Chapter 3-4 100 - 143

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Healthcare Finance 100 operating income (an operating loss). This situation is worrisome, because a business is on shaky financial ground if its core opera- tions are losing money, especially if they do so year after year. Note that the operating income reported on the income statement is defined by GAAP and represents an estimate of the long-run operating profitability of the busi- ness. It has some shortcomings—for one, it does not represent cash flow—that are similar to the shortcomings related to net income discussed in a later section. Still, measuring the core profitability of a business is critical to understanding its financial status. Nonoperating Income The next section of the income statement lists nonoperating income . As men- tioned earlier, reporting the income of operating and nonoperating activities separately is useful. The nonoperating income section of Sunnyvale’s income statement shown in Exhibit 3.1 reports the income generated from activities unrelated to the provision of healthcare services. The first category of nonoperating income listed is contributions. Many not-for-profit organizations, especially those with large, well-endowed foun- dations, rely heavily on charitable contributions as an income source. Those charitable contributions that can be used immediately (spent now) are reported as nonoperating income. However, contributions that create a permanent endowment fund, and hence are not available for immediate use, are not reported on the income statement. The second category of nonoperating income is investment income, another type of income on which not-for-profit-organizations rely heavily. It stems from two primary sources: 1. Healthcare businesses usually have funds available that exceed the minimum necessary to meet current cash expenses. Because cash earns 1. What is operating income? 2. Why is operating income such an important measure of profitability? SELF-TEST QUESTIONS Nonoperating income The earnings of a business that are unrelated to core activities. For a healthcare provider, the most common sources are contributions and investment income. care, directly related activities, and government appropriations. Each definition results in a differ- ent value for operating income. In general, as the definition of core operations expands, the value calculated for operating income increases. What do you think? Consider the hospital industry. What activities should be considered part of core operations? Should hospitals be required by GAAP to report multiple measures of operating income, each using a different defini- tion of core activities? (continued from previous page) Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

Chapter 3: The Income Statement and Statement of Changes in Equity 101 no interest, these “excess” funds usually are invested in short-term, interest-earning securities, such as Treasury bills or money market mutual funds. Sometimes these invested funds can be quite large—say, when a business is building up cash to make a tax payment or to start a large construction project. Also, prudent businesses keep a reserve of funds on hand to meet unexpected emergencies. The interest earned on such funds is listed as investment income. 2. Not-for-profit businesses may have a large amount of endowment fund contributions. When these contributions are received, they are not reported as income because the funds are not available to be spent. However, the income from securities purchased with endowment funds is available to the healthcare organization, and hence this income is reported as nonoperating (investment) income. In total, Sunnyvale reported $4,113,000 of nonoperating income for 2015, consisting of $243,000 in spendable contributions and $3,870,000 earned on the investment of excess cash and endowments. Nonoperating income is not central to the core business, which is providing healthcare services. Overreliance on nonoperating income could mask operational inefficiencies that, if not corrected, could lead to future financial problems. Note that the costs associated with creating nonoperating income are not separately reported. Thus, the expenses associated with soliciting contributions or investing excess cash and endowments must be deducted before the income is reported on the income statement. Finally, note that the income statements of some providers do not con- tain a separate section titled nonoperating income . Rather, nonoperating income is included in the revenue section that heads the income statement. In this situation, total revenues include both operating and nonoperating revenues. Net Income The second profitability measure reported by Sunnyvale Clinic is net income , which in Exhibit 3.1 is equal to Operating income + Total nonoperating income. Sunnyvale reported net income of $7,860,000 for 2015: $3,747,000 + $4,113,000 = $7,860,000. (Not-for-profit organizations use the term excess 1. What is nonoperating income? 2. Why is nonoperating income reported separately from revenues? Is this always the case? SELF-TEST QUESTIONS Net income The total earnings of a business, including both operating and nonoperating income. Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

Healthcare Finance 102 of revenues over expenses, but we call this measure net income because that is the more universally recognized term. Also, one could argue that there are three profitability measures on Sunnyvale’s income statement: operating income, nonoperating income, and net income. We wouldn’t object to that position, but accountants generally view nonoperating income as an entry on the state- ment rather than a calculated profitability measure.) Because of its location on the income statement and its importance, net income is referred to as the bottom line. In spite of the fact that Sunnyvale is a not-for-profit organization, it still must make a profit. If the business is to offer new services in the future, it must earn a profit today to produce the funds needed for new assets. Furthermore, because of inflation, Sunnyvale could not even replace its existing assets as they wear out or become obsolete without the funds generated by positive profitability. Thus, turning a profit is essential for all businesses, including not-for-profits. What happens to a business’s net income? For the most part, it is rein- vested in the business. Not-for-profit corporations must reinvest all earnings in the business. An investor-owned corporation, on the other hand, may return a portion or all of its net income to owners in the form of dividend payments. The amount of profits reinvested in an investor-owned business, therefore, is net income minus the amount paid out as dividends. (Some for-profit busi- nesses distribute profits to owners in the form of bonuses, which often occurs in medical practices. However, when this is done, the distribution becomes an expense item that reduces net income rather than a distribution of net income. The end result is the same—monies are distributed to owners—but the reporting mechanism is much different.) Note that both operating income and net income measure profitability as defined by GAAP. In establishing GAAP, accountants have created guide- lines that attempt to measure the economic income of a business, which is a difficult task because economic gains and losses often are not tied to easily identifiable events. Furthermore, some of the income statement items are estimates (e.g., provision for bad debt losses) and others (e.g., depreciation expense) do not represent actual cash costs. Because of accrual accounting and other factors, the fact that Sunnyvale reported net income of $7,860,000 for 2015 does not mean that the business actually experienced a net cash inflow of that amount. This point is discussed in greater detail in the next section. 1. Why is net income called “the bottom line”? 2. What is the difference between net income and operating income? 3. What happens to net income? SELF-TEST QUESTIONS Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

Chapter 3: The Income Statement and Statement of Changes in Equity 103 Net Income Versus Cash Flow As stated previously, the income statement reports total profitability (net income), which is determined in accordance with GAAP. Although net income is an important measure of profitability, an organization’s financial condition, at least in the short run, depends more on the actual cash that flows into and out of the business than it does on reported net income. Thus, occasionally a business will go bankrupt even though its net income has historically been positive. More com- monly, many businesses that have reported negative net incomes (i.e., net losses) have survived with little or no financial damage. How can these things happen? The problem is that the income statement is like a mixture of apples and oranges. Consider Exhibit 3.1. Sunnyvale reported net operating revenues of $169,979,000 for 2015. Yet, this is not the amount of cash that was actually collected during the year, because some of these revenues will not be collected until 2016. Furthermore, some revenues reported for 2014 were actually col- lected in 2015, but these do not appear on the 2015 income statement. Thus, because of accrual accounting, reported revenue is not the same as cash revenue. The same logic applies to expenses; few of the values reported as expenses on the income statement are the same as the actual cash outflows. To make mat- ters even worse, not one cent of depreciation expense was paid out as cash. Depreciation expense is an accounting reflection of the cost of fixed assets, but Sunnyvale did not actually pay out $6,405,000 in cash to someone called the “collector of depreciation.” According to the balance sheet (see Exhibit 4.1), Sunnyvale actually paid out $88,549,000 sometime in the past to purchase the clinic’s total fixed assets, of which $6,405,000 was recognized in 2015 as a cost of doing business, just as salaries and fringe benefits are a cost of doing business. Can net income be converted to cash flow —the actual amount of cash generated during the year? As a rough estimate , cash flow can be thought of as net income plus noncash expenses. Thus, the cash flow generated by Sunnyvale in 2015 is not merely the $7,860,000 reported net income, but this amount plus the $6,405,000 shown for depreciation, for a total of $14,265,000. Depreciation expense must be added back to net income to get cash flow because it initially was subtracted from revenues to obtain net income even though there was no associated cash outlay. Key Equation: Net Income to Cash Flow Conversion Because of accrual accounting, net income does not represent an estimate of the organization’s cash flow for the reporting period. This equation is used to convert net income to a rough estimate of cash flow: Cash flow = Net income + Noncash expenses. Because depreciation often is (continued) Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

Healthcare Finance 104 Here is another way of looking at cash flow versus accounting income: If Sunnyvale showed no net income for 2015, it would still be generating cash of $6,405,000 because that amount was deducted from revenues but not actually paid out in cash. The idea behind the income statement treatment is that Sunnyvale would be able to set aside the depreciation amount, which is above and beyond its cash expenses, this year and in future years. Eventually, the accumulated total of depreciation cash flow would be used by Sunnyvale to replace its fixed assets as they wear out or become obsolete. Thus, the incorporation of depreciation expense into the cost and, ultimately, the price structure of services provided is designed to ensure the ability of an organization to replace its fixed assets as needed, assuming that the assets could be purchased at their historical cost. To be more realistic, businesses must plan to generate net income, in addition to the accumulated depreciation funds, sufficient to replace existing fixed assets in the future at inflated costs or even to expand the asset base. It appears that Sunnyvale does have such capabilities, as reflected in its $7,860,000 net income and $14,265,000 cash flow for 2015. It is important to understand that the $14,265,000 cash flow calculated here is only an estimate of actual cash flow for 2015, because almost every item of revenues and expenses listed on the income statement does not equal its cash flow counterpart. The greater the difference between the reported values and cash values, the less reliable is the rough estimate of cash flow defined here. The value of knowing the precise amount of cash generated or lost has not gone unnoticed by accountants. In Chapter 4, readers will learn about the statement of cash flows, which can be thought of as an income statement that is recast to focus on cash flow. 1. What is the difference between net income and cash flow? 2. How can income statement data be used to estimate cash flow? 3. What is depreciation cash flow, and what is its expected use? 4. Why do not-for-profit businesses need to make a profit? SELF-TEST QUESTIONS the only noncash expense, the equation can be rewritten as Cash flow = Net income + Depreciation. To illustrate, Sunnyvale reported net income of $8,206,000 and depreciation of $5,798,000 in 2014. Thus, a rough measure of its 2014 cash flow is $14,004,000: Cash flow = Net income + Depreciation = $8,206,000 + $5,798,000 = $14,004,000. (continued from previous page) Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

Chapter 3: The Income Statement and Statement of Changes in Equity 105 Income Statements of Investor-Owned Businesses Our income statement discussion focused on a not-for-profit organization: Sunnyvale Clinic. What do the income statements for investor-owned businesses, such as Community Health Systems and Brookdale Senior Living, look like? The financial statements of investor-owned and not-for-profit businesses are generally similar except for entries, such as tax payments, that are applicable only to one form of ownership. Because the transactions of all health services organizations are similar in nature, ownership plays only a minor role in the presentation of financial statement data. In reality, more differences exist in financial statements because of lines of business (e.g., hospitals versus nursing homes versus managed care plans) than because of ownership. The impact of taxes and depreciation on net income and cash flow for for-profit businesses deserves discussion. Exhibit 3.2 contains four income statements that are based on Sunnyvale’s 2015 income statement presented in Exhibit 3.1. First, note that the Exhibit 3.2 statements are condensed to show only total revenues (including nonoperating income); all expenses except depreciation; depreciation; and net income. Lines for taxable income, taxes, and cash flow have also been added. The column labeled “Not-for-Profit” presents Sunnyvale’s income statement assuming not-for-profit status (zero taxes), so the reported net income and cash flow are the same, as discussed previously. Now consider the column labeled “For-Profit A,” which assumes that Sunnyvale is a for-profit business with a 20 percent tax rate. Here, the clinic EXHIBIT 3.2 Sunnyvale Clinic: Condensed Income Statements Under Alternative Tax Assumptions, Year Ended December 31, 2015 (in thousands) Not-for-Profit (Tax rate = 0%) For-Profit A (Tax rate = 20%) For-Profit B (Tax rate = 40%) For-Profit C (Tax rate = 40%) Total revenues Expenses: All except depreciation Depreciation Total expenses Taxable income Taxes Net income Cash flow (NI + depreciation) $174,092 $159,827 6,405 $166,232 $ 7,860 0 $ 7,860 $ 14,265 $174,092 $159,827 6,405 $166,232 $ 7,860 1,572 $ 6,288 $ 12,693 $174,092 $159,827 6,405 $166,232 $ 7,860 3,144 $ 4,716 $ 11,121 $174,092 $159,827 0 $159,827 $ 14,265 5,706 $ 8,559 $ 8,559 Note: Total revenues = Net operating revenues + Total nonoperating income. NI (net income). Copying and distribution of this PDF is prohibited without written permission. For permission, please contact Copyright Clearance Center at www.copyright.com Copyright © 2016. AUPHA/HAP Book. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. EBSCO Publishing : eBook Academic Collection (EBSCOhost) - printed on 5/12/2024 8:49 PM via LOUISIANA STATE UNIVERSITY AT SHREVEPORT AN: 1792718 ; Louis Gapenski.; Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition

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