3-1
Principles of Financial
Accounting
Introduction to financial accounting
Users of financial accounting info
The “Big 4” financial statements
The role of standards in financial
accounting practice
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
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Regulation and Standards
 The Securities and Exchange Commission (SEC)
has the legal authority to regulate the form and
content of financial statements.
 But, the SEC relies on the following organizations
for implementation:
 Financial Accounting Standards Board (FASB)
 Industry Committees of the American Institute
of Certified Public Accountants (AICPA)
 Principles and Practices Board of the
Healthcare Financial Management Association
(HFMA)
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GAAP
 The conventions that have evolved over time
from the pronouncements and rulings of the
implementing organizations constitute a
widely accepted set of guidelines for the
preparation of financial statements.
 These guidelines are called generally
accepted accounting principles (GAAP).
 The GAAP applies only to financial
accounting statements.
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
3-4
Introduction to Financial Accounting
Financial vs. managerial uses of
accounting information
Principles of financial accounting
The accounting entity vs. the legal entity
Organizational resources and obligations
Duality relationship
• Total assets = total liabilities plus net worth
• Accounting examples of duality relationship
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Introduction (Cont.)
Example #1 - MD purchase of X-ray
Increased total assets (+50K)
Decreased cash assets (-50K)
Duality relationship holds
Example #2 - Hospital purchase of ASC
Increased total assets (+2M)
Decreased cash assets (-200K)
Increased total liabilities (+1.8M)
Duality relationship holds
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3-6
Introduction (Cont.)
Asset Valuation Methods
Definition/purpose
Replacement cost valuation
Market valuation
Historical cost valuation
Advantages/disadvantages w/each
Application - ROI calculations
w/each valuation method (capital
budgeting)
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3-7
Introduction (cont’d)
 ROI Application
 MRI purchase by OP imaging facility
 Asset valuations:
• Historical cost -- $1M
• Market Value -- $800K
• Replacement cost -- $1.5M
 ROI estimates:
• ROI(H) -- 10%
• ROI(M) -- 12.5%
• ROI(R) -- 6.7%
 Comparison to cost of capital
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
3-8
Introduction (cont’d)
Cash vs. Accrual basis of accounting
Accrual-based accounting
• “Booking” of financial transactions
• GAAP accepted accounting basis
• Examples
Cash-based accounting
• Advantages/disadvantages compared with
accrual-based accounting
• Use(s) in financial statement preparation
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
3-9
The Balance Sheet and
Statement of Cash Flows
Balance sheet
Accounting identity
Assets
Liabilities and equity
Relationship between the income
statement and the balance sheet
Statement of cash flows
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Balance Sheet Basics
Whereas the income statement contains
information about a business’
operations, the balance sheet contains
information about:
The assets of an organization.
The liabilities and equity of the business, or
how the assets were financed.
The balance sheet presents a business’
position at a given point in time.
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Balance Sheet Basics (Cont.)
The balance sheet is organized with a
left side (or upper section) and right
side (or lower section):
Assets
Liabilities and Equity
Current assets
Long-term assets
Current liabilities
Long-term liabilities
Equity
Total assets
Total liabilities and equity
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
3 - 12
Sunnyvale Clinic: Assets
(in thousands)
Current Assets:
Cash
Marketable securities
Net patient accounts receivable
Inventories
Total current assets
Long-term investments
Property and Equipment:
Land
Buildings and equipment
Gross fixed assets
Less: Accumulated dep.
Net fixed assets
Other Assets: Goodwill
Total assets
1998
1997
$ 12,102
10,000
28,509
3,695
$ 54,306
$ 42,889
$
$
$
2,954
85,595
$ 88,549
36,099
$ 52,450
$ 5,170
$154,815
6,486
5,000
25,927
2,302
$ 39,715
$ 20,667
2,035
77,208
$ 79,243
30,144
$ 49,099
$ 5,620
$115,101
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Current Assets
Assets either possess (say, cash) or
create (say, buildings and equipment)
economic benefit to the business.
Current assets include:
Cash
Other assets that are expected to be
converted into cash within the next year:
• Marketable securities
• Net patient accounts receivable
• Inventories
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Current Assets (Cont.)
Cash represents actual cash in hand
and money held in commercial
checking accounts.
Marketable securities (MS) are shortterm investments in highly liquid,
typically low-risk securities:
 One example is Treasury bills (T-bills).
 MS are reported at cost, but their current market
value is given in the footnotes.
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Current Assets (Cont.)
Net patient accounts receivable
represents revenues owed to the
business but not yet collected.
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Current Assets (Cont.)
Inventories represent the dollar amount
of expendable supplies on hand.
For providers, inventories are primarily
medical supplies.
Only supplies actually consumed in
treating patients are expensed on the
income statement.
Providers with very small inventory
accounts often group inventories in
with another account.
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Current Assets (Cont.)
Other current assets is a catchall
account to hold short-term assets not
listed separately.
Note that current assets are listed in
order of liquidity, or nearness to cash.
Current assets are necessary to
support operations, but they provide
no explicit monetary return.
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Long-Term Investments
Long-term investments are
investments in securities (financial
assets) as opposed to buildings and
equipment (real assets).
Unlike marketable securities, these
assets have maturities greater than one
year.
Long-term investments are carried on
the balance sheet at fair market value.
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Property and Equipment
 Property and equipment, or fixed assets,
represent real assets having useful lives
greater than one year.
 Gross fixed assets are listed at historical
cost.
 Net fixed assets reflect an adjustment for
accumulated depreciation.
 Note that each year’s income statement
depreciation expense increases the
accumulated depreciation account.
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Other Assets: Goodwill
Other assets is a catchall account for
long-term assets that do not belong in
another category.
Goodwill is an intangible, as opposed
to tangible, asset.
It stems from buying businesses at
prices that exceed their book value of
equity. Presumably, such “excess”
value is due to intangible factors.
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Other Assets (cont’d)
Restricted Assets

Investment Assets
Organizational costs
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Sunnyvale Clinic: Liabilities and Equity
(in thousands)
1998
1997
Current Liabilities:
Current maturities of LT debt
Accounts payable
Accrued Expenses:
Wages and benefits
Taxes
Interest payable
Total current liabilities
Long-term debt
Total liabilities
Net assets (Equity)
4,344
844
881
$ 15,425
$ 85,322
$100,747
$ 54,068
$
$
$
$
Total liabilities and equity
$154,815
$115,101
$
2,834
6,522
$
2,345
7,933
3,523
996
518
15,315
53,578
68,893
46,208
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Current Liabilities
Liabilities represent claims against
assets that are fixed by contract.
Failure to meet these claims can result
in bankruptcy and potential closure.
Current liabilities include those claims
that must be paid within one year:
Notes payable
Current maturities of long-term debt
Accounts payable
Accrued expenses
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Current Liabilities (Cont.)
Notes payable are short-term debt
obligations, typically bank loans.
Sunnyvale has no bank loans in use.
Current maturities of long-term debt
represents principal payments coming
due on long-term debt obligations:
Serial bond issues
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Current Liabilities (Cont.)
Accounts payable stems from buying
goods (typically medical supplies) from
vendors on credit called trade credit.
Vendors often have payment terms such as
2/10, net 30. Here, the buyer can obtain a
2% discount if it pays in 10 days. If not, the
full purchase price is due in 30 days.
The amount purchased, but not yet paid, is
carried as an accounts payable.
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Current Liabilities (Cont.)
Accrued expenses (accruals) are
payment obligations of the business,
primarily to:
Employees
Taxing authorities
Debt suppliers
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Current Liabilities (Cont.)
Incurred but not reported (IBNR)
expenses is an important current
liability account for providers with a
high percentage of capitated revenues.
Payment is received before services are
provided
The matching principle requires expenses
to be matched to revenues
Some businesses have a catchall
account called other current liabilities.
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Long-Term Debt
Long-term debt represents debt
financing with maturities greater than
one year.
Detailed information typically is
provided in the footnotes.
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Equity
Equity represents the non-liability
claims against a business’ assets.
For investor-owned businesses, equity is
the amount of owner-supplied financing.
For not-for-profit businesses, equity is the
amount of capital supplied “by the
community.”
The equity account is really a residual:
Equity = Total assets - Total liabilities.
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Equity (Cont.)
The equity section of the balance
sheet, more than anything else,
distinguishes an investor-owned
business from a not-for-profit
business.
In not-for-profit corporations, the
equity account is called net assets--it
is the dollar value of assets net of
liabilities.
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Equity (Cont.)
A for-profit equity section might look
like this:
Stockholders’ Equity:
Common stock ($1 par value,
1,500,000 shares authorized,
1,000,000 shares outstanding)
Capital in excess of par
Retained earnings
Total equity
1998
1997
$ 1,000
$ 1,000
9,000
44,068
9,000
36,208
$54,068
$46,208
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Equity (Cont.)
Note that retained earnings, or the
entire net equity account for not-forprofit organizations, is influenced by
the amount of net income shown on
the income statement.
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Equity (Cont.)
The right side of the balance sheet
gives the mix of debt and equity
financing, which is called a business’
capital structure.
Capital structure is a key financing
decision because it affects the
business’:
Cost of financing.
Overall risk.
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Income Statement Basics
 Perhaps the most important question
about a business’ financial status is
whether or not it is making money.
 The income statement provides
information about the operations and
economic profitability of a business.
 The income statement is often called by
other names:
 Statement of operations
Statement of activities
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Income Statement Basics (Cont.)
The income statement reports the results
of operations over a some period of time,
say, a year. It has three key elements:
 Revenues, which represent both cash
received as well as payor obligations.
 Expenses, which are the resource
expenditures required to produce the
revenues.
• Operating expenses
• Financial expenses
 Net income (profit) = Revenues - Expenses.
Copyright © 1999 by the Foundation of the American College of Healthcare Executives
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Sunnyvale Clinic: Revenues
(in thousands)
Revenues:
Net patient service revenue
Other revenue
Total revenues
1998
1997
$169,013
7,079
$176,092
$140,896
5,704
$146,600
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Revenues
 Revenues are shown in several different
formats depending on the type of provider.
Sunnyvale has two revenue categories.
 Net patient service revenue. The key
definitions here are:
 Net
 Patient service revenue
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Revenues (Cont.)
 In reporting revenues, note the difference
in how the following adjustments are
handled:
 Discounts
 Charity care
 Bad debt losses
 Other revenue represents revenues from
sources besides patient care, including:
 Interest earned on investments
 Contributions
 Rental income
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Sunnyvale Clinic: Expenses
(in thousands)
1998
Expenses:
Salaries and benefits
$109,693
Medical supplies
20,568
Purchased medical services
9,863
Research and education
4,518
Lease expense
3,189
Depreciation and amortization
6,405
Provision for bad debts
2,000
Interest
5,329
Other
6,667
Total expenses
$168,232
1997
$ 89,953
18,673
7,448
3,710
2,603
5,798
1,800
3,476
4,933
$138,394
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Expenses
 Expenses represent the resources used to
create revenues--they are the costs of
doing business. Like revenues, expenses
do not necessarily reflect cash outlays.
 Expenses may be categorizes by:
 Natural classification, such as salaries,
supplies, research, and so on.
 Functional classification, such as inpatient
services, outpatient services, and so on.
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Expenses (Cont.)
 Salaries and benefits represents labor
costs.
 Typically, this is the largest expense category for
health services organizations.
 Although only summary information is given on
the income statement, details are available from
the managerial accounting system.
 Medical supplies represents the cost of
expendable materials.
 The amount shown represents the amount
consumed, not the amount purchased.
 Supply stocks are reported on the balance sheet.
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Expenses (Cont.)
 Sunnyvale bills patients for some
services performed by other providers.
Such expenses are reported as
purchased medical services.
 The clinic conducts a small medical
research and education program.
Related expenses are reported in the
research and education category.
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Expenses (Cont.)
 Sunnyvale owns its land and buildings,
but it leases much of its diagnostic
equipment. Lease expense reports the
cost of its leases.
 Some leased assets are reported directly on
the balance sheet while others appear only
in the footnotes. Regardless, all lease
expense is reported here.
 A footnote contains the expected future
expenses associated with operating (nonbalance sheet) leases.
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Expenses (Cont.)
 Depreciation expense recognizes that
buildings and equipment typically lose
value as they are used to provide services.
 Acquisition costs are not shown on the income
statement.
 Rather, the “cost” of long-term (fixed) assets is
pro-rated, or depreciated, over the life of the asset.
 For financial accounting purposes, depreciation is
calculated by the straight-line method.
 Amortization expense is associated with
business acquisitions.
 Both tie to the balance sheet.
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Expenses (Cont.)
 Provision for bad debts reports the
amount of net patient service revenue
that is expected to remain uncollected.
 Interest expense reports the amount of
interest paid on debt financing.
 Other expenses is a catchall category
for expenses not otherwise listed.
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Sunnyvale Clinic: Net Income
(in thousands)
1998
1997
Revenues:
Total revenues
$176,092
$146,600
Expenses:
Total expenses
$168,232
$138,394
Net income
$
$
7,860
8,206
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Net Income
 Although the reporting of revenue and
expenses is important, the most important
single line on the income statement is the
“bottom line,” which is net income.
 Net income measures economic profitability
as defined by GAAP.
 In not-for-profit businesses, net income is
called:
 Revenues over expenses
 Excess of revenues over expenses
 Change in net assets
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Net Income (Cont.)
 In a not-for-profit corporation, the entire
amount of net income belongs to and is
reinvested in the business.
 In a for-profit business, net income, which
constitutes the residual earnings of the
business, belongs to the owners.
 Some portion of a corporation’s net income often
is returned to stockholders as dividends.
 The remainder is reinvested in the business.
 The reinvested amount flows to the balance sheet.
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Net Income Versus Cash Flow
Because of accrual accounting, net
income does not represent cash flow.
 Some income statement items represent cash
flows, others do not.
 Some, such as revenues, represent partial cash
flows.
With only income statement data, cash
flow (CF) can be approximated by:
CF = Net income + Noncash expenses
= Net income + Depreciation/Amortization
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Income Statements of
Investor-Owned Businesses
 The income statements of investorowned and not-for-profit businesses
are very similar.
 The revenues and costs to organizations in the
same core business are similar, regardless of
ownership.
 However, some transactions, such as tax
payments, clearly are applicable only to one
form of ownership.
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Statement of Cash Flows
The statement of cash flows combines
both income statement and balance
sheet data to create an income
statement-like report that focuses on
cash flows.
It is designed to answer three questions:
Where did the business get cash? (sources)
What did it do with the cash? (uses)
How did its cash position change?
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Statement of Cash Flows (Cont.)
Like the income statement, it reports
transactions over some time period.
The top part of the statement is divided
into three sections:
Cash flows from operating activities
Cash flows from investing activities
Cash flows form financing activities
The bottom part reconciles the change
in cash on the statement with the cash
account on the balance sheet.
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Sunnyvale Clinic: Statement of CFs (1)
(in thousands)
1998
1997
Cash Flows from Operating Activities:
Net income
$ 7,860
Adjustments:
Depreciation and amortization
6,405
Change in accounts receivable
(2,582)
Change in inventories
(1,393)
Change in accounts payable
(1,411)
Change in accruals
1,032
Net cash from operations
$ 9,911
5,798
(1,423)
(673)
(966)
865
$11,807
Cash Flows from Investing Activities:
Capital expenditures
($ 9,306)
($ 1,953)
$ 8,206
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Sunnyvale Clinic: Statement of CFs (2)
(in thousands)
1998
1997
Cash Flows from Financing Activities:
Change in marketable securities
($ 5,000) $
0
Change in long-term investments
(22,222) (20,667)
Change in long-term debt
32,233
0
Net cash from financing
$ 5,011 ($20,667)
Net increase (decrease) in cash
$ 5,616
($10,813)
Cash, beginning of year
$ 6,486
$17,299
Cash, end of year
$12,102
$ 6,486
Copyright © 1999 by the Foundation of the American College of Healthcare Executives