Chapter3

2
This chapter begins our
discussion of financial
accounting. In addition
to providing the
fundamentals of financial
accounting, it covers two
important financial
statements: the income
statement and the
statement of changes in
equity.
Introduction to Financial Accounting

• Financial accounting involves identifying, recording, and

communicating the economic events (operational results)
and status of an organization.

• Financial accounting information is conveyed by a

business’s financial statements:

Statement
Statement
Income of Balance
of cash
statement changes sheet
flows
in equity
Introduction to Financial Acct. (Cont.)

• The requirement to provide financial accounting

information is driven by the need of outsiders to have
reliable information regarding the financial status of an
organization.

• However, the information presented in financial

statements is as important to managers as it is to
investors.
 DoShould
not-for-profit
the preparation
organizations
and presentation
have to prepare
of
Who are the outsiders?
financial financial
accountingstatements?
data be regulated?

• Yes
In a not-for profit organization: the stakeholders include
managers, staff physicians, employees, suppliers,
creditors, patients, and even the community at large
• In investor-owned organization: have the same set of
stakeholders plus owners
Regulation and Standards

• The regulation is based on the theory that financial information

constructed and presented according to the standardized rules allows
investors to make the best-informed decision.

• The Securities and Exchange Commission (SEC) has the legal authority
to regulate the form and content of financial statements.

• However, 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)
GAAP

• The conventions that have evolved from the

pronouncements and rulings of the implementing
organizations constitute a set of guidelines for the
preparation of financial accounting statements called
generally accepted accounting principles (GAAP).

• The GAAP applies only to financial accounting

statements (as opposed to statements constructed for
internal use)
 Cash accounting Accrual accounting

• Cash accounting • Accrual accounting

recognizes an event when recognizes an event when
a cash transaction takes a cash obligation is
place. created.
• Simple and easy • More complicated
• Mimics tax statements • Provides a better picture of
the true economic status of
a business
• Is required by GAAP
Recording and Compiling Data

• A transaction is an exchange of goods (including cash) or

services from one individual or business to another.

• Once a transaction is identified, it must be recorded, or

posted, to an account, which identifies a unique activity
within the business.

• Businesses use a chart of accounts to assign numeric

identifiers to individual accounts.
Recording and Compiling Data (cont.)

• Each transaction is posted by a journal entry.

• Because journal entries are always posted twice, the

system is called a double entry system.

• To handle the double entries, accounts are set up in a T

format, and hence they are known as T accounts.
Recording and Compiling Data (Cont.)
• Ultimately, the journal data are used to create financial
statements:
• Income statement
• Statement of changes in equity
• Balance sheet
• Statement of cash flows

• The primary means for disseminating financial statements is

the annual report.
• It begins with a verbal discussion of current operating results and
expectations for the future.
• Followed by the financial statements, which include footnotes.
Income Statement Basics

• Perhaps the most important question about a business’s

financial status is whether or not it is making money.
• The income statement provides information about a
business’s operations and economic profitability.

• The income statement is often called by other names:

Statement Statement Statement

of revenues
of of and
operations activities expenses
Income Statement Basics (Cont.)
• The income statement reports the results of operations
over some period of time, say, a year. It has three key
elements:
• Revenues, which under accrual accounting represent both
cash received and payer obligations.

• Expenses, which are the resource expenditures required to

produce the revenues. Again, note that under accrual
accounting both cash and noncash expenses are
recognized.

• Profit measure = Revenues - Expenses.

Sunnyvale Clinic: Revenues (in thousands)

2011 2010

Revenues:
Net patient service revenue $150,118 $123,565
Premium revenue 18,782 16,455
Other revenue 3,079 2,704
Total revenues $171,979 $142,724
Revenues
• Revenues are shown in several different formats
depending on the type of provider. Sunnyvale has three
revenue categories.
• Net patient service revenue reflects the amount of
revenues expected to be collected from the provision of
patient services (as opposed to gross revenue, which is
based on charge master prices).
• Premium revenue represents revenue from capitated
patients.
• Other revenue is revenue from activities directly related to
patient services, such as parking fees and cafeteria
revenues.
Revenues (Cont.)

• In reporting net patient service revenues, note how the

following categories are handled:
• Discounts and allowances from gross prices are not
reported as revenue.
• Charity care is not reported as revenue.
• Under current GAAP, bad debt losses are not reported as
revenue, but are reported in the expense section.
• In the future, expected bad debt losses will be reported
as a deduction in the revenue section.
Revenues (Cont.)

• Note that the revenue reported does not represent the

amount of cash collected:
• Some portion has not yet been collected. The uncollected
portion will appear on the balance sheet in an account
titled receivables (net patient account receivables).
• In addition, some revenues reported in the previous year
were collected this year.
Sunnyvale Clinic: Expenses (in thousands)

2011 2010

Expenses:
Salaries and benefits $126,223 $102,334
Supplies 20,568 18,673
Insurance 4,518 3,710
Lease 3,189 2,603
Depreciation 6,405 5,798
Provision for bad debts 2,000 1,800
Interest 5,329 3,476
Total expenses $168,232 $138,394
Expenses
• Expenses represent the resources used to create
revenues--they are the costs of doing business. Like
revenues, under accrual accounting expenses do not
necessarily reflect cash outlays.
• Expenses may be categorizes by:
• Natural classification, such as salaries, supplies, insurance,
and so on.
• Functional classification, such as inpatient services,
outpatient services, and so on.

Which
Whichclassification
system doessystem is better?
Sunnyvale use?
Expenses (Cont.)

• Supplies
Salaries and
expense
benefits
represents
expensetherepresents
cost of expendable
labor costs.
(primarily
• Typically,medical) materials
this is the used in category
largest expense providingforpatient
health
services.
services organizations.
•• The dollaronly
Although amount showninformation
summary represents is
the amount
given on the
consumed , not the details
income statement, amountarepurchased.
available internally from the
• managerial accounting
Supply stocks system.
are reported on the balance sheet.
Expenses (Cont.)
• Insurance expense represents the cost of commercial
insurance purchased to protect the clinic against several
risks, including:
• Property risks

Fire Weather
• Liability risks
• Managerial malfeasance
• Medical liability
Expenses (Cont.)
• Sunnyvale owns most of its land and buildings, but it
leases (rent) much of its diagnostic equipment. Lease
expense reports the cost of its leases.
• On the balance sheet, some leased assets are reported
directly (on the face) while others appear only in the
footnotes.
• Regardless of balance sheet treatment, all lease expense is
reported on the income statement.

Why do organizations use leases?

Expenses (Cont.)
• Depreciation expense arises because of the matching
principle--expenses must be matched to the revenues
with which they are associated.
• While operating costs such as labor and supplies are
assumed to produce immediate revenues and hence are
more-or-less immediately reported (expensed) on the
income statement, the costs of long-lived assets
(buildings and equipment) are not reported on the
income statement at the time the acquisition is made.
Expenses (Cont.)
• Rather, the “cost” of a long-lived asset is first capitalized
(recorded on the balance sheet as an asset of the
business). Then, this amount is amortized (or spread)
over the accounting life of the asset, which means the
cost is shown (expensed) on the income statement as
small increments over time.
• The amortization expense of buildings and equipment
when listed on the income statement is called
depreciation.
• For financial accounting purposes, depreciation is
calculated by the straight-line method.
Expenses (Cont.)
• Most expense items listed on the income statement only
approximate actual cash expenditures. The relationship
is not exact because of accrual accounting.
• However, depreciation (and amortization) are expenses
that typically have no associated cash expenditure
during the accounting period.
• Such an expense is referred to as a noncash expense.
Expenses (Cont.)
• Provision for bad debts reports the amount of net patient
service revenue that is not expected to be collected.
• It is an estimate based on past experience.
• Past estimates are reconciled when the data are known.
• Interest expense reports the amount of interest paid (or
obligated) on debt financing.
Sunnyvale Clinic: Operating Income
(in thousands)

2011 2010

Revenues:
Total revenues $171,979 $142,724

Expenses:
Total expenses $168,232 $138,394

Operating income $ 3,747 $ 4,330

Operating Income
• Although the reporting of revenue and expenses is
important, profitability is the most important element of
the income statement.
• Operating income measures economic profitability as
defined by GAAP with a focus on patient service
activities.
• It is an important measure of profitability because it
represents the organization’s core business.
Sunnyvale Clinic: Nonoperating Income
(in thousands)

2011 2010

Non-operating income:
Contributions $ 243 $ 198
Investment income 3,870 3,678
Total non-op. income $ 4,113 $ 3,876
Nonoperating Income
• Non-operating income reports income (revenues) from
activities not related to the provision of patient services.
• Contributions report donations to Sunnyvale Clinic that
can be immediately spent. (Contributions that create
endowments are not reported on the income statement.)
• Investment income lists income from
1. Excess cash held as reserves or to meet known future
needs and
2. Endowments.
Suannyvale Clinic: Net Income (in thousands)

2011 2010

Operating income $ 3,747 $ 4,330

Total nonop. income $ 4,113 $ 3,876

Net income $ 7,860 $ 8,206

Net Income
• The second measure of profitability, which is often
referred to as the “bottom line,” is net income.
• Net income measures the overall (total) economic
profitability as defined by GAAP.
• In not-for-profit businesses, net income typically is
called:

Excess of
Revenues
revenues
Change in
over over net assets
expenses
expenses
Net Income (Cont.)
• The income statements of some not-for-profit
corporations contain a section below the net income line
that reconciles net income with the balance sheet net
assets (equity) account. (Sunnyvale uses a separate
statement, discussed shortly.)
• Note that economic profitability is a complex concept
that is very difficult to measure, because economic gains
and losses often are not matched by easily identifiable
and measurable events.
What does this complexity mean for users of
financial statement information?
Net Income (Cont.)
• In a not-for-profit corporation, the entire amount of net
income 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 net income may be returned to owners as
dividends (or bonuses).
• The remainder is reinvested in the business.
Net Income Vs. 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
= $7,860,000 + $6,405,000 = $14,265,000.
Income Statements of Investor-Owned
Businesses
• The income statements of investor-owned and not-for-
profit businesses are very similar.
• The revenues and costs to organizations in the same line
of business are similar, regardless of ownership.
• However, some transactions, such as income tax
payments, clearly are applicable only to for-profit
businesses.
• Line of business differences have a greater impact on
financial statements than do ownership differences.
Impact of Depreciation Expense on Cash
Flow NFP (T = 0%) FP (T = 20%) FP (T = 40%) FP (T = 40% but No Dep)

Total revenues $174,092 $174,092 $174,092 $174,092

Expenses:
All except depreciation $159,827 $159,827 $159,827 $159,827
Depreciation 6,405 6,405 6,405 0
Total expenses $166,232 $166,232 $166,232 $ 159,827
Taxable income $ 7,860 $ 7,860 $ 7,860 $ 14,265
Taxes 0 1,572 3,144 5,706
Net income $ 7,860 $ 6,288 $ 4,716 $ 8,559

Cash flow $ 14,265 $ 12,693 $ 11,121 $ 8,559

Notes: (1) Cash flow = Net income + Depreciation

(2) The amount of taxes saved by depreciation is called the depreciation shield.
Sunnyvale Clinic: Statement of Changes
in Equity (in thousands)

2011 2010

Net income $ 7,860 $ 8,206

Equity, beginning of year $ 46,208 $ 38,002

Equity, end of year $ 54,068 $ 46,208

Note: The beginning-of-year equity values are taken from the balance sheet (to be
discussed next class).
Statement of Changes in Equity
• The statement of changes in equity reconciles the
income statement net income item with the balance
sheet equity account.
• For a not-for-profit organization, the entire amount of net
income flows to the balance sheet.
• In a for-profit business, there are typically deductions to
net income (often dividends) that reduce the amount that
flows to the balance sheet.
An Introduction to Financial Condition
Analysis
• In financial condition analysis, values from the financial
statements are combined to form ratios that have easily
interpretable economic meaning.
• For example, total (profit) margin:
Net income
Total margin =
Total revenue
$7,860
= = 0.045 = 4.5%.
$176,092

How is this ratio interpreted?

• This concludes our discussion of Chapter 3 (The Income
Statement and Statement of Changes in Equity).
• Although not all concepts were discussed in class, you
are responsible for all of the material in the text.
• Do you have any questions?