The Financial Accounting Standards Board (FASB) rules for recognizing revenue are changing, and leaders of healthcare organizations should understand how the new requirements may affect their financial modeling and reporting.
Net patient service revenue is one of the most important and highly scrutinized measures used to assess a healthcare entity’s financial performance. However, the accounting standards that healthcare providers must follow when recognizing revenue are changing. Organizations should understand the impact new recognition requirements will have and be prepared to implement them.
Given that nearly all healthcare organizations already struggle to address competing priorities, their financial leaders may find the idea of implementing changes to current processes daunting. Furthermore, the one-year postponement of the effective dates for the new revenue recognition standards—coupled with the subjectivity of the guidance in certain areas—might encourage procrastination. Nevertheless, to achieve the objectives of the new standards, organizations must plan ahead.
The 5 Steps to Revenue Recognition and Net Revenue Modeling Considerations
In May 2014, the FASB released Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), and the International Accounting Standards Board issued International Financial Reporting Standard 15. a These converged standards, which share the same title, represent a shift from industry-specific guidance to a single, global revenue recognition model and require significant judgment to implement and execute. b
Finance executives and managers in health systems, physician practices, hospice facilities, long-term care facilities, and other healthcare-related entities should understand not only what rules are changing but also how the updated standards may affect financial modeling and reporting. The core principle of the new guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects in exchange for those goods and services.
The FASB has outlined five steps entities should follow to comply with the core principle. Each step and the changes associated with it may affect the way healthcare organizations and their finance leaders approach net revenue modeling.
Step 1: Review contracts with customers. One of the first steps healthcare organizations should take to prepare for the new guidance is to review their current contracts with customers in the context of the updated standard. ASU 2014-09 requires that all of the following criteria be met to determine whether a contract exists and revenue is recognized:
- Both parties have approved the contract.
- Each party’s rights to transfer the goods can be identified.
- The payment terms for the goods and services can be identified.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration to which it will be entitled.
According to the updated standard, a contract is an agreement between two or more parties that creates enforceable rights and obligations. Contracts can be written, oral, or implied by an entity’s customary business practices. In addition, the practices and processes for establishing contracts with customers vary across legal jurisdictions, industries, and entities.
There are three primary revenue modeling considerations associated with the step of reviewing contracts.
First, patients without contracts and with similar payment circumstances should be grouped into payer groups that are fully reserved (i.e., the receivable has no value), for which, therefore, no revenue is initially recognized. Each of these “high-risk” groups should consist of patients identified by their unique payer class, with classes including, for example, uninsured patients who have not consented to treatment, patients with pending determination of eligibility for charity care, and patients determined to be eligible for charity care.
Revenue for these groups should be recognized only if all five criteria required to establish a contract are met. Lacking any one of these criteria, 100 percent of the revenue should be deferred until a contract is established. An understanding of all high-risk encounters during the admissions process and the corresponding assignment to the appropriate payer class in the patient-accounting system will help meet this revenue recognition requirement.
As contracts are established to cover patients in these high-risk groups, the patients are moved to groups in which revenue can be recognized, giving rise to the second revenue modeling consideration: the need for continued reassessment of accounts in high-risk payer groups after the admissions process to determine whether circumstances have changed to allow revenue to be recognized for these payer groups. As fully reserved payers convert from high-risk groups to payer groups with contracts, revenue can be recognized once a performance obligation has been satisfied. Finance leaders should consider whether their revenue and reserve models are robust yet flexible enough to accommodate this type of conversion and the ensuing impact on revenue recognition.
The third revenue modeling consideration relates to the idea of an implicit price concession, or the practice of providing self-pay discounts, which is an important and subjective component of identifying contracts with patients. Providers should analyze their existing approach to recognizing revenue within this population to validate that they are able to accurately estimate the consideration. The implementation of such concessions will have a broad impact on bad-debt reporting and may lead to modeling and reserve methodology inconsistencies within the industry.
Step 2: Identify the separate performance obligations in the contract or contracts. In the standard, a performance obligation is defined as a promise to transfer to the customer a distinct good or service, or a bundle of distinct goods or services. Distinct is defined by whether the customer benefits from the good or service on its own or together with other readily available resources. Furthermore, to be considered distinct, a good or service must be separately identifiable from other goods or services promised in the contract. If the good or service is not distinct, it should be combined with other promised goods or services until a bundle of distinct goods and services is identified. Consider lab services as an example. A distinct service may be provided to a patient whose employer requires the patient to have a drug or alcohol blood test, as a one-time, distinct event. The same type of services—a blood test in this example—may be bundled with a surgery for a patient who entered the emergency department (ED); had a series of procedures, including labs or tests and X-rays; and then went to surgery and was admitted for three days.
The standard specifies accounting for contracts on an individual basis; however, as a practical expedient, an entity may apply this guidance to a portfolio of contracts with similarly distinct characteristics, such as all inpatient Medicare accounts grouped in the same portfolio, where the entity can reasonably expect that the effects would not differ materially from the effects of applying this guidance to each individual contract in the portfolio. When accounting for a portfolio, an entity should use estimates and assumptions that reflect the portfolio’s size and composition.
An important revenue modeling consideration here is that inpatient and outpatient services should be delineated into distinct models as appropriate. Examples include rehab, psychiatric, skilled nursing facilities, and the ED. Models should then group accounts into like payer groups for further distinction.
Step 3: Determine the transaction price. Under the new standard, revenue recognition will be based on transaction price instead of contract price. The guidance requires an entity to estimate the transaction price—i.e., the amount that the entity expects to be paid in exchange for transferring the performance obligation to a customer. To determine the transaction price, several factors must be considered.
First, healthcare organizations must decide which of their contracts are fixed, which are variable, and which have features of both contract types. Fixed contracts typically are fairly straightforward, because their performance going forward will remain constant and predictable. Conversely, variable contracts can include terms with discounts, rebates, refunds, credits, incentives, penalties, or other items for which the entity’s entitlement to the consideration depends on the occurrence of a future event. This variable consideration in the transaction price will affect the amount of revenue recognized and may delay the timing of revenue recognition.
Although variable consideration exists for all accounts associated with nonfixed contracts, the degree of the variability may differ dramatically from plan to plan and from account to account. The variable-consideration amount included in a contract must be estimated and the estimate updated at each reporting date.
Either of two approaches is suggested to estimate variable consideration:
- Determine the expected value using a probability- weighted amount based on a range of possible outcomes.
- Use the amount associated with the single most likely outcome.
The entity should decide which method it expects to be a better predictor of the consideration to which it is entitled.
As a key revenue modeling consideration, zero-balance account analysis and hindsight analysis can be compared with expected pay as calculated by a contract modeling system to determine the most precise approach.
The guidance allows revenue to be recognized only to the extent that a significant reversal of the amount of cumulative revenue recognized to date is not probable. Factors that could indicate variable consideration in a transaction price, and that therefore might cause significant revenue reversal, include:
- A long period before uncertainty is resolved
- Practices of providing concessions
- A broad range of possible amounts of consideration
Another revenue modeling consideration involves third-party settlements, which also should be taken into account when determining the transaction price. For example, the Medicare transaction price may be influenced by significant cost report settlements. The transaction price should be estimated at the end of each period using one of the two approaches.
Step 4: Allocate the transaction price to the performance obligations in the contract. The transaction price should be allocated to each performance obligation—i.e., distinct good or service—in an amount that depicts the amount of consideration to which the seller expects to be entitled in exchange for transferring the good or service to the customer. If more than one performance obligation exists, consideration should be allocated based on the relative stand-alone selling price of each good or service at the contract’s inception.
Thus, at any given time, particularly for the month-end close reserve calculation, it is important to precisely determine the current payer liability on an account for valuation against that appropriate portfolio for the purpose of allocating the transaction price. For example, the transaction price for patients with high-deductible plans who have met their deductibles should be expected to be much higher than the transaction price for those patients who have not met their deductibles. Portfolios should distinguish between primary payers, secondary insurance after insurance, self-pay after insurance, and true self-pay. Furthermore, high-dollar accounts require a unique degree of scrutiny as the population may not fit into a given portfolio. As a result, an account-by-account review by payment professionals may be needed.
From a revenue modeling standpoint, primary account balances versus secondary account balances should be broken out into distinct payer groups, allowing historical rates to be applied to each based on similar adjudication history. Also, a large-balance account review could be conducted for outlier accounts in which it may not be appropriate to absorb a portfolio’s transaction price.
Step 5: Recognize revenue when, or as, the entity satisfies a performance obligation. Revenue should be recognized by an entity when or as it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when or as the customer obtains control of that good or service. An entity should evaluate whether control is established either over a period of time or at a single point in time. A service is transferred and revenue recognition occurs over a period of time if the patient simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs, such as during chemotherapy.
Alternatively, a good or service is transferred and revenue recognition occurs at a single point in time when an entity has a present right to payment for the service or the patient accepts the good or service, such as in the case of an outpatient visit to the ED.
A consideration regarding revenue modeling is the possibility of analyzing accruals on late charges and in-house, discharge-not-final-billed, and on recurring outpatient accounts to validate transaction price and verify that revenue is being recognized at the appropriate time.
Adjusting Financial Reports
The introduction of new factors into the revenue recognition model could significantly change the presentation of revenue and bad-debt expense on an organization’s financial reports.
Accounting Standards Update No. 2011-07, Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities, introduced the concept of assessing collectability prior to providing service as the indicator of where bad-debt expense was presented on the income statement. If a provider assessed collectability prior to performing the services, then the bad debt was presented in the expense section of the income statement. Thus, if collectability had been assessed already, anything the entity was unable to collect truly was bad debt. However, if the entity did not assess collectability prior to performing services, bad debt was instead presented as a deduction from patient service revenue.
Under the new standard, however, bad-debt expense will be classified as an operating expense for all entities. For many healthcare entities, because variable consideration is factored into the transaction price, the effect of the new standard could be a decrease in the revenue the entities report and in the amount of bad-debt expense they recognize.
The presentation and measurement of charity care will not be affected by the new standard.
Transitioning to the New Standard
Public business entities must adopt the new revenue recognition standard for annual reporting periods beginning after Dec. 15, 2017, including interim reporting periods within that reporting period. Early adoption is not permitted. All other entities must adopt the new guidance effective for annual reporting periods beginning after Dec. 15, 2018, and for interim periods within annual periods beginning after Dec. 15, 2019. Early adoption is permitted, but it can be no earlier than the effective date for public business entities.
The new standard provides two methods for applying the new rules. The FASB allows all entities to elect either option. The first option allows an organization to retrospectively apply the new revenue recognition standard to each prior reporting period presented. The other option allows an entity to adopt the new guidance retrospectively, with the cumulative effect recognized in the opening balance of retained earnings at the date of initial application. Comparative periods presented would not have to be restated.
Any organization that hasn’t started planning for implementation of the new revenue recognition model should consider starting now. The new model applies broadly, replacing substantially all of the existing U.S. generally accepted accounting principles for recognizing revenue from contracts with customers. The implementation may seem overwhelming, but delaying won’t make it any easier.
The required implementation dates will be here soon. Organizations selecting the full retrospective implementation option might need to have dual-reporting capabilities in place prior to the required implementation date so that comparative information is readily available at implementation.
Andrew Holloway, CHFP, is with Crowe Horwath LLP and a member of the Indiana Pressler Memorial Chapter of HFMA.
Jay Sutton, FACHE, is a partner with Crowe Horwath LLP and a member of the Indiana Pressler Memorial Chapter of HFMA.
Matt Swafford, CPA, is with Crowe Horwath LLP.
a. ASU 2014-09 comprises three sections: Section A – Summary and Amendments That Create Revenue From Contracts With Customers (Topic 606) and Other Assets and Deferred Costs – Contracts With Customers (Subtopic 340-40); Section B – Conforming Amendments to Other Topics and Subtopics in the Codification and Status Tables; Section C – Background Information and Basis for Conclusions.
b. For a more detailed overview of ASU 2014-09, see Lehman, S., and Wodka, A.J., Revenue From Contracts With Customers: Understanding and Implementing the New Rules , Crowe Horwath LLP, October 2014.