Lies, Damn Lies and Financial Statements

Are there Gremlins in Your Financial Statement?
By Dexter Braff

In the post-Enron alphabet soup of financial reporting, even under GAAP (Generally Accepted Accounting Principals), bottom line EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) has deteriorated into punch line EBBS (Earnings Before Bad Stuff). The financial statement has been revealed for what it truly is--a compilation of numbers that is only as accurate as the assumptions, discretion, and application of obscure rules that it is based upon. And lest you think reporting distortions are limited to over zealous public firms in their never ending quest to impress Wall Street, know that they permeate the most well intentioned privately held firms as well. Because even honest errors in accounting judgement and application can undermine the integrity of a firm's financials statements, and more importantly, the strategic decisions based upon them.

In some ways, health care companies are particularly susceptible to reporting inaccuracies and misinterpretation. Here then is a look at where you're most likely to find gremlins hiding in your financial statements. Simple enough, we might add, that even an auditor from Arthur Anderson can follow.

You say potato, I say revenue
Revenue. It seems so simple. So basic. But the reporting of revenue is extraordinarily ambiguous and discretionary. And with practically the entire financial statement being driven off revenues, it is the most logical place to begin.

The fundamental concept in reporting revenue is that it should be recorded or "matched" with the activities and expenses incurred in generating them. The better the matching, the more meaningful the measure of profits. Recognize revenues too early, like recording all the revenues from a contract when it is signed but before services are delivered, profits will be over stated. Recognize revenues too late, profits will be understated.

Unlike in the Medicare Home Health Prospective Payment System where companies can conceivably recognize a 60 day episode of revenues on day one, in the HME business there's little opportunity to post revenues too early. But virtually all companies post revenues too late. The worst violators? Companies that recognize revenues when cash is collected. With claim turnarounds averaging from 60-90 days, this method is woefully inadequate. Especially with fast growing firms where cash collections will always lag the activities and expenses necessary to generate them. Cash may be king, but not when it comes to recognizing revenues.

How about booking revenues when bills are generated--by far the most common method of revenue recognition we see today? Clearly billings are better matched to expenses than the cash method. But considering the time lag it often takes to bill--an average of 11 days according to industry surveys--billings are far from a perfect accounting match.

So what's the most accurate accounting method of recognizing revenues? Posting when services are delivered at their expected billing rate. Yes. It is a little risky as some unbilled services will never get billed. But most will. And that's what reserve accounts are for, as we will discuss in the next section.

But before that.one final comment on revenues. In the name of all that is holy in finance, if you still record inflated "retail" or gross revenues before contractual allowances where the allowances are standard, substantial, and clearly known at the time of billing, please stop the madness. Even though you can get to an accurate net figure after allowances, we've seen several problems arise. First, unanticipated (and sometimes controllable) adjustments get lost in the often-substantial allowance figures. Second, if you record the allowances when remittance is received--as many companies do-- receivables are always overstated. And, finally, it is our experience that companies that report inflated gross revenues tend to manage their businesses and perform benchmark comparisons off these revenues. So if your gross revenues are grossly irrelevant, skip the middleman and adjust your billing figures to reflect what you typically expect to get paid. It's simpler and simply more accurate.

In finance, it's good to be reserved
From a financial reporting perspective, the most significant area where home health care companies go wrong is how they account for--or don't account for--uncollectible revenues. Under recording or underestimating uncollectible revenue leads to inflated net receivables, inflated profit figures, and misinformed management decisions. And with so much revenue attributable to third party payers with complex billing procedures, accounting for uncollectibles is as difficult as it is extremely significant in terms of its impact on reported profits.

First observation. Note that we are talking about uncollectibles--not bad debt. I know that the country's budget surplus is dwindling and that State budgets are strained, but as far as I know, neither Medicare nor Medicaid has gone bust. When they and other third party payers don't pay, they have their reasons (convoluted and mind numbing as they may be), not lack of funds. In fact, true bad debt, or the simple inability to pay, makes up only a small portion of uncollectible revenues. The big culprits are billing errors, improper or missing documentation, negotiated adjustments etc. These are the real uncollectibles that must be accounted for.

Just like in revenue reporting, the concept of matching applies. So even though you may not find out until much later that a bill is uncollectible, you want to record it in the period in which the revenue is booked. That's why the direct write-off method, in which a billing adjustment is posted when the company determines that it is in fact uncollectible is unsatisfactory. Although it is very easy, which explains why so many companies use it, the timing is off. Accordingly, profits are always overstated until the write-off is actually posted. And it can become very tempting to keep up the façade of chasing after dead receivables simply to delay the inevitable write-down and hit to profits.

Accordingly the preferred method of accounting for uncollectibles is the reserve method, where uncollectible amounts are estimated each month and posted to the income statement before the actual write-off. Therefore they are more closely matched to their associated revenues [1] .

The big question of course is how do you determine the monthly reserve amount. The most common method is to track historical cash collections as a percentage of associated revenues to determine the average uncollectible percent. This percentage is then applied each month to revenues to calculate that month's estimate of uncollectibility.

The lone drawback to this method is that it is based on historic collections activity and is somewhat disconnected to the actual aging of receivables. As an alternative then, some companies estimate the collectibility of their receivables each month based upon aging categories (i.e. current, 30-60,60-90, 90-120, 120 and over) to determine an appropriate total reserve. The amount posted to the income statement each month then is the adjustment necessary to bring the total allowance to the required level.

Whichever method is used, the key is to use it aggressively, and to continually retest whether the key estimates--percentage of uncollectible revenues or percentage of uncollectible receivables per aged category--still reflect reality. Only then can you begin to assume that income statement profits won't vaporize in a write-off and will actually turn into cash.

COGS in a fog
Cost of goods sold should be simple. You sell a product, you record the expense of that product. Simple. Much easier said than done. If you have a bar coded perpetual inventory system where each product dispensed is "wanded" and then captured in COGS, you're pretty much there. But since these systems can be expensive and difficult to set up, most companies either book purchases directly to cost of goods sold, or impute it by taking beginning inventory, adding purchases, and subtracting ending inventory. The direct purchase method is easy, but since many companies try to make bulk purchases of inventory to get price breaks, COGS becomes extremely volatile and more importantly, unrelated or unmatched to revenues. The imputed method is designed to solve this problem, but it too has its problems. Since it requires accurate inventories that are typically performed only once a year, the computation is generally done only at year-end. So what is used during the interim periods? Direct purchases or estimates based on historical experience - obviously less than precise. And you may be surprised how many companies that use the imputed method magically have same beginning and ending inventory, i.e. no inventory was taken. In that case, the calculation comes down to nothing more than--yup, you guessed it-- purchases. So if sales are a big part of your business, perpetual is the only way to go.

At least we know it's a lease
Quick. What do you get when two companies are identical in all respects and they both lease equipment at the same price and terms, except one correctly treats its lease as a capital lease and the other mistakenly treats it as an operating lease? Companies with very different EBITDA (earnings before interest, depreciation, and amortization). When a lease is classified as a capital lease, it is considered a financing mechanism. Accordingly the equipment is actually booked to the firm's balance sheet as an asset and the lease payment is recorded as interest and depreciation. When a lease is classified as an operating lease, it is treated more like equipment rental. Therefore the equipment is not booked as an asset and the payment is recorded as a leasing expense. So in calculating EBITDA with a capital lease, the lease payment is "added back" in the form of interest and depreciation. Not so with the operating lease. Now don't harass your accountant to simply change your operating leases to capital leases. There are rules for this. But know that we've seen more than just a few companies with EBITDA hidden in misclassified leases.

Capital ideas
As opposed to current assets such as accounts receivable and inventory that are expected to be converted into cash within one year, those with longer "lives" are typically considered long-term assets. These assets are generally capitalized. That is, when they are purchased they are recorded as an asset on the balance sheet and, rather than recognize the expenses all at once on the income statement, the costs are spread out over their "useful lives" in the form of depreciation. In some situations, start-up costs, market research, and other "soft" assets can be capitalized to recognize that the investment is expected to generate returns over the long term. There is some discretion in determining whether or not to capitalize an asset.

Consider the purchase of a $750.00 concentrator. If one company decides that the minimum investment required for capitalization is $1,000 and another decides it should be $500, the first company expenses the entire purchase immediately while the other capitalizes it and records the expense as depreciation for perhaps five years. The first company takes a big hit in month one and is done. The second takes a much smaller hit in the first month but keeps posting depreciation expense for 5 more years. Big difference. Now suppose the companies are virtually identical and after a two-year ramp up in activity, they each stop buying concentrators. The first company, which was seemingly much less profitable than the second during the first two years (when they were expensing purchases) suddenly leapfrogs past the second in profitability. Not because they were better, but because of a difference in accounting policy. Pretty scary huh?

Straddle accounting
It's not uncommon to see discretionary financial decisions made either immediately before or after the end of an accounting period. This happens big time in publicly traded firms. If a company's in the midst of a bad year, the theory goes that you take all your discretionary write-downs of assets or charges before the year is out and get it over with. If it's a good year, finish it out and hold the adjustments until the next. But it also happens in private firms, albeit for different reasons. Know anybody that in December slows down billing or ramps up equipment expenditures - especially if they don't capitalize them--to reduce year-end income and taxes? How about someone that holds billings in January so that other health care providers have to bill patients for their Medicare deductibles? Although these and other straddle strategies (cool phrase, eh?) tend to "even out" over the course of a year, they can significantly distort interim quarterly financials.

As you reflect on how good financials go bad (a new Fox TV special?) it's important to remember that many accounting decisions are not a question of right or wrong, but what is most practical - and tax benevolent--given a company's resources, financial systems, and the needs of it's shareholders. The statement is a great starting point. But you've got to look behind the numbers to really know what it's saying.

1 For those of you with an accounting background, when the reserve amount is posted to the income statement, the same amount is simultaneously posted to an accounts receivable allowance account on the balance sheet. When a receivable is actually written off, the corresponding entry is posted against the allowance account.