Examine the notes to financial statements.

The financial statements for Local Community Hospital (LCH) tell a great deal about the organization. They provide information about the organizations resources, obligations, net worth (net assets), profitability, and cash flows. Yet financial statements are extremely limited in their ability to convey information. Therefore, audited financial statements must be accompanied by a set of notes. These notes explain the organizations significant accounting policies and provide disclosure of other information not contained in the balance sheet, statement of operations, and statement of cash flows, but that is necessary for the statements to be a fair representation of the organizations financial position and the results of its operations.

This chapter presents a hypothetical set of notes for the financial statements of LCH. We first present each note and then discuss it before moving on to the next note. This discussion is not exhaustive. Each organization has notes that apply to its own unique circumstances.

Significant Accounting Policies

The notes section begins with a statement of significant accounting policies used by the organization. This is particularly important because of the alternative choices of accounting methods allowed, even within the constraints of GAAP. In cases in which the organization has a choice of methods, that choice likely has an impact on both the balance sheet and the statement of operations and, possibly, on the statement of cash flows. The financial statement figures are not meaningful unless you know what choices the organization has made.

Note ASignificant Accounting Policies

1. Net Patient Services RevenueThe Hospital has arrangements with third-party payers that provide for payments to the Hospital at amounts different from established rates. Net patient services revenue is recorded at the estimated net realizable amounts from patients and third-party payers.

This note makes it clear that LCH does not claim full charges as revenue. As previously described (see Chapter 3), health care organizations have a variety of payment systems. Net patient service revenue represents the actual amount the hospital is entitled to collect for services it has provided, after subtracting charity care, negotiated discounts, and other contractual allowances.

2. Short-term investmentsShort-term investments are stated at their fair market value.

LCH has $32,000 of marketable securities at the end of fiscal year 2019 (see Table 12-1). Your expectation might be that these securities cost LCH $32,000 because that would correspond with the cost principle of accounting. However, objective market prices for stocks and bonds are available from many sources. We can determine the price at which identical securities were sold. Therefore, marketable securities are shown on the balance sheet at their fair market value, as indicated by this note.

3. InventoriesInventories are stated at cost, not to exceed market. Cost is calculated using the last-in, first-out (LIFO) method.

Here, the principle of recording at cost (based on objective evidence) conflicts with that of conservatism (adequate consideration of relevant risks). In this case, GAAP require use of lower of cost or market value (LCM). If the market value exceeds cost, the cost is used. If the cost exceeds market value, the market value is used. Essentially, inventory can be valued below its cost, but not above it. So inventories are stated using LCM because of the GAAP of conservatism. But how does LCH measure the cost of its inventory? This note indicates that LCH uses the LIFO method to determine inventory cost.

LIFO/FIFO is a choice the organization is allowed under GAAP.

4. Property, plant, and equipmentProperty, plant, and equipment are recorded at cost less depreciation. Depreciation taken over the useful lives of plant and equipment is calculated on the straight-line (SL) basis.

For financial reporting, a fair degree of latitude is provided in choosing a depreciation method. The organization could use a declining balance or SYD approach as an alternative to SL depreciation. For LCH, in 2019, operating costs included $28,000 of depreciation calculated on a SL basis. Suppose the DDB depreciation would have been $42,000 and that the SYD depreciation would have been $36,000.

The organizations reported net income can be greatly affected by the choice of accounting methods. Disclosure of choices, such as the inventory and depreciation methods used, provides users with a greater ability to understand the organizations financial situation.

5. Income TaxesLocal Community Hospital is a not-for-profit organization, as described in Internal Revenue Code 501(c)(3), and related income is exempt from federal income tax under Code Section 501(a).

Like many health care organizations, LCH is a not-for-profit organization and, therefore, does not pay income tax. This note identifies the specific sections of the IRS code under which LCH is claiming its tax-exempt status.

6. Charity CareThe Hospital provides care without charge to patients who meet certain criteria under its charity care policy. Because the Hospital has no expectation or claim on payment in such cases, no revenue related to charity care is reported. Charity care is reported based on the cost to provide that care.

Many health care organizations provide charity care. In fact, the IRS code specifically speaks to the issue of not-for-profits giving back to the community as a justification for their favorable tax-exempt status. Because the organization has no up-front expectation of being paid for the services rendered under its charity care policy, it cannot claim any revenues related to these services.

Often, readers of health care financial statements expect to see expenses related to charity care specifically highlighted on the statement of operations. In reality, the expenses related to providing charity care are included in the operating statement in the form of expenses such as wages and supplies. These expenses are not, however, listed as a separate expense, nor are they listed as revenue. However, the notes that accompany the statement disclose the costs of providing charity care.

7. Net assets with donor restrictionsNet assets with donor restrictions have been limited by donors to a specific time period, until a specific event occurs, or have some specific restriction that must be maintained in perpetuity.

As previously described, the net assets of not-for-profit health care organizations like LCH have two categories: without donor restrictions and with donor restrictions. This note outlines the definitions used for the donor-restricted net assets.

Other Notes

In addition to a summary of accounting policies, the annual report contains other notes that provide additional disclosure of information needed for the financial statements to provide a fair representation of the financial position of the organization and the results of its operations.

Note BLiquidity and Availability of Financial Assets

LCHs working capital and cash flows have routine variations during the fiscal year. To manage liquidity, LCH maintains a $200,000 line of credit with a local bank that is drawn upon when needed during the year and repaid in full before the end of the fiscal year.

LCH has $114,000 in total financial assets as of December 31, 2019. Only $110,000 of these financial assets is available for general use within 1 year because of internal designations. There are no donor designations that limit how financial assets are used. Amounts available include Board-approved appropriation from the endowment fund for the following year. Amounts not available include amounts set aside for operating and other reserves that could be drawn upon if the Board of Directors approved of such action.

Nonprofit organizations are required to disclose financial assets available to meet cash needs for general expenditures within 1 year, according to FASB accounting standards updated for the years after 2017.

Note CReceivables

Receivables at December 31, 2019, including applicable allowances, were as follows:

Patient accounts			$ 72,000
	Less allowances for:
		Contractual adjustments	(22,000)
		Uncollectibles	(6,000)
Receivables, net			$ 52,000

The note on receivables provides the user of financial statements with additional information on the relationship between charges and actual payments. Based on the information provided in this note, it is clear that the big difference between charges and net receivables is the contractual allowance. This note also allows the user of financial statements to track changes in uncollectibles to see if this is becoming a larger problem over time.

Note DBonds Payable

At December 31, 2019, the schedule of required payments on LCHs outstanding bonds consisted of the following:

Year Ending December 31	Principal	Interest	Total
2020	$	$ 2,000	$ 2,000
2021		2,000	2,000
2022		2,000	2,000
2023		2,000	2,000
2024		2,000	2,000
20252029	68,000	14,000	82,000
20302034	45,000	12,000	57,000
20352039	46,000	11,500	57,500
20402044	49,000	13,000	62,000
Total	$ 208,000	$ 60,500	$ 268,500

The balance sheet of LCH lists three classes of long-term debt: mortgages, bonds, and other. The long-term debt schedule included in the notes provides detailed information on the upcoming bond payment obligations. As the note shows, LCH has obligations that are stable for the next 5 years, through 2024. During the period from 2025 to 2029, they have $68,000 in bonds that come due and cause their total payments for those years to jump from $2,000 to $82,000. In most cases, health care industry bonds require that only interest be paid during the life of the bond with a full principal payment at maturity. The large principal payment at maturity causes spikes in an organizations debt payment schedule. In many cases, bonds, or portions of bonds, are refinanced as they reach maturity.

Note ECommitments, Contingencies, and Litigation

Local Community Hospital is involved in a number of legal proceedings and claims with various parties that arose during the normal course of business. In the opinion of management, the outcome of the legal proceedings and claims is not expected to have a material adverse effect on the financial position of the entity.

The organization is required to disclose any material obligations or other possible liabilities or litigations that are significant. Recall that a financial transaction is not recorded unless there has been exchange. The organization may have recently settled a malpractice suit but not had any accounting transactions occur yet. If the settlement is material, disclosure is required.

Note FGoodwill

The goodwill recorded on the balance sheet arose as a result of the acquisition of another organization for more than fair market value of the identifiable assets of the organization. It has been determined that, due to permanent changes in market conditions, the goodwill has lost 10% of its value during 2019. Therefore, goodwill has been reduced from $108,000 to $98,000 on the balance sheet and a $10,000 expense has been charged.

When one organization acquires another for more than the value of the specific identifiable resources, the excess is grouped under the category of goodwill. It is very common for goodwill to arise when acquisitions occur.

If the ongoing organization being acquired was not worth more than its specific assets, the purchaser might simply buy similar assets rather than acquiring the organization. Many intangibles arise over an organizations life, such as reputation for quality products and creditworthiness. Goodwill remains as an asset on the balance sheet indefinitely under current GAAP. Goodwill is only reduced when there is a clear impairment to its value. At such a time, the entire impairment is treated as a one-time reduction in the value of goodwill. This differs from tax treatment that allows for-profit organizations to deduct the cost of goodwill as an expense over a 10-year period.