In the first article of this series, we covered a high level overview of the revenue recognition standard found in Accounting Standards Codification (ASC) Topic 606. The following is a quick recap of the five-step process to achieve the core principle under the revenue recognition standard:
- Identify the contract(s) with the customer (i.e., patient).
- Identify the separate performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations in the contract.
- Recognize revenue when the entity satisfies a performance obligation.
In addition, we discussed implementation issues specific to the health care industry and the high level changes that hospitals and clinics will experience under the revenue recognition standard. Throughout the remainder of this article, we will illustrate in more detail, through examples, the five-step process for recognizing revenue, accounting for self-pay revenue, changes to bad debt expense, and the use of portfolios to estimate the transaction price for a group of patients.
The five-step process to recognize revenue
Identify the contract with the customer (i.e., patient)
For hospitals and clinics a legally enforceable contract can be written, oral, or implied based on the entity’s customary business practice. Written or oral contracts can include but are not limited to signed patient responsibility forms, consent of services forms, and patient scheduled appointments either online, in person, or via telephone. Certain hospitals and clinics are required by law to treat patients with emergency conditions regardless of their ability to pay. Since some hospitals and clinics are required by law to provide medically necessary care, it’s expected these organizations will take the position that they have an implied contract with patients. Furthermore, for many hospitals and clinics that are nonprofit, it is likely part of their exempt purpose to care for patients regardless of their ability to pay and this premise will commonly be used to support that the organization has an implied contract with patients.
Contracts must have the following requirements:
- Contract must have commercial substance.
- The parties have approved the contract and are committed to their respective obligations.
- Each party’s rights regarding the services provided are known.
- The payment terms for the services are known.
- It is probable that the entity will collect the amount of consideration to which the hospital or clinic will be entitled.
When the revenue recognition standard was first released, there was speculation that hospitals and clinics may not be able to meet the last requirement (it is probable that the entity will collect the amount of consideration the organization is entitled). Many hospitals and clinics assumed this meant recording revenue for these patients on a cash-basis method of accounting. The American Institute of Certified Public Accountants (AICPA) Healthcare Task Force along with the AICPA’s Financial Reporting Executive Committee (“FinREC”) clarified this speculation to be incorrect. The AICPA’s Healthcare Task Force released implementation guidance in July 2016 explaining that to meet the probability threshold a hospital or clinic that expects to receive even just one percent of the total gross charges is considered to meet the collectability threshold and fall within the revenue recognition five-step process. Patients that meet an organization’s financial assistance policy (i.e., charity care or community care) would not meet the collectability threshold and thus are excluded from the revenue recognition five-step process.
Identify the separate performance obligations in the contract
For hospitals and clinics, the performance obligation is to provide the necessary services that are needed for the particular patient.
Determine the transaction price
The revenue recognition standard defines the transaction price as the amount of consideration an entity expects to be entitled to in exchange for transferring promised goods or services to a customer. In simpler terms, the transaction price is ultimately the amount hospitals and clinics record as net patient service revenue for the services provided to a patient or portfolio of patients. The transaction price includes the effects of two factors: variable consideration, which can be either explicit or implicit price concessions of the gross charges, and the consideration of a constraint.
For hospitals and clinics, explicit prices concessions are commonly the negotiated contractual rates with third-party payors and publicized discounts offered to patients with no insurance (i.e., commonly called self-pay discounts). One of the significant changes impacting how hospitals and clinics will record revenue in the future for self-pay patient balances relates to a new term called implicit price concessions, which is highlighted in Example 1.
Hospitals and clinics may consider the following factors when determining whether they intend to provide an implicit price concession:
- The hospital or clinic has a customary business practice of not performing a credit assessment prior to providing services (i.e., the organization is required by law to provide the services or the organization’s mission is to provide medically necessary or emergency services prior to assessing the patient’s ability to pay).
- The hospital or clinic continues to provide services to a patient (or patient class) even when their historical experience indicates that it is not probable the organization will collect substantially all of the discounted charges.
If one of the above factors is present, the AICPA Healthcare Task Force and FinREC believes the organization has implicitly provided a price concession to a patient or patient class
As previously mentioned, one of the factors included within the transaction price is the consideration of a constraint. The revenue standard calls for an organization to consider the likelihood that a significant amount of the revenue recorded in the current period will not be adjusted up or down in future periods. This terminology under the revenue recognition standard seems complicated, but this practice is generally performed today within the health care industry.
In summary, hospitals and clinics should continue considering all information that is reasonably available to them when estimating net patient service revenue. This includes the evaluation of historical collections from individual patients or portfolios of patients, settlements from third-party insurance (i.e., cost reports), and risk-based payment arrangements.
Allocate the transaction price to the separate performance obligations in the contract
As noted in number two above, hospitals and clinics will generally have one performance obligation to provide the medically necessary care for the patient. Thus hospitals and clinics will continue to record gross revenues for the services provided to patents consistent with current industry practices.
Recognize revenue when the entity satisfies a performance obligation
For hospitals and clinics, the timing of when revenue is recorded today is not expected to change significantly under the revenue recognition standard.
What write-offs are reported as bad debt expense under the revenue recognition standard?
As highlighted in Part One of the article series, the definition of a bad debt changes significantly. Accounts written off as uncollectible will be reflected as bad debt expense only when one of the following exists:
- The hospital or clinic performs a credit assessment on a patient prior to providing the services. Elective procedures like plastic or reconstructive surgeries are common services where a hospital or clinic may complete a credit assessment before providing the services to a patient. Hospitals and clinics often require patients to pay in advance for elective services of this nature.
- The organization has a policy establishing when a patient account or a portfolio of patient accounts is written off as uncollectible due to a change in a patient’s or a portfolio of patients’ credit that was not known at the time services were provided.
We have illustrated the changes to bad debt expense in Example 2 below.
What is the portfolio approach and how can hospitals and clinics use this approach within the revenue recognition standard?
The revenue recognition standard generally was intended to be applied to an individual contract with a patient. However, as an alternative, hospitals and clinics may elect to apply the revenue recognition standard using a portfolio of contracts with similar characteristics if the entity reasonably expects that the financial statement effect would not differ materially. Today many hospitals and clinics already group patients by payor and service type categories to estimate the contractual and bad debt allowances at the end of reporting periods using the historical experience by payor and type of service. Under the revenue recognition standard, we anticipate hospitals and clinics will further refine the payor and service type groupings used today to estimate net patient service revenue in the future. Hospitals and clinics should consider a combination of the following when refining or developing portfolios to estimate revenue:
- Types of service – i.e., inpatient, outpatient, skilled nursing, home health
- Type of payors – i.e., insurance contract, governmental program, uninsured self-pay, pending Medicaid, etc.
- Timing of when contracts are entered into
The following examples are intended to illustrate how a hospital or clinic recognizes revenue for patients with uninsured balances, differentiates write-offs between bad debt expense and changes in net patient service revenue, and the utilization of the portfolio approach.
Example 1 – Revenue Recognition for Uninsured Patients
A patient walks into a hospital urgent care with a high fever and blurry vision. The patient is uninsured, does not qualify for the hospital’s financial assistance policy, and does not qualify for the State Medicaid Program. The hospital did not assess the patient’s credit before providing the services. The organization’s customary business practice is to offer a self-pay discount of 40% for medically necessary services provided to patients with no insurance. After a physician’s assessment and lab work, the total charges for the services provided totaled $1,200. Based upon history for this patient type and the services provided, the organization collects approximately 15% of the total charges.
The hospital has determined they have an implied contract with this patient. The organization ultimately expects to collect 15% of the gross charge ($1,200 x 15% = $180). The $180 is ultimately what the organization records as net patient service revenue. From the gross charges of $1,200, the hospital gave a self-pay discount (i.e., explicit price concession) of 40% ($1,200 x 40% = $480), which results in remaining charges of $720 ($1,200 – 480 = $720). Since the hospital ultimately only expects to collect the $180, the remaining $540 ($720 – 180 = $540) is considered to be an implicit price concession. The organization records both the explicit and implicit price concessions within contractual adjustments and discounts resulting in net patient service revenue of $180.
In current practice for hospitals and clinics, the amount reflected as an implicit price concession above is commonly reflected within the provision for bad debts. Under the revenue recognition standard, organizations will record all price concessions as contractual adjustments and discounts within net patient service revenue.
Example 2 – What is bad debt expense versus changes in net patient service revenue?
In Example 1, the hospital estimated the net patient service revenue for the services provided to be 15% of total gross charges equaling $180. So what happens if the hospital collects only $120 instead of the amount recorded as net patient service revenue of $180? The hospital would need to evaluate whether the difference between the amount recorded as net patient service revenue and the amount collected is due to one of the following:
- A change in management’s estimate, which would be reported as contractual adjustments and discounts within net patient service revenue.
- The patient experienced a change in credit not known at the time the services were provided and the hospital has a policy that establishes the acceptable changes in a patient’s credit that warrant the hospital to reflect the write-off as bad debt expense.
The AICPA Healthcare Task Force and FinRec believe in most instances where the actual collections is different from the amount recorded as net patient service revenue, hospitals and clinics will report these differences as a change in the transaction price and reflect the difference within contractual adjustments and discounts within net patient service revenue. Accounts written off and shown within bad debt expense will be isolated instances when patients or a portfolio of patients have unique changes in credit that resulted in the balance being written off. Examples could include but are not limited to:
- Change in a patient’s employment status (i.e., loss of job)
- Other qualifying life event (i.e., birth of child, death, etc.)
- Large employment reduction within the community
- Catastrophic event within the community (i.e., natural disaster)
Since bad debt expense will be isolated to unique changes in a patient or a portfolio of patients’ credit, it is expected the bad debt expense will significantly decline under the revenue recognition standard.
Example 3 – Utilization of the portfolio approach to recognize revenue
We expect hospitals and clinics will apply the portfolio approach to record net patient service revenue for patient accounts with similar demographics and characteristics for services provided in the future.
A hospital provides medically necessary outpatient services to patients who are covered by the Medicare Program. The hospital does not perform credit assessments on the various patients prior to providing the services. The hospital identifies these patients as a portfolio of contracts. For the period, charges amount to $2,000,000 for these patients. The charges consist of both amounts to be paid by Medicare and deductible amounts to be paid by patients. The hospital has a contractual agreement with Medicare that results in a 60% adjustment to gross charges (40% reimbursement). At the end of the period, gross receivables totaled $2,000,000 with amounts from Medicare of $1,760,000 and deductibles owed from patients of $240,000. The hospital expects to collect 100% of the balance due from Medicare and 40% of the deductibles based on historical experience. The hospital will record gross charges of $2,000,000, a contractual adjustment from Medicare of $1,200,000 ($2,000,000 x 60% contractual rate), and a contractual adjustment and discount for the implicit price concession of $144,000 ($240,000 x 60% the hospital expects it will not collect on the deductibles) and end with net patient service revenue and a net receivable balance of $656,000.
Again in this example, the implicit price concession of $144,000 is the amount the hospital does not expect it will receive from patients for outstanding deductibles and is reflected as a contractual adjustment and discount within net patient service revenue. Under today’s current practice this is commonly included within the provision for bad debts. Under the revenue recognition standard, these estimates are part of the transaction price and recorded in net patient service revenue.
While the language within the revenue recognition standard is quite technical and can be overwhelming to understand, this article illustrates a clearer picture of the five-step process to record revenue in the future and the impact the standard will have on hospitals and clinics in the future.
What will be covered in Part Three of the article series?
Part Three of this article series will include discussions on what hospitals and clinics need to consider as they prepare to implement the revenue recognition standard in the future.