Written by Johnny Zizzi, CPA; Lukas Recio, CPA
When considering a new acquisition or transaction, accurate financial reporting is paramount for informed decision making. One significant aspect of financial reporting is the choice of accounting method: cash, accrual, or a hybrid of both. Many companies begin their journey with cash accounting, but as they grow and evolve or are otherwise acquired by a larger entity, they often transition to accrual accounting to meet regulatory requirements or achieve a more comprehensive financial picture.
This transition is not without its pitfalls and considerations, particularly when understanding its impact on enterprise valuation resulting from the quality of earnings process. Key considerations when converting from cash to accrual accounting include revenue recognition in accordance with ASC 606, expense accrual recognitions, managing changes in working capital, and earnings volatility.
The Shift from Cash to Accrual Accounting
Cash accounting, also called checkbook accounting, entails recording transactions when cash changes hands, which provides management with a straightforward method for tracking cash flow. Small businesses often prefer this method because the IRS allows it when certain size criteria are met and because it is easier to track money as it moves in and out of bank accounts. Further, there is no need to evaluate accounts receivable or payable to determine income when using cash accounting, simplifying the management of the financial statements as a whole.
However, for healthcare entities, this simplicity can be misleading, as it does not capture the true financial obligations and revenues tied to patient care and insurance reimbursements. Accrual accounting, on the other hand, records revenues when they are earned and expenses when they are incurred, regardless of when cash is exchanged. While cash accounting may be simpler for small businesses, accrual accounting offers a more accurate representation of a company’s financial health, especially as they grow and become more complex.
A crucial component of most healthcare services transactions is the quality of earnings analysis, which aims to assess the sustainability and accuracy of historical earnings and the achievability of future earnings, thereby providing potential buyers with a clear understanding of the company’s true earning potential.
Revenue Recognition
Transitioning from cash-basis accounting to accrual accounting entails significant differences and challenges in revenue recognition. Under cash-basis accounting, revenue is recognized when cash is received, while accrual accounting dictates recognition when revenue is earned, irrespective of cash-flow timing. This shift necessitates adjustments to accurately reflect revenue generated within a given period, especially for long-term contracts or services rendered where cash receipts may occur at different points from when the revenue is earned. Challenges arise in estimating and timing revenue recognition, requiring careful assessment of performance obligations, delivery, and collectability.
Issues stemming from the diverse revenue streams and payment models prevalent in healthcare, such as fee-for-service, capitation, and bundled payments add an additional layer of complexity when converting from cash to accrual accounting, as each payment model has distinct timing and recognition criteria. Additionally, healthcare entities often engage in complex contractual arrangements with payors and providers, leading to variations in revenue and expense recognition practices. Moreover, healthcare organizations may have unique regulatory requirements and accounting treatments for certain transactions, further complicating conversion efforts.
Differences in case mix, payor mix, and procedure mix among healthcare entities can also impact revenue recognition as the collectability of outstanding accounts receivable is often different for specific payor and case mixes. Cash waterfalls, zero-balance analyses, and other revenue hindsight analyses are leveraged as part of VMG Health’s comprehensive quality of revenue analysis to ensure revenue recognition is converted from a cash basis to an accrual basis in accordance with ASC 606. Adherence to revenue recognition principles, while requiring meticulous analysis to mitigate misinterpretation and manipulation, is a critical component to a quality of earnings analysis, as it ensures financial statements provide a more comprehensive view of revenue performance, enhancing transparency and comparability. For further detail on quality of revenue analysis, see VMG Health’s previous article: Proceed with Caution: Five Key Considerations in Quality of Revenue Analysis.
Expense Accruals
Transitioning from cash to accrual accounting presents unique challenges beyond revenue recognition. One significant hurdle lies in accurately accounting for expenses, particularly in healthcare facilities where costs often span various departments and service lines. Accrual accounting requires recognizing expenses when incurred, irrespective of cash outflows, which can be intricate in healthcare settings due to the complex nature of patient care, procurement of medical supplies, and maintenance of facilities. Ensuring accountants properly match expenses to the periods in which they contribute to patient care or administrative functions may require complex allocation and estimation methodologies.
For instance, the timing and recognition of expenses related to medical supplies and pharmaceuticals can vary based on inventory management practices and rebate arrangements with suppliers. Historical cost of goods sold analysis and margin analysis are two of the most common strategies implemented to understand underlying changes in the business, providing a basis for accurately matching expenses to the relevant accounting periods. In large healthcare systems, these complexities are further amplified by the need to allocate costs accurately across multiple departments and service lines, such as inpatient, outpatient, surgical, and emergency services. Addressing expense accrual challenges necessitates a comprehensive understanding of healthcare operations and collaboration between finance and operational personnel to ensure the accuracy of accrual conversions.
In the context of a transaction, small businesses may prepay (malpractice insurance) or pay after the fact (common area maintenance charges) for certain expenses, which must be converted to an accrual basis to properly inform a buyer of the business’ financial condition.
Managing Changes in Working Capital
Shifting from cash to accrual accounting also affects the management and assessment of working capital. Under cash accounting, working capital appears straightforward, often mirroring the cash flow directly. However, accrual accounting requires a more nuanced view, recognizing accounts receivable, accounts payable, and inventory changes that may not have immediate cash implications but significantly impact liquidity and operational efficiency. Accurate tracking and managing these elements is crucial, as they influence a healthcare organization’s true financial position and operational performance and may have purchase price implications.
Understanding and converting net working capital on an accrual basis also helps shareholders and potential buyers identify a business’ strengths and potential weaknesses. For healthcare entities, a rise in accounts receivable under accrual accounting indicates future cash inflows but also highlights the importance of effective revenue cycle management, including timely billing and collection processes. Similarly, accounts payable under accrual accounting provide insights into a company’s obligations and upcoming cash outflows, lending toward robust vendor management and procurement practices. Healthcare entities must develop comprehensive systems for monitoring these working capital components to ensure they reflect the actual financial health and to make informed decisions regarding cash management, investment opportunities, and strategic planning. However, there must first be benchmark net working capital to compare future trends.
Earnings Volatility
Under cash accounting, earnings may appear more volatile, as revenues and expenses are recorded only when cash transactions occur. However, accrual accounting captures economic events more accurately and consistently. Fluctuations in reported earnings can be caused by timing differences in revenue and expense recognition and can be particularly pronounced in the healthcare sector, where seasonal variations and payor reimbursement lags are common, causing revenue to be recognized in one period and the corresponding expenses in another on a cash basis of accounting.
For stakeholders and potential investors, understanding the sources and implications of this volatility is crucial for assessing the company’s true financial health. Cash-to-accrual conversions within a quality of earnings analysis help identify and normalize these fluctuations, providing a clearer picture of sustainable earnings and operational performance. By aligning revenue and expense recognition to an accrual basis, stakeholders can benefit from more reliable insights into the company’s financial trajectory, aiding better investment and management decisions. For healthcare entities, this detailed analysis is particularly vital, given the sector’s unique financial dynamics and regulatory landscape. The application of advanced analytical techniques, such as trend analysis and scenario modeling, can further enhance the understanding of earnings volatility and its impact on long-term financial planning and stability.
Conclusion
Converting from cash accounting to accrual accounting in a quality of earnings analysis offers several positive benefits. Accrual accounting provides a more accurate reflection of a company’s financial performance by matching revenues and expenses to the periods in which they are earned or incurred, offering a clearer picture of the company’s profitability over time. This enables stakeholders to make better-informed decisions regarding operational changes, investment, lending, or acquisition opportunities. Additionally, accrual accounting enhances comparability with industry peers and facilitates benchmarking analysis, as financial statements prepared under an accrual basis are inherently more standardized and comparable. Moreover, accrual accounting can uncover trends and patterns in revenue and expense behaviors, providing deeper insights into the company’s underlying financial health and operational efficiency. Overall, the conversion to accrual accounting strengthens the transparency, reliability, and credibility of earnings analysis, fostering trust among investors, creditors, and other stakeholders.
