between Balance Sheet and Retained Earnings a bit further, you see that to complete the Balance Sheet, you must have a final balance for the Owner’s Equity section. To have a final balance in Owner’s Equity, you must have a final figure in Retained Earnings.

Statement of Retained Earnings. Our text does not discuss the Statement of Retained Earnings in detail, so I will describe it here. Please be sure to refer to this section when working on Activity 4. The format for preparing the Statement of Retained Earnings is as follows:

Keep in mind that there are different methods of accounting, each of which uniquely affects the information reported to interested users. The most commonly accepted method, and the one required for many entities under Generally Accepted Accounting Principles (GAAP), is the accrual method. The other is the cash method. Accrual accounting means that revenues are recognized (reported) when they are earned and that expenses are recognized when they are incurred (or when they take place).

Accrual Accounting. The revenue recognition principle, a corollary of accrual accounting, states that revenues are recognized upon the occurrence of two conditions: 1) when they are earned and 2) when they are realized or realizable in cash. The timing of the completion of the earnings process depends on the type of entity involved. If the company is involved in the sales of goods to generate income, then earning takes place when the goods are delivered to the ultimate consumer. If the entity performs services to generate income (typically the case with health service organizations), then earnings are considered to have taken place when the performance of services is completed.

Under the accrual method, expenses are recognized when incurred. In practice, expenses are recognized in the same period that the revenues with which they are associated are recognized. Recognizing expenses in the same period as their associated revenues are recognized is known as the matching principle. This matching of revenues and expenses avoids distortions in the reporting of income, which can occur under cash basis accounting. Under cash basis accounting, revenue is recognized when cash is received, and expenses are recognized when cash is dispersed.

To illustrate the distortions that can occur, let’s look at one category of transactions. Suppose a heart surgeon performs 20 surgeries in December, 2004. His patients are billed in January in 2005, and the patients’ insurance companies pay the bills in March through May, 2005. Assume that the following were paid in December, 2004: the salaries of the surgeon and his team, supplies, utilities, and the lease associated with the operating room. Applying the cash method under this scenario, all of the expense from this transaction would be recognized in 2004 (because that is when disbursement of cash took place) and all of the revenue from this transaction would be recognized in 2005 (because that is when the cash is collected).

The user of such financial information would be able to conclude only that the entity had a poor year for surgical procedures in 2004 and a great year in 2005. Under the accrual method, revenue would have been recognized in 2004 (under the revenue recognition rule, the earnings process would have been completed at the conclusion of the surgeries and any other related patient services and the fact that the patients had insurance made it likely that cash would be received/realizable). Applying the matching principle, we see that any expenses associated with the revenue-generating events, the surgeries, would be recognized in the period that the revenue was recognized. Therefore, the surgeon’s salary, surgical supplies, operating room lease costs, and utilities that could be traced to the surgery would also be recognized in 2004. Clearly, the accrual method provides a more accurate picture of what happened economically in 2004 and 2005. This example underscores the importance of reporting information which accurately reflects the economic effects of a given transaction. Invalid, incomplete, or inaccurate reporting of information may lead the user of such information to make inaccurate conclusions. From such inaccurate conclusions, users may make incorrect decisions.

Lecture and Research Update Bibliography

Penner, S. (2004). Introduction to Health Care Economics & Financial Management: Fundamental Concepts with Practical Applications. Philadelphia: Lippincott Williams & Wilkens.