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Accounting Standards Update 2014-09, “Revenue from Contracts (Topic 606)” was issued in 2014 and eliminates industry-specific revenue recognition guidelines and replaces it with a single, principles-based standard that applies to most industries, with exceptions. Although these changes went into effect in 2018 (for early adopters and public filers), many health care providers are only now understanding how to implement these new standards for their year-end financial statements.
With these new standards, health care providers may need to make changes to accounting systems, develop documentation, review contracts and add new disclosures to financial statements. Topic 606 creates additional considerations for health care providers to take into account when evaluating revenue.
The new standard includes criteria to determine whether a contract is within the scope of Topic 606. In the health care industry, the most relevant considerations will surround the requirement that the parties have approved the contract and are committed to perform their respective obligations as well as the requirement that the entity will collect all of the consideration to which it is entitled. In health care, the patient’s agreement to the contract may not always be apparent (i.e. in the case of emergency care; when the patient is unconscious; or suffers from mental health issues).
The portfolio approach
Topic 606 allows health care providers to apply the “portfolio approach” to account for patient contracts as specific groupings, rather than individually if the financial statement effects are not expected to materially differ from the individual contract approach. With as many patients as health care providers serve in any given accounting period, most providers are expected to utilize this “shortcut”. Factors to consider include the type of service provided, payor types, and geographic area(s) which services are performed. Additional considerations should include historical cash collections and changes to established reimbursement rates when developing estimates of price concessions and collectability. It is at the provider’s discretion to determine if they will apply a portfolio at a system-wide basis or use a separate approach for each facility, state, division, etc. within their network.
When applying the portfolio approach, management will need to use judgement when determining proper “portfolios”. Patient characteristics may be used to establish portfolios such as: “patients with Medicare”, “patients with commercial insurance”, “uninsured patients”, etc. Of course there may be other portfolios such as service type (inpatient, outpatient, home health care, etc.). Providers should not use an aging of service date to recognize explicit and implicit price concessions as these should be recognized when revenues are recorded. That being said, providers will likely continue to monitor aging information within individual portfolios to evaluate the adequacy of the estimate of the transaction price of a portfolio.
Determining the payor for a service may not happen until several weeks after services have been rendered. For example, some patients may be initially classified as “Medicaid pending” then be reclassified as Medicaid, charity care or self-pay once eligibility is determined. Past experience may be used for the Medicaid-pending population to estimate the outcome and related revenue recognition. If a health care entity has no past experience to estimate the outcome for a pending Medicaid account prior to receiving the eligibility determination, it may determine that a contract does not exist because it doesn’t meet the requirements of FASB ASC 606-10-25-1.
Implicit price concessions
Like most of the other variable pricing arrangements in provider contracts with payors, amounts expected to be paid by patients are subject to fluctuation which may be based on amount of billed charges relative to a patient’s financial status and other factors. It must be determined if there has been an implicit price concession provided to a patient with a self-pay balance. Criteria for the existence of an implicit price concession is whether (1) the patient expects that the entity will accept less than the stated price, or (2) facts and circumstances would point to the entity offering a price concession to the customer. Providers should consider whether a credit evaluation is performed prior to providing service and whether the entity will continue to provide services to patients in certain classifications even when past experience shows that
there is not a high probability of collecting the entire billed amount.
Example of implicit price concessions
A hospital treats an uninsured patient and is not in a position to, and does not, assess the patient’s ability to pay at the time of service. The hospital bills the patient $10,000. Although the hospital expects to pursue collection of that amount, its experience with similar patients indicates that it will only collect $1,000.
The hospital estimates that the transaction price is $1,000 when considering the guidance on variable consideration and the constraint. The $9,000 that it does not expect to receive is an implicit price concession as opposed to a bad debt; this is because the hospital was willing to provide services without performing a credit assessment before providing the service. Patient service revenue of $1,000 is recognized.
Subsequently, the hospital collects only $950 of the $1,000 it expected to collect. The difference of $50 is accounted for as an increase in the implicit price concession (reduction of patient service revenue), if there has been no patient-specific event indicating the patient no longer has the ability and intent to pay.
Alternatively, if there was a patient-specific event that is known to the hospital suggesting that the patient no longer has the ability and intent to pay the amount due (e.g. the patient had a job at the time of service but subsequently lost it), the amount not collected ($50) would be recognized as bad debt expense.
It is expected that many health care organizations will see a significant decrease in revenue (before the allowance for bad debts) and the provision for bad debts for services provided to uninsured and insured patients with co-payments and deductibles, compared to historical treatment, as amounts not expected to be collected based on historical experience will often be treated as an implicit price concession. Alternatively, when a health care organization determines that it is probable that it will collect substantially all of the amount that it bills a patient (and no implicit price concession is recognized), bad debt expense may be recorded.
Timing for recognition of price concessions
This concept looks to the ultimate collection expectation for an individual contract or established portfolio of contracts. It is important for health care providers to ensure that the practices utilized to establish allowances for implicit price concessions are designed to appropriately record implicit price concessions as revenue is recognized. Detailed collection and analysis of data may indicate a pattern in collection experience.
Collections may be minimal within the first 30 days as bills are prepared and submitted, followed by a period of stronger collections as payors process claims and explanation of benefits documents are distributed as well as bills. Collections will taper off as the remaining amounts pursued generally will be due from secondary payors, in ongoing litigation or negotiation, or patients with varying levels of financial accountability. Swings in collection should be considered as price concessions and recorded in connection with revenue so that only the ultimate amount expected to be collected is recognized. Providers will likely not want to give up their practices of analyzing receivables as they age, but cumulative allowances should be adequate so that receivables are recorded to only the extent that collection is ultimately expected at any point in the revenue cycle. The timing of implicit price concession may create an adoption impact for some providers.
Variable consideration should be recognized as part of transaction price only to the extent that it is probable that a significant reversal will not occur. Under the standard, contractual adjustments (i.e. the difference between what was billed and what was approved), and other revenue adjustments (e.g. discounts) result in variable consideration. A health care organization should consider using either the “most likely amount” method or “expected value” method. Management should determine which method will be a better predictor of the amount of consideration the entity will be entitled.
Most likely amount method
Single most likely amount in a range of possible consideration amounts. Appropriate if a contract has only two possible outcomes, however it may also be used in situations that present more than two possible outcomes.
Example of estimating variable consideration using the most likely amount method
An intensive care rehabilitation facility determines that using the most likely amount method would best predict the amount of consideration to which it will be entitled because it has a large number of contracts that have similar characteristics and manner of achieving a result.
For example, the organization discovered that in over 95% of its patients, legal professionals are utilized to pursue past due balances for services rendered. historical results also indicate that each patient’s legal outcome yielded different results. In this scenario, the organization used the industry and legal expertise of its legal counsel to determine what the most likely amount should be for each patient (and therefore the variable consideration and patient revenue to record).
Expected value method
A probability-weighted approach which lends itself to situations that may have multiple outcomes. There may be four possible outcomes, using this method each possible outcome is assigned a probability in order to determine the amount to be recorded.
Example of estimating variable consideration using the expected value method
A health care organization determines that using the expected value method would better predict the amount of consideration to which it will be entitled than using the most likely amount method because it has a large number of contracts that have similar characteristics, but historically have had differing reimbursement rates.
Under the expected value method, the health care organization estimates variable consideration of $1,075 ((1,000 x 75%) + (500 x 50%) + (300 x 25%)) (See table on page 3). The organization must then consider the effect of applying the constraint on variable consideration. Constraints could include, but are not limited to, new service lines, expansion of nexus, change in payor mix and large growth in companywide activity. To do this, the organization considered the factors that could increase the likelihood of a revenue reversal in ASC 606-10-32-12 and concluded that it has relevant historical experience with similar types of contracts and that the amount of consideration is not highly susceptible to factors outside of its influence.
After variable consideration is implemented, health care providers may see a difference in the amount recorded. Even if there are no differences in the amounts, entities should plan to document their analysis of the variable consideration constraint implications, and the underlying documentation supporting these estimates should be prepared using the method described in the standard, which is the better predictor of expected compensation. Variable consideration will also apply to many risk-sharing arrangements. In addition to considering the probability of a revenue reversal, providers will need to identify performance obligations within contracts, including any implied promises to patients. Distinct performance obligations entail the transfer of a good or service to a patient or another customer. Certain activities, like care coordination may be considered administrative and would not constitute a distinct performance obligation.
Financial statement display of revenues
Once a provider has completed an analysis to address the aforementioned criteria for Topic 606, they will be well positioned to consider financial statement display of revenues. All price concessions are expected to be netted within the patient service revenue line on financial statements. If a health care entity evaluates the credit risk of a customer, the entity may determine that it has not provided an implicit price concession but that it has chosen to accept the risk of default by the patient. Further defaults would be considered impairment losses and reported as bad debts within expenses on the financial statement.
For most providers, the new standard implies that most (or all) bad debt expenses shall be included on the net revenue line on the face of the financial statement. Details regarding price concessions may be disclosed in the provider’s notes to the financial statements. Disaggregation of revenue may be disclosed separately on the face of, or in the notes to the financial statement; however there is no requirement to display this revenue separately from net patient service revenue if service lines have similar characteristics.
While this is a brief overview of the new revenue recognition standard, there are many other considerations and specific situations that will impact implementation within your organization.