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FINANCIAL MANAGEMENT OF HEALTH CARE ORGANIZATIONS

FINANCIAL MANAGEMENT OF

HEALTH CARE ORGANIZATIONS

AN INTRODUCTION TO FUNDAMENTAL TOOLS, CONCEPTS, AND APPLICATIONS

Fourth Edition

William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas

Cover design by Jeff Puda Cover image : © imagewerks | Getty Copyright © 2014 by William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas. All rights reserved.

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Library of Congress Cataloging-In-Publication Data Zelman, William N., author. Financial management of health care organizations : an introduction to fundamental tools, concepts, and applications / William N. Zelman, Michael J. McCue, Noah D. Glick, and Marci S. Thomas. – Fourth edition. p. ; cm. Includes bibliographical references and index. ISBN 978-1-118-46656-8 (cloth) – ISBN 978-1-118-46659-9 (pdf) – ISBN 978-1-118-46658-2 (epub) I. McCue, Michael J. (Michael Joseph), 1954- author. II. Glick, Noah D., author. III. Thomas, Marci S., 1953- author. IV. Title. [DNLM: 1. Health Facility Administration–economics. 2. Financial Management, Hospital– methods. 3. Practice Management, Medical–economics. WX 157] RA971.3 362.1068'1–dc23 2013025598

Printed in the United States of America

fourth edition

HB Printing 10 9 8 7 6 5 4 3 2 1

CONTENTS

Preface xiii Acknowledgments xix The Authors xxi

Chapter 1 The Context of Health Care Financial Management 1

Changing Methods of Health Care Financing and Delivery 3 Addressing the High Cost of Care 9 Establishing Value-Based Purchasing 21 Summary 23 Key Terms 24 Review Questions 24

Chapter 2 Health Care Financial Statements 27

The Balance Sheet 28 The Statement of Operations 51 The Statement of Changes in Net Assets 65 The Statement of Cash Flows 68 Summary 73 Key Terms 75 Key Equations 75 Review Questions and Problems 76 Appendix A: Financial Statements for Sample

Not-for-Profit and For-Profit Hospitals, and Notes to Financial Statements 86

Chapter 3 Principles and Practices of Health Care Accounting 103

The Books 103 An Example of the Effects of Cash Flows on Profit Reporting

under Cash and Accrual Accounting 106 Recording Transactions 110 Developing the Financial Statements 120 Summary 126

Contentsvi

Key Terms 127 Review Questions and Problems 127

Chapter 4 Financial Statement Analysis 137

Horizontal Analysis 138 Trend Analysis 143 Vertical (Common-Size) Analysis 144 Ratio Analysis 146 Liquidity Ratios 151 Revenue, Expense, and Profitability Ratios 161 Activity Ratios 172 Capital Structure Ratios 175 Summary 183 Key Equations 186 Key Terms 187 Review Questions and Problems 187

Chapter 5 Working Capital Management 209

Working Capital Cycle 209 Working Capital Management Strategies 211 Cash Management 215 Sources of Temporary Cash 216 Revenue Cycle Management 222 Collecting Cash Payments 225 Investing Cash on a Short-Term Basis 228 Forecasting Cash Surpluses and Deficits: The Cash Budget 230 Accounts Receivable Management 233 Methods to Monitor Revenue Cycle Performance 237 Fraud and Abuse 239 Summary 243 Key Terms 246 Key Equations 246 Review Questions and Problems 246

Chapter 6 The Time Value of Money 259

Future Value of a Dollar Invested Today 259 Present Value of an Amount to Be Received in the Future 266 Future and Present Values of Annuities 270 Future and Present Value Calculations and Excel Functions

for Special Situations 275 Summary 283

Contents vii

Key Terms 284 Key Equations 284 Review Questions and Problems 286 Appendix B: Future and Present Value Tables 291

Chapter 7 The Investment Decision 301

Objectives of Capital Investment Analysis 302 Analytical Methods 306 Using an NPV Analysis for a Replacement Decision 320 Summary 325 Key Terms 327 Key Equation 327 Review Questions and Problems 327 Appendix C: Technical Concerns in Calculating

Net Present Value 335 Appendix D: Adjustments for Net Working Capital 342 Appendix E: Tax Implications for For-Profit Entities

in a Capital Budgeting Decision and the Adjustment for Interest Expense 344

Appendix F: Comprehensive Capital Budgeting Replacement Cost Example 348

Chapter 8 Capital Financing for Health Care Providers 359

Equity Financing 362 Debt Financing 364 Bond Issuance Process 375 Lease Financing 387 Summary 392 Key Terms 393 Key Equations 394 Review Questions and Problems 394 Appendix G: Bond Valuation, Loan Amortization,

and Debt (Borrowing) Capacity 399

Chapter 9 Using Cost Information to Make Special Decisions 409

Break-Even Analysis 410 Product Margin 433 Applying the Product Margin Paradigm to Making

Special Decisions 438 Summary 445 Key Terms 446

Contentsviii

Key Equations 447 Review Questions and Problems 447 Appendix H: Break-even Analysis for Practice Acquisition 458

Chapter 10 Budgeting 465

The Planning-and-Control Cycle 465 Organizational Approaches to Budgeting 470 Types of Budgets 481 Monitoring Variances to Budget 489 Group Purchasing Organizations 491 Summary 493 Key Terms 495 Key Equation 496 Review Questions and Problems 496 Appendix I: An Extended Example of How

to Develop a Budget 498

Chapter 11 Responsibility Accounting 521

Decentralization 521 Types of Responsibility Centers 524 Measuring the Performance of Responsibility Centers 529 Budget Variances 532 Summary 544 Key Terms 546 Key Equations 546 Review Questions and Problems 547

Chapter 12 Provider Cost-Finding Methods 551

Cost-to-Charge Ratio 551 Step-Down Method 552 Activity-Based Costing 559 Summary 571 Key Terms 572 Review Questions and Problems 572

Chapter 13 Provider Payment Systems 579

Evolution of the Payment System 583 Risk Sharing and the Principles of Insurance 608 Evolving Issues 614 Technology 614 Summary 616

Contents ix

Key Terms 617 Review Questions and Problems 618 Appendix J: Cost-Based Payment Systems 619

Glossary 627 Useful Websites and Apps 653

Index 659

To our families, for their love and patience

To our students and colleagues, for their invaluable

insights and feedback

PREFACE

This book offers an introduction to the most used tools and techniques of health care financial management. It contains numerous examples from a variety of providers, including health maintenance organizations, hospitals, physician practices, home health agencies, nursing units, surgi- cal centers, and integrated health care systems. The book avoids complicated formulas and uses numerous spreadsheet examples so that these examples can be adapted to problems in the workplace. For those desiring to go beyond the fundamentals, many chapters offer additional information in appendices. Each chapter begins with a detailed outline and concludes with a detailed summary, followed by a set of questions and problems. Answers to the questions and problems are available for download to instructors at www.josseybass.com/go/zelman4e. Finally, a number of perspectives are included in every chapter. Perspectives—examples from the real world— are intended to provide additional insight into a topic. In some cases these are abstracted from professional journals and in other cases they are state- ments from practitioners—in their own words.

The book begins with an overview in Chapter One of some of the key factors affecting the financial management of health care organizations in today’s environment. Chapters Two, Three, and Four focus on the financial statements of health care organizations. Chapter Two presents an intro- duction to these financial statements. Financial statements are (perhaps along with the budget) the most important financial documents of a health care organization, and the bulk of this chapter is designed to help readers understand these statements, how they are created, and how they link together.

Chapter Three provides an introduction to health care financial accounting. This chapter focuses on the relationship between the actions of health care providers and administrators and the financial condition of the organization, examining how the numbers on the financial statements are derived, the distinction between cash and accrual bases of account- ing—and the importance of defining what is actually meant by cost. By the time students complete Chapters Two and Three, they will have been introduced to a large portion of the terms used in health care financial management.

Prefacexiv

Building on Chapters Two and Three, Chapter Four focuses on inter- preting the financial statements of health care organizations. Three approaches to analyzing statements are presented: horizontal, vertical, and ratio analysis. Great care has been taken to show how the ratios are com- puted and how to summarize the results.

Chapter Five focuses on the management of working capital: current assets and current liabilities. This chapter emphasizes the importance of cash management and provides many practical techniques for managing the inflows and outflows of funds through an organization, including managing the billing and collections cycle and paying off short-term liabilities.

Chapter Six introduces one of the most important concepts in long- term decision making—the time value of money. Chapter Seven builds on this concept, incorporating it into the investment decision by presenting several techniques for analyzing investment decisions: the payback method, net present value, and internal rate of return. Examples are given for both not-for-profit and for-profit organizations.

Once an investment has been decided on, it is important to determine how this asset will be financed, and this is the focus of Chapter Eight. Whereas Chapter Five deals with issues of short-term financing, Chapter Eight focuses on long-term financing, with a particular emphasis on issuing bonds.

Chapters Nine through Twelve introduce topics typically covered in a managerial accounting course. Chapter Nine focuses on the concept of cost and on using cost information—including fixed cost, variable cost, and break-even analysis—for short-term decision making. In addition to cover- ing the key concepts, this chapter offers a set of rules to guide decision makers in making financial decisions. Chapter Ten explores budget models and the budgeting process. Several budget models are introduced, includ- ing program, performance, and zero-based budgeting. The chapter ends with an example of how to prepare each of the five main budgets: statistics budget, revenue budget, expense budget, cash budget, and capital budget. It also includes examples for various types of payors, including those with flat fee and capitation plans.

Chapter Eleven deals with responsibility accounting. It discusses the different types of responsibility centers and focuses on performance mea- surement in general and budget variance analysis in particular. Chapter Twelve discusses methods used by health care providers to determine their costs, primarily focusing on the step-down method and activity- based costing. This book concludes with Chapter Thirteen, “Provider Payment Systems.” This chapter, parts of which were combined with

Preface xv

Chapter Twelve in the first edition, describes the evolution of the payment system in the United States, especially under health reform, as well as the specifics of various approaches to managing care and paying providers.

Major Changes in the Fourth Edition As noted below, the major changes from the third edition involve

• New sections to reflect changes in the health care environment

• Updated data used in examples

• Updated data used in problems

• New problems

• New perspectives

Chapter One: The Context of Health Care Financial Management Changes to Chapter One, the introductory chapter, provide an updated and current view of today’s health care setting. Much has happened in the industry with the advent of value-based payment systems, population- based approaches to care, and the Patient Protection and Affordable Care Act (ACA). Other new concepts include patient-centered medical homes and accountable care organizations (ACOs).

Enhancements include updated statistics in the chapter text and all the pertinent exhibits. All perspectives have been replaced with ones that look at more recent events.

Chapter Two: Health Care Financial Statements Chapter Two has been updated to include recent changes in the literature issued by the Financial Accounting Standards Board (FASB). These changes address revenue recognition presentation of bad debt for many hospitals, increases in the level of charity care disclosure, and the guidance for self- insured risks. All perspectives and problems have been updated. There are also new key terms.

Chapter Three: Principles and Practices of Health Care Accounting In Chapter Three, the perspectives have been replaced with four updated versions. Problems 11 through 20 have been changed and updated.

Prefacexvi

Chapter Four: Financial Statement Analysis Chapter Four has been updated to include the latest hospital benchmark ratios from the 2013 Almanac of Hospital Financial and Operating Indica- tors (a reference work from Optum Inc.).

This chapter also addresses the change mentioned previously to the reporting of bad debt expense. All chapter problems have been updated as well. In addition, ratio problems 11 through 25 have been revised to provide a better picture of what each ratio analyzed means, beyond its being above or below the relevant benchmark.

Chapter Five: Working Capital Management Chapter Five has new sections on improving the revenue cycle manage- ment process and on fraud and abuse. All perspectives and problems have been revised and updated.

Chapter Six: The Time Value of Money Chapter Six now includes perspectives illustrating time value of money concepts in use, as well as a new section that explains the effective rate function. In addition, all the problem sets have been updated.

Chapter Seven: The Investment Decision Chapter Seven now offers an expanded discussion of how organizations measure the discount rate or cost of capital. This discussion also explains the weighted average cost of capital, which includes the cost of debt and the cost of equity. The key components of the capital asset pricing model, which is used to measure cost of equity, are presented as well. In addition, all perspectives have been updated, and problems have been changed and updated.

Chapter Eight: Capital Financing for Health Care Providers Chapter Eight now includes revisions to the explanation of interest rate swaps and a new section on bank qualified private placement loans. All the problems on lease financing and bond valuation have been revised and updated.

Chapter Nine: Using Cost Information to Make Special Decisions In Chapter Nine, the conceptual diagram and the related explanation for understanding breakeven have been substantially revised, and all perspec-

Preface xvii

tives have been replaced with updated versions. Most problems have updated figures, and three problems have been replaced with new ones. Also, a discussion of a new topic, physician practice valuation as it relates to the concept of breakeven, has been added as an appendix. This discus- sion also introduces the concepts of joint ventures and the value of downstream referrals.

Chapter Ten: Budgeting Though the organization of Chapter Ten remains essentially the same, the basic model on which this chapter is based has been almost totally revised. The new model is a hospitalist practice that has only two services, a sim- plification from the previous edition. The discussion of supply chain operations and maximizing savings from evaluation of group purchasing organization discounts has been retained, but the supplies budget has been dropped. All perspectives have been replaced with updated versions. The problems have been revised to reflect the new content, though the general format is the same.

Chapter Eleven: Responsibility Accounting The discussion of cost centers in Chapter Eleven has been modified slightly to recognize both service- and product-producing activities, and all per- spectives and problem sets have been updated.

Chapter Twelve: Provider Cost-Finding Methods The previous Chapter Twelve perspectives have been dropped, and two new ones have been added.

Chapter Thirteen: Provider Payment Systems Chapter Thirteen has been updated to provide a discussion of evolving issues in provider payment. Among these issues are value-based purchas- ing, changes in payment for hospital readmissions and never events, and bundled payments. There is a more robust discussion on the mechanisms that Medicare uses to pay for hospital inpatient, hospital outpatient, and physician services. All perspectives have been replaced with updated ver- sions. There are new key terms.

Glossary The glossary has been completely updated, and includes each term defined in a chapter sidebar and each key term.

Prefacexviii

Web Pages and Additional Materials The website for this book, including the instructor’s manual and Excel spreadsheets, is located at www.josseybass.com/go/zelman4e. Com- ments about this book are invited and may be sent to publichealth @wiley.com.

ACKNOWLEDGMENTS

We attempt throughout this book to challenge and enlighten. Quan-titative as well as qualitative issues are presented in an effort to help the reader better …