Merger and acquisition (M&A) activity in the hospital and health system sector was steadily on the rise from 2013 to 2015, with 2015 being a banner year, although 2016 activity decreased slightly. Most in the industry believe the 2016 decrease is likely attributable to increased regulatory scrutiny over deals rather than a decline in interest from the industry. In fact, M&A activity is expected to remain strong in 2017, with affiliation and partnership activity becoming more pronounced as a percentage of total transactions. This increasing M&A activity points to a unique concern for health systems contemplating a transaction: accounting basis differences between standard-setting organizations.
Depending on ownership and governance, a hospital in the United States may follow reporting guidance from the Financial Accounting Standards Board (FASB)for a public business entity (e.g., U.S. Securities and Exchange Commission [SEC] registrant), a public entity (e.g., a not-for-profit conduit bond obligor with tax-exempt bonds), a not-for-profit entity (e.g., tax not-for-profit community health provider without tax-exempt debt), or a nonpublic business entity (e.g., privately owned). All these entity types could have nuanced differences for reporting a very similar transaction under the respective reporting models.
The FASB’s accounting and reporting differences are encountered with increasing frequency in the healthcare M&A space—thanks to SEC registrant health system restructuring, the increased presence of private equity, and the proliferation of tax-exempt systems across the nation. These differences often are subtle, however.
The more significant differences exist between the FASB and the Governmental Accounting Standards Board (GASB) accounting and reporting rules for similarly structured and purposed healthcare organizations. And with the increased affiliation and other transaction activity between GASB reporters (such as academic health systems) and FASB reporters, understanding accounting basis differences can be critical both in evaluating the merits of a transaction and in managing the subsequent transaction integration.
Key FASB and GASB Differences
The look and feel of financial statements for a GASB reporting health system will be significantly different from those for a FASB reporting health system—even if the systems are engaged in very similar businesses. Nonetheless, many of the differences are cosmetic. For example, financial statements for GASB reporters will have components related to governmental elements of the business that will affect the consistency of the presentations, such as management discussion and analysis and required supplementary information, and different naming conventions for individual statements and related line items.
More significant, the basis of accounting between the FASB and the GASB will differ in several areas that might have a substantial impact on the accounting or disclosure of items that are otherwise identical or very similar. These areas are as follows.
Pension and post-retirement health obligations. For decades, the FASB has required that the unfunded projected benefit obligation for defined-benefit pension plans be recognized on the balance sheet. Until 2015, GASB standards did not have such a requirement. GASB Statement No. 68 changed that, requiring the net pension obligation to be recognized in the statement of net position, resulting in better alignment between the standard setting bodies. Of course, circumstances unique to government plans, such as cost-sharing plans, have unique accounting requirements. However, there can still be significant measurement differences between the two reporting conventions even for plans that otherwise seem quite similar.
The most significant measurement difference relates to the rate at which future expected benefit payments are discounted. The FASB settlement model requires the discount rate to reflect a liability amount that could be effectively settled at the balance sheet date. This amount would be indicative of rates implicit in current prices of annuity contracts or rates of return on high-quality fixed-income investments. Under GASB Statement No. 68, a funding model is generally used. The discount rate, when funding concerns are not present, would be the long-term investment rate of return.
In the recent and current interest rate environment, these two rates could be several hundred basis points apart, resulting in a net obligation for FASB reporting purposes that is much higher than that under the GASB methodology for plans with similar assets and expected future benefit payments.
Similarly, under the FASB guidance for post-retirement healthcare plans, an employer currently is obligated to provide retirees with healthcare benefits. The GASB does not currently require balance-sheet recognition of such an obligation, although that, too, will change in 2018. However, the differences in discount-rate conventions and the related valuation differences that result also wlll be an issue for other post-retirement benefit obligations.
Lease accounting. GASB Statement No. 62 codified lease accounting practices that were generally consistent with the FASB standards, and as a consequence, the GASB and the FASB now generally align in this area. However, that situation is likely to change as early as 2019 with the issuance of the FASB’s much discussed lease project (Accounting Standards Update [ASU] 2016-02) and its requirement that an organization recognize a right-of-use asset and lease obligation at inception for virtually all leases. This change will eliminate off-balance-sheet accounting for traditional operating leases under the existing FASB model. The GASB also has a lease project in the works, which also would require virtually all leases to recognize assets and liabilities at inception.
However, the two lease projects have different timing, and it’s likely that lease accounting will be very different on the balance sheet for FASB and GASB reporters for at least a couple of years. The projects also differ in their presentation of lease activity as it relates to results of operations. On the statement of income and cash flows, the FASB ASU treats finance leases differently from operating leases, whereas the GASB project treats them the same. Consequently, even if the two projects eventually align from a balance-sheet perspective, line items such as interest, amortization, and rent expense may be substantially different for similar lease instruments. This situation could have an impact on measures such as earnings before interest, taxes, depreciation, and amortization (EBITDA), if not adjusted for appropriately.
Debt issuance costs. Currently, the FASB requires the cost of issuing debt to be capitalized, offset against the obligation, and amortized over the related term. The GASB considers all costs of issuance, not including prepaid bond insurance premiums, to be period costs that are expensed as incurred.
Capital asset impairment. The FASB uses a recovery model evaluation for capital asset impairment, while the GASB uses a service utility model. Under the FASB model, impairment could occur if the asset’s carrying value cannot be recovered by future undiscounted net cash flows and is greater than its fair value, regardless of whether the asset is still being used as intended. However, under the GASB model, there is no impairment if the service utility of the asset has not declined significantly and unexpectedly, regardless of whether the carrying value is recoverable through future cash flows or estimated fair value. This difference in the models can result in accounting basis differences, particularly in situations of financial distress where future cash flows are uncertain but the operating utility of an asset hasn’t changed.
Insurance-related contingencies. Risk of contingent loss related to malpractice, workers’ compensation, or employee health benefits, whether self-insured or otherwise, is significant in health systems. The FASB and the GASB differ in how these potential liabilities are reported in financial statements. Under the FASB, insurance-related contingent liabilities are evaluated and recorded at gross without consideration of whether the risk has been transferred to another party, such as an insurance company. Any potential insurance coverage is evaluated and recorded as a related insurance recovery receivable. Under the GASB, these insurance-related contingencies are recorded as a liability and expense only if and to the extent that the risk has not been transferred to an unrelated third party. In other words, GASB reporters record the net liability related to these programs. The difference between gross and net liability can be significant and may lead to differing balance sheet presentations for similar risk management programs.
Operating indicator. The GASB is much more prescriptive than the FASB on what should and shouldn’t be included within an operating indicator for a statement of operations or its equivalent. Items that often are reported within an operating indicator for FASB reporting purposes—such as certain investment income, interest expense, contributions, and grant activity—are reported outside of the operating indicator for GASB purposes because they either relate to investing and financing activities or are nonexchange transactions. Healthcare organizations that have significant fundraising or research activity often can find big differences between the FASB and the GASB reporting models with respect to components of operating income.
M&A Impact of Differences
The FASB and the GASB have converged recently on several items that affect healthcare financial statements, such as split interest gifts, investment disclosures, and asset retirement obligations. However, as described above, significant differences remain in accounting for many transactions and balances prominent in healthcare financial statements that otherwise are similar between organizations. These differences can be critical in evaluating financial fit when looking to merge or affiliate with an organization that is under a different basis of accounting. Close scrutiny and reconciliation of the accounting basis is highly recommended.
Brian Conner, CPA, is a partner and national practice leader for the hospitals practice at Moss Adams LLP, Stockton, Calif., a member of HFMA’s Northern California Chapter, and the chair of HFMA’s Principles and Practices Board.