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Dec 1990

Evaluation of hospitals as entities able to continue as going concerns.

by Donoghue, Richard J.

    Abstract- Auditors should consider several issues when determining whether hospitals are able to continue as going concerns. Auditors should not rely on data from hospital associations that indicate that hospitals will be able to survive under poor financial conditions. Some 28 hospitals in New York, for example, did not file bankruptcy, but they operated with negative fund balances between 1979 and 1988. The factors that auditors should consider when evaluating hospitals include third-party reimbursements, labor settlements with unions, and salary levels.

New York Hospitals Represent Hospitals Everywhere

Hospitals in the State of New York are operating in what many consider to be the most regulated environment in the country. This article uses the conditions and environment surrounding hospitals in the State of New York to alert auditors of hospitals everywhere of going concern matters that must be considered.

One of the consequences of the environment in New York is the poor operating performance and financial condition of its hospitals. A comparison to hospitals in other states is shown in Table 1. New York's high level of regulatory control, however, has enabled these entities to continue operating in spite of financial conditions that would not be possible in other industries. An industry on the financial "edge" creates a significant dilemma for the independent auditor in applying SAS 59, "The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern. "

The Hospital Association of New York State (HANYS) periodically develops financial ratio analysis and other information from its database, which includes annual financial surveys of member hospitals. In many other states there is similar statistical information available. Some of the data provided by HANYS supports the belief held by many that hospitals in New York are so resilient that continuation in the worst financial conditions is possible., From 1979 through 1988, 28 hospitals were identified that continued to exist and had not filed for bankruptcy, despite operating with negative fund balances. Further, six of these facilities had negative fund balances for all 10 years; and three of these had liabilities exceeding assets by more than $20 million at some point during that period.

Don't Fall Asleep at the Switch

However, the auditor must not be lulled into a false sense of security by these seemingly immortal entities. Caution is clearly necessary as seen by the New York State hospital closures between 1980 and 1989, depicted in Table 2 omitted.

SAS 59 provides a significant number of examples of conditions and events that may, "when considered in the aggregate, indicate there could be substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time." The examples provided include negative trends, internal matters, external matters that have already occurred, and other indications of possible financial difficulties.

When evaluating the existence of negative trends, they must be viewed in light of other factors, in particular the industry averages rather than other business norms. SAS 59 provides four examples of negative trends, three of which apply to a substantial number of hospitals in New York and elsewhere: recurring operating losses, working capital deficiencies, and adverse key financial ratios. The fourth example, negative cash flows from operating activities, would generally apply to hospitals in New York if the state regulations requiring annual funding of depreciation on hospital assets were strictly enforced. The funding of depreciation could very well mean the difference between continuation as a going concern or not for a significant number of hospitals. This is an example in which hospitals are very much exposed to changes in or degree of enforcement of existing regulations.

External Matters

External factors, principally third party reimbursements and state regulators, have had a significant effect on the financial operations of hospitals over the last 10 years. Profitability and liquidity statistics for New York hospitals show that during 1983, and again in 1986, significant changes in the inpatient reimbursement system had a favorable impact on hospital operating and bottom line margins. The first phase of the New York Prospective Hospital Reimbursement Methodology (NYPHRM), which commenced in 1983, created one pool of funds to be disbursed to hospitals to defray the cost of bad debts and charity care and a separate pool for "financially distressed hospitals."

In 1986, the second phase of NYPHRM commenced, which was essentially the removal of the Federal Medicare program from the New York system. This provided hospitals with a substantial infusion of additional revenue through the Medicare Prospective Payment System (PPS).

The third phase of NYPHRM in 1988 brought contrasting and strikingly negative results. The Case Payment System (CPS), provided for payment to hospitals based upon a price for each discharge, similar to Medicare PPS. Both systems utilize diagnostic related groups (DRGs) to classify discharges. A service intensity weight is computed for each DRG based upon its average cost developed utilizing the New York or Medicare database. This service intensity weight is then multiplied by a base price to determine the payor's responsibility in each case.

It is important for the auditor to consider this information when looking to future external influences and a hospital's ability to absorb the impact. The problems of revenue shortfalls at the state and federal level are not going away.

The direct regulatory control over hospitals is not the only external factor that must be evaluated by the auditor. Health insurers, who provide a substantial portion of hospitals' payments, continually look for methods to reduce the amounts they pay. The dramatic movement of many surgical procedures from the inpatient setting to ambulatory surgery units is one such example.

Initiatives on the part of payors are leaving many hospitals with substantially lower revenues. In evaluating a hospital whose revenue base has been impaired, the auditor must look to the hospital's ability to respond. The following should be considered:

* Will the lost volume be replaced by additional requirements of existing medical staff?

* Are there bottlenecks that will preclude replacing the lost volume (i.e. ambulatory surgery using available operating rooms resulting in fewer inpatient procedures)?

* Were the cases removed from the inpatient base the profitable ones; leaving an intensive, costly, inpatient population?

* Can effective cost reductions be achieved? What were the ultimate results of previous measures?

Other Criteria

Compounding the outlook of further constraints on revenue, the auditor must not lose sight of the upward pressure on expenses. Labor settlements with health care unions can have a major impact. For example, a substantial portion of New York health care providers has been greatly affected by the labor settlement with Local 1199. This settlement has had a ripple effect throughout the entire downstate area. In addition, the contract provisions calling for the resumption of pension contributions and bonuses at the end of the contract period should be considered for audits conducted within a 12-month period before contract expiration.

The continued pressure to increase wages for market scarce positions has to be considered. The current shortage of registered nurses, therapists and technicians, is expected to continue in the foreseeable future. If a hospital under evaluation significantly lags behind the market, the implications of this positioning on cost or ability to attract adequate staff to maintain volume should be addressed.

One of the significant differences in evaluating the ability of a hospital to continue as a going concern, as opposed to other businesses, is the consideration of market share. There are many hospitals that have a virtual monopoly on their segment of the market but may still be in serious danger of continuing as a going concern. On the other hand, there are places in which significant competition for patients exists between facilities.

There are many communities with a patient population that cannot support a hospital. In some cases it is a rural community without the needed population base, and in other cases it is an inner city community without the needed financial resources. In these instances, the auditor should evaluate the governmental commitment to the facility. There are instances of local communities that have voted to underwrite the losses of their local voluntary hospitals through additional tax assessments. However, there are other rural communities that will live with greater distances to travel for care.

As mentioned earlier, incorporated within the New York State reimbursement system is a pool of funds available to "financially distressed facilities." These funds have allowed the continued operations of several facilities. However there is concern that the number of facilities eligible for distributions from this pool may be growing to the point that funds available are inadequate. In 1983 nine hospitals were approved for distributions, 13 in 1989.

Criteria Shared with Other Businesses

The auditors' going concern evaluations will include components that exist for any other business. Consideration should be given to compliance with debt covenants, the willingness of key suppliers to ship goods, existence of uninsured or underinsured losses (i.e., malpractice), delinquencies in remitting payroll taxes, and other indicators.

There are many who have likened the financial condition of hospitals to the savings and loan crisis that has rocked our country. In some ways that may be true--there are billions in federally backed bonds that are supported by mortgages on hospitals. However, in other ways the comparison is unfair. In the savings and loan crisis there appears to be significant fraud and mismanagement that is not evident in the hospitals.

It is clear, however, that the auditors of savings and loans have received significant criticism, even in instances where auditors' opinions noted reservations about the entity's ability to continue as a going concern. in many cases the auditors and others are blaming the regulators for the failures. Those serving the public and clients in the hospital industry should learn from the savings and loan situation and carefully discuss concerns with hospitals' boards, management, and in some cases, regulators. Based upon those discussions and evaluations, the auditor should consider the adequacy of disclosure in the financial statements, as well as the need for an explanatory paragraph in the auditor's report.

By Richard J. Donoghue, CPA, Executive Director of Finance, New York University Medical Center.

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