Healthcare Financial Management Agency Problems

Healthcare Financial Management

Agency problems lead to the possibility of agency costs. Agency costs are the dollar amount of value lost in market value of the organization, or in the health status of the patient, because of agency problems. How can agency issues be avoided (or minimized) in the health care setting to maintain revenue, but more importantly, protect the health status of patients?

The problem of agency costs is inherent in the control of doctor's diagnostic and therapeutic costs. Although DRG-based CPT codes help to take away some of the uncertainty of reimbursement, there are other controls on overall budget for higher-margin procedures.

There are two ways to reduce agency costs: (1) move to an HMO-type structure where possible with the hospital, in which capitated costs replace per-procedure reimbursement. In that way, the incentives between the hospitals, doctors and patients are aligned, and (2) for those areas which will still be fee-for-service, insure that proper billing and coding procedures are observed. It is important to insure that there is a system in place that enters the data properly, and that CPT coders work hand-in-hand with the health care providers to insure proper billing. (Robinson, 1997) (Fleisher, 1991)

2. The basic principles of accounting: going concern, conservatism, the recording of information in monetary terms, the accrual principle, and full disclosure are vital to the success of an organization. Briefly describe each of these concepts and explain its importance in accounting.

Basis principles of accounting: These are related to the GAAP (Generally Accepted Accounting Procedures) and the rules behind the Chart of Accounts. By proper definition and training of the accounting staff, mistakes are less likely to be made in the proper booking of revenues and expenses.

Recording of information in monetary terms: It is always tempting to lump difficult-to-classify expenses in "General and Administrative." This temptation should be avoided, as it hides the true costs and revenues associated with hospital expenses. The better the ability to relate costs to specific procedures, the clearer the accounting information will be in providing guidance over how to operate the business.

The Accrual Principle: This differentiates operating expenses from cash flow. If an expense is paid for at a later time period, but the obligation is taken in the current time period, accrual accounting will guarantee that that obligation to pay is accounted for, and there are no nasty surprises later on.

Full Disclosure: There is a temptation to push some expenses into areas where the spending is opaque. If there is a particular concentration on capital expenses, there may be a temptation to push capital expenses into operating expenses, and vice versa. The problem with this is that it is not possible to associate true costs with true revenues, and therefore to understand which areas are generating or using resources.

3. Each financial statement has a specific role and function. Explain the role and function of: the balance sheet, the income statement, the statement of cash flows, and the operating statement.

Statement of Cash Flows:

This is the alpha and omega of the financial statements. The movement of cash represents a way to understand if the hospital will be able to cover its obligations with its cash inflows. The reason that LBO buyers focus on EBIT-DA is that it is the clearest indicator of cash flow. Cash flow is net profit minus accounts receivable increase, capital expenditures and taxes, plus accounts payable change, depreciation and amortization, and equity or loan increases.

Income Statement:

This states the total revenues minus cost of delivering services as a net income. Then taxes, depreciation and interest are deducted to arrive at a net income. This ignores non-operating items, like one-time charges and the changes in balance sheet items which is accounted for in the above assumptions.

Balance Sheet:

This is the statement of assets, liabilities and equity. The change in balance sheet items reflects on cash flow, as shown above. For example, an increase in a/R, an assets item, will result in a decrease in cash and an increase in profits.

Equity on the balance sheet is the difference between total liabilities and total assets.

4. At any point in time, a security or any asset is only worth what someone is willing to pay for that security or asset. However, models result in a precise value or price. This appears to be a direct contradiction.

Explain, in detail, this issue.

Assets differ in their ability to be valued. The more liquid they are, the easier it is to establish a market valuation. The less liquid (i.e. less of a market, longer time to buy or sell), the more difficult to establish a value.

The more liquid assets on a balance sheet include cash and liquid assets, including short-term investments. These can be valued up-to-the-minute.

Less liquid, but still easy to evaluate, are accounts receivable and accounts payable, as well as inventory. In all these cases, there may be some discounts, such as doubtful payments, obsolete inventory and contested accounts payable. The differences between actual value and market are relatively small, however.

The least liquid assets are plant, property and equipment. That's because it is difficult to compare the value of these assets to others, and because it could take some time to sell the asset if need be. if, for example, a hospital places a value on the land and the building, it is making a guess as to the actual value. The two methods in most common use are "replacement," or "market" value, and "historical" value. The first method will give a higher value (usually) to the asset, while the latter is more conservative. Showing too-low asset value may not give an accurate indication of the value of the asset.

5. Distinguish between fixed, variable, and step-fixed costs. Explain the difficulty of identifying some costs as either fixed or variable.

Fixed costs are those that don't vary with revenues, number of procedures, or other counts of value. A good example of this might be a mortgage for a hospital building, which remains steady for 30 years, whether the hospital is at 100% or 50% census.

Variable costs are those that move completely in step with the revenue, number of procedures, or other measures of volume in the hospital. An example of this might be hospital gowns -- the more hospital gowns used, the more patient-days or bed-days booked.

Step-fixed costs are those which remain at a certain fixed level within a "band" of revenue, patient bed-days or other measures of volume. The step function increases or decreases if another "band" is breached. An example of this might be interventional cardiology: the use of a catheter laboratory may remain constant up to 2000 procedures per year. Adding another 1000 would require the addition of a new cath lab at $2 million, which represents a step-fixed cost increase.

6. Least squares regression and the high-low method are used to estimate fixed and variable costs. Explain the advantages and disadvantages of both methods. Which method is the best method and why?

High-low estimates have the advantage of "bracketing" the potential costs in a budget. Since fixed costs do not vary much, there is no need to use such a forecasting tool. For variable and step-fixed costs, one of those methods may be necessary (Shonkwiler, 1984).

Revenue prediction may be the most difficult, and lends itself well to least squares regression methodologies.

Least-square regression is useful in predicting revenue changes, but has two inherent issues which must be addressed:

There is no indication of the elasticity of demand. if, for example, our hospital were offering lower-cost elective surgeries paid for by the patient, that could increase volume. Similarly, a "sale" on certain procedures could convince some PPO and HMO providers to move to our hospital. This must be accounted for in the forecast, and will not be captured by this method.

One should not try to apply least-squares regression to too large a portion of revenues. It makes more sense to split it into the logical component parts, such as oncology procedures, MRI's and cardiac catheterizations.

High-low budgeting is better used for step-fixed costs where there is some uncertainty, but the ability to "bracket" the forecast.

7. Distinguish between fixed, flexible, zero-based, incremental,

-down, and bottom-up budgeting methods. What are the advantages and disadvantages of each method? Which method is the best method and why?

Fixed Costs: This is the method used by the NHS in Great Britain: each health care facility has a fixed budget, regardless of demand, and must make do. It works only if there is a fixed number of patients, procedures and costs. Since this never occurs, fixed costs don't offer enough flexibility for planning today.

Flexible Costs: One must make assumptions in demand and costs which reflect reasonable assumptions about changes in condition. The budget must be set at the beginning of the period, but there must be some flexibility through analysis of actual and rolling forecasts to change as the assumptions change.

Zero-based budgeting assumes that each department must justify itself every year, and that any department can be eliminated if this justification does not take place. It may be most appropriate when there is a question of adding a new service or getting rid of a current service, but makes less sense for a department which is expected to continue in service.

Incremental budgeting is a part of the rolling forecast system. If there is a sudden spike in revenue, for example, it may make sense to do an incremental budget to take into account the new variable.

-down budgeting means that the CEO or CFO dictates how much money is present, and allocates it to each department. This has the benefit of control of expenditures, but the drawback that the department managers feel no responsibility to hew to a budget in which they had little or no input.

A s-up: This method starts at the department level and builds to an overall picture. While each department may want to have its needs fulfilled, there needs to be a subsequent tops-down evaluation in order to adequately distribute resources; also, only the tops-down analysis can compare the relative value of investments in various departments.

8. Explain in detail why it is difficult for investors to consistently beat the market" and earn returns in excess of that required given the level of risk taken.