IN THE NEWS

Healthcare Revenue Recognition

Published December 5th 2023

The goal of the accounting function in any business, including healthcare, is to report on a company's transactions of economic substance. Financial reporting should be communicated in a way that is accurate, consistent, and timely. In the United States, accounting practices must adhere to generally accepted accounting principles (GAAP), which are organized and communicated through the Accounting Standards Codification (ASC). ASC is maintained by the Financial Accounting Standards Board (FASB). Revenue recognition for most healthcare companies is currently governed by ASC Topic 606, Revenue from Contracts with Customers.

Revenue recognition — which "identifies the specific conditions in which revenue is recognized and determines how to account for it" — is an essential concept for all healthcare companies, especially those looking to make an exit. Investors will want to know that revenue is recognized in a manner consistent and appropriate for the healthcare industry. Not adhering to revenue standards may affect the earnings on which your transaction is priced and can have a significant impact on your net proceeds.

Recent changes in accounting standards, including those relating to revenue recognition, move towards principles-based accounting as opposed to traditional, rules-based accounting. Principles-based accounting, the most popular system globally, is founded on the belief that it is better to adjust accounting principles to a company's transactions rather than adjust a company's operations to accounting principles. This gives companies more freedom in reporting and less complexity than rules-based principles. The framework standardizes revenue recognition across industries, making it easier for investors and other consumers of financial statements to compare results.

The framework of ASC 606 recommends that healthcare companies recognize revenue when control of goods or services transfer to the customer in the amount of consideration the healthcare organization expects to receive. The FASB has defined a five-step approach that healthcare companies should follow when applying this standard:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations
  3. Determine the transaction price
  4. Allocate the transaction price
  5. Recognize revenue when/as performance obligations are satisfied

Below we will take a closer look at each of these steps. Before we do so, it should be noted that this standard does not apply to insurance contracts, lease contracts, financial instruments, guarantees, and nonmonetary exchanges. It also excludes contributions and collaborative agreements. Healthcare companies that fall under ASC Topic 954: Health Care Entities and their insurance-driven revenue are included in the scope of ASC 606. Insurance entities engaged in administrative services only (ASO) contracts must adhere to ASC 606 for those contracts.

Step 1: Identify the Contract(s) with a Customer

A contract can be written, oral, or implied and, in essence, represents a "meeting of the minds." A contract must have commercial substance, parties that are committed to their obligations, identifiable rights, and known payment terms. It must also be probable that the amount of consideration will be collectable. This means healthcare organizations must immediately assess a customer's ability and intent to pay as their obligation becomes due.

A healthcare provider may use experience with the customer or a portfolio of historical data to make this assessment. If the collectability threshold is not "probable," no contract exists, and no revenue can be recognized. Determining collectability can be onerous for healthcare providers unable to evaluate a customer prior to care (e.g., ambulance arrivals, emergency room visits) as they must reevaluate collectability as information is received. Healthcare-specific collectability considerations may include insurance status, patient responsibility, employment status, and/or changes in the responsible party.

Step 2: Identify the Performance Obligations

A performance obligation is a promise to transfer goods or services to the customer that is distinct or a series of distinct goods or services — in other words, the "unit of account" under ASC 606. Distinct is defined as goods or services that can be benefitted from on their own or with other resources readily available to the customer. If a good or service cannot be defined as distinct, it must be bundled until the bundle of goods or services is considered distinct.

A transaction price may include multiple performance obligations in which the price must be allocated among the obligations (see step 4). For example, a healthcare company provides medical equipment (e.g., hospital beds) with a warranty. As the warranty likely holds no value without the equipment, this would be considered a bundle of goods or services that represents one performance obligation. If the hospital bed came with a free pillow, this would represent two distinct items, so two performance obligations are identified.

In the healthcare industry, services often include several elements, such as room, meals, nursing, physicians, and medications. These elements may or may not be considered distinct, depending on the specific circumstances.

Step 3: Determine the Transaction Price

The transaction price is the amount of consideration a business expects to be entitled to for completing its performance obligation(s). It can also be defined as the amount allocated to each performance obligation in the contract as those obligations are fulfilled. Transaction price excludes any amount collected by third parties, such as sales tax.

A healthcare company should include all sources of payment in the transaction price, including the customer, insurance companies, and governmental organizations. The transaction price may also include fixed and variable amounts. Any variable component to price must be determined at the inception of the contract and reevaluated at each reporting period end. Variable components may include implicit price concessions (contractual adjustment), prompt-pay discounts, uninsured discounts, contractual adjustments, and other revenue adjustments. Net patient revenue should represent the estimated cash flows expected to receive from services at the time they are provided.

As a result, healthcare companies recognize significantly less bad debt than seen under previous revenue recognition standards because bad debt is only recognized when the patient has a true inability to pay (e.g., job loss, loss of insurance coverage). Under ASC 606, price concessions (i.e., change in the estimate of price) are recorded as contra-revenue and impairment loss (i.e., patient bad debts) is considered an operating expense.

Step 4: Allocate the Transaction Price

Once the performance obligations have been identified and the transaction price has been established, the price must be allocated amongst the performance obligations. This is typically done in proportion to their standalone selling prices. The standalone selling price is the price each distinct good or service would have sold for separately at the inception of the contract. Discounts, calculated as standalone selling price less the transaction price, are generally allocated proportionally based on the standalone selling price, but there are some exceptions. Variable consideration may be allocated on a non-pro-rata basis if the variable payment relates specifically to one or more, but not all, performance obligations. If there is a change in the contract price, the new allocation should be completed using the same basis used at the inception of the contract.

Step 5: Recognize Revenue as Performance Obligations are Satisfied

Revenue is recognized when performance obligations are satisfied by transferring goods or services at the transaction price that was established per step 4. For healthcare companies, the transfer occurs when the customer or patient obtains control of goods or services. The transfer may occur at a point in time or over time. This means if a healthcare provider is reimbursed on a fee-for-service basis, revenue would be recognized when the service is provided. Alternatively, if the provider is reimbursed for providing a service over a period, revenue would be recognized pro-rata over the time of the service.

Comprehensive Example

Let's take a look at an example of ASC 606 in practice.

A residential treatment facility accepts a client for a 45-day treatment stay. An understanding by both parties is evidenced by a service agreement that details the rights of both parties, that includes the right for either party to terminate the contract at any time without penalty, and is signed by both parties. The agreement states the cost of a 45-day stay is $25,000. Payment of $25,000 is to be collected in two payments: $20,000 upon admission and $5,000 after the client is discharged for 15 days. The cost of service covers room and board, food, psychiatric analysis, and clinical services. The fee does not cover elective, non-medical ancillary services (e.g., haircuts, massage). At the end of the contract, the client may elect to extend for a period, with the price to be determined later. The treatment center feels it is probable that they will receive payment in full for all services because the client's credit assessment was favorable, and the center provided services to this patient last year and received timely payment.

The client makes the first payment of $20,000 upon admission. He also elects to use ancillary services resulting in fees of $500, which are paid for at the time of service. After the client is discharged for 15 days, the accounting department is unable to collect the second payment of $5,000 because the credit card on file declines. The treatment center then learns that the client lost his job while in treatment and is unable to pay for services rendered.

Now we can see how the five steps described above would be applied to this example.

Step 1: It is clear that a contract exists as there is a written agreement stating the obligations and rights of both parties and the payment terms. The collectability threshold is met by the historical payment experience with the customer. The receipt of new information regarding employment status triggers the recognition of bad debt expense in the amount of $5,000. The extension of services would require a new contract as the terms and payment are not defined.

Step 2: Although the client could benefit from some of the individual services included in the cost of service, the nature of the treatment center's service is to deliver (i.e., transfer) a combined item (i.e., residential rehabilitation services). Therefore, those services such as room and board, food, psychiatric analysis, and clinical services are considered one performance obligation. The non-medical ancillary services are capable of being distinct from the standard services provided in the contract, and these services could even be purchased elsewhere. These services represent a separate performance obligation that should be recognized as revenue as the service is provided.

Step 3: The treatment center expects to receive $25,000 for its performance obligation of residential treatment services; thus, the transaction price is $25,000. The $5,000 payment not received represents bad debt expense and not a price concession because it represents a true inability to pay and not a discount or other revenue adjustment. If the client were to seek services in the future, the treatment center would have to determine the amount of payment that is probable and record a price concession for the difference between the standalone selling price ($25,000) and the transaction price (i.e., amount expected to be collected).

Step 4: In this step, the transaction price must be allocated to the two performance obligations identified in step two.

  • Residential treatment: $25,000
  • Ancillary services: $500

Step 5: Residential treatment services are delivered over a period of 45 days, so revenue would be recognized pro-rata over the treatment period to the sum of $555.55 per day. The ancillary services are fee-for-service, so revenue of $500 would be recognized when the service is rendered. A bad debt expense of $5,000 would be recognized when the patient's insolvency is discovered.

Appreciating the Importance of Revenue Recognition

Applying GAAP revenue recognition policies is an imperative best practice for all healthcare companies as it affects the integrity and reliability of an organization's financial reporting. Revenue is one of the most important metrics used by potential buyers to measure value, and improper application of ASC 606 can delay or even derail the sales process. If you have questions regarding revenue recognition for healthcare companies or the M+A process, please reach out to us at VERTESS.

Continue Reading

COMMITTED TO CONSTANT IMPROVEMENT?

Want to stay current with trends in the medical/healthcare space as well as receive expert advice of veteran medical entrepreneurs?
SUBSCRIBE TO OUR BI-WEEKLY NEWSLETTER VERTESSPRESS
For over 10 years, we've been teaching ways you can improve the value of your healthcare company, focusing on informing you about mergers + acquisitions, including M+A trends in the healthcare market.
CHECK OUT VERTESSPRESS THE BLOG
No Spam Ever. We Promise
©2024 VERTESS. All Rights Reserved.