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CHAPTER 3
The Income Statement and Statement
of Changes in Equity
This chapter begins our discussion of
financial accounting. In addition to
providing the fundamentals of financial
accounting, it covers two important
financial statements: the income
statement and the statement of changes
in equity.
Copyright © 2012 by the Foundation of the American College of Healthcare Executives
10/25/11 Version
3-2
Introduction to Financial Accounting
◼Financial accounting involves identifying,
recording, and communicating the
operational results and status of an
organization (as opposed to a subunit).
◼Financial accounting information is
conveyed by a business’s financial
statements:
⚫Income statement
⚫Statement of changes in equity
⚫Balance sheet
⚫Statement of cash flows
3-3
Introduction to Financial Acct. (Cont.)
◼ The requirement to provide financial
accounting information is driven by the need of
outsiders to have reliable information regarding
the financial status of an organization.
◼ However, the information presented in financial
statements is as important to managers as it is
to investors.
Who are the outsiders?
Do not-for-profit organizations have to prepare
financial statements?
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Regulation and Standards
◼ The Securities and Exchange Commission
(SEC) has the legal authority to regulate the
form and content of financial statements.
◼ However, the SEC relies on the following
organizations for implementation:
⚫ Financial Accounting Standards Board (FASB)
⚫ Industry Committees of the American Institute
of Certified Public Accountants (AICPA)
⚫ Principles and Practices Board of the
Healthcare Financial Management Association
(HFMA)
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GAAP
◼ The conventions that have evolved from
the pronouncements and rulings of the
implementing organizations constitute a
set of guidelines for the preparation of
financial accounting statements called
generally accepted accounting principles
(GAAP).
◼ The GAAP applies only to financial
accounting statements (as opposed to
statements constructed for internal use).
Does the GAAP remain static over time?
3-6
Conceptual Framework for the
Recording of Economic Events
◼The goal of financial accounting is to
provide information that is useful to
present and future investors and other
users in making rational financial and
investment decisions.
◼To achieve this goal, GAAP specifies
four assumptions, four principles, and
four constraints.
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Conceptual Framework (Cont.)
◼Assumptions
⚫Accounting entity
⚫Going concern
⚫Accounting period
⚫Monetary unit
◼Principles
⚫Historical costs
⚫Revenue recognition
⚫Cost matching
⚫Full disclosure
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Conceptual Framework (Cont.)
◼Constraints
⚫Objectivity
⚫Materiality
⚫Consistency
⚫Conservatism
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Cash Versus Accrual Accounting
◼Cash accounting recognizes an event
when a cash transaction takes place.
⚫Simple and easy
⚫Mimics tax statements
◼Accrual accounting recognizes an event
when a cash obligation is created.
⚫More complicated
⚫Provides a better picture of the true
economic status of a business
⚫Is required by GAAP
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Recording and Compiling Data
◼ A transaction is an exchange of goods
(including cash) or services from one
individual or business to another.
◼ Once a transaction is identified, it must
be recorded, or posted, to an account,
which identifies a unique activity within
the business.
◼ Businesses use a chart of accounts to
assign numeric identifiers to individual
accounts.
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Income Statement Basics
◼ Perhaps the most important question
about a business’s financial status is
whether or not it is making money.
◼ The income statement provides
information about a business’s
operations and economic profitability.
◼ The income statement is often called by
other names:
⚫ Statement of operations
⚫ Statement of activities
⚫ Statement of revenues and expenses
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Income Statement Basics (Cont.)
◼ The income statement reports the results
of operations over some period of time,
say, a year. It has three key elements:
⚫ Revenues, which under accrual accounting
represent both cash received and payer
obligations.
⚫ Expenses, which are the resource
expenditures required to produce the
revenues. Again, note that under accrual
accounting both cash and noncash
expenses are recognized.
⚫ Profit measure Net Income = Revenues Expenses.
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Sunnyvale Clinic: Revenues
(in thousands)
2011
Revenues:
Net patient service revenue $150,118 $123,565
Premium revenue
18,782 16,455
Other revenue
3,079 2,704
Total revenues
$171,979 $142,724
2010
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Revenues
◼ Revenues are shown in several different
formats depending on the type of provider.
Sunnyvale has three revenue categories.
◼ Net patient service revenue reflects the
amount of revenues expected to be collected
from the provision of patient services (as
opposed to gross revenue, which is based on
chargemaster prices).
◼ Premium revenue represents revenue from
capitated patients.
◼ Other revenue is revenue from activities
directly related to patient services, such as
parking fees and cafeteria revenues.
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Revenues (Cont.)
◼In reporting net patient service revenues,
note how the following categories are
handled:
⚫Discounts and allowances from gross prices
are not reported as revenue.
⚫Charity care is not reported as revenue.
⚫Under current GAAP, bad debt losses are not
reported as revenue, but are reported in the
expense section.
◼Beginning in 2012, expected bad debt
losses will be reported as a deduction in
the revenue section.
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Revenues (Cont.)
◼Note that the revenue reported does
not represent the amount of cash
collected:
⚫Some portion has not yet been collected.
The uncollected portion will appear on the
balance sheet in an account titled
receivables.
⚫In addition, some revenues reported in the
previous year were collected this year.
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Sunnyvale Clinic: Expenses
(in thousands)
2011
Expenses:
Salaries and benefits
$126,223 $102,334
Supplies
20,568 18,673
Insurance
4,518 3,710
Lease
3,189 2,603
Depreciation
6,405 5,798
Provision for bad debts
2,000 1,800
Interest
5,329 3,476
Total expenses
$168,232 $138,394
2010
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Expenses
◼ Expenses represent the resources used to
create revenues--they are the costs of
doing business. Like revenues, under
accrual accounting expenses do not
necessarily reflect cash outlays.
◼ Expenses may be categorizes by:
⚫ Natural classification, such as salaries,
supplies, research, and so on.
⚫ Functional classification, such as inpatient
services, outpatient services, and so on.
Which classification system is better?
Which system does Sunnyvale use?
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Expenses (Cont.)
◼ Salaries and benefits expense represents
labor costs.
⚫ Typically, this is the largest expense category for
health services organizations.
◼ Supplies expense represents the cost of
expendable (primarily medical) materials.
⚫ The dollar amount shown represents the amount
consumed, not the amount purchased.
⚫ Supply stocks are reported on the balance sheet.
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Expenses (Cont.)
◼Insurance expense represents the cost
of commercial insurance purchased to
protect the clinic against several risks,
including:
⚫Property risks
• Fire
• Weather
⚫Liability risks
• Managerial malfeasance
• Medical liability
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Expenses (Cont.)
◼ Sunnyvale owns most of its land and
buildings, but it leases much of its
diagnostic equipment. Lease expense
reports the cost of its leases.
⚫ On the balance sheet, some leased assets
are reported directly (on the face) while
others appear only in the footnotes.
⚫ Regardless of balance sheet treatment, all
lease expense is reported on the income
statement.
Why do organizations use leases?
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Expenses (Cont.)
◼ Depreciation expense arises because of the
matching principle--expenses must be
matched to the revenues with which they
are associated.
◼ While operating costs such as labor and
supplies are assumed to produce
immediate revenues and hence are moreor-less immediately reported (expensed) on
the income statement, the costs of longlived assets (buildings and equipment) are
not reported on the income statement at
the time the acquisition is made.
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Expenses (Cont.)
◼ Rather, the “cost” of a long-lived asset is first
capitalized (recorded on the balance sheet as
an asset of the business). Then, this amount
is amortized (or spread) over the accounting
life of the asset, which means the cost is
shown (expensed) on the income statement
as small increments over time.
◼ The amortization expense of buildings and
equipment when listed on the income
statement is called depreciation.
◼ For financial accounting purposes,
depreciation is calculated by the straight-line
method.
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Expenses (Cont.)
◼Most expense items listed on the income
statement only approximate actual cash
expenditures. The relationship is not
exact because of accrual accounting.
◼However, depreciation (and amortization)
are expenses that typically have no
associated cash expenditure during the
accounting period.
◼Such an expense is referred to as a
noncash expense.
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Expenses (Cont.)
◼ Provision for bad debts reports the
amount of net patient service revenue
that is not expected to be collected.
⚫ It is an estimate based on past experience.
⚫ Past estimates are reconciled when the data
are known.
⚫ This item will be moved into the revenue
section in 2012.
◼ Interest expense reports the amount of
interest paid (or obligated) on debt
financing.
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Sunnyvale Clinic: Operating Income
(in thousands)
2011
2010
Revenues:
Total revenues
$171,979 $142,724
Expenses:
Total expenses
$168,232 $138,394
Operating income
$ 3,747 $ 4,330
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Operating Income
◼Although the reporting of revenue and
expenses is important, profitability is
the most important element of the
income statement .
◼Operating income measures economic
profitability as defined by GAAP with a
focus on patient service activities.
◼It is an important measure of
profitability because it represents the
organization’s core business.
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Sunnyvale Clinic: Nonoperating Income
(in thousands)
2011
2010
Nonoperating income:
Contributions
$ 243 $ 198
Investment income
3,870
3,678
Total nonop. income $ 4,113 $ 3,876
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Nonoperating Income
◼ Nonoperating income reports income
(revenues) from activities not related to
the provision of patient services.
◼ Contributions report donations to
Sunnyvale Clinic that can be immediately
spent. (Contributions that create
endowments are not reported on the
income statement.)
◼ Investment income lists income from (1)
excess cash held as reserves or to meet
known future needs and (2) endowments.
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Sunnyvale Clinic: Net Income
(in thousands)
2011
Operating income
Total nonop. income
Net income
2010
$ 3,747 $ 4,330
$ 4,113 $ 3,876
$ 7,860 $ 8,206
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Net Income
◼ The second measure of profitability, which
is often referred to as the “bottom line,” is
net income.
◼ Net income measures the overall (total)
economic profitability as defined by GAAP.
◼ In not-for-profit businesses, net income
typically is called:
⚫ Revenues over expenses
⚫ Excess of revenues over expenses
⚫ Change in net assets
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Net Income (Cont.)
◼ The income statements of some not-for-profit
corporations contain a section below the net
income line that reconciles net income with
the balance sheet net assets (equity) account.
(Sunnyvale uses a separate statement,
discussed shortly.)
◼ Note that economic profitability is a complex
concept that is very difficult to measure,
because economic gains and losses often are
not matched by easily identifiable and
measurable events.
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Net Income Versus Cash Flow
◼Because of accrual accounting, net
income does not represent cash flow.
⚫ Some income statement items represent cash
flows, others do not.
⚫ Some, such as revenues, represent partial cash
flows.
◼With only income statement data, cash
flow (CF) can be approximated by:
CF = Net income + Noncash expenses
= Net income + Depreciation
= $7,860,000 + $6,405,000 = $14,265,000.
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Income Statements of
Investor-Owned Businesses
◼ The income statements of investorowned and not-for-profit businesses
are very similar.
⚫ The revenues and costs to organizations in the
same line of business are similar, regardless of
ownership.
⚫ However, some transactions, such as income
tax payments, clearly are applicable only to forprofit businesses.
◼ Line of business differences have a
greater impact on financial statements
than do ownership differences.
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Sunnyvale Clinic: Statement of
Changes in Equity
(in thousands)
2011
Net income
2010
$ 7,860 $ 8,206
Equity, beginning of year $ 46,208 $ 38,002
Equity, end of year
$ 54,068 $ 46,208
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Statement of Changes in Equity
◼ The statement of changes in equity
reconciles the income statement net
income item with the balance sheet
equity account.
◼ For a not-for-profit organization, the
entire amount of net income flows to the
balance sheet.
◼ In a for-profit business, there are
typically deductions to net income (often
dividends) that reduce the amount that
flows to the balance sheet.
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An Introduction to
Financial Condition Analysis
◼ In financial condition analysis, values from
the financial statements are combined to
form ratios that have easily interpretable
economic meaning.
◼ For example, total (profit) margin: (2011)
Net income
Total margin =
Total revenue
$7,860
=
= 0.045 = 4.5%.
$176,092
How is this ratio interpreted?
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Operating Margin
◼ Measures the amount of operating profit
based on core activities of a business
◼ Operating Margin = operating income
divided by total operating revenues
Chapter 3 – Income Statements Highlights
The Income Statement is a critical element of financial status for health care organizations (and all
organizations) because it reports how profitable an organization has been over a certain period of time,
generally a year. It answers the question… is our organization making money… is it profitable?
The Income Statement provides 3 key elements:
1) Revenue – how much revenue did we earn during the period? This includes both operating
revenue (revenue generated from providing patient care) and nonoperating revenue (revenue
from donations and investments).
2) Expenses – how much did it cost us to the patient care we earned revenue from?
3) Net Income = Revenue - Expenses
Due to the use of Accrual Accounting, Revenue reported does not equal the amount of cash the
organization collected during the period. But from these 3 key elements, we can estimate the amount of
cash that a company has available. Cash Flow = Net Income + Noncash Expenses (depreciation).
We can also calculate the Total Profit Margin or Total Margin for the organization. Total Margin = Net
Income/Total Revenue. This ratio tells us how much profit the organization earns off of each dollar of
revenue.
We also discussed the use of the Operating Margin which is similar to the Total Margin except that it
considers Operating Income only and does NOT include nonoperating income such as donation or
investment income. Operating Margin = Operating Income/Total Revenue.
Problem 1
Consider the following BestCare HMO Income Statement
Revenue:
Premiums earned
Coninsurance
Interest and other income
Total Revenues
$ 845,657
$ 10,345
$ 2,860
$ 858,862
Expenses:
Salaries and benefits
Medical supplies and drugs
Insurance
Provision for bad debt
Depreciation
Interest
Total Expenses
$ 627,000
$ 23,980
$ 4,589
$ 2,000
$ 12,677
$
385
$ 670,631
NET INCOME
$ 188,231
3.2(d) What is BestCares total profit Margin?
Net Income
Total Revenue
Profit Margin
#DIV/0!
3.2(d) How can the profit margin be interpreted?
Problem 1
Consider the following Green Valley Nursing Home Income Statement
Revenue:
Net patient service revenues $
Other income
$
Total Revenues
$
3,862,000
206,146
4,068,146
Expenses:
Salaries and benefits
Medical supplies and drugs
Insurance and other
Provision for bad debt
Depreciation
Interest
Total Expenses
$
$
$
$
$
$
$
1,932,000
966,781
296,357
110,000
85,000
206,780
3,596,918
Operating income
Provision for income taxes
$
$
471,228
31,167
$
440,061
NET INCOME
3.3(b) Why does Green Valley show a provision for income taxes while BestCare HMO does not?
3.2(c) What is Green Valley's total profit margin?
Net Income
Total Revenue
Profit Margin
#DIV/0!
3.2(c) How can the profit margin be interpreted and how does that compare to Best HMO in Tab 1?
Problem 1
Consider the following Green Valley Statement of Changes in Equity.
Fill in the blanks.
2019
Net income
$
282,553 $
440,061
$
185,654
Equity (net assets), beginning of year
Equity (net assets), end of year
$
2018
282,553
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