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operating income (an operating loss). This situation is worrisome, because a business is on shaky financial ground if its core opera-
tions are losing money, especially if they do so year after year.
Note that the operating income reported on the income statement is defined by GAAP and represents an estimate of the long-run operating profitability of the busi-
ness. It has some shortcomings—for one, it does not represent cash flow—that are similar to the shortcomings related to net income discussed in a later section. Still, measuring the core profitability of a business is critical to understanding its financial status.
Nonoperating Income
The next section of the income statement lists nonoperating income
. As men-
tioned earlier, reporting the income of operating and nonoperating activities separately is useful. The nonoperating income section of Sunnyvale’s income statement shown in Exhibit 3.1 reports the income generated from activities unrelated to the provision of healthcare services.
The first category of nonoperating income listed is contributions.
Many not-for-profit organizations, especially those with large, well-endowed foun-
dations, rely heavily on charitable contributions as an income source. Those charitable contributions that can be used immediately (spent now) are reported as nonoperating income. However, contributions that create a permanent endowment fund, and hence are not available for immediate use, are not reported on the income statement.
The second category of nonoperating income is investment income,
another type of income on which not-for-profit-organizations rely heavily. It stems from two primary sources:
1. Healthcare businesses usually have funds available that exceed the minimum necessary to meet current cash expenses. Because cash earns 1. What is operating income?
2. Why is operating income such an important measure of profitability?
SELF-TEST QUESTIONS
Nonoperating income
The earnings of a business that are unrelated to core activities. For a healthcare provider, the most common sources are contributions and investment income.
care, directly related activities, and government appropriations. Each definition results in a differ-
ent value for operating income. In general, as the definition of core operations expands, the value calculated for operating income increases.
What do you think? Consider the hospital industry. What activities should be considered part of core operations? Should hospitals be required by GAAP to report multiple measures of operating income, each using a different defini-
tion of core activities?
(continued from previous page)
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Chapter 3: The Income Statement and Statement of Changes in Equity
101
no interest, these “excess” funds usually are invested in short-term, interest-earning securities, such as Treasury bills or money market mutual funds. Sometimes these invested funds can be quite large—say, when a business is building up cash to make a tax payment or to start a large construction project. Also, prudent businesses keep a reserve of funds on hand to meet unexpected emergencies. The interest earned on such funds is listed as investment income.
2. Not-for-profit businesses may have a large amount of endowment fund contributions. When these contributions are received, they are not reported as income because the funds are not available to be spent. However, the income from securities purchased with endowment funds is available to the healthcare organization, and hence this income is reported as nonoperating (investment) income.
In total, Sunnyvale reported $4,113,000 of nonoperating income for 2015, consisting of $243,000 in spendable contributions and $3,870,000 earned on the investment of excess cash and endowments. Nonoperating income is not central to the core business, which is providing healthcare services. Overreliance on nonoperating income could mask operational inefficiencies that, if not corrected, could lead to future financial problems. Note that the costs associated with creating nonoperating income are not separately reported. Thus, the expenses associated with soliciting contributions or investing excess cash and endowments must be deducted before the income is reported on the income statement.
Finally, note that the income statements of some providers do not con-
tain a separate section titled nonoperating income
. Rather, nonoperating income is included in the revenue section that heads the income statement. In this situation, total revenues include both operating and nonoperating revenues.
Net Income
The second profitability measure reported by Sunnyvale Clinic is net income
, which in Exhibit 3.1 is equal to Operating income + Total nonoperating income. Sunnyvale reported net income of $7,860,000 for 2015: $3,747,000 + $4,113,000 = $7,860,000. (Not-for-profit organizations use the term excess 1. What is nonoperating income?
2. Why is nonoperating income reported separately from revenues? Is this always the case?
SELF-TEST QUESTIONS
Net income
The total earnings of a business, including both operating and nonoperating income.
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of revenues over expenses,
but we call this measure net income
because that is the more universally recognized term. Also, one could argue that there are three profitability measures on Sunnyvale’s income statement: operating income, nonoperating income, and net income. We wouldn’t object to that position, but accountants generally view nonoperating income as an entry on the state-
ment rather than a calculated profitability measure.)
Because of its location on the income statement and its importance, net income is referred to as the bottom line.
In spite of the fact that Sunnyvale is a not-for-profit organization, it still must make a profit.
If the business is to offer new services in the future, it must earn a profit today to produce the funds needed for new assets. Furthermore, because of inflation, Sunnyvale could not even replace its existing assets as they wear out or become obsolete without the funds generated by positive profitability. Thus, turning a profit is essential for all businesses, including not-for-profits.
What happens to a business’s net income? For the most part, it is rein-
vested in the business. Not-for-profit corporations must reinvest all earnings in the business. An investor-owned corporation, on the other hand, may return a portion or all of its net income to owners in the form of dividend payments. The amount of profits reinvested in an investor-owned business, therefore, is net income minus the amount paid out as dividends. (Some for-profit busi-
nesses distribute profits to owners in the form of bonuses, which often occurs in medical practices. However, when this is done, the distribution becomes an expense item that reduces net income rather than a distribution of net income. The end result is the same—monies are distributed to owners—but the reporting mechanism is much different.)
Note that both operating income and net income measure profitability as defined by GAAP. In establishing GAAP, accountants have created guide-
lines that attempt to measure the economic income
of a business, which is a difficult task because economic gains and losses often are not tied to easily identifiable events.
Furthermore, some of the income statement items are estimates (e.g., provision for bad debt losses) and others (e.g., depreciation expense) do not represent actual cash costs. Because of accrual accounting and other factors, the fact that Sunnyvale reported net income of $7,860,000 for 2015 does not mean that the business actually experienced a net cash inflow of that amount. This point is discussed in greater detail in the next section.
1. Why is net income called “the bottom line”?
2. What is the difference between net income and operating income?
3. What happens to net income?
SELF-TEST QUESTIONS
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Chapter 3: The Income Statement and Statement of Changes in Equity
103
Net Income Versus Cash Flow
As stated previously, the income statement reports total profitability (net income), which is determined in accordance with GAAP. Although net income is an important measure of profitability, an organization’s financial condition, at least in the short run, depends more on the actual cash that flows into and out of the business than it does on reported net income. Thus, occasionally a business will go bankrupt even though its net income has historically been positive. More com-
monly, many businesses that have reported negative net incomes (i.e., net losses) have survived with little or no financial damage. How can these things happen?
The problem is that the income statement is like a mixture of apples and oranges. Consider Exhibit 3.1. Sunnyvale reported net operating revenues of $169,979,000 for 2015. Yet, this is not the amount of cash that was actually collected during the year, because some of these revenues will not be collected until 2016. Furthermore, some revenues reported for 2014 were actually col-
lected in 2015, but these do not appear on the 2015 income statement. Thus, because of accrual accounting, reported revenue is not the same as cash revenue. The same logic applies to expenses; few of the values reported as expenses on the income statement are the same as the actual cash outflows. To make mat-
ters even worse, not one cent of depreciation expense was paid out as cash. Depreciation expense is an accounting reflection of the cost of fixed assets, but Sunnyvale did not actually pay out $6,405,000 in cash to someone called the “collector of depreciation.” According to the balance sheet (see Exhibit 4.1), Sunnyvale actually paid out $88,549,000 sometime in the past to purchase the clinic’s total fixed assets, of which $6,405,000 was recognized in 2015 as a cost of doing business, just as salaries and fringe benefits are a cost of doing business.
Can net income be converted to cash flow
—the actual amount of cash generated during the year? As a rough estimate
, cash flow can be thought of as net income plus noncash expenses. Thus, the cash flow generated by Sunnyvale in 2015 is not merely the $7,860,000 reported net income, but this amount plus the $6,405,000 shown for depreciation, for a total of $14,265,000. Depreciation expense must be added back to net income to get cash flow because it initially was subtracted from revenues to obtain net income even though there was no associated cash outlay.
Key Equation: Net Income to Cash Flow Conversion
Because of accrual accounting, net income does not represent an estimate of the organization’s cash flow for the reporting period. This equation is used to convert net income to a rough estimate of cash flow: Cash flow = Net income + Noncash expenses. Because depreciation often is (continued)
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Here is another way of looking at cash flow versus accounting income: If Sunnyvale showed no net income for 2015, it would still be generating cash of $6,405,000 because that amount was deducted from revenues but not actually paid out in cash. The idea behind the income statement treatment is that Sunnyvale would be able to set aside the depreciation amount, which is above and beyond its cash expenses, this year and in future years. Eventually, the accumulated total of depreciation cash flow
would be used by Sunnyvale to replace its fixed assets as they wear out or become obsolete.
Thus, the incorporation of depreciation expense into the cost and, ultimately, the price structure of services provided is designed to ensure the ability of an organization to replace its fixed assets as needed, assuming that the assets could be purchased at their historical cost. To be more realistic, businesses must plan to generate net income, in addition to the accumulated depreciation funds, sufficient to replace existing fixed assets in the future at inflated costs or even to expand the asset base. It appears that Sunnyvale does have such capabilities, as reflected in its $7,860,000 net income and $14,265,000 cash flow for 2015.
It is important to understand that the $14,265,000 cash flow calculated here is only an estimate
of actual cash flow for 2015, because almost every item of revenues and expenses listed on the income statement does not equal its cash flow counterpart. The greater the difference between the reported values and cash values, the less reliable is the rough estimate of cash flow defined here. The value of knowing the precise amount of cash generated or lost has not gone unnoticed by accountants. In Chapter 4, readers will learn about the statement of cash flows, which can be thought of as an income statement that is recast to focus on cash flow.
1. What is the difference between net income and cash flow?
2. How can income statement data be used to estimate cash flow?
3. What is depreciation cash flow, and what is its expected use?
4. Why do not-for-profit businesses need to make a profit?
SELF-TEST QUESTIONS
the only noncash expense, the equation can be rewritten as Cash flow = Net income + Depreciation. To illustrate, Sunnyvale reported net income of $8,206,000 and depreciation of $5,798,000 in 2014. Thus, a rough measure of its 2014 cash flow is $14,004,000:
Cash flow = Net income + Depreciation
= $8,206,000 + $5,798,000
= $14,004,000.
(continued from previous page)
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Chapter 3: The Income Statement and Statement of Changes in Equity
105
Income Statements of Investor-Owned Businesses
Our income statement discussion focused on a not-for-profit organization: Sunnyvale Clinic. What do the income statements for investor-owned businesses, such as Community Health Systems and Brookdale Senior Living, look like? The financial statements of investor-owned and not-for-profit businesses are generally similar except for entries, such as tax payments, that are applicable only to one form of ownership. Because the transactions of all health services organizations are similar in nature, ownership plays only a minor role in the presentation of financial statement data. In reality, more differences exist in financial statements because of lines of business (e.g., hospitals versus nursing homes versus managed care plans) than because of ownership.
The impact of taxes and depreciation on net income and cash flow for for-profit businesses deserves discussion. Exhibit 3.2 contains four income statements that are based on Sunnyvale’s 2015 income statement presented in Exhibit 3.1. First, note that the Exhibit 3.2 statements are condensed to show only total revenues (including nonoperating income); all expenses except depreciation; depreciation; and net income. Lines for taxable income, taxes, and cash flow have also been added. The column labeled “Not-for-Profit” presents Sunnyvale’s income statement assuming not-for-profit status (zero taxes), so the reported net income and cash flow are the same, as discussed previously.
Now consider the column labeled “For-Profit A,” which assumes that Sunnyvale is a for-profit business with a 20 percent tax rate. Here, the clinic EXHIBIT 3.2
Sunnyvale Clinic: Condensed Income Statements Under Alternative Tax Assumptions, Year Ended December 31, 2015 (in thousands)
Not-for-Profit
(Tax rate = 0%)
For-Profit A
(Tax rate = 20%)
For-Profit B
(Tax rate = 40%)
For-Profit C
(Tax rate = 40%)
Total revenues
Expenses:
All except depreciation Depreciation
Total expenses
Taxable income Taxes
Net income
Cash flow (NI + depreciation)
$174,092
$159,827
6,405
$166,232
$ 7,860
0
$ 7,860
$ 14,265
$174,092
$159,827
6,405
$166,232
$ 7,860
1,572
$ 6,288
$ 12,693
$174,092
$159,827
6,405
$166,232
$ 7,860
3,144
$ 4,716
$ 11,121
$174,092
$159,827
0
$159,827
$ 14,265 5,706
$ 8,559
$ 8,559
Note:
Total revenues = Net operating revenues + Total nonoperating income. NI (net income).
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Healthcare Finance
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must pay taxes of 0.20 × $7,860,000 = $1,572,000, which reduces net income by a like amount: $7,860,000 − $1,572,000 = $6,288,000. In the next col-
umn, labeled “For-Profit B,” the tax rate is assumed to be 40 percent, which results in higher taxes of $3,144,000 and a lower net income of $4,716,000. The impact of taxes on net income is clear: The addition of taxes reduces net income, and the greater the tax rate, the greater the reduction.
Finally, let’s examine the impact of depreciation and taxes on cash flow (net income plus depreciation). The right column, labeled “For-Profit C,” is the same as the “For-Profit B” column, except the depreciation expense is assumed to be zero rather than $6,405,000. What is the impact of deprecia-
tion expense? Depreciation expense lowers taxable income by a like amount and hence lowers taxes by T
× Depreciation expense, where T
is the tax rate. The amount of taxes saved—0.40 × $6,405,000 = $2,562,000—is called the depreciation shield
. It is the dollar amount of taxes that will not have to be paid because of the business’s depreciation expense. Let’s check our work. According to Exhibit 3.2, the taxes due without depreciation expense are $5,706,000, but with depreciation taxes they are $3,144,000. Thus, the depreciation expense has saved the business $5,706,000 − $3,144,000 = $2,562,000, which is the amount of the depreciation shield just calculated. Also, note that the cash flow is higher by the same amount, so the depreciation expense, which reduces taxes but does not impact cash flow, has increased cash flow by the amount of the tax reduction (the depre-
ciation shield).
Key Equation: Depreciation Shield
Because depreciation expense reduces taxes, it is said to shield a for-profit business from taxes, and the amount of taxes saved is called the deprecia-
tion shield. If a business has $500,000 in depreciation expense and pays taxes at a 30 percent rate, its depreciation shield is $150,000:
Depreciation shield = T
× Depreciation expense = 0.30 × $500,000 = $150,000.
1. Are there appreciable differences in the income statements of not-
for-profit businesses and investor-owned businesses?
2. What are the impacts of taxes and depreciation on net income and cash flow?
3. What is the depreciation shield?
SELF-TEST QUESTIONS
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Chapter 3: The Income Statement and Statement of Changes in Equity
107
Statement of Changes in Equity
As discussed in a previous section, all or some portion of a business’s net income will be retained in the business. The statement of changes in equity
, also called statement of changes in net assets,
is a financial statement that indicates how much of an organization’s net income will be retained in the business and hence increase the amount of equity shown on the balance sheet.
Exhibit 3.3 contains Sunnyvale’s statements of changes in equity. Because we have simplified the financial statements presented in this book to facilitate understanding, the statements shown here are very basic. In most situations, the Exhibit 3.3 statements would contain several more lines reflecting transac-
tions that affect the amount transferred to the balance sheet.
Exhibit 3.3 tells us that, in 2015, the entire amount of Sunnyvale’s net income was retained in the business, hence the equity (net assets) of the clinic increased from $46,208,000 at the beginning of the year to $54,068,000 at the end of the year. This can be confirmed by the amount of equity shown for 2015 in Exhibit 4.1 (see Chapter 4).
To illustrate more complex statements of changes in equity, consider Exhibit 3.4, which assumes that Sunnyvale is a for-profit entity. Now, some portion of the earnings (net income) of the business is paid out as dividends. In 2015, the business had a net income of $7,860,000, but $2,000,000 of this amount was paid to owners. Thus, only $7,860,000 − $2,000,000 = $5,860,000 is available to increase the balance sheet equity account. Note that, in total, the 2015 ending equity was $54,068,000 − $50,168,000 = $3,900,000 greater in Exhibit 3.3 than in Exhibit 3.4. The difference is caused by the fact that Sunny-
vale, when assumed to be for-profit, paid out $3,900,000 total in dividends over 2014 and 2015; hence, the amount retained in the business was reduced by a like amount. (For simplicity, we did not reduce the net income in Exhibit 3.4 by the amount of taxes that would be paid if Sunnyvale were for-profit.)
Statement of changes in equity
A financial statement that reports how much of a business’s income statement earnings flows to the balance sheet equity account.
1. What is the purpose of the statement of changes in equity (net assets)?
2. How does the statement differ between not-for-profit and for-
profit entities?
SELF-TEST QUESTIONS
2015
2014
Net income
$ 7,860
$ 8,206
Equity (net assets), beginning of year
46,208
38,002
Equity (net assets), end of year
$54,068
$46,208
EXHIBIT 3.3
Sunnyvale Clinic: State-
ments of Changes in Equity (Net Assets), Years Ended Decem-
ber 31, 2015 and 2014 (in thousands)
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A Look Ahead: Using Income Statement Data in Financial Statement Analysis
Chapter 17 discusses in some detail the techniques used to analyze financial statements to gain insights into a business’s financial condition. At this point, however, it would be worthwhile to introduce financial ratio analysis
—one of the techniques used in financial condition analysis. In financial ratio analysis, values found on the financial statements are combined to form ratios that have economic meaning and help managers and investors interpret the numbers.
To illustrate, total profit margin
, usually just called total margin,
is defined as net income divided by total revenues, which includes nonoperating income. For Sunnyvale Clinic, the total margin for 2015 was $7,860,000 ÷ ($169,979,000 + $4,113,000) = $7,860,000 ÷ $174,092,000 = 0.045 = 4.5%. Thus, each dollar of revenues and income generated by the clinic produced 4.5 cents of profit (i.e., net income). By implication, each dollar of revenues and income required 95.5 cents of expenses. The total margin is a measure of expense control; for a given amount of revenues and income, the higher the net income, and hence total margin, the lower the expenses. If the total margin for other similar clinics were known, judgments about how well Sunnyvale is doing in the area of expense control, relative to its peers, could be made.
Sunnyvale’s total margin for 2014 was $8,206,000 ÷ $144,800,000 = 0.057 = 5.7%, so the clinic’s total margin slipped from 2014 to 2015. This finding should alert managers to examine carefully the increase in expenses in 2015. In effect, Sunnyvale’s expenses increased faster than its revenues plus investment income, which resulted in falling profitability as measured by total margin. If this trend continues, it would not take long for the clinic to be operating in the red (i.e., losing money).
Finally, let’s take a quick look at Sunnyvale’s operating margin
, which is defined as operating income divided by net operating revenues. For 2015, Sunnyvale’s operating margin was $3,747,000 ÷ $169,979,000 = 0.022 = 2.2%. Thus, each dollar of operating revenues generated by the clinic produced 2.2 cents of profit (operating income). Because operating margin does not include noncore revenues (contributions and investment income), it is lower than Sunnyvale’s total margin, which does include such income.
Total (profit) margin
Net income divided by total revenues. It measures the amount of total profit per dollar of total revenues.
Operating margin
Operating income divided by net operating revenues. It measures the amount of operating profit per dollar of operating revenues and focuses on the core activities of a business.
2015
2014
Net income
$ 7,860
$8,206
Less: Dividends paid
2,000
1,900
Increase in equity
$ 5,860
$6,306
Equity, beginning of year
44,308
38,002
Equity, end of year
$50,168
$44,308
EXHIBIT 3.4
Sunnyvale Clinic: Statements of Changes in Equity Assuming For-
Profit Status, Years Ended December 31, 2015 and 2014 (in thousands)
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Chapter 3: The Income Statement and Statement of Changes in Equity
109
A complete discussion of financial ratio analysis can be found in Chapter 17. The discussion here, along with a brief visit in Chapter 4, is merely intended to give readers a preview of how financial statement data can be used to make judgments about a business’s financial condition.
1. Explain how ratio analysis can be used to help interpret income statement data.
2. What is the total profit margin, and what does it measure?
SELF-TEST QUESTIONS
Key Concepts
Financial accounting information is the result of a process of identifying, measuring, recording, and communicating the economic events and status of an organization to interested parties. This information is summarized and presented in four primary financial statements: the income statement, the statement of changes in equity, the balance sheet, and the statement of cash flows. The key concepts of this chapter are as follows:
• The predominant users of financial accounting information
are parties who have a direct financial interest in the economic status of a business—primarily its managers and investors.
• Generally accepted accounting principles
(
GAAP)
establish the standards for financial accounting measurement and reporting. These principles have been sanctioned by the Securities and Exchange Commission (SEC), developed by the Financial Accounting Standards Board
(FASB),
and refined by the American Institute of Certified Public Accountants (AICPA)
and other organizations.
• The goal
of financial accounting is to provide information about organizations that is useful to present and future investors and other users in making rational financial and investment decisions.
• The preparation and presentation of financial accounting data are based on the following set of assumptions, principles, and constraints: (1) accounting entity, (2)
going concern, (3)
accounting period, (4)
monetary unit, (5)
historical cost, (6) revenue recognition, (7)
expense matching, (8)
full disclosure, (9)
materiality,
and (10)
cost–benefit.
• Under cash accounting,
economic events are recognized when the cash transaction occurs. Under accrual accounting,
economic (continued)
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events are recognized when the obligation to make payment occurs. GAAP requires that businesses use accrual accounting because it provides a better picture of a business’s true financial status.
• The collection and recording of financial accounting data use the following concepts: (1) transaction,
(2) posting,
(3) chart of accounts,
(4) general ledger,
(5) double entry,
and (6) T account.
• The income statement
reports on an organization’s operations over a period of time. Its basic structure consists of revenues, expenses,
and one or more profit
measures.
• Operating revenues
are monies collected or expected to be collected that are related to the core business, namely, patient services. Operating revenues are broken down into categories such as net patient service revenue,
premium revenue,
and other revenue
.
• Expenses
are the economic costs associated with the provision of services.
• Nonoperating income
reports earnings that are unrelated to patient services, typically unrestricted contributions and investment income.
• Operating income
focuses on the profitability of a provider’s core operations (patient services), while net income
represents the total economic profitability of a business as defined by GAAP.
• Because the income statement is constructed using accrual accounting, net income does not represent the actual amount of cash that has been earned or lost during the reporting period. To estimate cash flow,
noncash expenses (primarily depreciation) must be added back to net income.
• The income statements of investor-owned and not-for-profit businesses tend to look very much alike. However, the income statements of health services organizations in different lines of business can vary. The good news is that all income statements have essentially the same economic content.
• For-profit (taxable) entities must include taxes as an income statement expense item. Because depreciation expense reduces operating (taxable) income, and hence a business’s tax liability, it creates a depreciation shield equal to the tax rate times the depreciation expense. However, as a noncash expense, depreciation itself does not reduce cash flow, so the greater the amount of (continued from previous page)
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Chapter 3: The Income Statement and Statement of Changes in Equity
111
In this chapter, we focused on financial accounting basics, the income statement, and the statement of changes in equity. In Chapter 4, the discus-
sion of financial accounting continues with the remaining two statements: the balance sheet and statement of cash flows.
Questions
3.1 a. What is a stakeholder?
b. What stakeholders are most interested in the financial condition of a healthcare provider?
c. What is the goal of financial accounting?
3.2 a. What are generally accepted accounting principles (GAAP)?
b. What is the purpose of GAAP?
c. What organizations are involved in establishing GAAP?
3.3 Briefly describe the following concepts as they apply to the preparation of financial statements:
a. Accounting entity
b. Going concern
c. Accounting period
d. Monetary unit
e. Historical cost
f. Revenue recognition
g. Expense matching
h. Full disclosure
i. Materiality j. Cost–benefit
depreciation (and therefore, the depreciation shield), the greater the cash flow.
• The statement of changes in equity
indicates how much of the total profitability (net income) is retained for use by the reporting organization.
• Financial ratio analysis,
which combines values that are found in the financial statements, helps managers and investors interpret the data with the goal of making judgments about the financial condition of the business.
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3.4 Explain the difference between cash accounting and accrual accounting. Be sure to include a discussion of the revenue recognition and matching principles.
3.5 Briefly describe the format of the income statement.
3.6 a. What is the difference between gross revenues and net revenues? (Hint: Think about discounts, charity care, and bad debt.)
b. What is the difference between patient service revenue and other revenue?
c. What is the difference between charity care and bad debt losses? How is each handled on the income statement?
3.7 a. What is meant by the term expense
?
b. What is depreciation expense, and what is its purpose?
c. What are some other categories of expenses?
3.8 a. What is the difference between operating income and net income?
b. Why is net income called “the bottom line”?
c. What is the difference between net income and cash flow?
d. Is financial condition more closely related to net income or to cash flow?
3.9 a. What is the purpose of the statement of changes in equity?
b. What is its basic format?
Problems
3.1 Entries for the Warren Clinic 2015 income statement are listed below in alphabetical order. Reorder the data in proper format.
Depreciation expense
$ 90,000
General/administrative expenses 70,000
Interest expense
20,000
Investment income
40,000
Net income
30,000
Net operating revenues
410,000
Other revenue
10,000
Patient service revenue
440,000
Provision for bad debts
40,000
Purchased clinic services
90,000
Salaries and benefits
150,000
Total expenses
460,000
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3.2 Consider the following income statement:
BestCare HMO Statement of Operations Year Ended June 30, 2015 (in thousands)
Revenue:
Premiums earned $26,682
Coinsurance 1,689
Interest and other income 242
Total revenues $28,613
Expenses:
Salaries and benefits $15,154
Medical supplies and drugs 7,507
Insurance 3,963
Depreciation 367
Interest 385
Total expenses $27,376
Net income $ 1,237
a. How does this income statement differ from the one presented in Exhibit 3.1?
b. Did BestCare spend $367,000 on new fixed assets during fiscal year 2015? If not, what is the economic rationale behind its reported depreciation expense?
c. What is BestCare’s total profit margin? How can it be interpreted?
3.3 Consider this income statement:
Green Valley Nursing Home, Inc.
Statement of Income Year Ended December 31, 2015
Revenue:
Patient service revenue
$3,163,258
Less provision for bad debts (110,000)
Net patient service revenue
$3,053,258
Other revenue
106,146
Net operating revenues
$3,159,404
(continued)
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Expenses:
Salaries and benefits
$1,515,438
Medical supplies and drugs
966,781
Insurance and other
296,357
Depreciation
85,000
Interest
206,780
Total expenses
$3,070,356
Operating income
$ 89,048
Provision for income taxes
31,167
Net income
$ 57,881
a. How does this income statement differ from the ones presented in Exhibit 3.1 and Problem 3.2?
b. Why does Green Valley show a provision for income taxes while the other two income statements do not?
c. What is Green Valley’s total profit margin? How does this value compare with the values for Sunnyvale Clinic and BestCare?
d. The before-tax profit margin for Green Valley is operating income divided by total revenues. Calculate Green Valley’s before-tax profit margin. Why might this be a better measure of expense control when comparing an investor-owned business with a not-
for-profit business?
3.4 Great Forks Hospital reported net income for 2015 of $2.4 million on total revenues of $30 million. Depreciation expense totaled $1 million.
a. What were total expenses for 2015?
b. What were total cash expenses for 2015? (Hint: Assume that all expenses, except depreciation, were cash expenses.)
c. What was the hospital’s 2015 cash flow?
3.5 Brandywine Homecare, a not-for-profit business, had revenues of $12 million in 2015. Expenses other than depreciation totaled 75 percent of revenues, and depreciation expense was $1.5 million. All revenues were collected in cash during the year, and all expenses other than depreciation were paid in cash.
a. Construct Brandywine’s 2015 income statement.
b. What were Brandywine’s net income, total profit margin, and cash flow?
c. Now, suppose the company changed its depreciation calculation procedures (still within GAAP) such that its depreciation expense doubled. How would this change affect Brandywine’s net income, total profit margin, and cash flow?
(continued from previous page)
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d. Suppose the change had halved, rather than doubled, the firm’s depreciation expense. Now, what would be the impact on net income, total profit margin, and cash flow?
3.6 Assume that Mainline Homecare, a for-profit corporation, had exactly the same situation as reported in Problem 3.5. However, Mainline must pay taxes at a rate of 40 percent of pretax (operating) income. Assuming that the same revenues and expenses reported for financial accounting purposes would be reported for tax purposes, redo Problem 3.5 for Mainline.
3.7 Consider Southeast Home Care, a for-profit business. In 2015, its net income was $1,500,000 and it distributed $500,000 to owners in the form of dividends. Its beginning-of-year equity balance was $12,000,000. Use this information to construct the business’s statement of changes in equity. What is the ending 2015 value of the business’s equity account?
3.8 Bright Horizons Skilled Nursing Facility, an investor-owned company, constructed a new building to replace its outdated facility. The new building was completed on January 1, 2015, and Bright Horizons began recording depreciation immediately. The total cost of the new facility was $18,000,000, comprising (a) $10 million in construction costs and (b) $8 million for the land. Bright Horizons estimated that the new facility would have a useful life of 20 years. The salvage value of the building at the end of its useful life was estimated to be $1,500,000.
a. Using the straight-line method of depreciation, calculate annual depreciation expense on the new facility.
b. Assuming a 40 percent income tax rate, how much did Bright Horizons save in income taxes for the year ended December 31, 2015, as a result of the depreciation recorded on the new facility (i.e., what was the depreciation shield)?
c. Does the depreciation shield result in cash or noncash savings for Bright Horizons? Explain.
3.9 Integrated Physicians & Associates, an investor-owned company, had the following general ledger account balances at the end of 2015:
Gross patient service revenue (total charges) $975,000
Contractual discounts and allowances to third-party payers 250,000
Charges for charity (indigent) care 100,000
Estimated provision for bad debts 50,000
a. Construct the revenue section of Integrated Physicians & Associates’ income statement for the year ended December 31, 2015.
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b. Suppose the 2015 contractual discounts and allowances balance reported above is understated by $50,000. In other words, the correct balance should be $300,000. Assuming a 40 percent income tax rate, what would be the effect of the misstatement on Integrated Physicians & Associates’ 2015 reported:
1. Net patient service revenue?
2. Total expenses, including income tax expense?
3. Net income?
For each item (1–3), indicate whether the balance is overstated, understated, or not affected by the misstatement. If overstated or understated, indicate by how much. Resources
American Institute of Certified Public Accountants (AICPA). 2014. Audit and Account-
ing Guide for Healthcare Entities.
New York: AICPA.
Bailey, S., D. Franklin, and K. Hearle. 2010. “A Form 990 Schedule H Conundrum: How Much of Your Bad Debt Might Be Charity?” Healthcare Financial Man-
agement
(April): 86–87.
Center for Research in Ambulatory Health Care Administration (CRAHCA). 1996. Medical Group Practice Chart of Accounts.
Englewood, CO: CRAHCA.
Duis, T. E. 1994. “Unravelling the Confusion Caused by GASB, FASB Accounting Rules.” Healthcare Financial Management (November): 66–69.
———. 1993. “The Need for Consistency in Healthcare Reporting.” Healthcare Financial Management
(July): 40–44.
Giniat, E., and J. Saporito. 2007. “Sarbanes-Oxley: Impetus for Enterprise Risk Man-
agement.” Healthcare Financial Management
(August): 65–70.
Healthcare Financial Management Association (HFMA). 2007. “P&P Board Statement 15: Valuation and Financial Statement Presentation of Charity Care and Bad Debts by Institutional Healthcare Providers.” Healthcare Financial Manage-
ment (January): 94–103.
Heuer, C., and M. K. Travers. 2010. “FASB Issues New Accounting Standards for Business Combinations.” Healthcare Financial Management
(June): 40–43.
Holmes, J. R., and D. Felsenthal. 2009. “Depreciating and Stating the Value of Hos-
pital Buildings: What You Need to Know.” Healthcare Financial Management (October): 88–92.
Maco, P. S., and S. J. Weinstein. 2000. “Accounting and Accountability: Observations on the AHERF Settlements.” Healthcare Financial Management
(October): 41–46.
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117
Peregrine, M. W., and J. R. Schwartz. 2002. “What CFOs Should Know—and Do—
About Corporate Responsibility.” Healthcare Financial Management
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Reinstein, A., and N. T. Churyk. 2012. “FASB’s ASU 2011-7 Changes Financial Statement Reporting Requirements.” Healthcare Financial Management
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Seawell, L. V. 1999. Chart of Accounts for Hospitals.
Chicago: Probus Publishing.
Valetta, R. M. 2005. “Clear as Glass: Transparent Financial Reporting.” Healthcare Financial Management
(August): 59–66.
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CHAPTER
119
4
THE BALANCE SHEET AND STATEMENT OF CASH FLOWS
Introduction
Although the income statement, which was covered in Chapter 3, contains information about an organization’s revenues, expenses, and income, it does not provide information about the resources needed to produce the income or how those resources were financed. Another financial statement, the bal-
ance sheet, contains information concerning an organization’s assets and the financing used to acquire those assets.
In addition to the need to disclose resources and financing, accountants and managers have become increasingly aware that income alone does not give a complete picture of an organization’s financial condition. Although operating income and net income—which reflect an organization’s long-run economic profitability as defined by generally accepted accounting principles (GAAP)—are important profitability measures, financial condition, especially in the short run, is also related to the actual flow of cash into and out of a business. The second financial statement discussed in this chapter, the statement of cash flows, focuses on this important determinant of financial condition.
Although understanding the composition of the financial statements is essential, it is also important that managers understand the relationships among the financial statements. Thus, emphasis is placed on the interrelationships Learning Objectives
After studying this chapter, readers will be able to
• Explain the purpose of the balance sheet.
• Describe the contents of the balance sheet and its interrelationships with the income statement and the statement of changes in equity.
• Explain the purpose of the statement of cash flows.
• Describe the contents of the statement of cash flows and how it differs from the income statement.
• Describe how a business’s transactions affect its income statement and balance sheet.
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among the statements throughout the chapter. Finally, the end of the chapter contains a brief introduction to how actual business transactions work their way into an organization’s financial statements. Our purpose here is to provide readers with a feel for how financial statements are actually created.
Balance Sheet Basics
Whereas the income statement reports the results of operations over a period of time,
the balance sheet presents a snapshot of the financial position of an organization at a given point in time.
For this reason, the balance sheet is also called the statement of financial position.
The balance sheet changes every day as a business increases or decreases its assets or changes the composition of its financing. The important point is that the balance sheet, unlike the income statement, reflects a business’s financial position as of a given date, and the data in it typically become invalid one day later, even when both dates are in the same accounting period. Healthcare providers with seasonal demand, such as a walk-in clinic in Fort Lauderdale, Florida, have especially large changes in their balance sheets during the year. For such businesses, a balance sheet constructed in February can look quite different from one prepared in August. Also, businesses that are growing rapidly will have significant changes in their balance sheets over relatively short periods of time.
The balance sheet lists, as of the end of the reporting period, the resources of an organization and the claims against those resources. In other words, the balance sheet reports the assets of an organization and how those assets were financed. The balance sheet has the following basic structure:
Assets Liabilities and Equity
Current assets Long-term assets
Current liabilities Long-term liabilities Equity Total assets Total liabilities and equity
The assets side (left side) of the balance sheet lists, in dollar terms, all the resources, or assets, owned by the organization. In general, assets are broken down into categories that distinguish short-lived (current) assets from long-lived assets. The liabilities and equity side (claims side or right side) lists the claims against these resources, again in dollar terms. In essence, the right side reports the sources of financing (capital) used to acquire the assets listed on the left side. The sources of capital are divided into two broad categories: liabilities, which are claims fixed by contract, and equity, which is a residual claim that depends on asset values and the amount of liabilities. As with assets, liabilities are listed by maturity (short term versus long term).
Balance sheet
A financial statement that lists a business’s assets, liabilities, and equity (fund capital).
Asset
An item that either possesses or creates economic benefit for the organization.
Liability
A fixed financial obligation of the business.
Equity
The book value of the ownership position in a business, where book value
is the value that appears on a business’s financial statements. In other words, the value according to GAAP.
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Chapter 4: The Balance Sheet and Statement of Cash Flows
121
Perhaps the most important characteristic of the balance sheet is simply that it must balance—that is, the left side must equal the right side. This rela-
tionship, which is called the accounting identity
or basic accounting equation,
is expressed in equation form as follows: A
= L
+ E,
where A
= total assets, L
= total liabilities, and E
= equity. Because liability claims are paid before equity claims are if a healthcare organization is liqui-
dated, liabilities are shown before equity both on the balance sheet and in the basic accounting equation.
Note that the accounting identity can be rearranged as follows:
E
= A
− L.
This format reinforces the concept that equity represents a residual claim against the total assets of the business and also the fact that equity can be negative. If a business writes down (decreases) the value of its assets, perhaps due to obsolescence, its liabilities are unaffected because these amounts are still owed to creditors and others. If total assets are written down so much that their value drops below that of total liabilities, the equity reported on the balance sheet becomes a negative amount.
Exhibit 4.1 contains Sunnyvale’s balance sheet, which follows the basic structure as previously explained. The title of the exhibit reinforces the fact that the data are presented for the entire clinic. The balance sheet is not going to provide much information, if any, about the subunits of an organization such as departments or service lines. Rather, the balance sheet will provide an overview of the economic position of the organization as a whole. As we discussed in Chapter 3, for ease of understanding, the balance sheet presented here is simplified as compared to most actual statements, but it contains all of the essential elements.
The time frame for the data in the balance sheet is also apparent in the title. The data are reported for 2015 and 2014 as of December 31. Whereas Sunnyvale’s income statements indicate the data were for the year ended on December 31, the balance sheets merely indicate a closing date. This minor difference in terminology reinforces the point that the income statement reports operational results over a period of time, while the balance sheet reports financial position at a single point in time. Finally, the amounts reported on Sunnyvale’s balance sheet, just as on its income statement, are expressed in thousands of dollars.
The format of the balance sheet emphasizes the basic accounting equa-
tion. For example, as of December 31, 2015, Sunnyvale had a total of $154,815,000 Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com
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122
in assets that were financed by a total of $154,815,000 in liabilities and equity. Besides the obvious confirmation that the balance sheet balances, this statement indicates that the total assets of Sunnyvale were valued, according to GAAP, at $154,815,000. Liabilities and equity represent claims against the assets of the business by various classes of creditors, other claimants with fixed claims, and “owners.” Creditors and other claimants have first priority in claims for $100,747,000, and “owners” follow with a residual claim of $54,068,000. The right side of the balance sheet (liabilities and equity, which are in the bottom section of Exhibit 4.1) reflects the manner in which Sunnyvale raised the capital needed to acquire its assets. Because the balance sheet must balance, each dollar on the asset (left) side must be matched by a dollar on the capital (right) side.
1. What is the purpose of the balance sheet?
2. What are the three major sections of the balance sheet?
3. What is the accounting identity, and what information does it provide?
4. What is the relationship between assets and capital?
SELF-TEST QUESTIONS
EXHIBIT 4.1 Sunnyvale Clinic: Balance Sheets December 31, 2015 and 2014 (in thousands)
Assets 2015 2014
Current Assets: Cash and cash equivalents $ 12,102 $ 6,486 Short-term investments 10,000 5,000 Net patient accounts receivable 28,509 25,927 Inventories 3,695 2,302 Total current assets $ 54,306 $ 39,715 Long-term investments 48,059 25,837 Net property and equipment 52,450 49,549 Total assets $154,815 $ 115,101 Liabilities and Equity
Current Liabilities: Notes payable $ 4,334 $ 3,345 Accounts payable 5,022 6,933 Accrued expenses 6,069 5,037 Total current liabilities $ 15,425 $ 15,315 Long-term debt 85,322 53,578 Total liabilities $100,747 $ 68,893 Net assets (Equity) 54,068 46,208 Total liabilities and equity $154,815 $ 115,101 Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com
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Chapter 4: The Balance Sheet and Statement of Cash Flows
123
Assets
Assets
either possess or create economic benefit for the organization. Exhibit 4.1 contains three major categories of assets: current assets, long-term investments, and net property and equipment. The following sections describe each asset category in detail.
Current Assets
Current assets include cash and other assets that are expected to be converted into cash within one accounting period
, which in this example is one year. For Sunnyvale, current assets total $54,306,000 at the end of 2015. Suppose the short-term investments on the books at that time were converted into cash as they matured; the receivables were collected; and the inventories were used, billed to patients, and collected, all at the values stated on the balance sheet. With all else the same, Sunnyvale would have $54,306,000 in cash at the end of 2016. Of course, all else will not be the same, so Sunnyvale’s 2016 reported cash balance will undoubtedly be different from $54,306,000. Still, this little exercise reinforces the concept behind the current asset category: the assumption that these assets will be converted into cash during the next accounting period.
The conversion of current assets into cash is expected to provide all or part of the funds that will be needed to pay off the $15,425,000 in cur-
rent liabilities outstanding at the end of 2015 as they become due in 2016. Thus, current assets are one element that contributes to the liquidity of the organization. (A business is liquid
if it has the cash available to pay its bills as they become due.)
The difference between total current assets and total current liabilities is called net working capital
.
Thus, at the end of 2015, Sunnyvale had net working capital of $54,306,000 − $15,425,000 = $38,881,000. From a pure liquidity standpoint, the greater the net working capital, the better. However, as we discuss in Chapter 16, there are costs to carrying current assets, so health services organizations have to balance the need for liquidity against the associated costs of maintaining liquidity. Also, as we discuss in later chapters, there are other factors, such as expected cash inflows, that contribute to a business’s overall liquidity.
Within Sunnyvale’s current assets, there is $12,102,000 in cash and cash equivalents.
Cash represents actual cash in hand plus money held in commercial checking accounts (demand deposits). Cash equivalents are short-term securi-
ties investments that are readily convertible into cash. In general, accountants interpret that to mean securities that have a maturity of three months or less. Note that cash and cash equivalents are carried on the same line of the bal-
ance sheet, so readers cannot determine the relative sizes of each type of asset, which confirms the fact that these are considered to be identical in nature.
Current asset
An asset that is expected to be converted into cash within one accounting period (often a year).
Net working capital
A liquidity measure equal to current assets minus current liabilities.
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In addition to cash and cash equivalents, there is $10,000,000 of short-
term investments
(sometimes called marketable securities
), which represent cash that has been temporarily invested in highly liquid, low-risk securities such as bank savings accounts, money market mutual funds, US Treasury bills, or prime commercial paper having a maturity greater than 90 days but less than one year. (
Money market mutual funds
are mutual funds that invest in safe, short-
term securities such as Treasury bills and commercial paper. Treasury bills
are short-term debt instruments issued by the US government. Commercial paper
is short-term debt issued by very large and financially strong corporations. All of these securities are relatively safe investments because there is virtually 100 percent assurance that the borrowers will repay the loans when they mature.)
Organizations hold cash equivalents and short-term investments because cash earns no interest and money held in commercial checking accounts earns very little interest. Thus, businesses should hold only enough cash and checking account balances to pay their recurring operating expenses—any funds on hand in excess of immediate needs should be invested in safe, short-term, highly liquid (but interest-bearing) securities. Additionally, short-term investments are built up periodically to meet projected nonoperating cash outlays such as tax payments, investments in property and equipment, and legal judgments. Even though short-term investments pay relatively low interest, any return is better than none, so such investments are preferable to cash holdings.
Short-term investments normally are reported on the balance sheet at cost,
which is the amount initially paid for the securities. However, because of changing interest rates and other factors, these securities may actually be worth more or less than their purchase price. Still, because short-term investments have maturities of less than one year, it is rare for their market values to be substantially different from their costs.
Net patient accounts receivable
, often just called receivables,
represents money owed to Sunnyvale for services that the clinic has already provided. As discussed in Chapter 2 and reiterated in Chapter 3, third-party payers make most payments for healthcare services, and these payments often take weeks or months to be billed, processed, and ultimately paid. Sunnyvale’s patient accounts receivable amount of $28,509,000 at the end of 2015 is listed on the balance sheet net
of contractual allowances, charity care, and the provision for bad debt losses. Thus, the presentation on the balance sheet is consistent with the Chapter 3 discussion concerning net patient service revenue and the treatment of bad debt losses.
The $28,509,000 net receivable amount’s relationship to the income statement’s net operating revenues of $169,979,000 for 2015 (see Exhibit 3.1) is as follows. A total of $169,979,000 was billed to patients and payers, and was expected to be collected, during 2015. This is a “net” number as there is a higher amount of gross charges in Sunnyvale’s managerial accounting system that reflects charges before deductions for contractual allowances and charity care Net patient accounts receivable (receivables)
The amount of money billed for services provided but not yet collected.
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Chapter 4: The Balance Sheet and Statement of Cash Flows
125
and the provision for bad debt losses. The fact that $28,509,000 of this revenue remains to be collected suggests that the difference between $169,979,000 and $28,509,000, which totals $141,470,000, was collected during 2015. Where is this collected cash? It could be anywhere. Most of it went right out the door to pay operating expenses. Some of the collected cash may have been used to purchase assets (e.g., new equipment) and hence may be sitting in one of the asset accounts on the balance sheet. If the clinic were to close its doors on the last day of 2015, its patient accounts receivable balance of $28,509,000 would fall to zero when the entire amount was eventually collected (except for any errors in the bad debt loss forecast). However, if Sunnyvale continues as an ongoing enterprise, the receivables balance will never fall to zero because, although Sunnyvale’s collections are lowering it, new services are constantly being provided that create new billings, and hence new receivables, that are added to it.
The final current asset listed in Exhibit 4.1 is inventories,
which primarily reflects Sunnyvale’s purchases of medical supplies. The value of supplies on hand at the end of 2015 was $3,695,000. As with the cash account, it is not in a business’s best interest to hold excessive inventories. There is a certain level of supplies necessary to meet medical needs and to maintain a safety stock to guard against unexpected surges in use, but any inventories above this level create unnecessary costs.
Businesses that hold large amounts of inventories, such as medical supply companies, typically include a note to the financial statements that discusses the holdings in some detail. However, most healthcare providers hold relatively small levels of inventories, and hence extensive note information often is not provided. In fact, because of the materiality principle discussed in Chapter 3, some providers do not break out inventories as a separate item on their bal-
ance sheets but rather include the value of inventories in a catchall balance sheet account called other current assets
.
It should be obvious that the primary purposes served by the current asset accounts are to support the operations of the organization and to provide liquidity. However, current assets do not generate high returns. For example, cash earns no or very little return, and cash equivalents and short-term invest-
ments generally earn relatively low returns. The receivables account does not earn interest income or generate new patient service revenue, and inventories represent dollar amounts invested in items sitting on shelves, which earn no return until those items are used and patients are billed for their use. Because of the low (or zero) return earned on current assets, businesses try to minimize these account values yet ensure that the levels on hand are sufficient to sup-
port operations and maintain liquidity. (Readers will learn much more about current asset management in Chapter 16.)
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assets, are listed first, while the least liquid of current assets—inventories—is listed last. Dollars invested in inventories will first move into patient accounts receivable as the patients are billed for the supplies used. Then, accounts receivable will be converted into cash when they are collected and, perhaps, shifted to securities if the cash is not needed to pay current bills.
The importance of converting nonearning current assets into short-term investments as quickly as possible, and hence converting zero-return assets into some-return assets, cannot be overemphasized. Under most reimbursement methods, providers first must build the current assets necessary to provide the services; they then must actually do the work; and finally, at some later time (often 45 days or more), they get paid. Providers that operate under capita-
tion have a significant liquidity advantage compared with those that primarily receive fee-for-service revenue. Because capitated payments are received before the services are provided, organizations that are predominantly capitated will have much smaller accounts receivable balances and much larger cash and short-term investment balances than will providers, such as Sunnyvale, that operate in a predominantly fee-for-service environment.
Long-Term Investments
The second major asset category, after current assets, is long-term investments,
which reports the amount the organization has invested in various forms of long-term (maturities that exceed one year) securities. This account represents investments in financial assets
,
as opposed to investments in real assets such as buildings and MRI machines, which are listed next on the balance sheet as net property and equipment. The $48,059,000 reported by Sunnyvale at the end of 2015 represents the amount the clinic has invested in stocks, bonds, and other securities that have a longer maturity than its short-term investments in hopes they will provide higher returns.
Long-term securities investments are reported on the balance sheet at fair market value
(or just fair value
), rather than initial cost, so changes in market conditions over time will cause the value of this account to change, even if the securities held remain the same. Also, changes in market values of long-term investments result in unrealized gains or losses on the investments, which have additional financial statement implications that are beyond the scope of this book. A note to the financial statements usually will reveal the details of the types of security investments held by the organization and the resulting gains and losses. The income earned on both short-term and long-term investments is reported on the income statement under nonoperating income. As discussed in Chapter 3, Sunnyvale reported investment income of $3,870,000 for 2015.
The discussion of current assets emphasized that businesses try to mini-
mize the amounts held, maintaining only the amounts necessary to support operations. One of the benefits of prudent current asset management is that Financial asset
A security, such as a stock or bond, that represents a claim on a business’s cash flows. Financial assets are purchased with the expectation of receiving future payments.
Real asset
A physical asset, such as a medical practice or a piece of diagnostic equipment, that has the potential to generate future cash inflows.
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Chapter 4: The Balance Sheet and Statement of Cash Flows
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more money can be moved into long-term investments, both financial and real, which are expected to generate greater returns than those provided by current assets. The ultimate rewards for minimizing an organization’s current assets are the reduction in carrying costs (current assets cost money because each dollar in assets has to be matched by a dollar of financing) and the increased return expected from long-term investments.
Note, however, that Sunnyvale is not in the financial services business; it is in the business of providing healthcare services. Still, not-for-profit organiza-
tions typically carry large amounts of long-term securities investments, some funded from depreciation cash flow and hence often called funded depreciation
. (As we discussed in Chapter 3, depreciation is a noncash expense; hence it creates cash flow in addition to the amount of net income.) Eventually, these funds will be used to purchase real assets that provide new or improved services to Sunnyvale’s patients. In essence, the long-term investments account is a savings account that ultimately will be used to purchase new land, buildings, and equipment that either replaces worn-out or obsolete assets or adds to the asset base to accommodate volume growth or provide new services.
In contrast, investor-owned businesses usually do not build up such reserves. Any cash flow above the amount needed for near-term reinvestment in the business would likely be returned to the capital suppliers (creditors and stockholders), either by debt repurchases or, more typically, by dividends or stock repurchases. When additional capital is needed for long-term investment in property and equipment, an investor-owned business simply goes to the capital (bond and stock) markets and obtains additional debt or equity financing.
Net Property and Equipment
The third major asset category is net property and equipment,
often called fixed assets
. Fixed assets, as compared to current assets and even compared to long-term securities investments, are highly illiquid and typically are used over long periods of time by the organization. Whereas current assets rise and fall spontaneously with the organization’s level of operations, fixed assets, such as land, buildings, and equipment, are normally maintained at a level sufficient to handle peak patient demand.
The property and equipment value listed on the balance sheet represents the value of Sunnyvale’s fixed assets net of depreciation, so the effects of “wear and tear” are incorporated. The calculation of net property and equipment is included in the notes to the financial statements. To illustrate, Exhibit 4.2 contains Sunnyvale’s calculation.
The fixed assets (land, buildings, and equipment) are first listed at histori-
cal cost
(the purchase price). The total of such historical costs is labeled gross property and equipment. Accumulated depreciation
represents the total dollars of depreciation that have been expensed on the income statement against the Fixed assets
A business’s long-
term assets, such as land, buildings, and equipment. Usually labeled net property and equipment
on the balance sheet.
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historical cost of the organization’s fixed assets. Numerically, the amounts of depreciation expense reported on the income statement each year are totaled (accumulated) over time to create the accumulated depreciation account. The accumulated depreciation account is an example of a contra-asset
account because it is a negative asset. The greater the value of this account, the smaller an orga-
nization’s net property and equipment account. Contra accounts reduce the value of “parent” accounts; in this case, the parent account is gross property and equipment.
For Sunnyvale, the net balance of property and equipment is $52,450,000 at the end of 2015. The historical cost of these assets is $88,549,000. Some of the fixed assets were purchased in 2015, some in 2014, some in 2013, and some in prior years, but the total purchase price of all the fixed assets being used by Sunnyvale on December 31, 2015, is $88,549,000. The accumulated depreciation on these assets through December 31, 2015, is $36,099,000, which accounts for that portion of the value of the assets that was “spent” in producing income. The difference, or net, of $52,450,000, which reflects the remaining book value of the clinic’s property and equipment, is the amount reported on the balance sheet. The connection of the balance sheet net property and equipment account to the income statement is through depreciation expense. The accumulated depreciation of $36,099,000 reported on the balance sheet notes at the end of 2015 is $6,405,000 greater than the 2014 amount of $29,694,000, where $6,405,000 is the 2015 depreciation expense reported on the income statement.
Depreciation, even though it typically does not reflect the true change in value of a fixed asset over time, at least ensures an orderly recognition of value loss. Occasionally, assets experience a sudden, unexpected loss of value. One example is when changing technology instantly makes a piece of diag-
nostic equipment obsolete and hence worthless. When this occurs, the asset that has experienced the decline in value is written off,
which means that its value on the balance sheet is reduced (perhaps to zero) and the amount of the reduction is taken as an expense on the income statement. Such adjustments, called impairment of capital
by accountants, are routinely made to the plant Book value
The value of a business’s assets, liabilities, and equity as reported on the balance sheet. In other words, the value in accordance with generally accepted accounting principles (GAAP).
EXHIBIT 4.2 Sunnyvale Clinic: Net Property and Equipment
2015 2014
Property and equipment Land $ 2,954 $ 2,035 Buildings and equipment 85,595 77,208 Gross property and equipment $88,549 $79,243 Less: Accumulated depreciation 36,099 29,694 Net property and equipment $52,450 $49,549 Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com
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and equipment accounts on the balance sheet (and to revenues and expenses on the income statement) when assets are sold or lose value. However, these adjustments are beyond the scope of this book. In closing our discussion of assets, note that many providers report a fourth asset category: other assets.
This is really a catchall category of miscel-
laneous long-term assets, which may or may not be significant. Examples include fixed assets not used in the provision of healthcare services and funds that were used to support long-term debt sales that will be expensed over time.
Liabilities
Liabilities and equity, which comprise the right side of the balance sheet, are shown in the lower section of Exhibit 4.1. Together, they represent the capital
(the money) that has been raised by an organization to acquire the assets shown on the left side. Again, by definition, total capital (the sum of liabilities and equity) must equal total assets. Another way of looking at this is that every dollar of assets on the left side of the balance sheet must be matched by a dollar of liabilities or equity on the right side.
Liabilities
represent claims against the assets of an organization that are fixed by contract. Some of the liability claims are by workers for unpaid wages and salaries, some are by tax authorities for unpaid taxes, and some are by vendors that grant credit when supplies are purchased. (Even not-for-profit organizations, which do not pay income taxes, typically have unpaid payroll and withholding taxes on their employees.) However, the largest liability claims typically are by creditors
(lenders) who have made loans (supplied debt capital) to the business.
Most creditors’ claims are unsecured,
meaning that they are not tied to specific assets pledged as collateral for the loan. In the event of default
— nonpayment of interest or principal—by the borrower, creditors have the right to force the business into bankruptcy,
with liquidation
as a possible consequence. 1. What are the three major categories of asset accounts?
2. What is the primary difference between current assets and the remainder of the asset side of the balance sheet?
3. Give some examples of current asset accounts.
4. What is the difference between gross property and equipment and net property and equipment?
5. How does accumulated depreciation tie in to the income statement?
SELF-TEST QUESTIONS
Default
Occurs when a borrower fails to make a promised debt payment. Note that technical default occurs when the borrower fails to meet one of the restrictions in the loan agreement but is still making the required payments.
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If the assets of the business are sold (liq-
uidated), bankruptcy law requires that any proceeds be used first to satisfy liability claims before any funds can be paid to owners or, in the case of not-for-profits, used for charitable purposes. Furthermore, the dollar value of each liability claim is fixed by the amount shown on the balance sheet, while the own-
ers, including the community at large for not-for-profit organizations, have a claim to the residual proceeds of the liquidation rather than to a fixed amount. Finally, secured cred-
itors have first right to the sale proceeds of assets pledged as collateral for the loan.
Like assets, the balance sheet pre-
sentation of liabilities follows a logical for-
mat. Current liabilities, which are those liabilities that fall due (must be paid) within one accounting period (one year in this example), are listed first. Long-term debt, distinguished from short-term debt by hav-
ing maturities greater than one account-
ing period, is listed second. As shown in Exhibit 4.1, Sunnyvale had total liabilities at the end of 2015 of $100,747,000, which consisted of two parts: total current liabili-
ties of $15,425,000 and long-term debt of $85,322,000. The following sections describe each liability account in detail.
Current Liabilities
Current liabilities
include liabilities that must be paid within one accounting period. Many healthcare businesses use short-term debt—defined as having a maturity of less than one accounting period—to finance seasonal or cyclical working capital (current asset) needs. For example, in preparation for the busy winter season, the Fort Lauderdale walk-in clinic builds up its inventories of medical supplies, but when the season is over, the supplies fall back to a lower off-season level. This temporary increase in cur-
rent assets typically is funded by a bank loan of some type. When listed on the balance sheet, short-term debt is called notes payable
. We see that Sunnyvale had $4,334,000 of short-term debt outstanding at the end of 2015.
For Your Consideration
Should Governments Report Like Businesses?
Historically, states and cities used cash account-
ing methods to report infrastructure assets such as roads, bridges, and water and sewer facilities. Thus, the cost of an infrastructure investment was reported as an expense on the income state-
ment when it occurred, but the value of the physi-
cal asset did not appear on the balance sheet. In other words, the value of all infrastructure assets was off the books. The theory behind this treat-
ment is that infrastructure assets are, for the most part, immovable and of value only to the governmental unit (and its residents). Because infrastructure assets cannot be sold, there is no “value” to be reported on the balance sheet.
In actuality, of course, physical infrastructure assets like roads and bridges generally continue to have value, or usefulness, long after govern-
mental units have incurred the cost of construc-
tion. And, just as business assets depreciate in value, the value of infrastructure assets also declines over time. Thus, in 2001, the Government Accounting Standards Board (GASB) mandated that states and cities treat infrastructure assets just like businesses do—record them on the balance sheet at initial cost and depreciate this value over time. The idea here is that the new treatment would (1) improve financial reporting, (2) enhance awareness of fiscal issues facing gov-
ernmental units, and (3) emphasize the impor-
tance of maintaining infrastructure assets.
What do you think? Should governmental entities have been required to report financial status in the same way as businesses? Will the change in how infrastructure assets are treated cause states and cities to act differently?
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Accounts payable,
as well as accrued expenses, represents payment obliga-
tions that have been incurred as of the balance sheet date but that have not yet been paid. In particular, accounts payable represents amounts due to vendors for supplies purchases. Often, suppliers offer their customers credit terms
, which allow payment sometime after the purchase is made. For example, one of Sunnyvale’s suppliers offers credit terms of 2/10, net 30, which means that if Sunnyvale pays the invoice in ten days, it will receive a 2 percent discount off the list price; otherwise, the total amount of the invoice is due in 30 days. In effect, by allowing Sunnyvale to pay either 10 or 30 days after the supplies have been received, the supplier is acting as a creditor, and the credit being offered is called trade credit
. The balance sheet tells us that suppliers, at the end of 2015, had extended Sunnyvale $5,022,000 worth of such credit.
Wages and benefits due to employees resulting from work performed at the end of the accounting period, interest due on debt financing, utilities expenses not yet paid, taxes due to government authorities, and similar items are included on the balance sheet as accrued expenses
, or just accruals
. Such expenses occur because the business has incurred the obligation to pay for services received but has not made payment before the financial accounting books are closed.
Sunnyvale’s employees are used to illustrate the logic behind accruals. Sunnyvale’s staff earns its wages and benefits on a daily basis as the work is performed. However, the clinic pays its workers every two weeks. Therefore, other than on paydays (assuming no lag in payment), the clinic owes its staff some amount of salaries for work performed. Whenever the obligation to pay wages extends into the next accounting period, an accrual is created on the balance sheet. Sunnyvale reported $6,069,000 in accruals for 2015, which, when added to the other current liabilities, totals $15,425,000.
Long-Term Debt
The long-term debt
section of the balance sheet represents debt financing to the organization with maturities of more than one accounting period. In the Sunnyvale example, repayment is not required during the coming year. The long-term debt section lists any debt owed to banks and other creditors (e.g., bondholders) as well as obligations under certain types of lease arrangements. Detailed information relative to the specific characteristics of the long-term debt is disclosed in the notes to the financial statements.
To help understand how debt financing is handled on the financial state-
ments, it might be useful to briefly discuss the mechanics of a loan. Assume that Sunnyvale takes out a $300,000 bank loan with a maturity (term) of three years. For simplicity, assume that the loan agreement requires payments to the bank as shown in Exhibit 4.3.
When the loan is first obtained, $300,000 will be posted in the long-
term debt account and will appear on the balance sheet. At the end of the first year, Sunnyvale will pay the bank a total of $130,000, consisting of Credit terms
The statement of terms that extends credit to a buyer.
Trade credit
The credit offered to businesses by suppliers (vendors) when credit terms are offered.
Accrued expenses
A business liability that stems from the fact that some obligations, such as wages and taxes, are not paid immediately after the obligations are created.
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$30,000 interest on the loan and $100,000 repayment on the principal
portion of the loan. The $30,000 interest expense, which is paid to the bank for the use of its money, appears as an expense on the income state-
ment. The $100,000 principal repayment, on the other hand, is not an expense item, but rather it reduces the $300,000 carried in the long-term debt account on the balance sheet. In the second year, the loan will be treated in a similar way: $20,000 will appear as an expense on the income statement, and the loan amount on the balance sheet will be reduced by $100,000. (The features of long-term debt are discussed in detail in Chapter 11.)
In this example, as with many sources of long-term debt financing, some portion of the borrowed amount (the principal) must be repaid in each year. In addition, some long-term debt that was issued in the past may mature (come due) in any given year. The portion of long-term debt that must be paid in the coming year (accounting period) is recorded on the balance sheet as a current liability titled current portion of long-term debt.
Sunnyvale had no long-term debt payments due in either 2015 or 2014, but if it did, they would appear on the first line of the current liabilities section.
Liabilities Summary
Sunnyvale had total liabilities,
consisting of current liabilities and long-term debt, of Year 1 Year 2 Year 3
Loan Repayment Schedule: Interest on loan $ 30,000 $ 20,000 $ 10,000 Principal repayment 100,000 100,000 100,000
Total payment $130,000 $120,000 $110,000
EXHIBIT 4.3
Sunnyvale Clinic: Bank Loan with Three-
Year Maturity
Industry Practice
Leasing and Financial Statements
Under current accounting rules (GAAP), leases are reported on a lessee’s balance sheets in two ways. For long-term (capital) leases, the leased property is reported as an asset and the present value of lease payments is reported as a liability. But for short-term (operating) leases, the leased property does not appear on the balance sheet at all. Rather, operating lease obligations are reported in the notes to the financial statements. Because short-term leases are not shown directly on the balance sheet, such leases are called off-
balance-sheet financing
. Note, however, that all lease payments are listed as expenses on the income statement, regardless of length. It is likely that the current rules, in effect since 1977, will be replaced by new standards in 2016 or 2017. Although a complete discussion of old and new rules is beyond the scope of this text, we note here that the most important proposed change is that leases would no longer be classified by accountants as operating or capital. Instead, almost all leases would be accounted for in the same way on the balance sheet—there would be no difference between short-term and long-term leases. All leased property would be listed on the asset side as right-to-use assets
and on the liabil-
ity side as lease liabilities
. The ultimate effect of the proposed rule would be to eliminate operating leases as a source of off-balance-sheet financing.
What do you think about the proposed rule change? Would analysts find it easier to perform financial statement analyses? Do you think that the new rules would reduce the amount of leas-
ing that currently takes place? When all factors are considered, should the change take place?
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Chapter 4: The Balance Sheet and Statement of Cash Flows
133
$100,747,000 at the end of 2015. As we discuss in the next section, Sunnyvale reported $54,068,000 in net assets (equity), for total capital (which must equal total assets) of $154,815,000. Thus, based on the values recorded on the balance sheet, or book values,
Sunnyvale uses much more debt financing than equity financing. The choice between debt and equity financing is dis-
cussed in Chapter 13, while Chapter 17 includes coverage of alternative ways to measure the amount of debt financing used and its effect on a business’s financial condition.
Net Assets (Equity)
On the balance sheet, the ownership claim on an organization’s assets is called net assets when the organization has not-for-profit status. As the term net
implies, net assets represent the dollar value of assets remaining when a business’s liabilities are stripped out. However, as readers learned in Chapter 1, there is a wide variety of ownership types in the health services industry, which results in an almost bewildering difference in terminology used for the equity portion of the balance sheet. For example, depending on the type of business organization, the equity section of the balance sheet may be called stockholders’ equity
, owner’s net worth
, net worth
, proprietor’s worth
, partners’ worth
, or even something else.
To keep things manageable in this book, the term equity
typically is used, but the various terms all indicate the same thing: the amount of total assets financed by nonliability capital, or total assets minus total liabilities. To determine what belongs to the owners, whether explicitly recognized in for-profit businesses or implied in not-for-profit organizations, fixed claims (liabilities) are subtracted from the book value of the business’s assets. The remainder, the net assets (equity), represents the residual value of the assets of the organization.
The equity section of the balance sheet is extremely important because it, more than anything else in the financial statements, reflects the ownership status of the organization. Because Exhibit 4.1 lists the equity as net assets,
it 1. What are liabilities?
2. What are some of the accounts that would be classified as current liabilities?
3. Use an example to explain the logic behind accruals.
4. What is the difference between notes payable and long-term debt?
5. What is the difference between long-term debt and current portions of long-term debt?
SELF-TEST QUESTIONS
Net assets
The dollar value, according to GAAP, of a business’s assets after subtracting the business’s liabilities. In not-for-profit businesses, the term often is used on the balance sheet in place of equity
.
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Healthcare Finance
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is obvious that Sunnyvale is a not-for-profit corporation. Some of the equity capital reported on the balance sheet could have come from charitable contribu-
tions and some from government grants, but the vast majority of Sunnyvale’s equity capital was obtained by reinvesting earnings within the business. As discussed in Chapter 3, for a not-for-profit organization such as Sunnyvale, all earnings must be reinvested in the business
.
Sunnyvale’s equity increased by $54,068,000 − $46,208,000 = $7,860,000 from 2014 to 2015, which is the same amount that Sunnyvale reported as net income for 2015. It is important to recognize that this con-
nection between the bottom line of the income statement and the equity section of the balance sheet is a mathematical necessity. In the case of not-
for-profit businesses, there is simply nowhere else for those earnings to go. This highlights another connection between the balance sheet and the income statement. Of course, most organizations have adjustments to net income that either increase or decrease the amount that flows to the balance sheet equity account. Such adjustments are shown on the statement of changes in equity discussed in Chapter 3.
Sunnyvale’s balance sheet shows an equal amount of assets and liabili-
ties and equity (it balances) because the increase in equity of $7,860,000 was matched by a like increase in assets, along with asset increases that resulted from other financing. The asset increases might be in cash, receivables, sup-
plies, or some other account. The key point is that the equity balance is not a store of cash. As Sunnyvale earned profits over the years that increased the equity account, these funds were invested in supplies, property and equipment, and other assets to provide future services that would likely generate even larger profits in the future. Sunnyvale’s total assets grew by $154,815,000 − $115,101,000 = $39,714,000 in 2015, which was supported by an increase in total liabilities of $100,747,000 − $68,893,000 = $31,854,000 and an increase in equity of $54,068,000 − $46,208,000 = $7,860,000.
The net assets type of equity section shown in Exhibit 4.1 is typical of not-for-profit organizations such as community or religious hospitals. However, a relatively rare form of not-for-profit organization can sell stock privately, and such organizations may show a limited amount of stock outstanding. This type of stock is not sold in the open market, though, and does not convey ownership rights, as does the stock of investor-owned companies.
Thus far, the discussion of the balance sheet has focused on Sunnyvale, a not-for-profit corporation. In general, the asset and liability sections of the balance sheet are much the same regardless of ownership status. The equity section tends to differ in presentation for different types of ownership because the types have different forms of equity. That is the bad news. The good news is that the economic substance of the equity section remains the same.
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Chapter 4: The Balance Sheet and Statement of Cash Flows
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Exhibit 4.4 contains the equity section of the balance sheet assuming that Sunnyvale, with a new name (Southeast Healthcare), is an investor-owned (for-
profit) corporation. This is the type of presentation that would be seen on the balance sheets of for-profit health services businesses such as Community Health Systems and Brookdale Senior Living. The first major difference is the title of the section “Stockholders’ Equity.” This title, or a similar title such as “Shareholders’ Equity,” provides explicit recognition that stockholders (shareholders) own the business. (Chapter 12 provides details on stockholders’ rights and privileges.)
Southeast Healthcare was incorporated in 1980, with the bylaws autho-
rizing issuance of 1.5 million shares of common stock. At that time, 1 million shares were sold at a price of $10 per share, so $10 million was collected. Thus, this amount is shown in Exhibit 4.4 on the line labeled “common stock.” The retained earnings
account represents the accumulation of earn-
ings over time that are reinvested in the business. Each year, the amount of net income shown on the income statement, less the amount paid out to stockholders along with other adjustments, is transferred from the income statement to the balance sheet. Suppose that, as with Sunnyvale, Southeast Healthcare had actually earned $7,860,000 in 2015. Because the firm’s retained earnings account increased by a like amount, no distributions were made to stockholders during the year.
Retained earnings, like all equity accounts, represent a claim against assets, and they are not necessarily available to buy new equipment, to pay dividends, or for any other purpose. The financing represented by retained earnings has already been used within the business to buy property and equip-
ment; to buy supplies; and, yes, to increase the cash and cash equivalents, short-term investments, and long-term investments accounts. Only the portion of retained earnings that is sitting in the cash account is immediately available to the business for use.
Although Exhibit 4.4 shows only the equity section, it is likely that there would be significant differences in the values of other balance sheet accounts between investor-owned and not-for-profit businesses. For example, it is unlikely that a for-profit healthcare business would amass such a large amount 2015 2014
Stockholders’ Equity: Common stock $ 10,000 $10,000 Retained earnings 44,068 36,208 Total equity $54,068 $46,208 EXHIBIT 4.4 Southeast Healthcare: Balance Sheet Equity Section December 31, 2015 and 2014 (in thousands)
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Healthcare Finance
136
of long-term investments (securities) unless the funds were earmarked for a particular use in the next few years. Southeast’s stockholders would question why the company had more than $48 million in long-term securities because they would prefer to have all of the business’s capital invested in operating assets, which, as indicated earlier, usually earn a higher return than do securi-
ties investments. Thus, there would be stockholder pressure on management to either invest this capital in more financially productive operating assets or return it to owners (as dividends or stock repurchases) for redeployment. Stockholders have invested in Southeast Healthcare because it is a healthcare provider; if they had wanted to own a bank, they would have bought bank stock. If and when Southeast requires more capital for asset acquisitions, it can always obtain additional debt financing or sell more common stock.
Access to the capital markets is seen as an economic advantage that for-profit businesses—whether they are hospitals, medical practices, or man-
aged care plans—have over not-for-profit businesses. The ability to “open the faucet” to acquire more capital has certain advantages in today’s highly com-
petitive healthcare sector.
Fund Accounting
One unique feature of many not-for-profit balance sheets is that they classify certain asset and net asset (equity) accounts as being restricted.
When a not-
for-profit organization receives contributions that donors have indicated must be used for a specific purpose, or the board of trustees specifies that funds are being accumulated for a single purpose, the organization must create multiple funds to account for its assets and equity.
A fund
is defined as a self-contained pool set up to account for a spe-
cific activity or project. Each fund typically has assets, liabilities, and an equity balance. Because the balance sheet of an organization that receives restricted contributions is separated into restricted and unrestricted funds, this form of accounting is called fund accounting
. Only contributions to not-for-profit organizations are tax deductible to the donor; hence, few contributions are 1. What are net assets (equity)?
2. What are the differences in the equity sections of not-for-profit and investor-owned providers?
3. What is the relationship between the retained earnings account on the balance sheet and earnings (net income) reported on the income statement?
4. What is the purpose of the statement of changes in equity?
SELF-TEST QUESTIONS
Fund accounting
A system for recording financial statement data that categorizes accounts as restricted or unrestricted.
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Chapter 4: The Balance Sheet and Statement of Cash Flows
137
made to investor-owned healthcare businesses. Thus, fund accounting is only applicable to not-for-profit organizations.
To gain a better appreciation of fund accounting, consider Exhibit 4.5, which contains Sunnyvale’s net assets listing under fund accounting. Now, instead of a single line for net assets, the account is broken down into three subaccounts.
The first line lists unrestricted
net assets. These include funds that are derived from operating activities (retained earnings) and unrestricted con-
tributions—in other words, funds that are not contractually required to be used for a specific purpose. Such funds, as they are generated, are available to Sunnyvale to pay operating expenses, to acquire new property and equipment, or for any other legitimate purpose. Remember, though, that the $45,762,000 in unrestricted net assets is not a pot of money available for use at the end of 2015. Most, or all, of it has already been spent.
The next line contains temporarily restricted
net assets. These funds typi-
cally are provided by donors that have stipulated either time or predetermined goal restrictions. For example, a donor may specify that a contribution not be used until three years have elapsed or until the new children’s hospital is built. When the temporary restriction is met, assuming there are no additional restrictions, such monies are transferred to the unrestricted fund. The final line lists permanently restricted
net assets. These usually are contributions that must be maintained permanently by the organization; how-
ever, all or part of the associated earnings can be spent. Thus, the permanently restricted portion of such funds is not available for discretionary use.
Restricted contributions impose legal and fiduciary responsibilities on health services organizations to carry out the written wishes of donors. Numer-
ous rules are associated with fund accounting that go well beyond the scope of this book. The good news is that GAAP encourages organizations that use fund accounting to present outside parties with balance sheets that look roughly like the one presented in Exhibit 4.1. Thus, with the exception of further breakdown of some accounts into unrestricted and restricted compo-
nents, such balance sheets have the same economic content as those prepared using standard accounting guidelines.
2015 2014
Net Assets (Equity):
Unrestricted $ 45,762 $ 39,368 Temporarily restricted 3,455 2,669
Permanently restricted 4,851 4,171
Total net assets $54,068 $46,208 EXHIBIT 4.5 Sunnyvale Clinic: Balance Sheet Net Assets (Equity) Section Under Fund Accounting December 31, 2015 and 2014 (in thousands)
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Statement of Cash Flows
The balance sheet and income statement are traditional financial statements that have been required for many years. In contrast, the statement of cash flows has only been required since 1989 for for-profit businesses and since 1995 for not-for-profit businesses. This relatively new financial statement was created by accountants in response to demands by users for better information about a firm’s cash inflows and outflows.
While the balance sheet reports the cash balance on hand at the end of the period, it does not provide details on why the cash account is greater or smaller than the previous year’s value, nor does the income statement give detailed information on cash flows. In addition to the problems of accrual accounting and noncash expenses discussed in Chapter 3, there may be cash raised by means other than operations that does not even appear on the income statement. For example, Sunnyvale may have raised cash during 2015 by tak-
ing on more debt or by selling some fixed assets. Such flows, which are not shown on the income statement, affect a firm’s cash balance. Finally, the cash coming into a business does not sit in the cash account forever. Most of it goes to pay operating expenses or to purchase other assets, or for investor-owned firms, some may be paid out as dividends or used to repurchase stock. Thus, the cash account does not increase by the gross amount of cash generated, and it would be useful to know how the difference was spent. The statement of cash flows details where a business gets its cash and what happens to it.
Two formats can be used for the statement of cash flows: the direct format and the indirect format. Most providers prefer the indirect format. Sunnyvale’s 2015 and 2014 statements are presented in Exhibit 4.6 in the indirect format. To simplify the discussion, the data in the statements have been reduced; they are somewhat shorter and easier to comprehend than most “real world” statements. Nevertheless, an understanding of the composition and presentation of Exhibit 4.6 will give readers an excellent appreciation of the value of the statement of cash flows.
Statement of cash flows
A financial statement that focuses on the cash flows that come into and go out of a business.
1. What is fund accounting?
2. What type of health services organization is most likely to use fund accounting?
3. Explain the differences between unrestricted, temporarily restricted, and permanently restricted funds.
4. Is there a significant difference in the economic content of balance sheets created using fund accounting and those prepared under conventional accounting guidelines?
SELF-TEST QUESTIONS
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Chapter 4: The Balance Sheet and Statement of Cash Flows
139
The statement of cash flows is formatted to make it easy to understand why Sunnyvale’s cash position increased by $5,616,000 during 2015. In other words, it tells us Sunnyvale’s sources of cash and how this cash is used. The statement is divided into three major sections: cash flows from operating activi-
ties, cash flows from investing activities, and cash flows from financing activities.
Cash Flows from Operating Activities
The first section, cash flows from operating activities,
focuses on the sources and uses of cash tied directly to operations
. Of course, the most important source of operating cash flow is operating income, so its value for 2015 ($3,747,000) is listed first. However, operating income does not equal cash flow, so various adjustments must be made. The first, and typically most important, adjustment is to add back the noncash expenses that appear on the income statement. As we explained in Chapter 3, as a first approximation, the cash flow of a business can be approximated by adding back depreciation, 2015 2014
Cash Flows from Operating Activities: Operating income $ 3,747 $ 4,330 Adjustments: Depreciation 6,405 5,798 Increase in net patient accounts receivable (2,582) (1,423) Increase in inventories (1,393) (673) Decrease in accounts payable (1,911) (966) Increase in accrued expenses 1,032 865
Net cash from operations $ 5,298 $ 7,931 Cash Flows from Investing Activities: Capital expenditures ($ 9,306) ($ 1,953) Nonoperating income 4,113 3,876
Purchase of short-term securities (5,000) 0 Purchase of long-term securities (22,222) (20,667)
Net cash from investing ($ 32,415) ($ 18,744)
Cash Flows from Financing Activities: Proceeds from bank loan (notes payable) $ 989 $ 0 Proceeds from issuance of long-term debt 31,744 0 Net cash from financing $ 32,733 $ 0
Net increase (decrease) in cash $ 5,616 ($10,813)
Cash and cash equivalents, beginning of year 6,486 17,299 Cash and cash equivalents, end of year $ 12,102 $ 6,486 EXHIBIT 4.6 Sunnyvale Clinic: Statements of Cash Flows Years Ended December 31, 2015 and 2014 (in thousands)
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Healthcare Finance
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so Operating cash flow = Operating income + Depreciation = $3,747,000 + $6,405,000 = $10,152,000. Thus, depreciation expense of $6,405,000 is the first adjustment entry.
Note that we have started the section labeled “cash flows from operating activities” with operating income. An alternative format is to begin the sec-
tion with net income. This format does not separately identify operating and nonoperating income on the statement of cash flows. Because Sunnyvale does report operating income on the income statement, it makes the most sense to use it as the starting point for this section of the statement of cash flows.
Adjustments are then made for changes in those balance sheet current asset and liability accounts that are directly tied to operations. For Sunnyvale, this means the net patient accounts receivable, inventories, accounts payable, and accrued expenses accounts. The theory for these adjustments is that changes in the values of these accounts stem directly from operations; hence, any cash that is either generated by or used for these accounts should be included as part of cash flow from operations. In addition, using balance sheet data to calculate operating cash flow recognizes that, under accrual accounting, not every dollar of revenues or expenses listed on the income statement represents a dollar of cash flow.
Note that short-term investments and notes payable, although they are current accounts, reflect investment and financing decisions of a business rather than operations, and hence these accounts are not included in the first section of the statement of cash flows. Also, note that the entire statement focuses on the change in cash and equivalents, so that will be the output of the statement rather than one of its entries.
To illustrate the adjustments to operating cash flow, Sunnyvale’s net patient accounts receivable increased from $25,927,000 to $28,509,000, or by $2,582,000, during 2015. Because this amount was included in 2015 revenues and hence reported as operating income, but it was added to receiv-
ables instead of collected, it is not available as cash flow to Sunnyvale. Thus, it appears as a deduction (negative adjustment) to operating cash flow. To make this point in another way, an increase in an asset account requires that the business use cash, so the $2,582,000 increase in receivables reduces the cash flow available for other purposes. For another illustration, accrued expenses increased by $1,032,000 in 2015. Because an increase in accruals, which is on the right side (liabilities and equity) of the balance sheet, creates financing for the clinic and hence represents a source of cash (as opposed to a use), this change is shown as an addition to operating cash flow.
When all the adjustments were made, Sunnyvale reported $5,298,000 in net cash from operations for 2015. For a business, whether investor owned or not-for-profit, to be financially sustainable, it must generate a positive cash flow from operations. Thus, at least for 2015 and 2014, Sunnyvale’s operations Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com
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Chapter 4: The Balance Sheet and Statement of Cash Flows
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are doing what they should be doing—generating cash. However, the clinic’s cash flow from operations decreased from 2014 to 2015, so its managers should identify why this happened and then take appropriate action. Unlike Sunnyvale’s situation, a consistent negative net cash flow from operations would send a warning to managers and investors alike that the business may not be economically sustainable.
Cash Flows from Investing Activities
The second major section on the statement of cash flows is cash flows from investing activities.
For purposes of the statement of cash flows, investing activities are defined as both property and equipment (fixed assets) investments and securities investments.
Because depreciation is accounted for in the cash flows from operating activities section, the focus in this section is on the gross (total) investment in fixed assets. As detailed in Sunnyvale’s notes to the financial statements and as reported earlier in this chapter, the 2014 to 2015 change in gross property and equipment is calculated as 2015 gross property and equipment − 2014 gross property and equipment = $88,549,000 − $79,243,000 = $9,306,000. Thus, Sunnyvale spent this amount of cash to acquire additional fixed assets during 2015. This fact should not be alarming, even though the amount was greater than the cash flow from operations, as long as the investments are prudent. (Chapters 14 and 15 contain a great number of insights into what makes a prudent capital investment, at least from a financial perspective.)
In addition to investments in fixed assets, Sunnyvale invests in securi-
ties and earns nonoperating income. As reported on the income statement, Sunnyvale earned $4,113,000 in total nonoperating income in 2015, which is reported on the second line of the investing section of the cash flow statement. Finally, the clinic made additional securities investments in 2015. Sunnyvale’s short-term investments account on the balance sheet increased by $5,000,000, which means it used this amount of cash to buy short-term securities, hence an outflow was posted in the statement of cash flows. Also from the balance sheet, long-term investments increased by $48,059,000 − $25,837,000 = $22,222,000, so this purchase of long-term securities is shown as an outflow in the cash flows from investing activities section.
When all of the 2015 investing activities are considered, Sunnyvale’s resulting net cash flow is an outflow of $32,415,000. Even though it earned $4,113,000 in nonoperating income, it spent $9,306,000 on plant and equipment and further invested a total of $27,222,000 in short- and long-term securities.
Cash Flows from Financing Activities
The final major section of the statement of cash flows is cash flows from financing activities,
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and other business activities. The changes in balance sheet accounts from 2014 to 2015 indicate that the clinic took out a new bank loan of $989,000 and hence increased its notes payable by $989,000, which is a source of cash. Additionally, Sunnyvale took on an additional $85,322,000 − $53,578,000 = $31,744,000 in long-term debt, another source of cash. On net, Sunnyvale generated a $32,733,000 cash inflow from financing activities.
The previous (cash flows from investing activities) section of the state-
ment of cash flows shows that Sunnyvale used $27,222,000, the vast majority of the new debt financing, to purchase securities. In general, new debt would be used to acquire real assets rather than financial assets. However, Sunnyvale is planning to acquire a large group practice in 2016, and the financing activi-
ties undertaken in 2015 are in preparation for this purchase.
Net Increase (Decrease) in Cash and Equivalents and Reconciliation
The next line of the statement of cash flows is the net increase (decrease) in cash
. It is merely the sum of the totals from the three major sections. For Sunnyvale, there is a net increase in cash of $5,298,000 − $32,415,000 + $32,733,000 = $5,616,000 in 2015. Unlike the “bottom line” of the income statement, the change in cash line has limited value in assessing an organiza-
tion’s financial condition because it can be manipulated by financing activities. If an organization is losing cash on operations but its managers want to report an increase in the cash and equivalents account, in most cases they simply can borrow the funds necessary to show a net cash increase on the statement of cash flows. Thus, the net cash from operations line is a more important indicator of financial well-being than is the net increase (decrease) in cash line.
The net increase (decrease) in cash line is used to verify the entries on the statement of cash flows. As shown in Exhibit 4.6, the $5,616,000 increase in cash reported by Sunnyvale for 2015 is added to the beginning-
of-year cash and equivalents balance, $6,486,000, to get an end-of-year total of $12,102,000. A check of the end-of-2015 cash and cash equivalents bal-
ance shown in Exhibit 4.1 confirms the amount calculated on the statement of cash flows.
In summary, the income statement focuses on accounting profitability, while the statement of cash flows focuses on the movement of cash: Where did the money come from, and how did the organization use it? While the major concern of the income statement is economic profitability as defined by GAAP, the statement of cash flows is concerned with cash viability. Is the organization generating, and will it continue to generate, sufficient cash to meet both short-term and long-term needs?
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Chapter 4: The Balance Sheet and Statement of Cash Flows
143
Balance Sheet Transactions
As we discussed in the last chapter, the recording of transactions by the account-
ing staff is the first step in the creation of a business’s financial statements. Understanding how transactions ultimately affect the financial statements will help managers better understand and interpret their content.
The transactions that flow to the income statement are relatively appar-
ent. For example, net operating revenues stem directly from the provision of patient services and there is an expectation of receiving payment. Thus, the provision of services that have a reimbursement amount of $1,000 would increase the net patient services revenue account by $1,000. Most expenses are treated in the same way: For example, the obligation to pay wages of $150 to an employee for a day’s work would increase the salaries expense line by a like amount.
However, the transactions that flow to the balance sheet are less obvious. In this section, ten typical balance sheet transactions are presented. Under-
standing these transactions will help readers understand how an organization’s economic events are transformed into financial statement data. The primary concept behind all balance sheet transactions is that the basic accounting equation must be preserved—that is, the balance sheet must balance. Thus, each transaction must have a dual effect, either one on the left side and one on the right side or offsetting effects on the same side.
1. Investment by owners. Suppose five radiologists decide to open a diagnostic center that they incorporate as an investor-owned business called Bayshore Radiology Center. They each invest $200,000 cash in the business in exchange for $200,000 of common stock. The transaction results in an equal increase in both assets and equity. In this case, there is an increase in the cash account of $1,000,000 and an increase in the common stock account of $1,000,000. After the transaction, the balance sheet looks like this:
1. How does the statement of cash flows differ from the income statement?
2. Briefly explain the three major categories shown on the statement.
3. In your view, what is the most important piece of information reported on the statement?
SELF-TEST QUESTIONS
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Sixth Edition
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Healthcare Finance
144
Cash
$1,000,000
Common stock
$1,000,000
Total assets
$1,000,000
Total claims
$1,000,000
2. Purchase of equipment for cash. To support operations, the business needs diagnostic equipment. Assume that the first piece of equipment purchased costs $200,000 and it is paid for in cash. This transaction results in a change in the composition of the business’s assets, but the totals are unaffected:
Cash
$ 800,000
Common stock
$1,000,000
Net fixed assets
200,000
Total assets
$1,000,000
Total claims
$1,000,000
Total assets and total claims still amount to $1,000,000 because no new capital was acquired by the business.
3. Purchase of supplies on credit. Assume that Bayshore purchases medical supplies for $20,000. The supplier’s terms give the center 60 days to pay the bill. Assets are increased by this transaction because of the expected benefit of using these supplies to provide services. Also, liabilities (accounts payable) are increased by the amount due the supplier:
Cash
$ 800,000
Accounts payable
$ 20,000
Supplies
20,000
Common stock
1,000,000
Net fixed assets
200,000
Total assets
$1,020,000
Total claims
$1,020,000
4. Services rendered for credit. Assume that Bayshore provides services that result in $50,000 in billings to third-party payers. This transaction will increase assets (accounts receivable) and the retained earnings portion of equity. The $50,000 would also show up on the income statement as revenue, which, after expenses and any dividends are deducted, would ultimately flow through to the balance sheet and hence support the increase in equity: Cash
$ 800,000
Accounts payable
$ 20,000
Accounts receivable
50,000
Common stock
Retained earnings
1,000,000
50,000
Supplies
20,000
Net fixed assets
200,000
Total assets
$1,070,000
Total claims
$1,070,000
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