Chapter 4 Notes
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One Day of Notes
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Date Created: 02/02/15
Chapter 4 09062014 Introduction 0 The balance sheet contains information concerning an organization s assets and the nancing used to acquire those assets 0 Net income alone does not give a complete picture of an organization s nancial condition 0 The second nancial statement discussed in this chapter the statement of cash ows focuses on this important determinant of nancial condition 0 Important to understand the relationship among the nancial statements interrelationships among the statements Balance Sheet Basics 0 Income statement reports the results of operations overa period of time 0 Balance sheets presents a snapshot of the nancial position of an organization at a given point in time for this reason its also called the statement of nancial position 0 The balance sheet changes every day as a business inc or dec its assets or changes the composition of its nancing 0 Data of balance sheet often becomes invalid a day later even when both dates are in the same accounting period unlike the income statement Ex Healthcare providers with seasonal demand such as a walkin clinic in orida have large changes in their balance sheets during the year feb very diff from july Ex rapidly growing businesses will have signi cant changes in balance sheets over short periods of time 0 Lists the resources of an organization and the claims against those resources reports the assets of an organization and how those assets were nanced Assets on the left liabilities and equity on the right side 0 Assets side left all the resourcesassets owned by the organization Often broken down into categories and distinguish short lived current assets from longlived assets 0 Liabilities and Equity side claimsright side lists the claims against these resources in dollar termsljl reports the sources of nancing capital used to acquire assets on the left side Sources of capital divided into two broad categories n Liabilities claims xed by contract listed by maturity short vs longterm n Equity residual claim that depends on asset values and the amount of liabilities Assets Most important characteristic of balance sheet it must balance left side must equal right side This relationship is called the accounting identity or basic accounting equation A LE or EA L quotthis format reinforces the concept that equity represents a residual claim against the total assets of the business and also the fact that equity can be negative if a business decreases the value of its assets its liabilities are unaffected because these amounts are still owed to creditorsso if total assets value drops below that of total liabilities then the equity reported on the balance sheet becomes negative The balance sheet will provide an overview of the economic position of the organization as a whole Another difference between income and balance Income statement will indicate data for the year ENDED on Dec 31 Balance sheet will merely indicate a closing date quotas of Dec 31 Assets either possess or create economic bene t for organization 0 Current assets 0 include cash and other assets that are expected to be converted into cash within one accounting period The conversion of current assets into cash is expected to provide all or part of the funds that will be needed to pay off the current liabilities at the end of one scal year as they come due at the start of the next current assets are one element that contributes to the liquidity of the organization I Businessiquid if has cash to pay bills as come due 0 Net working capital 0 O O O The difference between total current assets and total current liabilities From a pure liquidity standpoint the greater the net working capital the better There are costs to carrying current assets so health service organizations have to balance the need for liquidity against the associated costs of maintaining liquidity Cash represents actual cash in hand money held in commercial checking accounts Demand deposits Cash equivalents are short term securities investments that are quotreadily convertible into cashquot Securities that have a maturity of three months or less Note that cash amp cash equivalents are on same line of bal sheet 0 Short term investments sometimes called marketable securities which represent cash that has been temporarily invested in highly liquid lowrisk securities such as bank savings accounts money market mutual funds US Treasury Bills etc Organizations hold these because cash earns no interest and money held in commercial checking accts earns very little so buz s hold only enough cash and checking account balances to pay recurring operating expenses immediate needs Normally reported on the balance sheet at cost the initial amount paid for the securities but bc of changing interest rates amp other factors those securities may actually be worth moreless than their purchase price but bc have maturities of less than 1 year substantial value change unlikely 0 Net patient accounts receivable represents money owed to the business for services that the clinic has already provided doesn t mean that is has been collected yet 0 Under accounts receivable this is the amount of revenue that remains to be collected which suggests a difference from the total service revenue amount The total service revacc rec amountcashmoney that was collected during the year o If business closes accounts receivable balance will fall to zero once the entire amount was collected o If a business remains open receivables balance will never fall to zero beacuase although the business s collections are lowering it new services are constantly being provided that create new billings receivables that are added to it o Inventories primarily re ects the business s purchase of supplies 0 As with the cash account it s not in the business s best interest to hold excessive inventories certain level of guard against unexpected surges in use so smart to have a safety stock 0 Business s that hold large amounts of inventories typically include a footnote that discusses the holdings in some detail 0 Some providers include the value of inventories in a catchall account called quotother current assetsquot 0 Primary purpose served by the current asset accounts are to support the operations of the organization and to provide liquidity Current assets do not generate high returns cash earns no return cash equivalents and shortterm investments generally earn low returns receivables account doesn t earn interest income nor generate new service revenue and inventories represent dollar investments sitting on shelves which earn no return til a customer is billed for their use bc of low returns businesses try to minimize these account values yet ensure that the levels on hand are suf cient to support operations 0 Current assets section on balance sheet is listed in order of liquidity 0 Cash and equivalents are listed rst and least liquid assets inventories listed last 0 Note providers that operate under capitation have a signi cant liquidity advantage compared with those that primarily receive feeforservice revenue because capitated payments are received before the services are actually provided organizations that are predominantly capitated will have much smaller act rec balances and much larger cash and short term investments balances than providers that operate in a feeforservice environment 0 LongTerm Investments 0 Represents investments in nancial assets as opposed to investments in real assets such as buildings and machines 0 Investments in stocks bonds other securities that have longer maturity dates than shortterm investments in hopes that they ll provide higher returns 0 Reported on the balance sheet at fair market value rather than initial cost so changes in market conditions over time will cause the value of this account to change 0 Income earned on both short and longterm investments is reported on the income statement under nonoperating income Businesses try to maintain the amounts held maintaining only the amounts necessary to support operations Bene t of prudent current asset management more money can be moved into longterm investments both nancial and real are expected to generate greater returns than those provided by current assets Re wards for minimizing an organizations current assets Reduction in carrying costs current assets cost money bc each dollar in assets has to be matched by a dollar in nancing Increased return expected from longterm investments Not for pro ts The long term investment account not only holds endowments but is a savings account that ultimately will be used to purchase new land buildings and equipment that either replaces wornout or obsolete assets or adds to the asset base to accommodate volume growth or provide new services Investorowned in contrast do not build up such quot reserves any cash ow above the amount needed for nearterm reinvestment in the business would likely be returned to the capital suppliers creditorsstockholders either by dept repurchases or dividends or stock repurchases When additional capital is needed for longterm investment in propertyequipment business simply goes to the capital bondstock markets and obtains additional debt or equity nancing 0 Net Property and Equipment 0 O 0 Third major asset category often called quot xed assetsquot Highly illiquid and used over long periods of time whereas current assets rise and fall spontaneously with the business s level of opertions xed assetsbuildings land etc are normally maintained a level suf cient to handle peak demand Property amp equipment value listed on balance sheet represents the value of xed assets net of depreciation so the effects of quotweartear are incorporated calculation of net property and equipment is included in the notes to the nancial statements Fixed assets are rst listed quothistorical costquotpurchase price D Total of such hist costs is labeled quotgross property and equipmentquot Accumulated depreciation represents total dollars of deprec that have been expensed on the income statement against the historical cost of the business s xed assets n This accountexample of a quotcontraasset account because it s a negative asset l the greater the value of this account the smaller an organization s net property amp equip account n Contra accounts reduce the value of the quotparentquot accounts xed assets in this case Book value the value of a business s assets liabilities and equity as reported on the balance sheet In other words the value in accordance with generally accepted accounting principles GAAP The connection of the balance sheet net property and equipment account to the income statement is through depreciation expense Depreciation even if doesn t re ect the true change in value of a xed asset over time at least ensures an orderly recognition of value loss 0 Example when changing technology instantly makes a piece of equipment obsolete and hence worthless the asset has experienced a sudden decline in value and the decline in value is quotwritten offquot or the value on the balance sheet is reduced perhaps to O and the amount of the reduction is taken as an expense on the income statement o Other Assets 0 Fourth asset category catchall category of misc longterm assets Liabilities Liabilities and Equity together represent the capital or money raised by an organization to acquire the assets shown on the left side 0 Again by de nition total capital the sum of liabilities and equity must equal total assets every dollar on left side must be matched by a dollar on right side 0 Liabilities represents claims against the assets of business that are xed by contract 0 Some of the liabilities claims are by workers for unpaid wages and salaries some are by tax authorities for unpaid taxes and some are by vendors that grant credit when supplies are purchased even not for pro ts have unpaid payroll and withholding taxes on their employees 0 The largest liability claims are typically by creditors lenders who have made loans supplied debt capital to the business Most creditors claims are unsecured meaning that they are not tied to speci ed assets pledged as collateral for the loan 0 Default by the borrower nonpayment of interest or principal creditors have the right to force the business into bankruptcy with liquidation assets sold as a possible consequence Bankruptcy requires that proceeds from any assets sold liquidated rst be used to satisfy liability claims before any funds can be paid to owners or used for charitable purposes Dollar value of each liability claim is xed by the amt shown on the balance sheet and owners have a claim to the residual proceeds after liquidation rather than to a xed amount Secured creditors have the rst right to the sale proceeds of assets pledged as collateral for the loan 0 Liabilities on the balance sheet current liabilities fall due within one accounting period are listed rst long term debt maturities greater than one accounting period is listed second lastly short term debt 0 Current Liabilities 0 Include liabilities that must be paid within one accounting period 0 Shortterm debt many businesses use short term debt maturity date less than 1 accting period to nance seasonal or cyclical working capital current asset needs On balance sheet short term debt is called notes payable 0 Accounts payable represent payment obligations that have been incurred as of the balance sheet date but have not yet been paid l represents amount due to vendors for supplies purchases Credit terms often offered by suppliers to customers the statement of terms that extends credit to buyers allows payment sometime after the purchase is made I By allowing a customer to pay either 10 or 30 days after supplies have been received the supplier acts as a creditor and the credit being offered trade credit o Accrued expensesaccruals a business liability that stems from the fact that some obligations such as wages and taxes are not paid immediately after the obligations are created Wagesbene ts to employees for work interest due on debt nancing utilities expenses not yet paid etc 0 Long term debt 0 This section of the balance sheet represents debt nancing to the organization with maturities longer than one accounting period and hence repayment isn t required during the coming year Lists any debt owed to banks and other creditors as well as obligations under certain types of lease arrangements Ex a 300000 bank loan with a long maturity such as 3 year I when loan 1st obtained 300000 will appear on the balance sheet I at end of rst year pay back the bank a total of 130000 30000 of interest 100000 repayment on the PRINCIPAL portion of the loan 0 the 30000 that s paid to the bank as in interest expense for the use of the money is posted as an expense on income statement but the 100000 is NOT an expense item but rather reduces the 300000 carried in the long term debt account n at end of 2nOI year loan will be treated similar 20000 will appear on income statement as expense 10 int rate and loan amount on balance sheet reduced by 100000 Current portion of long term debt The portion of longterm debt that must be paid in the coming year accounting period is recorded on the balance sheet as a CURRENT liability titled quotcurrent portion of longterm debt Net Assets Equity 0 Net Assets Ownership claim on an organization s assets represents the dollar value of assets remaining when a business s liabilities are stripped out 0 Equity the amount of total assets nanced by nonliability capital or total assets minus total liabilities 0 To determine what belongs to the owners xed claims liabilities are subtracted from the book value of the business s assets 0 The remainder net assetsequity represents the residual value of the assets of the organization 0 Importance of equity section of balance sheet re ects the ownership status of the organization 0 may be called stockholders equity owner s net worth net worth proprietor s worth partner s worth etc 0 Note Equity reported on the balance sheet needs to match the net income on the income statement this connection is a mathematical necessity Connections between the balance sheet and income statement 0 Bad debt expense o Depreciation 0 Equity on bal sheet net income on income statement Equity is NOT a store of cashas a business earns pro ts that increases the equity account these funds are invested in supplies property etc to provide future services that would likely generate even larger pro ts in the future The quotnet assetsquot type of equity section is typical of not for pro ts A relatively rare form of notforprofs can sell stock privately and these organizations may show a limited amount of stock outstanding o This stock is NOT sold in open market amp doesn t convey ownership rights Main difference in how the equity section is presented for notforprofs and in vestoro wned organizations 0 Title for investorowned quotStockholders Equityquot sh s own business 0 Stockholders Equity section of bal sheet consists of 2 parts Contributed capital sum of common stock and capital in excess of par amounts represents the dollars of capital contributed directly or paid out of pocket by stockholders or partners of investorowned business Retained earnings account represents the accumulated earnings of the organization that have been reinvested in the business because notfor profs cant pay dividends all earnings must be retained in business but in forpro t business s some portion or all may be distributed to owners through dividend payments or stock repurchases represent a claim against assets and are not available to buy propertysuppliesetc Par value the face nominal value of a security The par value of a debt security is the amount to be repaid at maturity speci es the minimum liability of shareholders in the event of bankruptcy Differences in the values of other balance sheet accounts between investor owned and notforprofits o Unlikely that a forpro t healthcare business would amass a large amount of long term investments securities unless the funds were earmarked for a particular use in a few years would prefer to have all the business s capital invested in operating assets which usually earn higher return than securities investments so there s more stockholder pressure on management to either invest this capital in more nancially productive operating assets or return it to owners in dividends o Forpro t economic advantage over notforprofs access to the capital markets ability to quotopen the faucetquot to acquire more capital Fund Accounting Unique feature of many notforpro t balance sheets they classify certain asset and net asset equity accounts as being restricted Fund a selfcontained pool set up to account of a speci c activity or project each fund typically has assets liabilities and an equity balance Fund accounting the system for recording nancial statement data that categorizes accounts as restricted or unrestricted only applicable to notforpro ts o Breaks net assets into three sub accounts Unrestricted net assets rst line include funds that are derived from operating activities retained earnings and unrestricted contributions funds that are not contractually required to be used for speci c purposes Temporarily restricted assets these funds are typically provided by donors that either have time or predetermined goal restrictions when the temporary restriction is met assuming there are no additional restrictions the money is transferred to the unrestricted fund I Ex a donor may specify that a contribution not be used until 3 years have elapsed or until the new children s hospital is built Permanently restricted net assets usually contributions that are donor restricted to a speci cpurpose such as building a new cancer facility or providing neonatal care charity srvices l these funds are not available for discretionary use restricted contributions impose legal and duciary responsibilities on health services organizations to carry out the written wishes of owners The Statement of Cash Flows Statement of Cash ows the nancial statement that focuses on the cash ows that come into and go out of a business 0 Created by accountants in response to demands by users for better information about a rm s cash in ows and out ows 0 Balance sheet and income statement have been required for many years but the statement of cash ows has only been required since 1989 for forpro ts and 1995 for notforpro ts 0 Details where a business gets cash and what happens to it o How it s different from the balance sheet and income statement 0 The balance sheet reports the cash balance on hand at the end of a period but it DOES NOT provide details on why the cash account is greater or smaller than the previous year s value 0 The income statement also does NOT give detailed information on cash ows 0 Problem with accrual accounting there may be cash raised by means other than operations that does not appear on the income statement 0 Two formats can be used for the statement of cash ows o 1 Direct format 0 2 Indirect format Most providers prefer this format 0 Statement is divided into three sections o 1 Cash ows from operating activities Focuses on the sources and uses of cash tied directly to operations The most important source of operating cash is income so its value is listed rst Note Operating income does NOT equal cash ow so various adjustments must be made I First amp most important adjustment add back the noncash expenses that appear on the income statement 0 Operating cash ow Operating Income Depreciation n Adjustments are then made for changes in those balance sheet current assets and liabilities accounts that are directly tied to operations I The theory for these adjustments changes in the values of these accounts stem directly from operations hence any cash that either is generated by or is used for these accounts should be included as part of cash ow from operations Alternative format is to begin the section with net incomethis format is appropriate if the organization s income statement did not separately identify operating income Under accrual accounting not every dollar of revenues or expenses listed on the income statement represents a dollar of cash ow Note short term investments and notes payable although current accounts re ect investment and nancing decisions of a business rather than operations and hence these accounts are not included in the rst section of the statement of cash ows The entire statement focuses on the change in cash and cash equivalents For a business regardless of type to be nancially sustainable it must generate a positive cash ow from operations n A consistent negative ow from operations would send warning to managersinvestors that the business may not be sustainable o 2 Cash Flows from Investing Activities Second major section on the statement of cash ows For purposes of the statement of cash ows investing activities are de ned as both property and equipment xed assets investments and securities investments Because depreciation is accounted for in the cash ows from operating activities section the focus in this section is on the gross total investment in xed assets lf short term investments account on the balance sheet increased meaning that the business used this amount of cash to buy shortterm securities hence an out ow of cash is posted in the statement of cash ow 0 3 Cash Flows from Financing Activities Final major section of the statement of cash ows focuses on a business s use of securities to nance its operations and other business activities In general new debt would be used to acquire real assets rather than nancial assets 0 Net Increase Decrease in Cash and Reconciliation o The next line of the statement of cash ows o It is merely the sum of the totals from the three major sections Difference from income stmt 0 Unlike the quotbottom line of the income statement the change in cash line has limited value on assessing an organization 5 nancial condition because it can be manipulated by nancing activities Ex If an organization is losing cash on operations but its managers want to report an increase in the cash account they can usually simply borrow the funds necessary to show a net cash increase on the statement SO 0 Income statement focuses on accounting pro tability statement of cash ows focuses on the movement of cash where came from how org used it etc 0 Major concern of the income statement is economic pro tability as de ned by GAAP the statement of cash ows is concerned with cash viability Transactions The recording of transactions by accountants is the rst step in the creation of a business s nancial statements understanding how transactions ultimately affect nancial statements will help managers better understand and interpret their content Transactions that ow to the income statement are relatively apparent but transactions that ow to the balance sheet are less obvious The primary concept behind all balance sheet transactions the basic accounting equation must be preserved each transaction must have a dual effect either one on the left side and one on the ride side or offsetting effects on the same side TEN typical balance sheet transactions 0 Investment by owners Suppose 5 radiologists decide to open a diagnostic center that they incorporate as an investorowned business Each one invests 200000 in exchange for 200000 of common stock this transaction results in an equal increase in both assets and equity increase in cash account of 1 million and an increase in the common stock account of 1 million a Purchase of equipment for cash To support operations business needs diagnostic equipment If rst piece of equipment purchased costs 200000 and is paid for in cash this transaction results in a change in the composition of the business s assets but the totals are unaffected l decrease in cash account increase in suppliesequipmentcapital account by 200000 each a Purchase of supplies on credit If the business purchases supplies for 20000 and the supplier gives the center 60 days to pay the bill assets are increased by 20000 because of expected bene t of using these supplies to provided services and the liabilities account accounts payable is increased by the 20000 due to the supplier 0 Services rendered for credit If the center provides services that result in 50000 in billings to third party payers this transaction will increase assets accounts receivable and the retained earnings portion of equitythis 50000 would also show up on the income statement as revenue which would ultimately ow to the balance sheet and hence support the increase in equity n Note retained earnings equity has increased when revenues are earned although no cash has been generated When funds are collected later cash acct will increase and receivables will decrease a Purchase of advertising on credit The center receives a bill for 10000 from the newspaper for advertising its grand opening but it doesn t have to pay the bill for 30 days so this transaction results in an increase in liabilities and a decrease in equity speci cally increased accounts payable and decreased retained earnings this decrease in equity will make its way through the income statement as a 10000 advertising expense here equity is reduced when expenses are incurred a Payment of expenses If the center paid 50000 in cash for rent salaries and utilities these payments result in an equal decrease in cash and equity The decrease in equity will be matched by a reduction in net income on income statementequity is now worth less than the total capital supplied by the center s stockholders 0 Recognition of supplies used If 2000 worth of supplies were used in providing healthcare services to patients the cost of supplies used is an expense that decreases assets and equity this expense is also shown on the income statement and hence net income is reduced by the same amount a Payment of accounts payable advertising bill If the center paid its 10000 advertising bill which was due in 30 days this payment on an account for an expense already recognized previously recorded as a payable decreases both assets cash and liabilities payables by 10000 a Payment of account payable supplies bill A month later the center paid its 20000 supplies bill which decreases cash assets and accounts payable liability by 20000 0 Receipt of cash from a thirdparty payer Assume that 5000 is received in payment for patient services rendered from one of the center s thirdparty payersthis transaction doesn t change the center s total assets or total claims but it changes the composition of assets by reducing receivables and increasing cash Debt ratio Total debt divided by total assets A debt utilization ratio that measures the proportion of debt versus equity nancing typically de ned as total debt liabilities divided by total assets Judgments about a business s capital structure could NOT be made easily without constructing the debt ratio and other ratios interpreting the dollar value is too hard
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