fund accounting in nonprofit hospitals: a lobbying perspective

Financial Accountability t3 Manapnent , 5(4), Winter 1989 0267-4424 $2.50

FUND ACCOUNTING IN NONPROFIT HOSPITALS: A LOBBYING PERSPECTIVE

DANA FORGIONE AND GARY GIROUX*

The hospital industry includes both for-profit (FP) and not-for-profit (NP) hospitals. Ninety percent of the 7,000 or so hospitals in the US are NP. Although operations are virtually identical, financial accounting differs between the two types of hospitals. A major difference has been the use of fund accounting by NP hospitals. A primary rationale for fund accounting is the separation and control of contributions and grants that are restricted for specific purposes by the donors. Recently, the Healthcare Financial Management Association (HFMA) which represents a “third tier” authority on accounting matters after the SEC and FASB, issued Statement No. 8 which supports single fund reporting for NP healthcare organizations (HFMA, 1986).’

The HFMA received 26 comment letters representing HFMA chapters, CPA’s, multihospital systems, independent hospitals and other industry constituents concerning the provisions of Statement No. 8 before it was issued. The HFMA incorporates a broad spectrum of economic factors, theory, and long term objectives - in balance with current preferences - as essential influences in the formulation of its position on accounting standards, and such letters reflect the formal input of the HFMA’s constituency on a proposed pronouncement. Comment letters received from specific HFMA chapters represent a collective mechanism for their diverse member hospitals to participate on a group consensus basis in the formulation of healthcare accounting standards. In this study we focus our attention on 13 letters which allowed us to identify 24 individual hospitals. The 13 letters in the sample were equally split between in-favour and opposed (six each plus one that straddled).‘ Although only a trace sample, and therefore not necessarily representative of the diverse opinions and factors involved in the formulation of the standard, the data were nonetheless found to be consistent with our model predictions. The purpose of the study is to describe incentives associated with hospital financial reporting using an agency theoretic framework, and to use this framework to consider the positions of these hospitals and other respondents to HFMA Statement No. 8.

*The authors are respectively, Assistant Professor, and Professor of Accounting at the College of Business Administration, Texas A&M University. They gratefully acknowledge the helpful comments of Ronald R . Kovener, Vice President of the Healthcare Financial Management Association; and Sarah Reed, Assistant Professor of Accounting at Texas A&M University.

233

234 FORGIONE AND GIROUX

THE HEALTHCARE ENVIRONMENT

Historically, hospitals have been predominantly NP, with FP hospital corporations expanding rapidly after the introduction of Medicare in 1965. The majority of hospital patients have relied on third party payers, especially health insurers, to finance the bulk of direct healthcare cost. Third party payers, primarily insurance companies and government programmes, provided about 75 percent of healthcare funding in 1985 (US Bureau of the Census, 1987). Unfortunately, millions of Americans have been uninsured (or underinsured), placing a large burden on charity services and the government. One major purpose of fund accounting has been to segregate and highlight contributions and grants designated for specific purposes by donors, such as charity services.

Initially, Medicare and Medicaid were cost-based reimbursement systems which provided no incentives to minimize the costs of providing healthcare. Instead, the incentives were to maximize revenue by expanding services to Medicare/Medicaid recipients. The result, in combination with rapid advances in medical technology and changing patient demographics, was an explosion of costs - particularly by the federal government. For example, Medicare payments rose from $7.5 billion (16.8% of total healthcare costs) in 1970 to $72.3 billion (29.6%) in 1985. During the same period the index of medical care prices increased 334 percent, much faster than the consumer price index (US Bureau of the Census, 1987). Hospitals increased revenues and profits dramatically and FP hospital chains became a growth industry that was applauded on Wall Street.

In 1982 Medicare instituted its Prospective Payment System (PPS) (US Department of Health and Human Services, 1983) to change the reimbursement scheme and dramatically affect the incentives of hospitals. PPS essentially is a fixed fee system based on the discharge diagnosis (the patient is categorized in one of 467 diagnostic related groups or DRGs). The Medicare payment generally is not affected by the patient length of stay (LOS) or the specific services or costs of services performed for the patient. Thus, the incentives under PPS are to minimize LOS and the associated costs of providing services. Whether the use of such cost containment systems has, or will, lead to greater efficiency or lower quality of patient care has been the subject of considerable debate (see: Averill and Kalison, 1983; Aaron and Schwartz, 1985; and Chilingerian and Sherman, 1987).

NP hospitals rely on private philanthropy to continue providing certain types of care, including charity services. In 1985, $1 1.3 billion in private philanthropy was provided for health and hospitals. However, as Medicare/Medicaid and other public programmes have expanded along with associated payroll and other taxes, philanthropy to hospitals has been declining. For example, hospital capital grants from corporate sponsors declined from $29.8 million in 1980 to $24.7 million in 1984 (US Bureau of the Census, 1987). Throughout the 1965-82 period, the relative decline in philanthropy was largely offset by rising Medicare

FUND ACCOUNTING IN NONPROFIT HOSPITALS 235

revenues. As Medicare payments have failed to keep up with rising health care costs under PPS, NP hospitals that were unable to adjust to this new environment were caught in a cash squeeze.

In general, the incentives of NP hospitals resemble those of commercial organizations. The hospitals recover costs of providing services from charges to patients and third party payers. However, the NP hospitals are responsive to social needs rather than profitability. Thus, indigent care, charity services, and many types of high cost care that FP hospitals avoid are routinely - or disproportionately - handled by NP hospitals (Ohsfeldt, 1985; and Schlesinger et al., 1987). A sizable precent of these costs must be covered by philanthropy or public programmes if the NP hospitals are to survive.

Philanthropic activity is effectively being crowded out by Medicare and related public programmes (Foster, 1987). Consequently, NP hospital management has incentives to increase economically defined efficiency, perhaps at the expense of social services. Since Medicare essentially provides flat fee reimbursement, the need for financial viability encourages the managers to reduce both LOS and unit costs of patient care. FP hospitals have accom- modated the new incentives and now have average LOS about two days shorter than NP hospitals (Forgione, 1987).

FUND ACCOUNTING

Accountiny practices for hospitals have developed over many years largely through the efforts of the American Hospital Association (AHA) and the HFMA. In 1975 the HFMA established the Principles and Practices (PfkP) Board for the purpose of formulating positions on accounting issues of concern to the HFMA membership. Membership in the HFMA now exceeds 26,000 individuals organized into 74 Chapters nationally, and the P&P board has issued ten Statements. The intent of the Statements is to provide guidance to organizations with “authority to issue pronouncements” (HFMA, 1986). Statement No. 8 addressed the issue of multiple fund accounting for external reporting purposes.

NP hospitals have traditionally used fund accounting, the accounting entity for control and reporting purposes. All of the operating entries (e.g., revenues and expenses) are recorded in the Unrestricted Funds, along with fixed assets and associated long-term debt and board designated (internally restricted) assets and related liabilities. There have been three categories of restricted funds: (1) Specific Purpose Funds, to account for expendable assets that are externally restricted by third party donors for specific operating purposes; (2) Plant Replacement and Expansion Funds, externally restricted for the acquisition or construction of fixed assets; and (3) Endowment Funds, the earnings of which are usually donor restricted (American Hospital Association, 1976). Common practice has been to intermix board designated funds along with externally


restricted funds, considering that donor restriction only effectively relates to the equity side of the ledger.

HFMA Statement No. 8 would essentially eliminate the balance sheet restricted funds and incorporate these activities with those of the Unrestricted Funds for external reporting purposes - with appropriate labelling and footnote disclosure of the limited use of the combined assets. However, the related issues of revenue reporting and changes in equity were still being studied by the P&P Board at the time Statement No. 8 was released. This left some uncertainty as to what conclusions the Board would ultimately reach on the subject. For example, prior to HFMA Statement No. 8 investment earnings associated with donor restricted assets increased the fund balance within the appropriate restricted fund. If subsequent pronouncements were to provide for the elimination of separate fund accounting for income, investment earnings would be recognized as non-operating revenues were earned. This change would increase net income, which could have the potential to discourage further donations and encourage further reimbursement reductions, despite the fact that the earnings would be donor restricted.

The primary arguments favouring fund accounting relate to the use of separate funds to highlight philanthropy and the related stewardship respon- sibilities. The positions supporting fund accounting considered by the HFMA included:

1. Fund reporting is needed to properly monitor and report the activities

2. Fund reporting enhances philanthropy by clearly disclosing stewardship undertaken.

responsibility (HFMA, 1986).

NP hospitals that anticipate philanthropy to continue or may for other reasons be reluctant to conform to the incentives associated with Medicare payments, would be expected to favour fund accounting.

The arguments for eliminating fund accounting focus on increased efficiency and suggest that users analyze the financial position of NP hospitals much as they would any commercial business. The positions supporting elimination of fund accounting considered by the HFMA included:

1. . . . [Ilnformation on total operating results is considered more important than detailed stewardship disclosures.

2 . In addition to directors and trustees other primary users of financial reports include investors and creditors. These users often must make decisions on the basis of the overall picture of the organization. It is difficult to obtain the necessary overview of the organization’s activities using fund reporting.

3. . . . [Plroviders need to use funds in accordance with their stated purpose, but the organization’s responsibility to manage effectively is also of critical importance.

4. In today’s environment of increased attention to control of costs, a business oriented financial statement portrays these results more effectively than a fund reporting format (HFMA, 1986).

An additional argument cited in Statement No. 8 is that fund accounting may


confuse users and obscure the activities of an inefficient and ineffective rnanage- ment. NP hospitals that have made the transition to economically defined efficient operations and business-oriented practices, or that do not have large endowment funds in place, are expected to be among those favouring the elimination of fund accounting.

After deliberating on the many related issues, and receiving input from a broad representation of healthcare and other constituents, the HFMA decided to eliminate balance sheet fund accounting in Statement No. 8 - suggesting that NP incentives have changed, primarily because of Medicare and other cost containment programmes, and that external financial reporting should reflect the new environment. In other words: (1) contributions have significantly decreased as the federal government has taken increased responsibility for healthcare and (2) all hospitals must emphasize management performance.

T H E MODEL AND DATA

Considerable research has been done on the comparative, real valued performance of hospitals. Studies, such as Berry (1974), Rafferty and Schweitzer (1974), Bays (1977 and 1979), Elnicki (1977), Neumann (1979), Becker and Steinwald (1981), Coyne (1982, 1984, 1985a and 1985b), Pattison and Katz (1983), Renn et al. (1985), Watt et al. (1986), Sherman (1986), Herzlinger and Krasker (1986), and Chilingerian and Sherman (1987) have identified numerous and systematic differences among hospital financial and operating variables relating to debt, size, profitability, case mix, LOS, cost per day, cost per case, and a variety of other factors. Simnett (1987) has related organizational factors to the presence of certain financial disclosures in the reports of private NP organizations selected at random. However, we have not been able to identify any studies that have attempted to relate economic factors to the accounting standard setting process within the healthcare industry.

In terms of applying a theory of accounting and economic behaviour to the NP sector in general, Fama and Jensen (1 983) discussed the agency problem within NP organizations, and Conrad (1984) has used agency theory and capital market theory to argue that under cost based reimbursement, the granting of additional reimbursement for a return on equity capital to FP hospitals (but not to NPs) was tantamount to a 100 percent tax on NP equity returns. Wallace (1987) has presented a discussion of the general applicability of agency theory to NP organizations, while Foster (1987) used agency theory and an access to capital argument to analyze the hospital’s choice of organizational form. We apply agency theory as a descriptive model of the relationship between the economic incentives brought to bear on hospital management by regulators, donors and creditors, and the lobbying positions taken by managers on accounting standards.

Refore HFMA Statement No. 8 was issued NP hospitals could lobby either


Table 1

Source of Response

HFMA Other Position CPAs Chapters Hospitals Totals

In-favour 2 0 p p o s e d 2 Straddled 0

8 3 0

5 5 1

15 10

1

Total 4 11 11 26

for or against fund accounting. The 26 formal comment letters received on this issue are categorized by source in Table 1. Fifteen of the comment letters favoured eliminating fund accounting and ten preferred maintaining fund accounting. The HFMA Chapter letters represent the consensus view of a large number of member hospitals, and reflect a 73 per cent in-favour response. The focus of our empirical analysis will be on the 12 letters, either pro or con (13 less one that straddled), which enabled us to identify specific hospital organizations. This allowed us to obtain data on an individual hospital basis, and to evaluate the hospital responses within the context of economic incentives. The other groups included both Big 8 and non-Big 8 CPA firms and one state CPA society, that provided comment letters in equal numbers on both sides of the issue.

The hospitals favouring eliminating fund accounting are expected to be among those that have adapted to the new environment of increased economic eficiency andor have lower reliance on philanthropy. These in-favour hospitals should have financial and operating ratios that would support this position. First, it is expected that they would have a shorter average case mix adjusted LOS than opposed hospitals, since Medicare reimbursement generally does not increase for longer stays. It may be likely that this group has a higher percentage of Medicare patients (MED%). These two nonfinancial measures can be considered proxies for efficiency, and exposure to federal incentives to control costs, respectively. If increased economic efficiency is achieved, then this group should also achieve a higher profit margin (PM) in general. The in-favour group may have benefitted less from philanthropy, in which case they would be expected to have less investment income (INVEST) than the opposed group. Also, if they are the more efficient organizations, they may be expected to have less investment income related to non-philanthropic sources, such as longstanding funded depreciation accounts which have not been reinvested in new capital facilities. The in-favour group may have a larger proportion of debt (DEBT) than the opposed group, in which case there would be added demand for financial statements which conform to commercial standards. In summary, the model developed is:


Lobby = f(LOS, MED%, PM, INVEST, DEBT) + - + + -

where,

Lobby = a dummy variable equal to 1 if the hospital favoured

LOS MED% PM = profit margin on net patient revenue INVEST = total investment income in $000 DEBT = total debt per adjusted patient case

Data for the hospitals were taken from the American Hospital Association’s Guide to the Healthcare Field (1 985) and Directory of Multihospital Systems (1 985) as well as from the Health Care Financing Administration’s Hospital Cost Report Information System (HCRIS) files, and Case Mix Index files. The data used were from 1984-85, approximating the period of distribution for the HFMA’s Discussion Memorandum (May 1984), Exposure Draft (December 1984), and final Statement No. 8 (December 1985).

eliminating fund accounting = case mix adjusted average length of stay in days = percentage of Medicare and Medicaid patients to all patients

RESULTS

The sample hospital respondents included both single and multihospital organizations. Since data were available by individual member hospital identified in the 12 letters, the in-favour variables represented 16 hospitals and opposed six. (One of the seven opposed group hospitals was eliminated from the analysis for lack of data.) Because of the limitations of such a small sample, results are evaluated on the basis of direction and relative magnitude, rather than multivariable statistical analysis. The averages for the five ratios are presented in Table 2. Specific variable definitions are presented in the Appendix.

Table 2

Averages for the Five Factors*

Zn-fauour Opposed Factor (n = 16) (n = 6) Difference Predicted

LOS 5.8 days 6 . 0 days -0.2 days - MED% 42.6% 37.3% 5.3% + PM 8.3% 4.5% 3.8% +

$1,463 - $1,040 - INVEST % 423 DEBT $1,655 $ 756 $ 899 + LOBBY 1 0

~~

‘Based on data from 22 hospitals (24, less one straddled opinion, less one eliminated for lack of data).


Patient LOS is a measure of efficiency, given the flat fee reimbursement structure associated with Medicare. The two groups of hospitals in the sample had nearly identical LOS, an unexpected result. The in-favour group also had considerably more Medicare/Medicaid patients, an added incentive to increase efficiency. The P M for in-favour hospitals was nearly twice as large as the opposed group, possibly the effect of greater overall organizational efficiency on the bottom line. It is interesting to note that the in-favour group had both higher average costs ($2,919 per adjusted case vs. $2,321) and higher average net patient revenue ($2,952 per adjusted case vs. $2,315) than the opposed group. The in-favour group apparently derived greater revenues from operations despite the greater proportion of generally low paying Medicare services. One explanation may be that these hospitals on average provided more complex, more costly and better paid care than the opposed group. The lower PM experienced by the opposed group also suggests that these hospitals had not adjusted sufficiently to the new emphasis on economic efficiency.

It was expected that the opposed group would be more dependent on philanthropy. As predicted, investment income for these hospitals was more than three times as great as the in-favour hospitals within the sample. Invest- ment income for the opposed group represented 26 percent of net income, compared to 18 percent for in-favour hospitals. This might also imply that the opposed group on average had old capital facilities which had long been converted into interest bearing investments (through the accumulation of funded depreciation amounts) which had not been reinvested in plant assets over time. Thus, considering limited representativeness, these hospitals may be more concerned with financial reports that emphasize stewardship over donated monies rather than measures of overall organizational performance.

It was assumed that in-favour hospitals would have larger debt proportions, requiring financial reporting consistent with commercial firms. Although ratios of total debt to total assets were somewhat higher for the in-favour group (47 % vs. 42 %), the amount of debt per adjusted patient case (the source of cash flow for repayment) was more than twice as large for the in-favour hospitals as for the opposed group. Therefore, there is some evidence that debt covenants may have an effect on lobbying behaviour by hospitals.

Specific statements made within the comment letters submitted by both groups were also consistent with our empirical findings. For example, the opposed group perceived that elimination of the concept of separate funds could lead to misinterpretation by users:

Problems could arise from interest earnings related to Medicare and the offset of those earnings against current expenses . . .

The major problem I foresee is that in a state such as . . . where an anti hospital politically motivated healthcare law has been enacted, a single fund reporting format would be utilized to further erode the financial base of healthcare institutions.

FUND ACCOUNTING IN NONPROFIT HOSPITALS 24 1

The expressed concern about interest income, its potential offset against operating expenses, and perceived politically motivated erosion of the hospital’s financial base indicate concern about what, in agency theory terms, is defined as a political cost issue. Further:

Many of our hospitals do not want to disclose investment income in their reports to the public. They do this today by either setting up foundations or simply encouraging the acceptance of restricted gifts.

Our CFO members (and their bosses) will say, why is our (your) organization advocating such positions when other authorities continue to recognize the distinction between general and restricted fund reporting?

Considering that HFMA Statement No. 8 did not prescribe changes in income reporting, these comments seem to indicate two issues: (1) that important reporting implications relating to donor-restricted investment inccme exist, and (2) HFMA Statement No. 8 was perceived to represent an increased emphasis in authoritative support away from the general concept of account segregation - which has historically been relied upon to separate that income. This was perceived to have the potential to promote further reductions in third party payment programmes, hence effecting a non-cosmetic wealth transfer from the endowments to the public sector.

The in-favour hospitals in our sample submitted comment letters which focused on the issues of reducing confusion and presenting an overall picture of the hospitals finances. There seemed to be little concern expressed regarding a loss of separate fund reporting of investment income, or of any potential for wealth transfers. This implies that the sample hospitals with less investment income on average, were not as concerned about the wealth transfer implications, and supported the accounting change on clarity and overall organizational performance issues. For example:

Financial statements prepared using Fund Accounting are confusing to most readers and changing to Single Fund Reporting should help eliminate this confusion.

Frequently information which shows the overall financial picture is totally lacking in the general purpose financial statements of organizations using fund reporting.

Whether those organizations are for-profit or not-for-profit, the people who read the financial reports all tend to read them with the same idea in mind. When financial reports are broken up in unrestricted and restricted (restricted may be one or many different funds), the reader of the . . . financial statements will not be able to put the full picture into perspective.

HFMA Statement No. 8 therefore may be viewed as having two dimensions: (1) an improvement in overall assessment of organizational performance (i.e., when operating finances dominate the hospitals’ financial reports), and (2) the signal of a possible future direction toward a combined-fund income effect (which becomes important when non-operating finances play a dominant role in the hospitals’ financial reports).


One individual comment letter concurred with the concept of single fund reporting, but was opposed to the Statement due to an expressed concern about exposure to the political cost-type issues.

Although I believe there are many very valid reasons for supporting a single aggregated balance sheet, I would not be in favour of the exposure draft as written because I believe that the financial statements which would result would be even more misleading . . . This becomes particularly critical in healthcare institutions with significant endowment funds or ones which conduct major research which is supported by restricted grants. A single aggregated balance sheet in those two instances would represent a serious inflation of the operational position of the organization and may cause both the board of directors, creditors, and other third party readers to make serious misjudgments.

We concluded that the potential for relative economic benefits or costs from the change in accounting standard was evidenced by the sample hospital data, as related to the positions taken in the comment letters. It was expected that hospitals responding to the pronouncement would have lobbying positions consistent with their individual economic circumstances. Although individual hospitals may not necessarily be representative of the broad based group consensus provided through the HFMA chapters and other constituents, our findings were nonetheless consistent with the theoretical model.

CONCLUSION

The healthcare industry, with its competing FP and NP organizations, has provided a unique opportunity to analyse the effects of economic relationships on the accounting standard setting process. The lobbying positions taken by hospitals seem to be related to the perceived relative benefits to be gained or costs incurred from the alternatives. Four of the five variables analysed for the sample were consistent with economic incentives. The evidence presented, though highly tentative in nature, is supportive of the arguments derived from agency theory and demonstrates its usefulness in analysing the effects of changing economic relationships on the demand for and formulation of accounting standards within the healthcare industry. Further research is thus suggested to analyse accounting issues pertinent to the healthcare industry in an agency theory context.

APPENDIX

Variable Definitions Total Inpatient Bed Days

Total Admissions X Case Mix Index' LOS =

Medicare + Medicaid Admissions Total Admissions MED% =

FUND ACCOUNTING IN NONPROFIT HOSPITALS

Net Income Net Patient Revenue

- I’M

INVEST = Total Investment Income in $000

DEBT = Total Debt

Case Mix Ad,justed Admissions‘*

*Case Mix Index = 1984 Medicare Case Mix Index (1.0 = average) ”Case Mix Adjusted Admissions =

243

Inpatient + Outpatirnt Revenue Inpatient Revenue

Case Mix Index X Total Admissions X

NOTES

1

2

See the section hraded Fund Accounting lor a further description of the role and work of the HFMA. This was not proportionate to the population of letters.

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fund accounting in nonprofit hospitals: a lobbying perspective

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