I recently took part in reminisces of some of the organizations that some of my friends and I have served or known about. One of the more common reasons for CEO turnover is an unexpected accounting adjustment. Eight figure adjustments that go the wrong way are too common and there are few things that will get a CEO fired faster than his board learning that they are going to have to absorb a $50+ million loss that occurred on the CEO’s watch. Like it or not, the CEO will be held accountable for hiring or retaining a CFO that could not produce accurate and timely financial reports. He is expected to have a sufficient grasp of what the CFO is doing to control their work.
A common cause of this type of an adjustment is overstatement of the value of accounts receivable or stated another way, understatement of contractual allowances. These understatements lead to interim income statements being overstated in terms of operating margin. How does this happen? Sometimes the CFO does not fully understand what he is doing, his models fail or he becomes confused by changes he cannot explain. In other instances, CFOs are under withering pressure to produce results to meet expectations of a financial plan, corporate organization or worst of all, incentive compensation targets.
In my experience, few CEOs appreciate the degree of potential error in net revenue estimates or the degree to which their CFO may be exercising judgment in the determination of the appropriate valuation of accounts receivable. Unless there is absolute transparency and crystal clear communications between the CEO and CFO on these issues, there is a very good chance that the CEO is setting himself up for a very unpleasant surprise.
Given this risk, what is a CEO to do? How does the CEO manage and mitigate this risk? How can he know his balance sheet is properly stated?
Without going into vexing detail about how all of these calculations are done, there are a few high level indicators that every CEO should be watching as indicators that things are not as they appear. First, the CEO should review and understand every adjusting entry made by the outside auditors during the external audit. Each of these entries represents either the correction of an error found by the auditors or a difference of opinion between the auditor and the CFO as to how a transaction should be recorded. In a perfect world, there would be no audit adjustments and they are sometimes symptomatic of problems in your finance department. If you have experienced adjustments, your focus should be to see that they are eliminated. If your finance team cannot get this done, you have a problem that will probably not improve on its own. These errors are also symptoms of the fact that your interim financial statements were not correct. The magnitude of the adjustments or the difference of reported income between the last interim statement and the audit indicates the lack of precision of your finance team.
The CEO should be cognizant of the contents of the management letter. The management letter addressees internal control matters. Again, in a perfect world, there would be no comments. I have seen organizations that did not even get a management letter which is almost as bad.
Another thing the CEO should be doing is meeting privately with the audit partner. There is no one that is in a better position to evaluate the efficacy of an organization’s accounting and finance functions. My point here is not to address the audit process but to help a CEO avoid being blind sided by a large, unexpected adjustment.
Time and again, I have seen CEOs taken totally by surprise when their auditors recommend large, unfavorable adjustments to the value of receivables, revenues and profits. All of these items are directly linked. Time and again, the CEO that likely had no idea what was going on in his finance department is one of the first victims of the transitions these events precipitate. The point of this article is to explain this linkage and give a CEO a couple of VERY POWERFUL tools to identify a potential problem.
Each month, your accounting department revalues receivables and in this process recomputes the reserves needed to reduce receivables to their realizable amount. While these calculations can be very complex, the idea behind them is simple and compelling. The other side of the adjustment to the value of receivables is the contractual allowance on the income statement. The contractual allowance is what reduces gross revenue to net or ESTIMATED realizable revenue. If the contractual is too small, net revenue is inflated which leads to an inflation of operating income. If the contractual is too large, net revenue and operating income are unnecessarily reduced. Unfortunately, most errors go the wrong way resulting in a reduction of income. Note that I am including bad debt expense as it too is a deduction from revenue (contractual) that reduces self pay receivables to their realizable amount.
How on earth can a CEO know if all of this is right? The answer is extremely simple. The CEO needs to look at only two indicators. The first is the ratio of cash collections related to patient services to net revenue. Net patient service revenue (NPSR) is nothing more complicated than an estimate of how much of the gross revenue will ultimately be collected. If the NPSR estimate is correct, it will be proven over time by cash collections related to that patient revenue. In other words, if your cash collections related to patients is less than your NPSR, you have a potential problem brewing. In every situation where I became engaged in an organization that had just experienced a large negative adjustment to receivables, the cash to NPSR statistic was below 100%.
A lot of people fail to grasp the magnitude of money involved in these estimates. One organization I served was running a cash to NPSR ratio of 93% just before it experienced a write-down in receivables of over $60 million. Consider a medium sized hospital with $1 billion of gross revenue. Every percentage point of $1 billion is $10 million per year. Be understated by 7% as was the case in the example I cited and you are looking down the barrel of a $70 million accounting adjustment that will reduce (or maybe obliterate is a better word) your operating margin for years and set you on a new, unplanned career path. If anyone had been looking at this statistic, this tragedy may have been averted. In the cited case, the CEO and CFO along with a few others were ‘freed up to seek other opportunities.’
Changes in the magnitude of receivables (AR Days) can affect this statistic but if the cash is much below 97.5%, you had better start getting an explanation of the cause. Why do I say 97.5%? To account for normal variation, it is not unusual to see this statistic vary across a 5% (+/- 2 1/2%) range. When it gets outside of that corridor, the CEO had better be pressing for answers. He cannot say he was surprised by a proposed adjustment if his cash to NPSR ratio was low. He (and his CFO for that matter) should have seen it coming.
The second key indicator is yield on gross revenue. What is NPSR as a percentage of Gross Patient Revenue? The nominal value is not particularly important as it varies widely by organization and by region of the country. The explanation of this phenomena is beyond the scope of this article. If the organization raises its prices and nothing else happens, yield will decrease because all payors do not participate equally in a price increase. For example, an organization does not realize much of a price increase charged to Medicaid and/or self pay patients. If the yield is going up, there are two primary reasons. The first is that revenue cycle performance is improving significantly and if this is the (rare) case, good for you. This improvement should be validated by a decrease in gross and net A/R days. The second reason for increasing yield is that the contractual allowances discussed above are inadequate and you have increasing risk of an unfavorable adjustment in your future. As I stated earlier, the nominal value of the yield statistic is not as important as its change over time. A change in yield can be reconciled to the dollar by someone that knows what they are doing. If the statistic is not decreasing slowly over time, you should be asking for explanations or seeking help from independent advisors to help you understand what is happening if you do not like the explanations you are getting.
A lot of the financial pressure on hospitals is rooted in yield that is declining faster than gross revenue is increasing but that is the topic for another article.
I would be the first to agree that it is unfair to see a CEO get whacked for a problem like this developing on his watch. Unfortunately, I have seen this happen time after time as one unsuspecting CEO after another became a victim to judgment or accounting errors in their finance department. I had Board members in a hospital that had relieved the entire leadership team at one time express remorse for knowing something was wrong but not knowing what questions to ask. A savvy CEO will know what indicators to watch to give himself the best possible chance of not being caught looking.
If you would like to discuss any of this content or ask questions, I may be reached at email@example.com. I look forward to engaging in productive discussion with anyone that is a practicing interim executive or a decision maker with experience engaging interim executives in healthcare.