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. 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 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 ad ...

1. 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.
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

2. 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 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 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

3. 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 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 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 LONG-TERM CARE FACILITIES
AND 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

4. 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
financing provided a stable source of payment that was not
present before Medicaid. Table 12-2 Industry Composition,
2008 Industry/Firm Most Recent evenue (millions) Health
insurance UnitedHealth Group $81,186 WellPoint, Inc.
$61,251 Aetna $30,951 Nursing Kindred Healthcare
$4,151 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 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
1995 2000 2005 2007 Private financing 43 43 37 38
Insurance 8 8 7 7 Out-of-pocket 28 30 26 27 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 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

5. 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 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 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

6. 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 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 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

7. 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 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 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 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

8. 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 Current portion of long-term liabilities
426,163 374,663 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 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 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 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

9. 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 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 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 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 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 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) Excess of revenues
over expenses & nonoperating loss $1,312,651 $384,480 The
amount of the entrance fee may be based on age at entrance.
The fund is then amortized or recognized as income as the

10. 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-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 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 $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: Entry No. 1
Record receipt of the $35,000 entrance fee Increase entrance fee

11. 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 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. LEARNING OBJECTIVE 3 Discuss the major sources
of revenue and expenses of medical groups. MEDICAL
GROUPS 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 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

12. 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
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 Physician Expenditures 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
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

13. 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 Table 12-7.
Healthcare Visits Per Year, 2006: Percent Distribution by Age
Group 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 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 organization to counterbalance these large
bargaining entities, physicians perceived themselves as being at

14. a disadvantage. 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 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 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

15. 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 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 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 Retained
earnings ($4,356,391) Total equity $4,125,546 Total liabilities
and equity $4,836,350 Table 12-9 Income Statement, WHC,
Year Ending December 31, 2008 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 Personnel expense

16. $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) 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 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. Table 12-10
Comparative Operating Norms for WHC Indicator WHC Value
Medical Management 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 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 Source: Cost
Survey for Multispecialty Practices, Medical Group

17. Management Association, 2008. WHC has fewer operating
expenses than does a typical medical 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 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. 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

18. 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 Year Personal Health
Care Expenditures (Millions) Private Health Insurance
Payments (Millions) Administrative and Net Cost of Private
Health Insurance (Millions) Administrative 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% 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
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

19. 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 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 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 them a per capita rate or a negotiated fee-
for-service rate. 6. Mixed model: This model combines two or
more of the previous options. The information in Tables 12–12
and 12–13 presents financial statements for a small hospital-
owned HMO. It is important to point out that financial and
operating information on any HMO is usually available publicly
by contacting the Department of Insurance in the state where
the HMO operates. In fact, this is the source of the financial
information used in our example. Table 12-12 Hospital HMO
Balance Sheet 2010 2009 Assets Current assets
Cash and cash equivalents $1,363,932 $1,719,453

20. Short-term investments 1,709,056 1,495,481
Premiums receivable 813,427 1,233,975 Investment
income receivables 29,054 45,339 Amounts due from
affiliates 7,727 2,588 Total current assets $3,923,197
$4,496,836 Other assets Restricted cash and other assets
$177,966 $139,059 Long-term investments 708,941
957,306 Total other assets $886,907 $1,096,365 Property and
equipment Total property and equipment 397,842 247,047
Total assets $5,207,946 $5,840,247 Liabilities and net worth
Current liabilities Accounts payable $406,163 $539,624
Claims payable (reported and unreported) 1,063,696
1,209,314 Unearned premiums 101,056 161,318 Aggregate
write-ins for current liabilities 10,300 13,390 Total current
liabilities 1,581,216 1,923,646 Other liabilities Amounts
due to affiliates 1,677,791 2,283,933 Total liabilities
3,259,007 4,207,579 Net worth Total net worth 1,948,939
1,632,668 Total liabilities and net worth $5,207,946
$5,840,247 The data in Tables 12–12 and 12–13 reveal a lot
about the structure of an HMO. First, note that a small
percentage of the total assets of the HMO are invested in
property, plant, and equipment—less than 8%. HMOs are not
fixed-asset intensive; the bulk of their investment is in cash and
investments. Our HMO has $1,948,939 in equity at the end of
2010, which represented about 37% of the total assets. This
gives the appearance of a debt-laden organization relative to the
financial standards listed in Table 12–1, but it should be noted
that a loan due to an affiliate in the amount of $1,677,790 also
exists. The sponsoring hospital granted this loan and, in some
ways, reflects equity. A large portion of this loan was paid off
during 2010, which can be seen from the decline in the loan
balance from $2,283,933 in 2009 to $1,677,791 at the end of
2010. The income statement in Table 12–13 depicts a large
decrease in net income, from $808,199 in 2009 to $208,471 in
2010. One reason for this decline is the drop in member months,
from 191,465 in 2009 to 174,967 in 2010. Table 12–14 analyzes
the expenses on a per member per month (PMPM) basis. Table

21. 12-13 Hospital HMO Statement of Revenue, Expenses, and Net
Worth 2010 2009 Member months 174,967 191,465 Revenues
Premium $21,509,196 $22,008,779 Fee-for-service 0 0
Title XVIII-Medicare 0 0 Investment 60,784 27,422
Aggregate write-ins for other revenues 47,038 76,537 Total
revenues $21,617,019 $22,112,738 Expense Medical and
hospital Physician services $1,582,006 $1,689,578
Other professional services 1,835,226 1,788,844 Outside
referrals 4,300,561 4,344,071 Emergency room and out-of-
area 963,382 1,425,666 Inpatient 7,865,005 7,462,942
Aggregate write-ins for other medical and hospital expenses
2,811,346 2,794,410 Subtotal $19,357,525 $19,505,512
Reinsurance expenses net of recoveries 376,541 370,753 Total
medical and hospital $19,734,067 $19,876,264 Administration
Compensation $902,617 $781,656 Occupancy, depreciation,
and amortization 83,809 105,994 Aggregate write-ins for other
administration expenses 688,055 540,625 Total administration
$1,674,481 $1,428,275 Total expenses 21,408,548 21,304,540
Net income (loss) $208,471 $808,199 The decline in net income
for our HMO example is the direct result of premiums on a
PMPM basis increasing less than expenses. Although not the
largest increase, administration expenses increased sharply on
both an absolute basis and a PMPM basis. Much of the cost in
this area is fixed and cannot be reduced when volume declines.
Inpatient expenses also sharply increased. It is not clear from
this information whether the cause is higher rates per hospital
visit or higher utilization. Additional information in the
insurance filing not produced in our tables shows that inpatient
days in 2010 were 4,187, or 287 days per 1,000 members. Table
12-14 PMPM Profitability 2010 2009 Premium $122.93 $114.9
Expense Physician services $9.04 $8.83 Other
professional services 10.49 9.34 Outside referrals 24.58
22.68 ER and out-of-area 5.51 7.45 Inpatient 44.95 38.98
Other medical and hospital 16.07 14.60 Reinsurance net of
recoveries 2.15 1.94 Total medical and hospital $112.79
$103.80 Administration 9.57 7.46 Total expenses $122.35

22. $111.26 Net income $0.5 $3.6 ER, emergency room. In 2009
inpatient days per 1,000 members were 278, or 4,447 total days.
The average price per inpatient day paid in 2010 was $1,878
($7,865,005/4,187) compared with $1,678 ($7,462,942/4,447) in
2009. Therefore, both increased use and higher per diems paid
to the hospitals contributed to the inpatient expense increase.
The American Association of Health Plans publishes the HMO
Industry Profile, which provides numerous financial, operating,
and utilization statistics. For example, the 1996 edition of this
book provides utilization information for enrollers younger than
65 years (Table 12–15). Table 12-15 Inpatient HMO Use Rates
Utilization Measure Use Rate per 1,000 Members Acute
inpatient discharges 68.7 Acute inpatient days 258.8
Ambulatory encounters 4.3 SUMMARY This chapter briefly
examined the financial and operating characteristics of
alternative healthcare firms. Although the concepts of financial
analysis are the same across all firms, there are some industry
specifics that alter the interpretation of financial results. It is
important to become familiar with the industry sector being
analyzed before reaching general conclusions regarding the
performance of any given firm. ASSIGNMENTS 1. Using the
information provided in Table 12–16 for UnitedHealth, a major
HMO, discuss some of the primary observations that you would
conclude regarding the financial performance of the firm. Relate
your discussion to the values presented in Table 12–1. Table 12-
16 UnitedHealthcare Group, Inc., 2008 (Data in Millions)
Balance sheet data Current assets Cash & short-term
investments $8,209 Net accounts receivable 1,929
Inventory 2,199 Other current assets 3,436 Total current
assets $14,990 Net fixed assets 2,181 Long-term
investments 13,366 Goodwill and other intangible assets
22,417 Other assets 2,861 Total assets $55,815 Liabilities
and equity Total current liabilities $19,761 Long-term
debt 11,338 Other liabilities 3,936 Equity 20,780 Total
liabilities & equity $55,815 Income statement data Total
revenue $81,186 Expenses Depreciation & amortization

23. $981 Other operating expense 74,942 Total operating
expense $75,923 Interest expense 639 Net income before
taxes $4,624 Income tax 1,647 Discontinued operation loss
0 Net income after tax $2,977 2. Using the information in Table
12–17 for Kindred Healthcare, a major nursing home firm,
discuss some of the primary observations that you would
conclude regarding the financial performance of the firm. Table
12-17 Kindred Healthcare, Inc., 2008 (Data in Thousands)
Balance Sheet Data 12/31/2008 12/31/2007 12/31/2006
Assets Current assets Cash & cash equivalents
$337,778 $264,570 $248,722 Net accounts receivable
611,032 598,108 588,166 Other current assets 153,825
150,969 156,560 Total current assets $1,102,635 $1,013,647
$993,448 Property, plant, and equipment, net 735,960
683,338 551,230 Goodwill 72,244 69,100 107,852
Intangible assets 64,367 79,956 117,345 Other assets
1,309,190 1,247,158 1,239,700 Total assets $2,181,761
$2,079,552 $2,016,127 Liabilities Total current liabilities
625,270 $629,942 $606,998 Long-term debt 349,433 275,814
130,090 Other liabilities 187,804 202,412 184,749
Deferred long-term liability charges 104,279 109,260 98,712
Total liabilities $1,266,786 $1,217,428 $1,020,549 Total
stockholders’ equity $914,975 $862,124 $995,578 Income
Statement Data 12/31/2008 12/31/2007 12/31/2006 Revenue
$4,151,396 $4,179,891 $4,090,365 Expenses Salaries,
wages, and benefits 2,409,673 2,358,914 2,217,582 Supplies
320,410 546,075 671,857 Rent 344,952 343,717 294,186
Other operating expenses 868,026 743,497 660,731 Other
income (17,407) (7,701) 0 Investment income (7,101)
(16,109) (14,491) Depreciation 121,413 120,421 116,182
Earnings before interest and taxes $111,430 $91,077
$144,318 Interest expense 15,373 17,044 13,920 Income
before taxes $96,057 $74,033 $130,398 Income tax expense
37,164 34,385 51,417 Net income from continuing
operations $58,893 $39,648 $78,981 Discontinued
operations, net of income taxes (22,608) (86,518) (270) Net

24. income $36,285 ($46,870) $78,711 SOLUTIONS 1. Table 12–18
provides financial ratio values for UnitedHealth for 2008.
UnitedHealth is achieving values of profitability that are on par
with industry averages. UnitedHealth’s high return on equity
results from judicious use of debt in its capital structure relative
to their profit margin. Their current liquidity position also
appears adequate, with favorable days in receivables relative to
industry averages. UnitedHealth also appears to be using assets
efficiently, although their fixed asset efficiency is low relative
to industry averages. Table 12-18 Financial Ratios
UnitedHealthcare, 2008 Financial Ratio 2008 Industry Average
Liquidity Current ratio 0.76 0.74 Days in receivables
8.67 16.6 Days’ cash-on-hand 105.1 146.9 Capital structure
Debt financing % 62.8% 65.2% Long-term debt to
capital% 35.3% 30.9% Cash flow to debt % 11.3% 9.0%
Times interest earned* 8.23 8.7 Activity Current asset
turnover 5.4 5.6 Fixed asset turnover 37.2 53.8 Total asset
turnover 1.5 1.2 Profitability Return on equity % 14.3%
14.3% Total margin % 3.7% 4.1% * Times interest earned is net
income before interest and taxes divided by interest. 2. Table
12–19 provides financial ratios for Kindred Healthcare for the
last 3 years. Kindred has an uneven performance over the past 3
years. On average, Kindred has experienced profit margins that
are low compared with industry averages. In addition, Kindred’s
return on equity is relatively low compared with industry
averages, likely due to its relatively low use of leverage in its
capital structure. Coverage of existing debt obligations appears
to be more than adequate when compared with industry
averages. Short-term liquidity at Kindred also appears to be
improving over the 3-year period and is adequate compared with
industry averages. Kindred also has lower relative asset
efficiency. Much of this is due to low fixed-asset efficiency.
The low values for fixed-asset turnover may be a reflection of a
newer plant-and-equipment base. Table 12-19 Financial Ratios,
Kindred Healthcare, 2008 Financial Ratio 2008 2007 2006
Industry Average Liquidity Current ratio 1.8 1.6 1.6 1.4

25. Days in receivables 53.7 52.2 52.5 56.7 Days’ cash-on-
hand 31.3 24.2 23.6 35.2 Capital structure Debt
financing % 58.1% 58.5% 50.6% 62.8% Long-term debt to
capital % 27.6% 24.2% 11.6% 42.7% Cash flow to debt %
12.4% 6.0% 19.1% 11.4% Times interest earned* 7.2 5.3 10.4
4.87 Activity Current asset turnover 3.76 4.12 4.12 1.78
Fixed asset turnover 5.64 6.12 7.42 11.9 Total asset
turnover 1.90 2.01 2.03 6.40 Profitability Return on
equity % 4.0% –5.4% 7.9% 12.7% Total margin % 0.9% –
1.1% 1.9% 3.1% * Times interest earned is net income before
interest and taxes divided by int
Chapter 10 Accounting for Inflation LEARNING OBJECTIVES
After studying this chapter, you should be able to do the
following: 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
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.

26. 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
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: • 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

27. 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
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 dimensions: the method

28. 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 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

29. 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 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 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 1987) 1.769
Restated cost of land $1,769,000 Adjusted gain on sale
$1,231,000 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 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

30. 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 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 Asset Valuation Method
Unit of Measurement 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 summarizes the effects the four reporting methods would
have on the three critical income statement items: depreciation
expense, purchasing power gains or losses, and unrealized gains
in replacement values. Table 10-2 Major Effect of Alternative
Reporting Methods on Net Income Measurement Impact
Variables Reporting 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
position No change/not recognized CV Increase/will recognize

31. 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
LEARNING OBJECTIVE 4 Describe the uses of financial report
information. USES OF FINANCIAL REPORT INFORMATION
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 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

32. 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
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 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

33. Center (000s Omitted) HC 20Y4 Constant Dollar (HC-GPL)
20Y4 Current Cost (CV-GPL) 20Y4 Operating revenue $3,556
$3,625 $3,625 Operating expenses 3,253 3,316 3,316
Depreciation 74 164 185 Interest 102 104 104 Net income $127
$41 $20 Purchasing power gain from holding net monetary
liabilities during the year — $43 $43 Increase in specific prices
of property, plant, and equipment during the year — — $136
Less effect of increase in general price level — — $144
Increase in specific prices over (under) increase in the general
price level — — ($8) Change in equity due to income
transactions $127 $84 $55 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 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 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 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: 1. The unadjusted value of the account in
historical or nominal dollars 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

34. 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) 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 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 $2,053 $2,513 $4,533 $4,838
Unadjusted amount × 20Y4 CPI/20Y3 CPI or $ 1 , 203 × 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 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

35. 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 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
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

36. 315.5/303.5 $1,251 –Repayment (6/30/Y4) 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. 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 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 20Y4 126
315.5/315.5 126 $2,228 $4,948 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 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

37. 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 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. 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

38. buildings and equipment. With this estimate, depreciation
expense could be adjusted as follows: Appraisal cost
Historical cost × Depreciation expense =
Restated depreciation expense or $ 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. 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 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) 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

39. 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 conceptual understanding of the
adjustment. We assume the following data: 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
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
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

40. value for accumulated depreciation was derived as follows: =
Adjusted accumulated depreciation Unadjusted accumulated dep
reciation × Appraisal value − Current year acquisitions
Historical cost − Current year acquisitions = or $ 2 , 186 = $
844 × ( $ 5 , 570 − $ 126 ) ( $ 2 , 228 − $ 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 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 appraised value $3,147 $500 $3,647 Beginning
net appraised value restated for general price level
(315.5/303.5) $3,791 Increase in specific prices over general
price level ($3,783 less $3,791) ($8) 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 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

41. return on assets and return on equity for Williams Convalescent
Center. Table 10-11 Effect of Alternative Reporting Methods on
Financial Measures Historical Cost Constant Dollar Current
Cost Return on assets Net income/total assets 5.1% 0.9%
0.40% Revised return on assets Change in equity due to income
transaction/total assets 5.1 1.9 1.1 Return on equity Net income
equity 23.4 1.6 0.7 Revised return on equity Change in equity
due to income transactions/equity 23.4 3.2 1.9 These reductions
are so drastic they would prompt an investor to seriously
question the continuation of the present investment, let alone
replacement. More profitable avenues of investment very likely
may be available. To the extent that our Williams Convalescent
Center example is representative of many healthcare firms (and
it probably is), decisions regarding health care business
continuation must be evaluated seriously. It is imperative that
health care companies, like all other businesses, adjust their
financial reports to reflect inflation. Whether the method used is
current cost or constant dollar is not the issue. The important
point is that ignoring the effects of inflation is unwise at best.
ASSIGNMENTS Use the data and information presented in
Exhibit 10-2 to answer the following questions: 1. What index
was used to restate to constant dollars? 2. What method was
used to determine current cost values? 3. Is the American
Medical Firm (AMF) a net debtor or a net creditor? 4. In 2001
AMF showed a minus $24 million value for the increase in
specific prices over general prices. What does this mean? 5.
Why are AMF’s net operating revenues in 2004 identical for the
HC, constant dollar, and current cost methods of reporting? 6.
Why is depreciation expense greater in the current cost method
than in the constant dollar method? SOLUTIONS AND
ANSWERS 1. AMF used the CPI, which is required by FASB
Statement 33 to restate historical costs to constant dollars. 2.
AMF used specific price indexes to restate historical costs to
current costs. This method contrasts with the use of appraisals
discussed in the chapter example. 3. AMF is a net debtor. It has
experienced a purchasing power gain in each year from 2000 to

42. 2004. Because prices were increasing during that period, AMF
must have had a net monetary liability position in each year. 4.
In 2001 the specific prices of AMF’s fixed assets must have
increased less than the general price level as determined by
using the CPI. 5. AMF does not restate revenues or expenses to
the fiscal year end, December 31. Instead, they restate to the
midpoint of the fiscal year, June 30. Because it is usually
assumed that revenues are received equally throughout the year,
the midpoint (June 30) represents the index from which the
conversion is made. Because AMF is converting to the midpoint
index, the adjustment is 1.0. 6. Depreciation expense under the
current cost method exceeds depreciation expense under the
constant dollar method because the current cost value of
depreciable assets exceeds the constant dollar value of
depreciable assets. Exhibit 10-2 Supplementary Financial
Information for American Medical Firm (AMF) EFFECTS OF
CHANGING PRICES The company’s financial statements have
been prepared in accordance with generally accepted accounting
principles and reflect historical cost. The goal of the
supplemental information that follows is to reflect the decline
in the purchasing power of the dollar resulting from inflation.
This information should be viewed only as an indication,
however, and not as a specific measure of the inflationary
impact. The constant dollars were calculated by adjusting
historical cost amounts by the CPI. Current costs, however,
reflect the changes in specific prices of land, buildings, and
equipment from the date acquired to the present; they differ
from constant dollar amounts to the extent that prices in general
have increased more or less rapidly than specific prices. The
current cost of buildings and equipment was determined by
applying published indices to the historical cost. Net income
has been adjusted only for the change in depreciation expense.
Other operating expenses, which are the result of current
transactions, are, in effect, recorded in amounts approximating
purchasing power on the primary financial statements.
Depreciation index was determined by applying primary

43. financial statement depreciation rates to restated building and
equipment amounts. Because only historical costs are deductible
for income tax purposes, the income tax expense in the primary
financial statements was not adjusted. During a period of
inflation, the holding of monetary assets (cash, receivables,
etc.) results in a purchasing power loss, whereas owing
monetary liabilities (current liabilities, long-term debt, deferred
credits, etc.) results in a gain. Net monetary gains or losses are
not included in the adjusted net income amounts reported.
Consolidated Statement of Income Adjusted for Changing Prices
($ IN MILLIONS) For the Year Ended December 31, 2004
As reported in Primary Statements (Historical Cost) Adjusted
for General Inflation (Constant $) Adjusted for Changes in
Specific Prices(Current Costs) Net operating revenue $2,065
$2,065 $2,065 Operating and administrative expenses $1,698
$1,698 $1,698 Depreciation and amortization 84 98 111
Interest 91 91 91 Total cost and expenses $1,873 $1,887
$1,900 Income from operations $192 $178 $165
Investment earnings $24 $24 $24 Income before taxes on
income $216 $202 $189 Taxes on income $95 $95 $95 Net
income $121 $107 $94 Effective income tax rate 44% 47%
50% Changing price gains not included in adjusted income:
Increase in specific prices (current cost) of property, plant,
and equipment held during the year* $139 Less effect of
increase in general price level 68 Excess of increase in
specific prices over increase in the general price level $71
FINANCIAL DATA ADJUSTED FOR EFFECTS ON
CHANGING PRICES ($ IN MILLIONS) 2004 2003 2002 2001
2000 Net operating revenues Adjusted for general
inflation $2,065 $1,852 $1,271 $1,070 $832 Net income
Adjusted for general inflation 107 85 73 54 36 Adjusted for
changes in specific prices 94 73 64 46 27 Earnings per share
Adjusted for general inflation 1.54 1.29 1.18 .95 .82
Adjusted for changes in specific prices 1.35 1.12 1.04 .82 .61
Purchasing power gain from holding net monetary liabilities
during the year 28 15 16 22 32 Increase in specific prices of

44. property, plant, and equipment over (under) increase in the
general price level 71 85 16 (24) .77 Net assets at year end
(total assets less total liabilities) Adjusted for general
inflation 1,095 972 756 657 413 Adjusted for changes in
specific prices 1,332 1,162 894 809 470 Cash dividends
declared per common share Adjusted for general inflation $0.43
$0.39 $0.34 $0.28 $0.21 Market price per common share at year
end: adjusted for general inflation $20.24 $29.41 $12.39 $24.30
$11.66 Average CPI—all urban consumers 303.9 293.4 280.3
257.5 230.0 * As of December 31, 2004, current cost of
property, plant, and equipment, net of accumulated
depreciation, was $1,915 (historical cost $1,349). “Property,
plant, and equipment” in both the previous and following data
includes land held for expansion.