This article is an excerpt from AAOE’s financial module series, The Profitable Practice
. This excerpt is designed to introduce and describe to young ophthalmologists, administrators and physician owners the practical uses of the financial statements that are commonly prepared in connection with the operation of ophthalmology practices.
Cash Accounting Versus Accrual Accounting
Financial statements are normally prepared in accordance with what are called generally accepted accounting principles. Although this term sounds a bit fuzzy, it actually has a very specific meaning: It requires the use of the accrual method of accounting.
Under the accrual method
, revenue is considered earned and is recognized in statements for the period when the revenue transaction occurred, regardless of when the related cash is collected. So, for example, under the accrual method, a practice’s earnings are posted at the time services are provided. Similarly, expenses are incurred at the moment the liability is incurred, regardless of payment terms.
For example, on any given day, a practice’s expenses include the hourly wages earned by staff members that day, even though the payroll funds may be paid out only twice a month, which might be a week or more away.
This method is very different from the cash-basis accounting system commonly used by ophthalmology practices. Under the cash-basis method of accounting, revenue is not recognized until it is received and expenses are not recognized until they are paid.
Most ophthalmic practices, particularly small or solo practices, use the cash-basis method of accounting because of its simplicity and because their financial statements are constructed only for the practice’s owner(s) and perhaps a local banker. However, the accrual-basis reports, by their nature, are more comprehensive and have greater utility.
Even practices that prepare their financial statements using the accrual method generally use the cash-basis method of accounting for filing their tax returns. Cash-basis filings are generally permitted by the IRS. Don’t confuse financial statements and income tax returns — they are two very different things.
Often, when assessing a practice, our firm will ask to see both the practice’s financial statements and its tax returns. Although the tax returns have less utility, we generally review them for the purpose of ensuring consistency with the financial statements. However, some small practices do not engage accountants to prepare financial statements.
In these instances, the tax returns must be relied upon. In cases where we have only cash-basis financial statements and/or tax returns to review, we essentially “convert” these to accrual statements ourselves by gathering the necessary additional information (i.e., accrued income and expenses) and making the necessary adjustments, rendering the statements more useful.
Basic Financial Statements
The financial statements most commonly prepared for ophthalmic practices are balance sheets and income statements. Financial statements are prepared as of the final date of each fiscal year, although they can also be prepared on an interim basis as well.
Indeed, a well-run practice should be preparing income statements (although not necessarily balance sheets) at least quarterly, if not monthly. However, these interim reports can be somewhat less formal. Financial statements are also often prepared for use in comparative reporting. For example, results for the fiscal year just completed and for the immediately preceding year or for the first quarter of the current year and the first quarter of the prior year(s).
The balance sheet presents the assets, liabilities and owners’ equity of a business as of a specific date, usually the end of the fiscal year.
Note: The fiscal year typically corresponds to the calendar year — in which case the year-end date is Dec. 31. But the fiscal year can be any 12-month period the business chooses.
Interim balance sheets are generally unnecessary, since the typical practice does not need to review a statement of its assets, liabilities and equity on a frequent basis. However, as mentioned, interim balance sheets can be prepared on a monthly, quarterly or semiannual basis, for example, or upon request by a bank or prospective purchaser.
Assets are the economic resources or entitlements owned by the practice, including equipment, cash and accounts receivable. Typical asset classes appearing on an accrual-based balance sheet include:
- Cash and cash equivalents;
- Accounts receivable;
- Furniture, fixtures and equipment;
- Leasehold improvements; and
- Security deposits on property (i.e., office) leases.
The balance sheet typically does not contain a detailed description of the assets, but is rather a summary of the asset classes. (Most practices should also have a detailed inventory of what they own, from which the balance sheet data are derived.)
A cash-basis balance sheet often will include such categories as cash and property — i.e., furniture, equipment and leasehold improvements — and leasehold deposits. Property assets are stated at cost and then reduced by the total depreciation taken thereon.
Liabilities are the debts of a practice, which may include bank debt and vendor accounts payable. Short-term liabilities are those due and payable within one year. Accounts payable are an example of a short-term liability.
Long-term liabilities are those due and payable in a year or more. A five-year bank loan is partly long-term and partly short-term. That is, the portion due within one year is considered a short-term liability and the remaining balance long-term. On the liability side of the ledger, the cash-basis balance sheet’s most common significant omissions are:
- Accounts payable,
- Accrued payroll, and
- Accrued retirement contribution.
Owners’ equity represents the residual financial interest in a business. Put another way, the owners’ equitable interest in the practice is what remains after subtracting its liabilities from its assets. This remainder is commonly referred to as the practice’s book value.
Owners’ equity includes contributions paid into the practice by its owners. It also includes profits that are retained by the practice and used for capital purposes (e.g., new equipment, office improvements), rather than distributed to the practice owners.
The income statement (also commonly referred to as a profit and loss statement) reports both the revenues and operating expenses of the business entity for a given time period, usually the fiscal year, although income statements are often prepared monthly or quarterly as well. The revenues remaining after subtracting the operating expenses constitutes the practice’s income (also referred to as profit). If the operating expenses exceed revenues, the deficit constitutes an operating loss.
The sum of all revenue sources from core business operations, including patient services, research, lectures and optical sales, is referred to as gross revenue. If a practice’s revenues are derived from various sources, the revenues can be broken out and identified by source.
This portion of the income statement also generally reports adjustments to gross revenues from patient and insurance refunds. In the case of optical, direct costs of goods sold, such as the cost of the purchase of frames and lenses, are included in this portion of the income statement as adjustments to gross revenues. The after-adjusted gross revenue is referred to as net revenue.
The expenses that appear on the income statement are operating expenses. Operating expenses (also commonly referred to as overhead) are distinguishable from capital expenses, which are not included on the income statement. Operating expenses are payments incurred in connection with the practice’s day-to-day operations. Capital expenses, on the other hand, are expenditures for assets such as equipment and furnishings and are recorded on the balance sheet, as discussed previously.
Statement of Cash Flows
The statement of cash flows is similar in appearance to the balance sheet. However, the purpose of the statement of cash flows is to provide a clear picture of the practice’s money flow, as distinguished from profit. What is the difference? Well, certain payments, while actual cash outlays, do not constitute operating expenses. As mentioned above, capital expenditures are not operating expenses. Similarly, loan repayments are not expenses.
Conversely, the income statement may show certain operating expenses that do not represent actual cash outlays, such as depreciation expense. Thus, it is entirely possible — and is, in fact, usually the case — that although a practice’s income statement may report a certain amount of “profit,” the combination of what the practice’s owners actually took home or retained in the practice may be significantly less, or more, than that figure. The statement of cash flows essentially ties to the income statement and then shows adjustments that, in effect, convert profit to cash.
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About the author: This article originally appeared in the March 2010 issue of Executive Update. It was written by Mark Abruzzo, a principal in Wade Goldstein, Landau and Abruzzo, PC. Mark has a tax background, having been employed as a tax consultant for a worldwide accounting firm. He counsels health care providers on all areas of business, corporate, partnership and contract law. He has considerable expertise in areas involving formations, co-ownership arrangements, mergers, consolidations, and acquisitions and sales of provider practices and business organizations. He is also a member of the AAOE Consultant Directory.