• •Intensity of service • •Charges for specific procedures (Cleverley 243-254) Cleverley, William O. Essentials of Health Care Finance, 7th Edition. Jones & Bartlett Learning, 20101022. VitalBook file. Chapter 12 Financial Analysis of Alternative Healthcare Firms LEARNING OBJECTIVES After studying this chapter, you should be able to do the following: • 1.List some of the major nonhospital and nonphysician sectors of the healthcare industry. • 2.Discuss the sources of revenue for the nursing home industry. Average Case Weight = 36 30 = 1.2 • 3.Discuss the major sources of revenue and expenses of medical groups. • 4.List and describe the major organizational types of physician groups. • 5.Describe alternative health maintenance organization arrangements. REAL-WORLD SCENARIO Laura Rose has been recently appointed to the Board of ElderCare, a large, for-profit operator of skilled nursing facilities (SNFs) around the country. Laura’s first committee assignment is to the Treasury Committee because of her prior business experience. Although Laura had extensive experience as a hospital administrator, she had relatively little familiarity with the SNF industry. Upon reviewing ElderCare’s recent financial statements, she was concerned about the dramatically declining financial position. She noticed that revenues were declining on per facility and per patient bases. Meanwhile, the company’s debt had been downgraded, and its borrowing costs had risen substantially. She is aware that Medicare implemented a SNF prospective payment system as part of the Balanced Budget Act of 1997. Payment increases by Medicare and Medicaid have not kept pace with increases in costs in recent years. She wonders whether this might be a factor in the company’s financing issues. In general, profitability in the long-term care industry has declined significantly in recent years, and several industry leaders had filed for bankruptcy protection. Although some believe that SNF prospective payment systems were largely to blame, other factors, such as ill-advised acquisitions, excessive long-term debt, and poor balance sheets, probably contributed as well. In essence, she is unsure whether ElderCare’s financing difficulties are unique to management issues at ElderCare or whether they reflect more general market conditions and economic and reimbursement trends. To understand the issue better, Laura needs to estimate the direct financial impact of SNF reimbursement. She asked the ElderCare treasury and controller’s office staff to prepare an analysis of the financial performance of selected long-term care facilities over the period 2006 to 2010. In particular, she wants to know how SNF-bond ratings have been affected by prospective payment systems and what other factors might have contributed to the industry’s deteriorating financial performance. In Chapter 11 we discussed the measures and concepts of financial analysis in some .

1. • •Intensity of service
• •Charges for specific procedures
(Cleverley 243-254)
Cleverley, William O. Essentials of Health Care Finance, 7th
Edition.
Jones & Bartlett Learning, 20101022. VitalBook file.
Chapter 12 Financial Analysis of Alternative
Healthcare Firms
LEARNING OBJECTIVES
After studying this chapter, you should be able to do the
following:
• 1.List some of the major nonhospital and nonphysician
sectors of the healthcare industry.
• 2.Discuss the sources of revenue for the nursing home
industry.
Average Case Weight =
36
30
=
1.2

2. • 3.Discuss the major sources of revenue and expenses of
medical groups.
• 4.List and describe the major organizational types of
physician groups.
• 5.Describe alternative health maintenance organization
arrangements.
REAL-WORLD SCENARIO
Laura Rose has been recently appointed to the Board of
ElderCare, a
large, for-profit operator of skilled nursing facilities (SNFs)
around the
country. Laura’s first committee assignment is to the Treasury
Committee because of her prior business experience. Although
Laura
had extensive experience as a hospital administrator, she had
relatively little familiarity with the SNF industry. Upon
reviewing
ElderCare’s recent financial statements, she was concerned
about the
dramatically declining financial position. She noticed that
revenues
were declining on per facility and per patient bases. Meanwhile,
the
company’s debt had been downgraded, and its borrowing costs
had
risen substantially.
She is aware that Medicare implemented a SNF prospective
payment
system as part of the Balanced Budget Act of 1997. Payment
increases by Medicare and Medicaid have not kept pace with
increases in costs in recent years. She wonders whether this
might be
a factor in the company’s financing issues. In general,

3. profitability in
the long-term care industry has declined significantly in recent
years,
and several industry leaders had filed for bankruptcy protection.
Although some believe that SNF prospective payment systems
were
largely to blame, other factors, such as ill-advised acquisitions,
excessive long-term debt, and poor balance sheets, probably
contributed as well. In essence, she is unsure whether
ElderCare’s
financing difficulties are unique to management issues at
ElderCare or
whether they reflect more general market conditions and
economic
and reimbursement trends.
To understand the issue better, Laura needs to estimate the
direct
financial impact of SNF reimbursement. She asked the
ElderCare
treasury and controller’s office staff to prepare an analysis of
the
financial performance of selected long-term care facilities over
the
period 2006 to 2010. In particular, she wants to know how SNF-
bond
ratings have been affected by prospective payment systems and
what
other factors might have contributed to the industry’s
deteriorating
financial performance.
In Chapter 11 we discussed the measures and concepts of
financial

4. analysis in some detail, but most of the examples and industry
standards were from the hospital sector. The hospital industry is
by far
the largest sector in the healthcare industry, but it is not the
only
sector; its rate of growth in recent years has been slower than in
other
areas. This chapter provides some additional information about
alternative health-care firms.
LEARNING OBJECTIVE 1
List some of the major nonhospital and non-physician sectors of
the
healthcare industry.
First, we discuss the financial characteristics of the following
three
specific alternative sectors:
• 1.Nursing homes
• 2.Medical groups
• 3.Health plans
It is impossible to describe all the specific operating
characteristics for
these three sectors in one chapter, but we highlight the
important
differences that affect financial measures. It is important to
remember
that the financial measures and concepts discussed in Chapter
11 are
still applicable. For example, the concept and measurement of
liquidity
are the same for a hospital as they are for a health plan.
However,
operating differences between health plans and hospitals
produce
different values and standards. Health plans have much lower

5. days in
receivables than do hospitals and are required to carry much
higher
cash balances to meet transaction needs, namely claims
payment.
It is not just the higher relative growth rates of non-hospital
sectors
that cause us to separately examine the topic of financial
analysis for
alternative health-care firms. Many of the alternative healthcare
firms
have been consolidating through both horizontal and vertical
mergers
and have now become major corporations in our nation’s
economy.
For example, UnitedHealth Group, Aetna, and Wellpoint are
among
the largest corporations in the country, employing large
numbers of
people and absorbing significant amounts of capital to finance
their
continued growth. Much financial analysis and discussion are
now
devoted to these firms because of their almost continuous needs
for
financing. Major brokerage houses now have analysts who
devote
their time to narrow sectors of the healthcare industry, such as
home
health firms or medical groups.
Table 12–1 presents 2008 financial ratio medians for two of the
three
sectors, along with comparative values for the investor-owned

6. hospital-industry sector. We calculated ratio averages by
computing
the ratio average for three large publicly traded firms in each
industrial
group. Table 12–2 shows the composition for each of the three
groups.
Table 12-1 Financial Ratio Medians, 2008
Nursing
Homes
Health
Insurers
Investor-
Owned
ospitals
Liquidity
Current 1.41 0.74 1.50
Days in receivables 56.65 16.60 52.04
Days-cash-on-hand 35.21 146.92 14.67
Capital structure
Debt financing percentage 62.81 65.22 81.79
Long-term debt to capital 42.72 30.95 73.74
Cash flow to debt
percentage
11.39 9.00 9.57
Times interest earned 4.87 8.69 2.82
Activity
LONG-TERM CARE FACILITIES AND

7. NURSING HOMES
It is not always clear what types of firms individuals are
referring to
when they talk about the long-term care industry. For our
purposes we
refer primarily to nursing homes, both skilled and intermediate-
care
facilities. The nursing home industry has experienced
significant
growth during the last decade, and expectations about the aging
of
America have led many analysts to project even more rapid
growth in
the future. Growth in the nursing home industry is inextricably
linked to
government payment and regulatory policy.
As of 2007 there were over 15,827 nursing homes in the United
States, and of those more than 65% were investor owned.
Investor-
owned presence in the nursing home industry is much larger
than it is
in the hospital industry, where only 17% of hospital capacity is
investor owned. Many of the investor-owned nursing homes are
part
of large national chains, such as Kindred Healthcare, Sun
Healthcare
Group, and Odyssey Healthcare. However, many investors may
own
as few as 1 or 2 nursing homes to as many as 20. Most of the
large
investor-owned chains became involved in the industry when
the
government started to finance a sizable percentage of nursing
home
care through the Medicaid program. Heavy government

8. financing
provided a stable source of payment that was not present before
Medicaid.
Total asset turnover 1.78 1.19 1.06
Fixed asset turnover 11.89 53.84 2.26
Current asset turnover 6.40 5.59 4.57
Profitability
Total margin percentage 3.07 4.07 2.09
Return on equity
percentage
12.75 14.29 16.75
Table 12-2 Industry Composition, 2008
LEARNING OBJECTIVE 2
Discuss the sources of revenue for the nursing home industry.
Financing of nursing home care is a critical driver of nursing
home
supply as it is for most other health care sectors. Table 12–3
summarizes sources of financing trends for nursing homes as of
2007.
Table 12-3. Financing Percentages for
Nursing Home Expenditures
Industry/Firm Most Recent evenue (millions)
Health insurance
UnitedHealth Group $81,186
WellPoint, Inc. $61,251
Aetna $30,951
Nursing
Kindred Healthcare $4,151

9. Sun Healthcare Group, Inc. $1,824
Odyssey Healthcare $616
Investor-owned hospitals
Universal Health Services $5,022
Community Health Systems $10,840
Tenet Healthcare $8,663
1995 2000 2005 2007
Private financing 43 43 37 38
Insurance 8 8 7 7
Out-of-pocket 28 30 26 27
Source: Reprinted from the Centers for Medicare & Medicaid
Services, National Health
Expenditure Data. Retrieved July 6, 2010, from
http://www.cms.gov.
The data in Table 12–3 reflect the dramatic increase in the
percentage
of nursing home financing derived from public sources and a
corresponding reduction in private financing. The percentage of
Medicare financing increased sharply in the first half of the
1990s as
hospitals discharged more patients into nursing home settings to
cut
their costs per case and to maximize their profit per Medicare
case.
Much of this shift probably was related to the financial
incentives
created by the Medicare program when the government shifted
to a
per case payment system in 1983.
Although the federal government pays more than 50% of
Medicaid

10. nursing home costs, actual nursing home payments for Medicaid
patients are set by the states. There is wide variation among the
states between retrospective and prospective systems. In many
states
there may be a mix of both systems. For example, capital costs
may
be paid on a retrospective basis, whereas all other costs may be
paid
on a prospective basis. Many states also use a case-mix-
adjustment
methodology to provide higher payments for nursing homes
treating
more severely ill patients.
Medicaid payments from states are usually the second largest
state
expenditure and, as a result, are subject to dramatic changes
based
on the economic condition in the state. When economic times
are bad
and states have a difficult time meeting their budgets, one of the
areas
usually affected is nursing home payments.
The level of nursing home beds by state varies dramatically.
Many
states have used the supply of nursing home beds as a means to
control state expenditures for nursing home care. The number of
nursing home beds per 1,000 people older than 85 years ranges
from
All other 7 5 4 4
Public 57 57 63 62
Medicare 9 11 16 18
Medicaid 46 44 45 42
All other 2 2 2 2

11. 184.8 in West Virginia to 504.4 in Indiana (Centers for
Medicare &
Medicaid Services, Division of Payment Systems, 1999, http://
www.cms.gov). Licensure laws and certificate of need have
been the
primary means for controlling nursing home beds in most states.
Rates of payment for Medicaid patients also serve as an indirect
method of controlling nursing home capacity. As rates are held
down,
less capital becomes available for expansion and renovation.
Major
national nursing home chains have been known to sell all their
nursing
homes in certain states where they believed that reasonable
profits
would be difficult to obtain because of restrictive state payment
policies.
It is expected that demand for nursing home care will increase
dramatically in the next 30 years as the baby boomers reach the
age
of 75 plus, which is the age at which nursing home demand
peaks.
Nursing homes are also diversifying and expanding their
product lines.
For example, many nursing homes are becoming continuing care
retirement communities (CCRCs). In a CCRC there is a
continuum of
care that runs the gamut from independent living to assisted
living to
skilled care.
CCRCs also have discovered that their resident populations are
desirable targets for health maintenance organizations (HMOs)
that
are seeking to expand their Medicare risk contracts. The CCRC
is in a

12. strong position to market itself to a managed care group because
of
the economies of scale provided from its continuum of care and
its
personal relationship to a Medicare population. At the same
time,
hospitals are looking for ways to expand their revenue base and
have
begun to develop skilled care units and other subacute units that
can
expand their business along the continuum of care and compete
with
existing nursing homes. In many respects some of the historical
distinctions among healthcare industry segments are becoming
blurred as vertical integration accelerates.
The financial statements in Tables 12–4 and 12–5 reflect the
operations of Friendly Village, a church-owned CCRC. A
review of
these financial statements gives the reader some idea of the
nature of
business operations in this type of healthcare organization. A
CCRC
usually provides three levels of care: nursing home care,
assisted
living, and independent living. Often, residents progress
through these
three levels of care. An elderly person may enter the CCRC in
an
independent-living status and occupy one of the independent-
living
apartments. These apartments often are similar to apartments in
other
settings except residents are all retired and keep active through

13. a
variety of social activities. As the health of a resident erodes,
that
resident may move to an assisted-living environment. In an
assisted-
living environment some healthcare services are provided to
enable
the resident to maintain daily activities. For example,
medication
administration, medical monitoring, or some help with daily
living
functions such as bathing, toileting, and cooking may be
required.
Many residents are prolonging admission into an assisted-living
center, and assisted-living residents are becoming similar to the
nursing home residents of 10 years ago. The last level of care is
nursing home services, either intermediate or skilled.
Table 12-4. Friendly Village and Subsidiary
Consolidated Balance Sheets
June
2010 2009
Assets
General funds
Current assets
Cash and cash equivalents $228,693 $173,134
Investments (at cost-approximate
market value of $293,000 in 2010
and $530,000 in 2009)
199,811 409,393
Cash and investments that have
limited use

14. 634,918 310,629
Receivable-Friendly Church
entrance-fee fund
2,151,994 2,169,635
Resident and patient accounts
receivable, less allowance for
doubtful accounts (2010—
$195,000; 2009—$115,000)
803,634 445,291
Mortgage escrow deposits 30,891 81,961
Inventories, prepaid expenses,
and other assets
118,565 144,093
Total current assets $4,168,506 $3,734,136
Assets that have limited use
Cash and investments (at cost,
which approximates market
value):
Under bond indenture agreement-
held by trustee
$5,103,399 $662,217
Repair and replacement—held by
trustee

15. 283,179 355,392
Resident deposits 292,762 284,749
$5,679,340 $1,302,358
less cash and investments
required for current liabilities
(634,918) (310,629)
$5,044,422 $991,728
Receivable-Friendly Church fee-
fee fund, less portion classified as
current assets
5,862,673 5,142,678
$10,907,095 $6,134,406
Property and equipment, less
allowances for depreciation
$13,312,799 $10,747,006
Unamortized debt financing costs 551,700 226,100
Total general funds $28,940,101 $20,841,648
Donor-restricted funds
Cash and investments (at cost-
approximate market value of
$1,121,000 in 2010 and
$1,210,000 in 2009)
$1,206,604 $1,075,115

16. Receivable-Friendly Foundation 198,414 189,608
Due from general funds 196,594 188,578
Due from nurse scholarship
recipients
14,357 6,064
Due from employee hardship
recipients
3,266 0
Total donor-restricted funds $1,619,235 $1,459,364
Liabilities and fund balances
General funds
Current liabilities
Accounts payable $888,489 $694,390
Interest payable 340,460 220,318
Salaries, wages, and related
liabilities
759,495 696,458
Funds held for others 30,562 30,077
Due to donor-restricted funds 196,594 188,597
Estimated third-party settlement 45,842 441
Current portion of deferred
entrance fees
824,000 987,251
Current portion of note payable to
Friendly Church fee-fee fund
28,291 40,889

17. Current portion of long-term
liabilities
426,163 374,663
Many CCRCs also may have specialized units to treat patients
with
Alzheimer’s disease or who have experienced a stroke.
The income statement of Table 12–5 reports revenues from a
variety
of sources. The largest share is from the nursing home and is
referred
to as routine healthcare center services ($6,214,764 in 2010).
The
second largest source of revenue is fees generated from care and
Total current liabilities $3,539,897 $3,233,083
Deferred entrance fees, less
current portion
2,975,343 4,284,149
Deposits—residents 288,040 274,578
Note payable to the fee-fee fund,
less current portion
635,776 666,549
Long-term liabilities, less current
portion
15,972,531 8,265,908
Refundable entrance fees 28,110 29,907

18. Obligation to provide future
services and use of facilities
190,550 190,550
General fund balance 5,309,854 3,942,682
Total general funds 28,940,101 $26,365,697
Donor-restricted funds
Fund balances
Sustaining fund $751,708 $692,320
Foundation fund 198,413 189,608
Medical-memorial fund 344,657 336,169
Specific-purpose fund 196,595 188,597
Nurse-scholarship fund 47,451 45,624
Employee-hardship fund 12,227 7,066
Pooled-income fund 68,184 0
Total donor-restricted funds $1,619,235 $1,459,383
services provided to residents of the assisted-living center or
the
independent-living apartments ($4,039,897 in 2010). Some
other
revenue is generated from entrance fees and consists of
$1,080,635
from an amortization of entrance fees and $287,261 from
investment
income earned on the entrance fee fund. Some residents pay
entrance fees upon entrance into the independent-living or
assisted-
living center. These deposits guarantee that a nursing home bed
will
be available if needed and that the rate for that nursing home
bed will
be less than the nursing home’s current rates. For example, the

19. CCRC may guarantee the resident to pay only 50% of the posted
rate
for a nursing home bed if needed.
Table 12-5. Friendly Village and Subsidiary
Consolidated Statements of Revenues and
Expenses of General Funds
Year Ended June 30
2010 2009
Revenues
Routine
healthcare
center services
—net
$6,214,764 $5,863,469
Care and
service fees—
net
4,039,897 3,795,875
Amortization of
entrance fees
1,080,635 987,252
Other medical
services

20. 690,593 676,216
Applicant fees 6,386 6,077
Investment
income on
restricted funds
287,261 97,265
Other 284,761 209,449
Total revenues $12,604,296 $11,635,603
Expenses
Salaries and
wages
$5,903,470 5,581,287
Employee
benefits
1,052,944 964,048
Purchased
services
1,023,900 976,639
Other medical
services
780,176 763,314

21. Supplies 1,076,176 953,586
Repairs and
maintenance
137,898 109,047
Utilities 600,423 534,664
Equipment
rental
7,757 4,881
Interest and
amortization
1,312,727 793,622
Provision for
doubtful
accounts
65,718 25,415
Taxes 388,164 370,308
Insurance-
property, liability,
and general
78,830 93,782
Other 84,098 87,618

22. Total expenses $12,512,281 $11,258,211
Gain from
operations
before
depreciation
and other
operating
revenues
$92,015 $377,392
Other operating
revenues and
expenses
Unrestricted
contributions
19,807 67,504
Investment
income on
entrance-fee-
fund, net(1)
2,174,411 774,901
Gain from
operations
before
depreciation
$2,286,233 $1,219,797

23. Provision for
depreciation
(922,501) (825,221)
Gain from
operations
$1,363,732 $394,577
Nonoperating
loss
Loss on
disposal of
property and
equipment
(51,082) (10,096)
The amount of the entrance fee may be based on age at
entrance.
The fund is then amortized or recognized as income as the
patient
ages or dies. There is also income earned on the deposits that is
recognized as income each year. The entrance fee fund is listed
several times in the balance sheet depicted in Table 12–4. On
the
asset side, there is a receivable from the church, which holds
the
entrance fees, in both the current asset and assets that have
limited-

24. use sections. On the liability side, there are accounts in both the
current and noncurrent sections that represent deferred entrance
fees.
We discuss below what these accounts represent because they
are
one of the most confusing accounting aspects of CCRCs.
The expense structure of a CCRC or nursing home is similar to
other
healthcare providers and is labor
intensive. At Friendly Village salaries and wages plus benefits
constitute slightly more than 50% of total expenses. Also,
notice that
depreciation is not shown in the expense section but is
separately
shown as other expense. This is not uncommon for not-for-
profit
CCRCs that often regard capital as a gift and do not regard
replacement of the existing assets as an operating expense.
Perhaps the most unusual feature of a CCRC’s financial
statement
relates to the entrance fee fund and the deferred revenue that
results
from the receipt of those moneys upon admission to the
retirement
community. To understand the concepts of entrance fees and
their
amortization and deferred revenue recognition, we use a simple
example and then relate those concepts to the data for Friendly
Village. Let’s
assume that a resident enters the CCRC at the beginning of the
year
and contributes $35,000 to the entrance fee fund. This amount is
amortized over the expected life of the resident, which we will
assume

25. to be 7 years. During the year the resident spends 20 days in the
SNF
and is required to pay only 60% of the $150 per day charge, or
$90
per day. This means that a payment of $60 per day for 20 days,
or
Excess of revenues over
expenses & nonoperating loss
$1,312,651 $384,480
$1,200, will be paid to the SNF for 40% of the residents’
charges by
the entrance fee fund. Finally, assume that the $35,000 entrance
fee
fund earned investment income during the year in the amount of
$2,000. The following entries would be made:
These are the accounting entries made to reflect activities
related to
the entrance fee fund and the deferred revenue account relating
to the
entrance fee fund. The entrance fee fund is an asset account that
represents the funds available to meet contractual commitments
to
provide future healthcare services to residents. The deferred
revenue
account is a liability account that represents the estimated
present
value of future contractual obligations to provide healthcare
services
to residents.

26. LEARNING OBJECTIVE 3
Discuss the major sources of revenue and expenses of medical
groups.
MEDICAL GROUPS
Entry No. 1 Record receipt of the $35,000 entrance fee
Increase entrance fee fund by $35,000
Increase deferred revenue by $35,000
Entry No. 2 Record transfer of money to SNF
Increase unrestricted cash by $1,200
Decrease entrance fee fund by $1,200
Entry No. 3 Record annual amortization of entrance fee
fund
Increase revenue account amortization of
entrance fees by $5,000
Decrease deferred revenue by $5,000
Entry No. 4 Record the investment income earned during
the year
Increase entrance fee fund by $2,000
Increase investment income on entrance fee
fund by $2,000
Expenditures for physician and clinical services amounted in
2007 to
approximately $479 billion and are second only to hospital
expenditures. Physician expenditures have been increasing more
rapidly than expenditures of most other sectors of the healthcare
industry, which has increased the relative importance of
physicians.
However, it is not just the absolute level of expenditures made

27. to
physicians that make doctors an important element in our
healthcare
industry. It is widely believed that doctors directly or indirectly
control
up to 85% of all healthcare expenditures. Doctors admit and
discharge
patients to hospitals, prescribe drugs, order expensive
diagnostic
imaging services, and schedule rehabilitative services. The
stroke of a
doctor’s pen directs a massive amount of healthcare resources to
or
away from an individual patient. Managed care plans realized
the
demand-influencing behavior of physicians early and have
attempted
to incorporate incentives for cost control in physician payment
plans.
Although few would debate the importance of physicians in
controlling
healthcare costs, physicians have yet to realize their importance
in the
medical marketplace because of their lack of organization. Of
the
300,000 physicians in the United States, two-thirds operate in
one- or
two-person practices. It is difficult for physicians to realize
their central
role in cost and quality decision making in healthcare
negotiations.
This is because most of them are part of delivery organizations
that
are too small to exert much, if any, bargaining leverage in
healthcare
negotiations. Physicians are slowly realizing this weakness and

28. are
now becoming part of larger organizations being developed by
hospitals, health plans, large practice management companies,
and
large physician-controlled medical groups.
Table 12–6 presents some data on sources of financing for the
physician sector of the healthcare industry. Perhaps the most
significant trend is the dramatic reduction in the percentage of
physician expenditures financed by out-of-pocket payments
from
patients. From 1985 to 2007 the percentage dropped from 27%
to
10%. It is not exactly clear what caused this decrease, but the
decline
of indemnity coverage and the corresponding increase in HMO
and
preferred provider organization plans may be possible causes.
Many
HMO plans require a low copayment or no copayment for
routine
office visits, whereas most traditional indemnity programs have
a
coinsurance and deductible provision. For example,
indemnity programs may require a subscriber to make all
routine
physician payments until some deductible is met, for example,
$500.
This might change in the years ahead if consumer-driven health
plans
with large deductibles become more pervasive.
Table 12-6. Financing Percentages for

29. Physician Expenditures
Source: Reprinted from the Centers for Medicare & Medicaid
Services.
Physicians do receive a much larger percentage of their total
revenue
from the private sector than do most other major healthcare
sectors. In
2007 physicians received 66% of their total revenues from the
private
sector, whereas hospitals received only 41%. Medicare covers
nearly
100% of hospital service charges for the elderly but is subject
to a
20% coinsurance payment for most physician services. Most
Medicare
beneficiaries finance this payment with supplemental insurance,
which
creates a shift from public to private financing.
Physician expenditures are increasing because there is
increasing
usage of physician services. Table 12–7 documents the
increasing
number of healthcare visits as
1985 1995 2005 2007
Private financing 71 68 66 66
Insurance 37 48 49 49
Out-of-pocket 27 12 10 10
All other 7 8 7 7
Public financing 29 32 34 34
Medicare 19 19 20 20
Medicaid 4 7 7 7
All other 6 5 6 6

30. Table 12-7. Healthcare Visits Per Year,
2006: Percent Distribution by Age Group
Source: National Center for Health Statistics. Based on a
summary measure that
combines information about visits to doctors’ offices or clinics,
emergency departments,
and home visits. Retrieved July 6, 2010, from
http://www.cdc.gov.
people get older. The number of visits within age groups also is
increasing (not shown). As the population ages, demand for
physician
services is expected to increase sharply. The substitution of
ambulatory care for inpatient care also further accelerates
demand for
physicians.
As we discussed earlier, physicians are beginning to align
themselves
with larger groups and are moving quickly from one- or two-
person
practices to these larger groups. Some of this movement is a
reflection of personal tastes. Physicians who practice in larger
groups
can make arrangement for weekend or evening coverage. Large
group practices often provide their doctors with better
consultative
services and also reduce administrative burden, permitting
greater
patient-contact time. Lifestyle considerations may be an
important
cause of physicians joining larger groups, but the primary cause
is
related to economics. Physicians have seen hospitals and health
plans merge and become more and more dominant in the local
healthcare marketplace. Before increasing physician

31. organization to
counterbalance these large bargaining entities, physicians
perceived
themselves as being at a disadvantage.
Age Group None 1–3 4–9 10 or More
Under 18
years
10.9 57.2 24.6 7.3
18–44 25.3 45.8 17.8 11
45–64 16.4 44.3 23.6 15.7
65–74 6.7 34.6 36.6 22.1
Older than
74
5.3 31.5 35.7 27.6
LEARNING OBJECTIVE 4
List and describe the major organizational types of physician
groups.
Physicians can choose whether to align with other physicians or
to
remain independent. If they choose to align with other
physicians,
there are four primary organizational alternatives for them to
consider:
• •Alignment with other medical groups
• •Alignment with hospitals
• •Alignment with health plans
• •Alignment with physician practice management firms

32. Alignment with physicians is, in some respects, most appealing
to
physicians because their control is maximized in this type of
organizational setting. Often, the critical limitation is capital.
To
achieve large-scale integration and development of new
information
systems and administrative structures, massive amounts of both
financial and human capital are required. Only recently have
outside
investors come forward to provide this
external capital. For integration with other physicians to be
successful,
a physician activist is needed who will not only arrange the
financing
of capital needs but who will also provide the administrative
leadership.
Hospitals have the financial capital to create large groups, but
in some
cases their administrative experiences with physician practice
management are limited. This limitation, coupled with differing
incentives, can lead to organizational conflict. In a managed
care
environment the objective is to empty hospital beds, not fill
them, and
this often leads to conflict between hospitals and doctors.
Hospitals
also have been dominated by specialists, but primary care
physicians
are the key in managed care markets. Primary care physicians
often
believe that hospitals do not understand them or their needs.
Health plans also have the capital to put together large medical
groups, but a conflict may arise between the incentives of health

33. plans
and its employee doctors. The health plan has a strong incentive
to
reduce fees or salaries of its doctors while also controlling
utilization.
Physicians do not react favorably to lower income and also
object to
mandates or controls over their practice patterns.
Physician practice management firms are a relatively recent
development that has evolved to meet the needs of both the
physicians and the marketplace. Some of these firms are
publicly
traded and can have capital and management pools to draw on to
develop large, integrated organizations. Physician practice
management firms usually offer physicians some type of profit
sharing
and also provide for an equity stake in the firm. This equity
participation can make the attraction of merger or acquisition by
a
physician practice management firm hard to resist. In short,
physician
practice management firms often can afford to pay large sums of
money to acquire physician practices and also promise
physicians a
strong degree of autonomy.
The financial statements in Tables 12–8 and 12–9 provide
financial
information for Waverly Health Clinic (WHC), a hospital-
owned
network of eight primary care clinics with 24 full-time
physicians and
122 nonphysician employees. The clinic recorded 101,542
patient

34. encounters during the past year with an average resource-based
relative value scale relative value unit (RBRVS RVU) of 1.5 per
patient
encounter. WHC is a separately incorporated for-profit
subsidiary of
the hospital, and all its physicians are salaried with profit and
productivity incentives.
Table 12-8 Balance Sheet, WHC,
December 31, 2008
Assets
Current assets
Cash $375,570
Net accounts receivable $1,453,343
Prepaid expenses $147,785
Other current assets $753,497
Table 12-9 Income Statement, WHC, Year
Ending December 31, 2008
Total current assets $2,730,195
Net property, plant, & equipment $1,911,545
Intangible assets $194,609
Total assets $4,836,350
Liabilities and equity
Current liabilities
Accounts payable $173,175
Withheld taxes $87,235
Employee benefits withheld $3,379
Accrued salaries and wages $345,578
Other current liabilities $101,436
Total current liabilities $710,804
Equity
Contributed capital $8,481,937

35. Retained earnings ($4,356,391)
Total equity $4,125,546
Total liabilities and equity $4,836,350
Revenue
Gross physician charges $13,691,347
Other revenue $2,952,073
Adjustments and write-offs ($3,170,855)
Net revenue $13,472,565
Operating expenses
The financial statements of WHC provide some interesting
information
about physician practices, especially those owned by hospitals.
We
can see that the practices lost $1,825,716 in the current year. It
is not
unusual for hospital-owned physician practices to lose money.
Revenues from the practice are often less than expenses. Many
hospital executives argue that although the direct revenues and
expenses of the practice may show a loss, there are substantial
benefits realized from operating the practice. These benefits
result
from the admitting and referral patterns of the acquired
physician
practices, which raise volume at the hospital. Greater
interrogation
with the physicians themselves also may result in better cost
control,
which is important for managed care contracts. Although all this
may
be true, in many cases it is simply poor management that creates
the
financial loss. Most of these acquired practices were profitable

36. before
hospital acquisition, yet once they become hospital owned and
operated, they suddenly become unprofitable. A review of the
financial
information for WHC can help shed some light on the most
common
reasons for lack of profitability. Table 12–10 shows values for
WHC
expressed on a per physician full-time equivalent (FTE) basis,
compared with national values for primary care medical group
practices derived from a study by the Medical Management
Association in 2008.
Personnel expense $6,179,382
Supplies expense $540,956
Occupancy expense $2,530,195
Purchased services $275,422
General and administrative
expense
$1,189,032
Total operating expense $10,714,987
Physician expense $4,583,294
Total expense $15,298,281
Net Profit ($1,825,716)
Table 12-10 Comparative Operating Norms
for WHC
Source: Cost Survey for Multispecialty Practices, Medical
Group Management
Association, 2008.
WHC has fewer operating expenses than does a typical medical

37. group. Some of this is due to staffing. WHC has 5.08 support
staff
persons per physician FTE, whereas the national norm is close
to
4.54. The bottom line is that WHC spends $28,182 ($473,639 –
$445,457) per physician FTE below what a typical medical
group
would spend for operating expenses. However, WHC generates
$78,054 less revenue per physician FTE than the national norm.
Therefore, it is clear that the real issue is related to low
physician
productivity. WHC physicians generated lower RBRVS RVUs
than
expected when compared with national averages—9,850 versus
12,572.
WHC is losing money because its physicians see fewer patients.
On a
positive note, operating expenses are well below the national
average.
It is doubtful that these same physicians practiced in this
manner
when they were in private practice. The critical factor for the
long-term
Indicator WHC Value Medical
Managemen
t Association
Median
Operating expense per physician FTE $445,457 $473,639
Revenue per physician FTE $561,356 $637,677
Physician compensation per physician
FTE
$190,970 $269,024

38. Support staff per physician FTE 5.08 4.54
Operating expenses to net revenue
percent
79.50% 66.27%
RBRVS RVUs per physician FTE 9,850 12,572
success of owning physician practices is directly related to the
incentive structures used for physicians. Ideally, incentives
should
promote and not destroy physician entrepreneurial spirit.
LEARNING OBJECTIVE 5
Describe alternative health maintenance organization
arrangements.
HEALTH PLANS
Most individuals in the United States are covered by either
public or
private health insurance. In some cases both public and private
coverage may be combined. For example, many Medicare
beneficiaries have obtained private health insurance to pay for
health
expenses not covered by Medicare. At the end of 2008, most of
the 40
million Medicare beneficiaries had obtained Medicare
supplemental
insurance from private insurance companies. Although the vast
majority of Americans have health insurance of some type,
many
Americans do not have either public or private health insurance.
The
Bureau of the Census estimated that
approximately 46.3 million Americans were uninsured in 2008.

39. This
large pool of non-covered Americans creates costs of treatment
that
must be paid by someone. To date, it is not clear who will be
responsible for paying for this group of people. Will it be the
government, the health plans, or the providers?
The cost of private health insurance has been rapidly increasing
during the last 20 years, as Table 12–11 shows. Health
insurance
companies always have been big business, but the amount of
money
spent in selling, administration, reserve retention, and profit has
increased greatly. In 2008 administrative costs accounted for
approximately 13.3% of private health insurance payments.
Table 12–
11 shows that the cost of private health insurance in relation to
administrative costs have generally increased over the past three
decades. It is this administrative cost that has caused much
discussion among policy analysis. It is argued that most of these
monies spent for administration and profit are not necessary and
add
to the cost of health care in the United States.
Table 12-11 Private Insurance Trends
The cost of private health insurance may not be wasteful,
however.
The nature of risk and regulation in the industry may require
these
levels of expenditures. Insurance companies agree to provide a
benefits package of services for some specified sum of money.
If
costs of services exceed this amount, the insurance company
loses

40. money. This is often referred to as underwriting risk. In
addition,
insurance companies are regulated and are required to maintain
certain reserve balances to protect policyholders in the event of
a
financial catastrophe. The only alternative to private health
insurance
would be some type of government-financed and -managed
program.
Government costs might be just as high or higher.
Healthcare insurance companies come in many different forms.
The
Health Insurance Association of America (now known as
America’s
Health Insurance Plans) categorizes healthcare insurance firms
as
commercial, Blue Cross Blue Shield, and HMOs. The trend
toward
managed care has blurred some of these distinctions.
Commercial
insurance companies often provide an HMO option, as do most
Blue
Cross Blue Shield plans. HMOs have broadened their coverage
plans
to include more traditional indemnity programs, and most
provide
some point-of-service option whereby enrollees can go outside
the
Year Personal Health
Care
Expenditures
(Millions)
Private Health

41. Insurance
Payments
(Millions)
Administrativ
e and Net
Cost of
Private
Health
Insurance
(Millions)
Administrativ
e Cost (%)
2008 1,952,255 691,179 91,978 13.3%
2000 1,139,192 402,802 51,983 12.9%
1990 607,563 204,664 29,080 14.2%
1980 214,786 61,205 7,642 12.5%
HMO network for care if they are willing to pay higher
copayments or
deductibles.
In their 1995 Source Book of Health Insurance Data, the Health
Insurance Association of America defined managed care as a
system
that integrates the financing and delivery of appropriate
healthcare
services to covered individuals. The most common examples of
managed care organizations are HMOs and preferred provider
organizations. A preferred provider organization typically offers
more

42. flexibility than does an HMO by allowing more provider choice,
but it
attempts to direct patients to providers with whom it has
negotiated
special contracts.
Usually, five types of HMOs are defined in the literature (also
discussed in Chapter 7):
• 1.Staff model: Physicians practice as employees of the
HMO and are usually paid a salary.
• 2.Group model: HMO pays the physician group a per capita
rate, which the physician group then distributes among its
members.
• 3.Network model: HMO contracts with two or more groups
and pays them on a per capita rate, which the groups then
distribute to individual physicians.
• 4.Independent practice association model: HMO contracts
with individual physicians or with associations of independent
physicians and pays
(Cleverley 267-277)
Cleverley, William O. Essentials of Health Care Finance, 7th
Edition.
Jones & Bartlett Learning, 20101022. VitalBook file.
Chapter 10 Accounting for Inflation
LEARNING OBJECTIVES
After studying this chapter, you should be able to do the
following:

43. • 1.Discuss the major types of asset valuation.
• 2.Describe the alternative units of measurement in financial
reporting.
• 3.Define the major financial reporting alternatives.
• 4.Describe the uses of financial report information.
• 5.Describe the difference between monetary and
nonmonetary accounts.
REAL-WORLD SCENARIO
Lydia Renee is the CEO of a large metropolitan hospital that
has
come under recent attacks from the local press regarding profit
levels
at her hospital. Last year Lydia’s hospital earned more than $10
million, which was described in the local press as “obscene”
because
the hospital is tax exempt. Lydia tried to explain that all the
earnings
for the hospital were earmarked for future investment and
replacement
Carrying Amount Fair Value
20X7
Cash and cash equivalents $82,815 $82,815
Assets limited as to use 518,313 518,313
Due to broker 15,128 15,128
Long-term debt 444,289 444,349
20X6
Cash and cash equivalents $59,696 $59,696
Assets limited as to use 472,176 472,176
Due to broker 19,608 19,608
Long-term debt 338,262 340,809

44. of physical facilities, but the local reporter was adamant about
profiteering at Lydia’s hospital.
Lydia’s CFO, William Olin, has told her that the need for profit
is
directly related to the existence of inflation in the cost of plant
and
equipment that the hospital needs to purchase. For example, a
new
digital mammography unit was recently acquired for $750,000
to
replace an older unit acquired 5 years ago for $350,000. The
hospital
recognized historical cost depreciation on this older
mammography
unit of $70,000 per year ($350,000/5), but the real replacement
cost of
the equipment was much larger.
Mr. Olin showed Lydia that firms with heavy investments in
plant and
equipment such as hospitals must make positive profits because
the
historical accounting costs of depreciation grossly understate
true
replacement costs. Mr. Olin then recast the hospital’s financial
statements using the principles of “constant purchasing power
accounting” to demonstrate that the hospital actually incurred a
modest loss of $1,000,000 in the most recent year. Lydia
understands
the nature of the purchasing power adjustments that Mr. Olin
has
made but is seeking a way to communicate this in a clear
manner to
the local press.
To adjust for the effects of changing price levels, the Financial
Accounting Standards Board (FASB) has issued a number of

45. pronouncements over the last 35 years. In September 1979 the
FASB
issued Statement 33, which required large public enterprises to
provide supplemental information on the effects of changing
price
levels in their annual financial reports. In particular, Statement
33
required firms to disclose primarily current cost and constant
dollar
earnings; certain other income statement items; and current cost
of
inventory, property, plant, and equipment in notes to the
financial
statements. This was a major step for the FASB and represented
for
the first time that firms were required to report price-level
effects in
their financial reports.
In 1986, when the inflation rate had subsided to less than 5%,
the
FASB substantially modified its initial position set forth in
Statement 33
with the publication of Statement 89. This pronouncement left
much of
Statement 33 intact, except that it designated the reporting as
voluntary. Consequently, most publicly traded companies
stopped
disclosing inflation-adjusted earnings. In Statement 89 business
enterprises were encouraged, but not required, to report
supplementary information on the effects of changing prices in
the
following areas for the most recent 5 years:

46. • •Net sales and operating revenues, using constant
purchasing power
• •Income from continuing operations on a current cost basis
• •Purchasing power gains or losses from holding monetary
items
• •Increases in specific prices of net plant, property, and
equipment net of inflation
• •Foreign currency translation adjustments on a current cost
basis
• •Net assets (assets less liabilities) on a current cost basis
• •Income per common share from continuing operations on
a current cost basis
• •Cash dividends per common share
• •Market price per common share at year end
The rationale for these changes in financial reporting stems
from the
inaccuracy and inability of present historical cost reporting to
measure
financial position accurately in an inflation-riddled economy.
Although
the U.S. inflation rate has been low in recent years, inflationary
pressures can increase at any time and will never be removed
entirely.
Many countries around the world still experience high inflation.
Mexico
and Brazil have required some accounting inflationary
adjustments for
over 20 years. Furthermore, some analysts expect a worldwide
shortage of energy sources by 2020, which might lead to a long-
term

47. increase in inflation rates. Thus, inflation accounting will
continue to be
relevant.
Most people understand the effects that general inflation has on
their
purchasing power, and they realize that a dollar of 1997 is not
equivalent to a dollar in 2007. Most of us will intuitively make
price-
level adjustments to account for differences. A person who had
a
salary of $50,000 in 1997 and a salary of $50,000 in 2007
knows that
their overall financial position has eroded because of increases
in the
Consumer Price Index (CPI). The accounting profession’s task
is to
make its financial statement adjustments easy to understand by
most
people who use and rely on these statements as scorecards of
business success.
The major purpose of this chapter is to discuss and describe the
major
alternatives for reflecting the effects of inflation in financial
statements.
Specific methods are described, and the adjustments that need
to be
made to convert historical cost statements are illustrated. This
discussion should provide a basis for understanding and using
financial statements that have been adjusted for inflation.
LEARNING OBJECTIVE 1
Discuss the major types of asset valuation.
REPORTING ALTERNATIVES
Methods of financial reporting can be categorized using two

48. dimensions: the method of asset valuation and the unit of
measurement. In Chapter 8 we discussed five major principles
of
accounting, two of which are cost valuation and a stable
monetary
unit. When historical cost values do not change and inflation or
deflation does not exist, accountants can feel very comfortable
using
unadjusted historical cost as the method for valuing assets
acquired
by the firm. If asset values do change or the monetary unit is
not
stable, then alternative asset valuation rules may be
needed. Two alternative methods of asset valuation are
acquisition (or
historical) cost and current (or replacement) value.
Asset valuation at acquisition cost means that the value of the
asset is
not changed over time to reflect changing market values.
Amortization
of the value may take place, but the basis is the acquisition cost.
Depreciation is recorded, using the acquisition (historical) cost
of the
asset. Use of an acquisition cost valuation method postpones the
recognition of gains or losses from holding assets until the point
of
sale or retirement. Current valuation of assets revalues the
assets in
each reporting period. The assets are stated at their current
value
rather than their acquisition cost. Likewise, depreciation
expense is

49. based on the current value, not the historical cost. Current
valuation
recognizes gains or losses from holding assets before sale or
retirement. If it was easy to obtain objective measures of
current asset
values, all assets would be restated to current value, but in
many
cases objective measures of current value may not be
obtainable.
LEARNING OBJECTIVE 2
Describe the alternative units of measurement in financial
reporting.
There are also two major alternative units of measurement in
financial
reporting: nominal (unadjusted) dollars and constant dollars
measured
in units of general purchasing power. Use of a nominal dollar
unit of
measurement simply means that the attribute being measured is
the
number of dollars. From an accounting perspective, a dollar of
one
year is no different from a dollar of another year. No
recognition is
given to changes in the purchasing power of the dollar because
purchasing power is not measured. The major outcome
associated
with the use of this measure unit is that gains or losses,
regardless of
when they are recognized, are not adjusted for changes in
purchasing
power. For example, if a piece of land that was acquired for $1
million
in 1987 sold for $3 million in 2007, it would have generated a
$2
million gain, regardless of changes in the purchasing power of

50. the
dollar during the 20-year period.
A constant dollar measuring unit reports the effects of all
financial
transactions in terms of constant purchasing power. The unit
that is
usually used is the purchasing power of the dollar at the end of
the
reporting period or the average during the fiscal year. The
measurement is made by multiplying the unadjusted, or
nominal,
dollars by a price index to convert to a measure of constant
purchasing power. During periods of inflation, when using a
constant
dollar measuring unit, gains from holding assets are reduced,
whereas
losses are increased. Thus, in the previous land sale example,
the
initial acquisition cost would be restated to 2007 purchasing
power
units to reduce the gain in Exhibit 10-1. Because the CPI
increased
from 114.4 in 1987 to 202.4 in 2007, we restate the 1987 cost
by the
conversion factor (202.4/114.4, or 1.769).
Exhibit 10-1 Restatement of Land Cost
Constant dollar measurement has a further significant effect on
financial reporting: The gains or losses created by holding
monetary
liabilities or monetary assets during periods of purchasing
power
changes are recognized in the financial reporting. Monetary

51. assets
and liabilities are defined as those items that reflect cash or
claims to
cash that are fixed in terms of the number of dollars, regardless
of
changes in prices. Almost all liabilities are monetary items,
whereas
monetary assets consist primarily of cash, marketable securities,
and
receivables.
Purchasing power gains or losses are recognized on monetary
items
because there is an assumption that the gains or losses are
already
realized, because repayments or receipts are fixed. For example,
an
entity that owed $25 million during a year when the purchasing
power
of the dollar decreased by 10% would report a $2.5 million
(0.10 × $25
million) purchasing power gain. All gains or losses would be
recognized, regardless of the asset valuation basis used.
LEARNING OBJECTIVE 3
Unadjusted historical cost
Sale of land in 2007 (CPI = 202.4) $3,000,000
Purchase of land 1987 (CPI =
114.4)
$1,000,000
Unadjusted gain on sale $2,000,000
Purchasing power cost
Sale of land in 2007 (CPI = 202.4) $3,000,000
Conversion factor (CPI 2007/CPI

52. 1987)
1.769
Restated cost of land $1,769,000
Adjusted gain on sale $1,231,000
Define the major financial reporting alternatives.
The interfacing of the valuation basis and the unit of
measurement
basis produces four alternative financial reporting methods
(Table 10–
1). Each of the four methods is a possible basis for financial
reporting.
The unadjusted historical cost (HC) method represents the
present
method used by accountants; the other three methods are
alternatives
that provide some degree of inflationary adjustment not present
in the
HC method. The HC-general price level adjusted (HC-gPL)
method is
often referred to as constant dollar accounting, whereas the
current
value-general price level adjusted (Cv-gPL) method is referred
to as
current cost accounting.
Table 10-1 Alternative Financial Reporting
Bases
Table 10–2 summarizes the effects the four reporting methods
would
have on the three critical income statement items: depreciation

53. expense, purchasing power gains or losses, and unrealized gains
in
replacement values.
Asset Valuation Method
Unit of
Measure
ment
Acquisition Cost Current
Value
Nominal
dollars
Unadjusted historical cost (HC) Current value
(CV)
Constant
dollars
Historical cost-general price level adjusted
(HC–GPL) Constant dollar accounting
Current
value-general
price level
adjusted
(CV–GPL)
Current cost
accounting
Table 10-2 Major Effect of Alternative

54. Reporting Methods on Net Income
Measurement
LEARNING OBJECTIVE 4
Describe the uses of financial report information.
USES OF FINANCIAL REPORT
INFORMATION
Impact Variables
Reportin
g
Methods
Depreciation
Expense
Purchasing Power
Gains/Losses
Unrealized Gains in
Replacement Value
HC No change No change/not
recognized
No change/not
recognized
HC-GPL Increase/GPL
depreciation
recognized
Gain or loss/
depends on the net
monetary asset

55. position
No change/not
recognized
CV Increase/will
recognize
replacement
cost
No change/not
recognized
Gain/will recognize
increase in
replacement cost
CV-GPL Increase/will
recognize
current
replacement
cost
Gain or loss/
depends on the net
monetary asset
position
Gain/will recognize
increase in
replacement cost
but will reduce
amount by changes
in the GPL

56. The measurement of financial position is an important function,
and its
results are useful to a great variety of decision makers, both
internal
and external to the organization. Changes in financial reporting
methods unquestionably alter the resulting measures of financial
position reported in financial statements. These changes are
likely to
produce changes in the decisions that are based on the financial
reports (Figure 10–1).
Figure 10-1 Financial Data in Decision Making
Lenders represent an important category of financial statement
users
who may change their decisions on the basis of a new financial
reporting method. The lender’s major concern is the relative
financial
position of both the individual firm and the industry. A decrease
in the
relative financial position of the industry could seriously affect
both the
availability and the cost of credit. If, for a variety of reasons,
new
measurements of financial position make the healthcare industry
appear weaker than other industries, financing terms could
change.
Particularly for the healthcare industry, which is increasingly
dependent on debt financing, the importance of changes in
financial
reporting methods cannot be overstated. Research on the results
of

57. changing to an HC-GPL or constant dollar accounting method
has
shown that the relative financial positions of individual firms
and
industries are also likely to change.
Changes in financial reporting methods also could have an
effect on
decisions reached by regulatory and rate-setting organizations.
As a
result of such changes, comparisons of costs across institutions
may
be more meaningful than they were previously. For example,
depreciation in firms that operate in relatively new physical
plants
cannot be compared with the unadjusted historical depreciation
costs
of older facilities. Without financial reporting adjustments, new
facilities
may appear to have higher costs and thus be less efficient,
whereas,
in fact, the opposite may be true.
The actions of interested community leaders who have access to
and
make decisions based on financial statements also might be
affected
by reporting method changes. For example, suppose that
individual,
corporate, and public agency giving is in part affected by
reported
income. Many, in fact, regard reported income as a basic index
of
need, and the relationship between income and giving seems
logical.
Thus, because each of the alternative financial reporting
methods we
discussed produces a different measure of income, total giving

58. in each
case could be affected.
Internal management decisions also might change with a new
financial reporting method. Perhaps the most obvious example
of such
a change is rate setting. Organizations that have control over
pricing
decisions and are not reacting to market-determined prices
should set
prices at levels at least high enough to recover their costs. The
use of
any of the three alternative methods of reporting increases
reported
cost levels and therefore increases rates.
CASE EXAMPLE: WILLIAMS
CONVALESCENT CENTER
In the remainder of this chapter we show how adjustments are
made
in the income statement and balance sheet of Williams
Convalescent
Center, a 120-bed skilled and intermediate care facility, to take
into
account the effects of inflation. The center’s two financial
statements
are shown in Table 10–3 and 4. Note that values are reported for
each
of the following three reporting methods: HC, HC-GPL, and
CV-GPL.
In this discussion we do not describe or apply the CV method.
The
accounting profession presently is not seriously considering this
method, and it is not likely to be considered in the future. The
CV

59. method suffers from a serious flaw: It does not recognize the
effects of
changing price levels on equity. In short, the CV method
treats increases in the replacement cost of assets as a gain and
does
not restate them for changes in purchasing power.
Table 10-3 Statement of Income for
Williams Convalescent Center (000s
Omitted)
HC 20Y4 Constant Dollar (HC-GPL)
20Y4
Current Cost
(CV-GPL) 20Y4
Operatin
g
revenue
$3,556 $3,625 $3,625
Operatin
g
expense
s
3,253 3,316 3,316
Deprecia
tion

60. 74 164 185
Interest 102 104 104
Net
income
$127 $41 $20
Purchasi
ng power
gain from
holding
net
monetary
liabilities
during
the year
— $43 $43
Increase
in
specific
prices of
property,
plant,
and
equipme
nt during
the year
— — $136

61. Table 10–5 presents values for the CPI, the price index
presently used
by the accounting profession to adjust financial statements for
the
effects of inflation.
Price Index Conversion
Both methods we selected to adjust the financial statements of
the
Williams Convalescent Center (CV-GPL and HC-GPL) use
purchasing
power as the unit of measurement. This means that unadjusted
dollars
are not the measurement unit for reporting accounting
transactions
and that all reported values in the financial statements are
expressed
Less
effect of
increase
in
general
price
level
— — $144
Increase
in
specific
prices
over
(under)
increase

62. in the
general
price
level
— — ($8)
Change
in equity
due to
income
transacti
ons
$127 $84 $55
in dollars of a specified purchasing power. Usually, the
purchasing
power used is the period end value. In our case example
Williams
Convalescent Center uses purchasing power as of December 31,
20Y4, as its unit of measurement. This means we restate all
accounts
to a purchasing power of 315.5, the CPI value at 20Y4.
Table 10-5 Consumer Price Index, Year-
End Values
Restatement of nominal or unadjusted dollars to constant dollars
is a
relatively simple process, at least conceptually. All that is
required are
the following three pieces of information:

63. • 1.The unadjusted value of the account in historical or
nominal dollars
Year CPI
19X0 119.1
19X1 123.1
19X2 127.3
19X3 138.5
19X4 155.4
19X5 166.3
19X6 174.3
19X7 186.1
19X8 202.9
19X9 229.9
20Y0 258.4
20Y1 283.4
20Y2 292.4
20Y3 303.5
20Y4 315.5
• 2.A price index that reflects the purchasing power in which
the unadjusted value is currently expressed
• 3.A price index that reflects the purchasing power at the
date the account is to be restated
For example, Williams Convalescent Center’s long-term debt at
December 31, 20Y3, is $1,203 (see Table 10–4). To express that
amount in constant dollars as of December 31, 20Y4, the
following
adjustment would be made:
Table 10-4 Balance Sheet for Williams
Convalescent Center (000s Omitted)

64. HC
20Y3 20Y4 Constant
Dollar
(HC-
GPL)
20Y4
Current
Cost
(CV-
GPL)
20Y4
Current assets
Cash $98 $21 $21 $21
Accounts receivable 217 249 249 249
Supplies 22 27 27 27
Prepaid expenses 36 36 36 36
Total current assets $373 $333 $333 $333
Property and equipment
Land 200 200 530 525
Building and equipment 2,102 2,228 4,948 5,570
2,302 2,428 5,478 6,095
Unadjusted amount × 20Y4 CPI/20Y3 CPI
or
$
1
,
203

65. ×
315.5
303.5
=
$
1
,
251
The value of the beginning long-term debt for the center would
be
$1,251, expressed in purchasing power as of December 31,
20Y4.
The previously described adjusted method is the same for all
other
accounts. The price index to which the conversion is made is
usually
the price index at the ending balance sheet date (December 31,
20Y4,
in our example). The price index from which the conversion is
made
Less accumulated
depreciation
783 844 1,874 2,186
Investments 161 596 596 596
Total assets $2,053 $2,513 $4,533 $4,838
Current liabilities 412 493 493 493
Long-term debt 1,203 1,478 1,478 1,478
Partner’s equity 438 542 2,562 2,867

66. $2,053 $2,513 $4,533 $4,838
represents the purchasing power in which the account is
currently
expressed. This value varies depending on the classification of
the
account as either monetary or nonmonetary.
LEARNING OBJECTIVE 5
Describe the difference between monetary and nonmonetary
accounts.
Monetary Versus Nonmonetary Accounts
When restating financial statements from one based on an HC
method
to one based on a constant dollar method, it is critical to
distinguish
between monetary accounts and nonmonetary accounts.
Monetary
accounts are automatically stated in current dollars and
therefore
require no price-level adjustments. Monetary items, discussed
earlier
in this chapter, consist of cash, claims to cash, or promises to
pay
cash that are fixed in terms of dollars, regardless of price-level
changes. Nonmonetary accounts require price-level adjustments
to be
stated in current dollars.
Because of the fixed nature of monetary items, holding them
during a
period of changing price levels creates a gain or loss. For
example, if
a firm holds cash during a period of inflation, the firm will
experience a
monetary loss because the purchasing power of the cash has

67. eroded
over the holding period. Conversely, if a firm has a monetary
liability
during a period of inflation, it will experience a gain because it
will
repay the liability with dollars of a lower purchasing power; n
constant
dollar accounting purchasing power is the unit of measurement,
not
unadjusted dollars. This can be seen in Table 10–6, which
includes
data from the Williams Convalescent Center.
The data in Table 10–6 assume that a repayment of long-term
debt
and new issue occurred at the midpoint of
the year, June 30, 20Y4. The price index at that point would
have
been approximately 309.5. This resulted from taking the average
of
the beginning and ending values (303.5 + 315.5) ÷ 2. In
constant
dollars the Williams Convalescent Center would have reported
$1,531
of long-term debt as of December 31, 20Y4. However, the
actual value
of the long-term debt at that date was $1,478. The difference of
$53
represents a purchasing power gain to the center during the
year.
Because the price level increased during 20Y4, the value of the
long-
term debt actually owed by the center declined when measured

68. in
constant purchasing power.
Nonmonetary asset accounts must be restated to purchasing
power
as of the current date. The price index at the time of acquisition
represents the price index from which the conversion is made.
The
price index at the current date represents the index to which the
conversion is made. To illustrate the adjustment, assume that
the
building and equipment account of the Williams Convalescent
Center
has the age distribution presented in Table 10–7.
Table 10-6 Computation Purchasing Power
Gains and Losses (000s Omitted)
Unadjusted
Historical
Dollars
Conversion
Factor
Constant
Dollars
Beginning long-
term debt
(12/31/Y3)
$1,203 315.5/303.5 $1,251
–Repayment
(6/30/Y4)

69. 152 315.5/309.5 155
+New debt
(6/30/Y4)
427 315.5/309.5 435
Ending long-
term debt
(12/31/Y4)
$1,478 $1,531
–Actual ending
long-term debt
(12/31/Y4)
$1,478
Purchasing
power gain
$53
The data in Table 10–7 show that assets with a historical cost of
$2,228 represent $4,948 of cost when stated in dollars as of
December 31, 20Y4. The latter value is much more meaningful
than
the former as a measure of actual asset cost in 20Y4. It provides
the
center with a measure of cost that is expressed in dollars as of
the
current date and thus better represents its actual investment.

70. Depreciation expense also should be restated in 20Y4 dollars to
accurately portray the center’s actual cost of using its building
and
equipment in the generation of current revenues.
Table 10-7 Restatement of Nonmonetary
Assets
Adjusting the Income statement
Operating Revenues
If one assumes that revenues are realized equally throughout the
year, the restatement is significantly simplified. If the
assumption is
valid––and in most cases it is––it means that the revenues can
be
considered realized at the midpoint of the year, in our case June
30,
20Y4. As already noted, the price index at June 30, 20Y4, can
be
assumed to be the average of the beginning and ending price
index,
or 309.5. The restated operating revenue is calculated as
follows:
Operating revenues × 20Y4 CPI ÷ 20Y4 mid-year CPI
or
$3,556 × 315.5 ÷ 309.5 = $3,625
Year Acquired Cost Conversion
Factor
Constant Dollar
Cost (12/31/Y4)
19X0 $1,500 315.5/119.1 $3,974
19X8 401 315.5/202.9 624
20Y1 201 315.5/283.4 224

71. 20Y4 126 315.5/315.5 126
$2,228 $4,948
Operating Expenses
Based on the same assumption that we used with operating
revenues,
the adjustment for operating expenses is as follows:
$3,253 × 315.5 ÷ 309.5 = $3,316
Operating expenses do not include depreciation or interest.
Separate
adjustments for these two items may be required.
Depreciation
The depreciation expense adjustment is different from the
earlier
adjustments in two ways. First, depreciation expense represents
an
amortization of assets purchased over a long period, usually
many
years. This means that the midpoint conversion method used for
operating revenues and operating expenses is clearly not
appropriate.
Second, the adjustment methods for the HC-GPL or constant
dollar
and CV-GPL or current cost methods diverge. Depreciation
expense
may vary considerably because the current cost of the assets
may
differ dramatically from the constant dollar cost. Remember, a
price
index represents price changes for a large number of goods and
services; specific price changes of individual assets may vary
significantly from that index. For example, the general price
level may

72. have increased 20% in the last 5 years, but the cost of a specific
piece
of equipment may have increased 50% during the same period.
Constant Dollar Adjustment
We estimate the depreciation expense value for Williams
Convalescent Center under the constant dollar method by using
the
relationship of constant dollar buildings and equipment cost in
Table
10–7 to historical cost. This gives us a multiplier of restated
cost to
historical cost that we can then apply to historical cost
depreciation.
The multiplier from Table 10–7 is calculated as follows:
Constant dollar cost
Historical cost
=
$
4
,
948
/
$
2
,
228
=
2.221
We then multiply this factor times the historical depreciation
expense
of $74 to yield a constant dollar depreciation expense of $164.

73. Current Cost Adjustment
The identification of the current cost of existing physical assets
is a
subjective and complex process. To many individuals the
current cost
method provides little additional value compared with the
constant
dollar method. Whether it will be eventually eliminated and
replaced
by the constant dollar method is not clear at this time.
The first issue to address is the definition of current cost. By
and large,
current cost can be equated to the replacement cost of the
assets. In
short, we must determine what the cost of replacing assets in
today’s
dollars would be. This could be estimated through a variety of
techniques using, for example, insurance appraisals or specific
price
indexes. In the case of Williams Convalescent Center, we
assume that
a recent insurance appraisal indicated a replacement cost of
$5,570
for buildings and equipment. With this estimate, depreciation
expense
could be adjusted as follows:
Appraisal cost
Historical cost
×
Depreciation expense
=
Restated depreciation expense
or

74. $
5
,
570
$
2
,
228
×
$
74
=
$
185
Interest Expense
We again assume that interest expense is paid equally
throughout the
year. This assumption produces the following interest expense
adjustment:
$102 × 315.5 ÷ 309.5 = $104
Purchasing Power Gains or Losses
A purchasing power gain results if one is a net debtor during a
period
of increasing prices, whereas a purchasing power loss results if
one is
a net creditor during such a period. In most healthcare firms,
purchasing power gains result because liabilities exceed
monetary
assets. A firm is thus paying its debts with dollars that are of
less value
than the ones it received.

75. To calculate purchasing power gains or losses, net monetary
asset
positions must first be calculated. The net monetary position for
Williams Convalescent Center is presented in Table 10–8.
The actual calculation of the purchasing power gain for
Williams
Convalescent Center is presented in Table 10–9.
Because the center was in a net monetary liability position
during the
year, it experienced a purchasing power gain of $43. This value
is not
an element of net income; rather, it is shown below the net
income line
in Table 10–3. It thus affects the change in equity.
Table 10-8 Net Monetary Asset Schedule
Increase in Specific Prices Over General
Prices
The adjustment to consider—an increase in specific prices over
general prices––is made only in the current cost method. The
constant
dollar method does not recognize any increases (or reductions)
in
prices that are different from the general price level. In short,
no gains
or losses from holding assets are permitted in the constant
dollar
method.
The calculations involved in this adjustment can be complex. In
our
Williams Convalescent Center example, we make some
assumptions
to simplify the arithmetic without impairing the reader’s

76. conceptual
understanding of the adjustment. We assume the following data:
Beginning
(12/31/Y3)
Ending (12/31/
Y4)
Monetary assets
Cash $98 $21
Accounts receivable 217 249
Prepaid expenses 36 36
Investments 161 596
Total monetary assets $512 $902
Monetary liabilities
Current liabilities $412 $493
Long-term 1,203 1,478
Total monetary liabilities $1,615 $1,971
Net monetary assets ($1,103) ($1,069)
• Insurance appraisal of buildings and equipment, 12/31/Y3:
$5,015
• Insurance appraisal of buildings and equipment, 12/31/Y4:
$5,570
• Appraised value of land, 12/31/Y3: $500
• Appraised value of land, 12/31/Y4: $525
• New equipment bought on 12/31/Y4: $126

77. Table 10–10 shows the increase in specific prices over general
prices.
These data show that, during 20Y4, the value of physical assets
held
by Williams Convalescent Center did not increase more than the
general price level. In fact, there was an $8,000 decline in the
specific
prices of assets held by the firm when compared with the
increase in
general price level during the year. This may be a positive sign
for the
center if it is not contemplating a sale. The replacement cost for
its
assets is increasing less than the general price level. Therefore,
revenues could increase less than the general price level and
replacement could still be ensured.
Adjusting the balance sheet
Monetary Items
None of the monetary items—cash, accounts receivable, prepaid
expenses, investments, current liabilities, or long-term debt––
requires
adjustment. The values of these items already reflect current
dollars.
Land
In our discussion of the increase in specific prices over the
general
price level in the Williams Convalescent Center’s income
statement,
we assumed an appraisal value for land of $525. That value is
used
here with the current cost method. With the constant dollar
method,
we assume that the land was acquired in 19X0 for $200. To
restate
that amount to purchasing power as of December 31, 20Y4, the

78. following calculation is made:
$200 × 315.5 ÷ 119.1 = $530
Buildings and Equipment
Values for the center’s buildings and equipment and the related
accumulated depreciation already have been cited for the
current cost
method. We assume those same values here. This produces a
value
for buildings
and equipment of $5,570 (000s omitted) based on an appraisal.
The
value for accumulated depreciation was derived as follows:
or
$
2
,
186
=
Adjusted accumulated depreciation Unadjusted accumulated dep
reci
ation
×
Appraisal value
−

79. Current year acquisitions
Historical cost
−
Current year acquisitions
=
=
$
844
×
(
$
5
,
570
−
$
126
)
(
$
2
,
228
−
$

80. 126
)
Table 10-9 Purchasing Power Gain (Loss)
Schedule
Actual Dollars Factor
Conversion
Constant
Dollars
Beginning net
monetary
liabilities
$1,103 315.5/303.5 $1,147
–Decrease 34 315.5/309.5 35
Ending net
monetary
liabilities
$1,069 $1,112
–Actual $1,069
Purchasing
power gain
$43
Table 10-10 Increase in Specific over
General Prices Schedule

81. Building and
Equipment
Land Total
Ending
appraised value
less acquisitions
of $126
$5,444 $525 $5,969
–Accumulated
depreciation on
appraised value
2,186 0 2,186
Ending net
appraised value
$3,258 $525 $3,783
Beginning
appraised value
$5,015 $500 $5,515
–Accumulated
depreciation on
appraised value
1,868 — 1,868
Beginning net

82. appraised value
$3,147 $500 $3,647
Beginning net
appraised value
restated for
general price
level
(315.5/303.5)
$3,791
Equity
Equity calculations are not discussed in any detail here. It is
enough
for our purposes to recognize that equity is a derived figure.
Equity
must equal total assets less liabilities. In our Williams
Convalescent
Center example, this generates values of $2,562 for the constant
dollar method and $2,867 for the current cost method.
SUMMARY
Financial reporting suffers from its current reliance on the HC
valuation concept. Inflation has made many of the reported
values in
current financial reports meaningless to decision makers. The
example used in this chapter illustrates this point. The total
asset
investment of Williams Convalescent Center is approximately
100%
larger when adjusted for inflation under the current cost or
constant

83. dollar method. Net income, however, decreased. The result is a
dramatic deterioration in return on investment––the single most
important test of business success. Table 10–11 summarizes
(Cleverley 227-237)
Cleverley, William O. Essentials of Health Care Finance, 7th
Edition.
Jones & Bartlett Learning, 20101022. VitalBook file..
Chapter 11 Analyzing Financial Position
LEARNING OBJECTIVES
After studying this chapter, you should be able to do the
following:
• 1.Describe the balanced scorecard and dashboard
reporting.
• 2.Describe the four key elements of dashboard reporting.
Increase in
specific prices
over general
price level
($3,783 less
$3,791)
($8)
Required Resources
Required Text
1. Cleverley, W. O., Song, P. H., & Cleverley, J. O.
(2011). Essentials of health care finance (7th ed). Sudbury, MA:
Jones & Bartlett Learning.
· Chapter 8: General Principles of Accounting
· This chapter focuses on core principles of accounting and the
differences between financial and managerial accounting. Cash

84. basis, accrual basis, and three categories of net assets are
discussed.
· Chapter 9: Financial Statements
· This chapter discusses the main four types of financial
statements and the importance to know the scope of business
being reviewed when using financial statements.
· Chapter 10: Accounting for Inflation
· This chapter discusses the major types of asset valuation,
alternatives units of measurement in financial reporting and the
major financial reporting alternatives. The uses of financial
information and the difference between monetary and
nonmonetary accounts are also examined.
· Chapter 11: Analyzing Financial Position
· This chapter focuses on balanced scorecard and dashboard
reporting. The primary financial objective and the critical
drivers of financial performance in healthcare firms are
analyzed.
· Chapter 12: Financial Analysis of Alternative Healthcare
Firms
· This chapter discusses the major nonhospital and non-
physician sections of the healthcare industry and their financial
analysis.
LearnScape Simulation
1. Jones & Bartlet Learning. Healthcare Finance LearnScape
[Access Code]. Sudbury, MA: Jones & Bartlett Learning.
Recommended Resources
Articles
1. Olden, P. (2008). Hospitals, community health, and balanced
scorecards. Academy of Health Care Management Journal, 4(1),
39. Retrieved from the ProQuest database.
· This article discusses the balanced scorecard tool.
· Abstract: Community health improvement has been part of
many hospitals' mission statements and strategic plans, although
it has been less common in their actual work. Recently, hospital
industry leaders and stakeholders have called on hospitals to do

85. much more to improve health status in their local communities.
For hospitals to satisfy external demands for improved
community health, they must re-direct some of their goals,
resources, activities, and work processes.
2. Panayiotis, C. & Roupas, T. (2009). Health care finance, the
performance of public hospitals and financial statement
analysis. European Research Studies, 12(4), 199. Retrieved
from the ProQuest database.
· Abstract: Regional form of Organization of the health care
that are called today DyPE, have as a main goal to promote
more rational resource allocation through decentralization in the
decision making process. The concern for more effective and
efficient use of resources devoted into the health care sector
renders hospitals a critical vehicle of the quest for superior
economic performance, especially if we take into our
consideration their mounting over time deficits. Economic
performance is primarily traced through a set of specific
financial ratios, which embrace important elements that
constitute the substance of the financial well-being of hospitals
as economic units. An array of financial ratios is critically
reviewed and a combination of them is proposed as a means of
effective financial management.
Textbook PowerPoint Presentations
1. Chapter 8 General Principles of Accounting
2. Chapter 9 Financial Statements
3. Chapter 10 Accounting for Inflation
4. Chapter 11 Analyzing Financial Position
5. Chapter 12 Financial Analysis of Alternative Healthcare
Firms
6. HFMA PowerPoint on Financial Reporting