Robert M. Valletta

If your financial statements aren't transparent, you may be setting your organization up for scrutiny.

At a Glance 

  • To be transparent, financial information needs to be easily accessible, timely, content-rich, and narrative. 
  • Not-for-profit hospitals and health systems should report detailed financial information quarterly. 
  • They need internal controls to reduce the level of complexity throughout the organization by creating standardized processes. 

Financial executives at many not-for-profit hospitals and health systems are feeling like a bull's eye at target practice these days. Increased scrutiny of financial reports and requests for information are coming from all angles-the IRS, creditors, bondholders, regulatory bodies, legislators, class action attorneys, community and patient-advocate groups, even consumers.

Each entity has its reasons for poring through hospital financial statements, and not-for-profit hospitals have good reason to open their books, whether it is to access capital or to defend and promote the organization's public image, reputation, and competitive advantage in the market.

In a post-Sarbanes-Oxley world, not-for-profit institutions are being held to the same high standards of corporate governance, risk management, and financial reporting as their public counterparts. Although the Sarbanes-Oxley Act of 2002 does not expressly apply to not-for-profit hospitals, strong arguments exist to support efforts by state charity regulators, the IRS, and the American Institute of Certified Public Accountants Accounting Standards Executive Committee to increase disclosure requirements for not-for-profit entities.

Foremost among these arguments is that it's important to provide potential donors, as well as bondholders, with reliable, timely financial information concerning the organization, because many hospitals are making capital access initiatives an annual event. Such information is also useful to stakeholders as an early warning sign of hospitals in financial distress.

The most recent interest in financial reporting by not-for-profit hospitals stems from growing speculation over not-for-profit hospitals' tax-exempt status, potential tax abuses, and whether these hospitals should continue to be granted tax exemption. Hospital financial executives are being asked to supply volumes of detailed information such as the breakdown of charity care and debt, income streams related to joint ventures, cost-sharing arrangements, the allocation of expenses, and the standards by which financial information is collected, monitored, and reported.

The bottom line is that there is a tremendous burden on healthcare financial managers not only to produce more information but also to ensure the accuracy of financial statements and disclosures. Although the risk of errors and misstatements in financial reporting at a not-for-profit health system is not close to what a public company faces, the stakes are higher than ever. Not-for-profit hospitals would be well served to emulate their public counterparts by going beyond responding to requests for information and incremental increases in disclosure requirements that address individual issues separately and instead strive for transparency.

The current focus of Congress will likely lead to reforms affecting financial reporting by charitable organizations that in many ways emulate Sarbanes-Oxley provisions. In addition, more states will emulate provisions in legislation targeting not-for-profit organizations, such as legislation passed in Massachusetts and California. Major market reforms have traditionally been initiated by regulators and legislators and resisted by the industry, and compromise is discovered somewhere in the middle. For this reason, hospitals and health systems need to take the initiative and seek transparency if they desire a better outcome.

What Is Transparency?

Financial disclosure, while necessary for stakeholders to obtain the information they need, does not, in itself, constitute transparency. The current reporting model focuses narrowly on financial reporting and fails to provide a clear picture of a hospital's or health system's results and associated risks.

Transparency means improved disclosure beyond generally accepted accounting principles, Governmental Accounting Standards Board, or statutory reporting requirements, where and when needed, to provide users with the information they need to make informed decisions about an organization. It entails not only financial information but also nonfinancial information accompanying, by either law or custom, the audited financial statements.

Improving transparency means articulating the "whole story" of an organization as seen through the eyes of management, including nonfinancial indicators of current and future performance, risks, and other factors necessary to better understand the business. Some of this information is already conveyed in corporate and community reports, but the reporting model can and should evolve to include important information about growth strategy, people issues, brand and market share, and supply chain issues, supported by quantitative nonfinancial performance measures and operating metrics. In addition, transparency includes improving access to, timeliness of, and relevance of information that is useful to stakeholders.

Telling the Whole Story

Health care has operating characteristics that differentiate it from other market segments. While publicly traded companies may be watching earnings reports, healthcare providers are focused on admissions, patient days, payment, and contractual allowances. Key challenges for healthcare providers to communicate include:

  • The cost of caring for the uninsured
  • Declining payment from government and insurance payers
  • Increased compliance costs, such as those associated with the Health Insurance Portability and Accountability Act of 1996 and Medicare fraud
  • Strategies for access to capital and other sources of financing
  • The cost of recruiting and retaining qualified staff
  • Malpractice insurance and litigation defense
  • Portfolio strategies to maintain investment returns in an economic downturn
  • Demographics and health status
  • Significant facilities and capital investment needs, notably IT in support of quality initiatives, electronic health records, and pay-for-performance models
  • Employer pressures to contain costs and improve quality
  • The continued rise in consumerism

To be considered transparent, a hospital's or health system's information should be:

  • Easily accessible. Today, that means making information available in a variety of formats, such as quarterly financial news releases, annual reports to the community, and on the Internet.
  • Timely. In an era of immediacy, annual reports are no longer sufficient. They often present yesterday's news. Transparency entails making fresh information available more often and updating information as circumstances warrant.
  • Content-rich. Information is needed that helps explain the key drivers of a hospital's operations and evaluate its ability to meet its goals, repay its debts, and manage risk.
  • Narrative. A narrative discussion from management, as in a management discussion and analysis, is vital for explaining management's interpretation of financial performance, key drivers, actions taken, and risks associated with the organization's performance.

Historically, organizations have resisted using web sites to report detailed financial information, in part due to legal concerns. But the use of web sites has been embraced by rating agencies, the Securities and Exchange Commission, and other regulatory bodies as a way of promoting transparency, liquidity, and efficiency. The advantage of using web sites is that information can be disseminated simultaneously and can be easily updated.

Many hospitals and health systems, including Ascension Health, Catholic Healthcare Partners, New York Presbyterian, Christus Health, and the Mayo Foundation, are posting their audited financial statements online. An increasing number also are posting quarterly financial statements, including balance sheet, income statement, cash flow statement, days cash on hand, and debt service coverage ratios; operating information and utilization, such as patient volume, bed counts, payer mix, FTEs, and outpatient revenue; and overall results and data for individual operating units (at least those that contribute more than 15 percent of health system revenue).

In addition, the management discussion and analysis explains why the organization's financial results turned out as they did, as well as any significant variances or events. For example, hospitals owned by city or county governments may be subject to special accounting treatment that leaves some of their costs unreported on their balance sheet or results in apparently higher expenses. In addition, hospitals vary widely in how they account for charity care and the funds they receive to help pay for such care. These variances should be explained in a management discussion and analysis.

Significant events that would need explanation include potential acquisitions or divestitures, new off balance sheet ventures, nonroutine capital projects, changes in managed care contracts, investigations or lawsuits, the entrance of new competitors, medical staff changes or other significant FTE changes, collective bargaining agreements, and covenant compliance matters.

The Challenges of Transparency

A number of hurdles exist for hospitals in the quest for transparency. First and foremost are the complexity of the modern health system, its voluminous processes and transactions, the traditional disaggregation of operations, and the inefficient and sometimes haphazard way that technology is used to link operations.

Transparency is easy when things are going well. But problems can create a host of additional problems. The name of the game is "no surprises." In the not-for-profit healthcare environment, misstatements are more likely to be accidental than deliberate. Nevertheless, potential misstatements invariably are connected to problems in the control environment or in communications within the organization, or both.

Hospitals should not wait for a year-end audit to discover surprises. Public companies have accounting systems that permit them to report detailed financial information quarterly. Not-for-profits should be able to report similar information. Some would argue that the cost of these systems will divert resources from clinical needs. That's true. But this argument assumes accounting systems in the not-for-profit context are a waste of money. That's not true. Not-for-profits may not generate dividends for shareholders, but they do produce tangible benefits for their stakeholders. They are being held no less accountable in terms of the return generated on the public's investment.

Attesting to the Accuracy of Financial Reporting

A prominent provision of Sarbanes-Oxley is that CEOs and CFOs of public companies make personal, knowledge-based certifications with respect to a number of factors related to the material accuracy of corporate financial statements. The perceived corporate-responsibility benefits of such certification transcend corporate status (i.e., for-profit versus not-for-profit).

Not-for-profit corporations should anticipate similar regulation with respect to their financial matters. Hospital and health system CEOs and CFOs at the corporate level are required to certify financial statements and/or are required to sign an annual Form 990 declaring under penalties of perjury that the signing officer, to the best of his or her knowledge, believes the information is true, correct, and complete. Individual hospitals at subsidiaries need to provide information that will enable CEOs to certify the statement's accuracy.

Accordingly, financial managers of not-for-profit organizations should establish an internal process that would facilitate the ability of officers to certify in writing the material accuracy of corporate financial matters. Some not-for-profit boards are actively pursuing an internal certification process for their own compliance purposes. Not-for-profit hospitals also should consider quarterly reviews, similar to public companies.

The Importance of Internal Controls and Documentation

A key to accurate reporting with no surprises is having sufficient controls throughout the organization. The goal is not just to ensure accurate accounting and financial reporting, but also to reduce the level of complexity within the finance department and throughout the organization by creating standardized processes.

Internal controls are essential to the success of the business operations of healthcare organizations. They assist board members and management in carrying out their fiduciary duties and operating responsibilities and help to facilitate the preparation of timely and accurate financial reports, ensure that the organization complies with all applicable federal and state laws and regulations, and foster effective and efficient operations.

Internal controls are receiving greater attention in light of the focus at the state and federal level on hospitals' tax-exempt status. Under existing laws in many states, attorneys general and other state officials are responsible for monitoring the activities of charitable organizations with regard to the solicitation of funds from the public as well as the community benefit of these organizations.

Notwithstanding activities at the state and federal level, closer scrutiny of internal controls is appropriate as hospitals strive for transparency in financial reporting. Hospitals and health systems of all types and sizes should be prepared to provide greater assurance to regulators, lenders, donors, and other stakeholders about the effectiveness of internal controls.

The problem is that internal controls mean different things to different people, which leads to confusion and miscommunication. Hospitals and health systems should consider formally establishing internal disclosure controls and procedures. This process, effected by the organization's board of directors, management, and other personnel, should be designed to provide reasonable assurance regarding the effectiveness and efficiency of operations, the reliability of financial reporting, and compliance with applicable laws and regulations.

Defining individual accountability for key control activities, especially in large, decentralized institutions, is crucial. The stronger the internal controls, the less likelihood for misstatements or letting something slip through the cracks. Ultimately, the board's audit committee is responsible for the oversight of the overall substance and effectiveness of the auditing and reporting functions, including the internal control environment. The audit committee should ensure that management can articulate the controls on which they rely. Relevant questions for the audit committee about internal controls include:

  • Is management confident that the existing controls result in accurate financial information?
  • Are the controls sufficient to safeguard the organization's assets and transactions?
  • Are compliance and risk management controls in place and effective?
  • What is the role of the internal audit function in ensuring an adequate internal control environment? What is the external auditor's role?
  • Is the organization's financial reporting transparent?

Financial managers should prepare an assessment of internal financial controls for inclusion in the corporation's annual report. The assessment would acknowledge management's responsibility for establishing and maintaining an adequate internal control structure and procedure for financial reporting and contain an assessment of the effectiveness of the internal control structure and of corporate procedures for financial reporting.

Challenges of Reporting Charity Care

Recent attention by the courts, states, and Congress have put charity care on the front burner of financial reporting topics. At issue is whether the tax benefits given to hospitals should be curtailed, as well as potential tax abuses by tax-exempt organizations. Inconsistencies in the way charity care is delivered, reported, and paid for, however, have made it a confusing and difficult topic. These details have never been more important than they are now.

Behind the court cases, congressional hearings, and newspaper stories on this issue is a complicated financial reporting issue that cannot be explained in simple sound bites. The problem is that no one knows for sure the exact value of charity care provided by U.S. hospitals, and without this important information, hospitals individually and collectively face a public relations and financial reporting nightmare.

In the early 1990s, the AICPA mandated that hospitals separate bad debt from charity care in their financial reports. The onus is on hospitals to capture this information and report it on financial statements, Medicare cost reports, Form 990s submitted to the IRS, and in many cases to the state.

There is a clear distinction drawn in principle between charity care, which is rendered to patients with no expectation that they will pay, and bad debt, which is care rendered with an expectation of payment but for which no payment was received. Analysis of hospital financial reports indicates, however, that this distinction is blurred in practice. Some hospitals report virtually no bad debt; others virtually no charity care. As a result, analysts have routinely combined these two amounts to create an estimate of "uncompensated care," for which hospitals receive no direct payment from patients or third-party insurers.

No uniform regulatory guidance exists regarding a patient's qualification for charity care or the quantification of community benefits. Although accounting rules for displaying charity care in financial statements are clear, the industry is dealing with a patchwork quilt of regulations, suggestions, and guidelines on setting hospital policy and other related issues. The use of multiple methods across the hospital industry makes it difficult to calculate the true cost of charity care, benchmark hospitals, or track aggregate trends. Ultimately, the numbers reported are approximations because charges can vary widely by hospital and are typically much higher than actual costs.

Earlier this year, PricewaterhouseCoopers published the results of a survey of more than 100 hospital financial executives on charity care issues. PricewaterhouseCoopers' 2005 Charity Care Survey showed that 92 percent of hospital financial executives believe that some of their bad debt could be classified as charity care. These data illustrate that charity care numbers reported by hospitals may be underestimated because of the difficulty in qualifying patients and the complications surrounding sliding scale discounts.

Hospitals provide an average of 5 percent of net operating income in charity care, though some provided a substantially higher amount. The survey also showed that 76 percent of hospitals calculate their charity care in terms of charges, not costs, and an additional 9 percent use a combination of charges and costs, suggesting that the majority of charity care numbers are based on charges. Some providers include discounts from certain governmental programs, such as Medicaid, as part of charity care. Others do not, but may disclose such discounts separately in their charity care disclosure.

Health Care Organizations-AICPA Audit and Accounting Guide provides accounting and financial reporting standards for charity care and bad debt. The Audit Guide Revision Tax Force has discussed with the AICPA Accounting Standards Executive Committee modifications to its guidance and agreed to:

  • Clarify that charity care does not include services provided when payments are accepted under contracts with third-party payers (such as Medicare or Medicaid) if accepted payments are less than full amounts billed under the providers' rate.
  • Strengthen the reference to timing of identification of charity care, specifically that no substantial collection may be initiated before it has been determined whether the individual meets the criteria for charity care. This modification would better delineate charity care from bad debt because it would clarify that the decision to treat an individual as charity care should not be based on whether the individual responds to increased collection efforts.
  • Remove reference to measuring the level of charity care in terms of the provider's rates, units of service, or "other statistical measures," which would mean that the disclosed measure could be only in terms of the provider's costs. If other measures of the level of charity care are disclosed as well, such as the provider's rates, details should be included as to the source of those measures and how they are determined.

Charity care policies are a mission, accounting, tax, operational, financial, and public relations issue for hospitals. Every not-for-profit hospital needs to have in place policy guidelines that clearly articulate for the community how the uninsured will be treated and billed for services. Those policies need to be transparent. They need to be readily available, and they should be based not on hospital charges, but on something that can be understood. To address the issue transparently, hospital managers should develop a comprehensive uncompensated care strategy that includes:

  • Aligning patient charges to the uninsured with the same rates paid by Medicare and managed care
  • Simplifying qualification procedures for financial assistance and charity care and minimize requirements for patients
  • Clearly communicating financial assistance policies to patients so they understand the program, how to access it, and whom to contact with questions
  • Clearly distinguishing charity care from other community benefits
  • Enhancing transparency by developing and publicly disclosing online and through an annual community benefit report
  • Ensuring complete and accurate submission of IRS Form 990

Being Good Financial Stewards

Transparency in financial reporting reflects the responsibility of healthcare organizations to be good financial stewards of the community assets and to openly report financial performance to the community, as is being done with clinical quality results. It is in the industry's best interest to build trust by moving toward greater transparency. The challenge for hospitals and health systems will be to go beyond calls for the disclosure of more and more information, which may not be useful or even relevant to patients, and instead to provide information in a way that paints a full and comprehensive picture of what the hospital seeks to achieve for patients and the community and the progress being made toward those goals.

"No legacy is so rich as honesty."
-William Shakespeare, All's Well that Ends Well

Publication Date: Monday, August 01, 2005

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