By Thomas A. Ratcliffe

Getting Up to Date

The new accounting and audit guide, Health Care Organizations, was issued to respond to the many changes in the health-care industry as well as recent pronouncements of the FASB affecting not-for-profit organizations. It is applicable to investor owned, governmental, and not-for-profit organizations whose principal operations consist of providing or agreeing to provide health-care services that earn substantially all of their revenues from the sale of goods and services or organizations whose primary activities are planning, organizing, and overseeing such organizations.

Some of the unique aspects of the guide include--

* the requirement for not-for-profit health care organizations to include a "performance indicator" in the statement of operations.

* a restriction on how such organizations provide information about liquidity.

* the use of APB Opinion No. 16 as a framework for providing general guidance on accounting for business combinations in the health-care industry.

* the inclusion of health-care organizations under the provisions of SOP 94-3 relating to consolidations.

* the elimination of one of the options of SFAS No. 116 relating to donor-imposed restrictions on long-lived assets.

In June 1996, the American Institute of Certified Public Accountants (AICPA) issued a new audit and accounting guide, Health Care Organizations (the guide), which supersedes the previous audit and accounting guide, Audits of Providers of Health Care Services. The new guide also supersedes AICPA Statement of Position (SOP) 89-5, Financial Accounting and Reporting by Providers of Health Care Services, and SOP 90-8, Financial Accounting and Reporting by Continuing Care Retirement Communities.

Subsequent to the last revision of the previous guide, the health-care industry has undergone several changes that have raised accounting and reporting issues not addressed in existing pronouncements (including the previous guide); these changes have resulted in inconsistent accounting and reporting practices within the industry. Further, the Financial Accounting Standards Board (FASB) has issued several pronouncements that affect not-for-profit organizations, most notably Statement of Financial Accounting Standards (SFAS) No. 116, Accounting for Contributions Received and Contributions Made; SFAS No. 117, Financial Statements of Not-for-Profit Organizations; and SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations.

The new guide is applicable to investor-owned, governmental, and not-for-profit organizations whose principal operations consist of providing or agreeing to provide health-care services and that substantially earn their revenues from the sale of goods and services. Also, the guide is applicable to organizations whose primary activities are planning, organizing, and overseeing such organizations, e.g., parent or holding companies of health-care providers. The following types of organizations are within the scope of the new guide:

* Hospitals

* Nursing homes

* Health maintenance organizations (HMOs) and similar organizations

* Continuing care retirement communities (CCRCs)

* Home health agencies

* Drug and alcohol rehabilitation centers

* Clinics, medical group practices, individual practice associations, individual practitioners, emergency care facilities, laboratories, surgery centers, and other ambulatory care organizations.

The new guide does not result in major changes for investor-owned and governmental health-care entities (except for those that meet the guide's new definition of governmental health-care organizations). The significant changes that will impact not-for-profit health-care organizations are discussed below.

Financial Statement Display

The new guide incorporates and provides guidance on the application of SFAS No. 117 to financial statements of not-for-profit organizations. SFAS No. 117 made significant modifications to financial statements of such organizations by requiring that the statements be prepared for the entity as a whole (the fund basis of accounting no longer is acceptable for external financial reporting). SFAS No. 117 requires that all not-for-profit organizations provide a statement of financial position, a statement of activities (referred to in the guide as a statement of operations), and a statement of cash flows.

The statement requires reporting amounts for the organization's total assets, liabilities, and net assets in a statement of financial position; reporting the change in an organization's net assets in a statement of activities; and reporting the change in its cash and cash equivalents in a statement of cash flows. SFAS No. 117 also requires classification of an organization's net assets and its revenues, expenses, gains, and losses based on the existence or absence of donor-imposed restrictions. It requires the amounts for each of three classes of net assets (unrestricted, temporarily restricted, and permanently restricted) be displayed in the statement of financial position and the amount of change in those net asset classes be displayed in a statement of activities.

Perhaps the most significant changes required by this new guide relate to the statement of operations. For not-for-profit health-care organizations, the statement of operations should include a "performance indicator," and it clearly should be labeled with a descriptive term such as revenue over expenses, revenues, and gains over expenses and losses, earned income, or performance earnings. Notes to the financial statements should include a description of the nature and composition of the performance indicator. (SFAS No. 117 contains no requirement that a performance indicator be included in the statement of activities). Not-for-profit health-care organizations should report the performance indicator in a statement that also presents the total changes in unrestricted assets; other changes in net assets may be presented separately or in the same statement.

Health-care organizations should report the following items separately from the performance indicator:

* Transactions with owners acting in that capacity.

* Equity transfers involving other entities that control the reporting entity, are controlled by the reporting entity, or under common control with the reporting entity.

* Receipt of restricted contributions, including temporary (based on time or purpose) or permanent restrictions.

* Contributions of (and assets released from donor restrictions related to) long-lived assets.

* Unrealized gains and losses on investments not restricted by donors or by law (except for those investments classified as trading securities).

*Investment returns restricted by donors or by law.

* Other items required by generally accepted accounting principles (GAAP) to be reported separately, e.g., extraordinary items, the effect of discontinued operations, or the cumulative effect of accounting changes.

Consistent with the requirements of SFAS No. 117, health-care organizations have the flexibility of presenting an intermediate measure of operations, although the guide does not define what should be included or excluded from that intermediate measure. As an example, within a class or classes of changes in net assets, a health-care organization may classify items as operating and nonoperating, expendable and nonexpendable, earned and unearned, recurring and nonrecurring, or in other ways. Exhibit 1 provides an example of a statement of operations that displays an intermediate measure of operations.

SFAS No. 117 and the guide allow not-for-profit health-care organizations that historically have reported expenses by natural classifications in the statement of operations to continue that practice and report expenses by functional classifications in the notes to the financial statements. Other alternatives also are available, e.g., organizations may use a matrix format that presents information about both functional and natural classifications, or functional expenses may be presented in a separate statement.

SFAS No. 117 allows not-for-profit organizations to provide information about liquidity by--

* sequencing assets according to nearness of conversion to cash and sequencing liabilities according to nearness of maturity,

* classifying assets and liabilities as current and noncurrent, or

* disclosing information about liquidity or maturity of assets and liabilities in notes to the financial statements. The guide requires that health-care organizations (except for CCRCs) classify assets and liabilities as current and noncurrent. CCRCs are allowed to sequence assets according to nearness of conversion to cash and liabilities according to nearness of maturity.

Assets Limited as to Use

Organizations should report assets whose use is internally limited, e.g., funded depreciation, separately from assets where use is externally restricted, e.g., a debt service fund required by bond agreements. Ordinarily, this requirement can be achieved by presenting these amounts separately on the face of the statement of financial position. Exhibit 2 provides an illustration of how assets limited as to use may be disclosed in a statement of financial position.

Investments

Investor-owned and governmental health-care organizations that apply paragraph 7 of Governmental Accounting Standards Board (GASB) Statement No. 20, Accounting and Financial Reporting for Proprietary Funds and Other Governmental Entities that Use Proprietary Fund Accounting, should account for investments in marketable equity securities and all debt securities in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Not-for-profit health-care organizations now are required to follow the accounting prescribed in SFAS No. 124.

Unlike SFAS No. 115, SFAS No. 124 requires all investments within its scope (i.e., equity securities with readily determinable fair values and all debt securities) be measured at fair value with gains and losses reported in the statement of operations. The guide requires that unrealized gains and losses on securities classified as trading securities be reported above the performance indicator; unrealized gains and losses on securities not classified as trading securities should be reported below the performance indicator. Unless specifically restricted by donors or by law, investment income, realized gains and losses, and other-than-temporary impairment losses on all securities should be reported above the performance indicator.

Contributions

SFAS No. 116 made significant changes in accounting for contributions. Unconditional promises to give are recognized by both the donor and the donee at the date of the unconditional promise, conditional promises are recognized once the conditions are satisfied, and contributed services are recognized if the contributed service is of a specialized nature and would have to have been acquired by the not-for-profit entity if the service had not been contributed.

The vast majority of health-care organizations that fall within the scope of the new guide do not receive a significant amount of contributions; as such, the guide provides only limited guidance related to contributions. However, the AICPA audit and accounting guide, Not-for-Profit Organizations, provides extensive information on several issues related to contributions, including the following:

* Unconditional promises to give (pledges)

* Distinguishing contributions from exchange transactions

* Gifts in-kind

* Deferred giving arrangements

* Contributed services

Health-care organizations that receive significant contributions should refer to the not-for profit guide for guidance on applying the provisions of SFAS No. 116.

Business Combinations

Accounting Principles Board (APB) Opinion No. 16, Business Combinations, provides accounting guidance related to business combinations. However, that guidance primarily discusses business combinations from the perspective of for-profit entities; guidance related to not-for-profit entities is limited. The new guide uses APB Opinion No. 16 as the framework for providing general guidance on accounting for business combinations. The use of APB Opinion No. 16 as the basic framework for the industry is supported by SOP 94-2, The Application of the Requirements of Accounting Research Bulletins, Opinions of the Accounting Principles Board, and Statements and Interpretations of the Financial Accounting Standards Board to Not-for-Profit Organizations.

The new guide expands on the guidance in APB Opinion No. 16 by providing that if a business combination involves monetary consideration, a change in legal title to assets, and/or assumption of liabilities, the transaction is similar to a purchase transaction as described in APB Opinion No. 16. Conversely, if the transaction involves a change in control (e.g., a change in sole corporate member) without the exchange of consideration, the transaction is similar to a pooling of interests transaction under APB Opinion No. 16, and no step-up in basis of the related assets results. Because transactions among not-for-profit health-care organizations generally are more complex than an outright purchase or sale of assets or a transfer of sole membership status without consideration, the facts and circumstances of each transaction should be reviewed carefully to provide assurance that the accounting for and reporting of the transaction reflects its substance.

Reporting Entity and Related Organizations

The dynamics of change in the health-care industry and their impact on evolving organizational structures must be considered in defining the reporting entity. Networks among health-care organizations (both vertical and horizontal) continually are being formed, and new organizational structures continually are being developed. For example, a not-for-profit health-care organization parent may be sole corporate member of another entity, control another entity through a charter or contract, or have an economic interest in another entity.

Before the issuance of this new guide, health-care organizations applied the provisions of Accounting Research Bulletin (ARB) No. 51, Consolidated Financial Statements, which generally requires consolidation of affiliated entities through direct or indirect ownership of a majority of voting interests. This requirement generally is met when a parent organization (either for-profit or not-for-profit) owns a majority of the voting stock of a for-profit subsidiary. But questions have existed related to the unique affiliation that exists when a parent has a relationship with not-for-profit affiliates. The guide includes specific guidance on the consolidation of not-for-profit entities, which is based on the provisions of SOP 94-3, Reporting of Related Entities by Not-for-Profit Organizations. Before the issuance of the guide, health-care providers were excluded from the scope of SOP 94-3. The requirements in the new guide probably will result in consolidation of more entities.

Donor-Imposed Restrictions/Long-Lived Assets

The guide requires that contributions of long-lived assets (including the use of long-lived assets such as land, buildings, and equipment) be reported at fair value as support or gains in the period received. If the donor places no restrictions on the use of the asset, the contribution is reported as unrestricted support. Contributions of long-lived assets with explicit donor restrictions are reported as temporarily or permanently restricted support.

SFAS No. 116 allows not-for-profit entities to recognize the expiration of donor-imposed restrictions on long-lived assets either when the asset is placed into service, or over the useful life of the asset. The new guide requires that expirations of donor restrictions be reported when the stipulation is fulfilled and the assets are placed in service. At the time the donor-imposed restriction is satisfied, temporarily restricted net assets are reclassified to unrestricted net assets and reported in the statement of operations as net assets released from restriction. As such, the guide eliminates the second option allowed under SFAS No. 116 by requiring that the expiration of the restriction be recognized when the asset is placed in service.

The GAAP Hierarchy

In several areas, the accounting and reporting provisions of the new guide are more stringent than the conclusions reached by the FASB in SFAS Nos. 116, 117, and 124. In SFAS No. 117, the FASB concluded the AICPA may provide more specific reporting guidance for certain not-for-profit organizations. Statement on Auditing Standards (SAS) No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report, requires that an entity adopt cleared AICPA industry audit and accounting guides and cleared SOPs that become effective after March 15, 1992.

As used in SAS No. 69, "cleared" means the FASB has indicated it does not object to the issuance of the proposed pronouncement. The FASB did not object to the more specific requirements included in the health-care organizations guide. As such, in preparing financial statements in accordance with GAAP, not-for-profit health-care organizations are required to follow the requirements of the guide, even if the requirements are less flexible than the requirements in SFAS Nos. 116, 117, and 124.

Effective Date and Transition

The new guide is effective for financial statements for periods beginning after June 15, 1996. Earlier application is permitted. Many not-for-profit health-care organizations were required to adopt SFAS Nos. 116 and 117 in fiscal years beginning after December 15, 1994. Not-for-profit entities with less than $5 million in total assets and less than $1 million in annual expenses could defer the effective date of SFAS Nos. 116 and 117 to fiscal periods beginning after December 15, 1995. SFAS No. 124 is effective for fiscal periods beginning subsequent to December 15, 1995.

The guide may be adopted retroactively or the effect of initially applying the guide may be reported as a cumulative effect change in accounting principle in accordance with the provisions of APB Opinion No. 20, Accounting Changes. A not-for-profit health-care organization that applies the provisions of the guide retroactively should restate the beginning balances of each of the three categories of net assets for the earliest year presented. The nature of the restatement and its effect on the change in net assets for each period presented should be disclosed. *

Thomas A. Ratcliffe, PhD, CPA, is chairman of the accounting program at Troy State University.