new FASB standard addresses revenue recognition considerations

A new standard on revenue recognition issued by the Financial Accounting Standards Board may require unbundling and separate recognition of components of some types of revenue that previously could be recognized collectively. It also may result in revenue being recognized at a different point in time than previous accounting standards permitted.

In May 2014, the Financial Accounting Standards Board (FASB) finalized and issued a major new 156-page standard on revenue recognition, Revenue from Contracts with Customers (Topic 606), which will replace most prior revenue recognition guidance, including industry guidance.3 The standard originally was slated to be effective for annual reporting periods beginning after Dec. 15, 2016, for public business entities and not-for-profit entities that have issued bonds traded on an exchange or over-the-counter market. It was also to be effective for all other entities (nonpublic) for annual reporting periods after Dec. 15, 2017. There is an option for early adoption.

The new standard created so many implementation issues that the FASB issued a standard update in August 2015 that deferred implementation for one year beyond the original implementation dates (to 2017 and 2018).b On Aug. 31, 2015, and Sept. 30, 2015, the FASB also issued exposure drafts for two additional standards updates that propose a variety of revisions to the original standard and provide additional implementation guidance.

To avoid facing last-minute implementation issues, healthcare organizations should immediately begin thinking about and planning for application of this new standard. Each organization will either have to adopt the new standard and apply it retrospectively to each financial reporting period presented or adopt it and apply it retrospectively with a cumulative effect at date of initial application. Modifications to existing processes and systems will almost certainly be needed. A viable approach is depicted in the exhibit below.

The FASB's new guidance is both detailed and lengthy, so a comprehensive discussion of its contents is beyond the scope of this article. The goal of this discussion, therefore, is to highlight key issues.

Overview of New Guidance

The new, largely principles-based standard affects any healthcare entity that enters into contracts to transfer goods or services to customers.

The guidance applies to accounting for individual contracts or performance obligations, but it may be applied to a portfolio of similar contracts or performance obligations that have similar characteristics if essentially the same result is achieved as if it been applied individually. For example, an entity may decide to treat self-pay patients who have insurance as one portfolio and self-pay patients who lack insurance as another portfolio.

The FASB's definition of what constitutes revenue remains unchanged from how it was presented in its Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, where the term revenues is defined as "inflows or other enhancements of assets or an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations."0

What has changed is how revenue is to be recognized. The core principle in the guidance is that revenue should be recognized to depict the transfer of goods or services to customers in an amount that reflects expected consideration to be received. What may change for some healthcare entities is that some types of revenue may have to be "unbundled" and the components recognized separately and in different time periods. For example, a specialty hospital that provides, for a single fixed fee, surgery followed by physical rehabilitation may have to split the fee and recognize the surgical revenue at time of surgery while deferring recognition of the physical rehabilitation fee until such services are fully rendered.

Steps for Revenue Recognition

Under the FASB's guidance, an entity is expected to apply the following steps in revenue recognition.

Identify the customer contract. A contract is simply an agreement between two or more parties that creates enforceable rights; it may be oral, written, or in accordance with customary business practices.

A customer contract would be created when a patient signs a consent to services and, financial responsibility form upon checking into a hospital or clinic for surgery. A potential lack of contract is created when a patient's medical condition is such that he or she is not able to competently enter into an agreement. This situation could occur, for example, during circumstances involving emergency treatment or mental decline.

Identify the performance obligations in the contract. Promises to transfer distinct goods or services are performance obligations to be accounted for and recognized separately. A service is distinct if the patient benefits from the service by itself and if it is separately identifiable from other promises in the contract. For example, in a contract that explicitly includes three months of home health monitoring after surgery in a hospital, the home health monitoring would be a distinct service obligation.

Performance obligations may not be limited to those explicitly stated in a contract because they may be implied by customary business practices, publ ished policies, or specific statements that create a valid customer expectation.

Under some circumstances, it can be difficult to identify distinct services for revenue segmentation. One such instance occurs when a healthcare entity receives a bundled payment for a lengthy episode of care that involves different services extending across multiple fiscal periods.

Continuing care retirement communities (CCRCs) also may be challenged to identify the performance obligations for providing future services and use of facilities. They are required to measure their obligation for future access and services annually and to record a liability based on actuarial assumptions if advance and periodic fees are insufficient to meet the future obligations.

Determine the transaction price. This is the fixed or variable pricing consideration that an entity believes it will be entitled to receive on completing the contract. (See the sidebar on page 75 for an example of a variable consideration with respect to emergency department services.)

An explicit collectability threshold of probable for variable consideration is required before an entity can recognize revenue from a contract. In its Statement of Financial Accounting Standards No. 5 : Accounting for Contingencies, the FASB defines probable as follows: "The future event or events are likely to occur."** Many accountants believe that this definition means "more likely than not," requiring a probability threshold of 51 percent or higher.

A contract price may be considered variable if the customer has a valid reason to expect-based on the entity's customary business practices, published policies, or specific statements-that the consideration accepted will be less than full price. Such accounting can be challenging if there is not a single most-likely amount, because the entity then must compute the expected value of probability-weighted amounts in a range of possible considerations.

Allocate the transaction price to the performance obligations in the contract. Allocation is typically based on the relative stand-alone selling price of the performance obligations.

The absence of a stand-alone price for individual services compensated in a bundled payment scheme can be problematic because it would require either input methods involving costs or output methods involving services being used to allocate overall revenue to various performance obligations.

Recognize revenue when-or in some circumstances, as-the entity satisfies the performance obligation. The performance obligation is satisfied when the customer obtains control of the good or receives the service.

For example, revenue might be recognized by a radiology practice when a patient receives a single CT scan that is not part of bundled care or it might be recognized as a patient with cancer undergoes a biweekly course of radiation treatments.

This step can be problematic in bundled payment circumstances, such as when a patient who is discharged from a healthcare entity is expected to require some level of postdischarge monitoring or follow-up without separate billing (part of the "episode-of-care" payment). The postdischarge services may be a separate performance obligation. The healthcare entity must decide how to recognize revenue from the postdischarge services, possibly with either a per-visit, contact-based recognition or a time-periodbased recognition.

A prepaid health services contract can pose a problem with revenue recognition if the contract seems likely to result in a loss, because such a loss must be recognized in the current fiscal period. The new guidance has not changed the obligation to defer revenue that is not earned in a fiscal period. A contract prepayment results in a contract liability. When the entity satisfies its performance obligation, the contract liability should be derecognized and the revenue recognized.

Lease contracts, insurance contracts, financial instruments, guarantees other than product or service warranties, and nonmonetary exchanges between entities in same line of business are generally exempted from the new standard.

The new guidance requires an entity to disclose disaggregate revenue from contracts with customers in categories that depict how the nature, timing, and uncertainty of revenue and cash flows are affected by economic factors. For example, a healthcare entity might have separate categories for contracts with government payers, commercial payers, and individual-patient private payers. It also requires disclosure of assets recognized from the costs incurred to obtain or fulfill a contract. For example, a healthcare entity would have to disclose that it recorded an asset for significant costs incurred to modify its computer system to directly link to a large payer's computer system, for which a new contract is scheduled to commence in the next fiscal year.

Payment from Government Programs

Contracts with governmental payers typically would be deemed to involve variable consideration because the payment usually is subject to audit and adjustment for several years. The FASB's new revenue standard limits the amount of variable consideration recognized to the amount deemed probable, meaning a significant reversal of the amount of cumulative revenue has little likelihood of occurring when uncertainties are resolved.

Healthcare entities making a best estimate of revenue from third-party payers will need to carefully examine their processes to make sure they are both complying with the probable guideline and documenting their compliance. For example, an entity's finance managers who believe both that they have properly filed and that their organization is entitled to 100 percent of payments submitted might record only a standard contract adjustment percentage with a specific payer, and not recognize that past history with the payer indicates a significantly larger contract adjustment is probable. However, if the healthcare organization's past experience indicates that over time, in addition to standard contractual adjustments, a specific third-party payer has been able to successfully challenge and refuse to pay about of 2 percent of billings due to coding errors, then the organization should reduce its revenue estimate by 2 percent to reflect the probable outcome.

Revenue Collections Taking Longer Than One Year

The FASB's standard states that the consideration received should be adjusted for the time value of money if the timing of the payments (either explicitly or implicitly) provides the customer with a significant financing benefit. The FASB's purpose is to ensure the cash price equivalent for goods or services is recognized. This requirement can be ignored when payment occurs in one year or less. If collections taking longer than one year are a significant part of the revenue stream, however, then the entity might have to separately value, and recognize, the financing component- possibly using a specific collection portfolio. For example, suppose a hospital agrees to provide surgical care costing $30,000, with payment at the rate of $7,500 a year for four years. Assuming a financing rate of 10 percent, the $30,000 would be split into two components (assuming rounded amounts): $24,000 in surgical services revenue, which could be recognized at time of service, and $6,000 in interest income, which would be recognized over the four-year collection period.

Principal Versus Agent Considerations

A healthcare provider that uses another party to provide goods or services should determine the nature of its promise to its customers in such instances-for example, when a hospital offers radiology imaging services, but an independent radiology group interprets images. From an accounting standpoint, the question in such instances is whether the provider's promise is to provide the goods or services or to arrange for the other party to provide those goods or services.

The difference between the two classifications is that a principal may satisfy a performance obligation by itself or it may engage another party to satisfy some or all of the performance obligation on its behalf. A principal may recognize revenue for the gross amount of consideration to be received. An agent recognizes only a fee or commission for arranging for the other party to provide the goods or services (prohibited in many healthcare instances).

If patients undergo radiology imaging at a hospital but are not explicitly informed that a separate entity will interpret the images, the implication is that the hospital is acting as the principal for both services (i.e., imaging and interpretation) and should bill for both. A hospital that does not intend to bill and collect for both services might need to change its patient agreements for such services.

Tax Considerations

One potential problem that for-profit healthcare entities might face is that the new standard could create or increase financial-accounting (FASB) and tax-accounting (Internal Revenue Code) differences. It could cost corporate taxpayers a lot of time and money to adjust their accounting processes and systems to account for these differences. Corporate tax departments and tax advisers should be involved with any revenuerecognition-related changes to the financialaccounting systems to ensure that the tax perspective and related problems can be considered.

An Opportunity for Improved Disclosures

The FASB's new revenue recognition standard, which replaces most prior revenue recognition literature and is more principles-based than prior guidance, will soon become effective. Healthcare entities need to plan and prepare for the transition.

The new standard requires improved revenuerelated disclosures to provide for clearer accounting of reported revenue, thereby helping financial statement users better understand an entity's past performance and future prospects. A byproduct is that the presentation and disclosure of charges for uninsured or underinsured patients should improve.

Processes and documentation for estimating variable consideration from government programs may need to be improved. *

AT A GLANCE

Healthcare organizations are expected to apply the following steps in revenue recognition under the new standard issued in May 2014 by the Financial Accounting Standards Board:

* Identify the customer contract.

* Identify the performance obligations in the contract.

* Determine the transaction price.

* Allocate the transaction price to the performance obligations in the contract.

* Recognize revenue when-or in some circumstances, as-the entity satisfies the performance obligation.

The core principle in the guidance is that revenue should be recognized to depict the transfer of goods or services to customers in an amount that reflects expected consideration to be received.

Proposals by the FASB to Reduce the Cost and Complexity of Its New Standard on Revenue Recognition

In Its May 12,2015, proposed standard update, the Financial Accounting Standards Board (FASB) proposed reducing the cost and complexity of the 2014 revenue recognition standard in two ways.

First, it would not require application of the new guidance to goods or services provided to a customer that are immaterial in the context of the contract. This proposal, if adopted, might eliminate segmenting minor performance obligations, such as providing transportation services to patients, from the overall performance obligation.

Second, the FASB proposed making a distinction about whether the entity's promise constitutes an overall promise, for which individual items are merely inputs, or a promise for the individual items. The following are factors that could indicate that two or more promises may not be separately identifiable.

The entity provides a significant integration of the goods or services. For example, a specialty hospital provides integrated surgical and postsurgical treatment (i.e., counseling and therapy) for prostate cancer. The post-surgical treatment is not available to nonsurgical patients.

One of the goods or services significantly modifies another of the goods or services. For example, a drug-addicted patient who is receiving twiceweekly individual counseling might also receive medication at the end of each counseling session, depending on results of the session.

The goods or services are highly interdependent or interrelated. An example is a series of chemotherapy treatments where each treatment can vary somewhat depending on an assessment of the effect of the previous treatment on the patient's condition.

If this proposal is adopted, it raises the possibility that a hospital meeting one or more of the factors may not have to separately identify and segment revenue from an admission or episode of care.

Implicit Price Concession for ED Patients

The Financial Accounting Standards Board's standard on revenue recognition, Revenue from Contracts with Customers (Topic 60b), requires organizations to determine whether a patient's nonpayment for emergency department (ED) services constitutes bad debt or a price concession. Consider the following scenario, for example:

A hospital provides ED medical services to an uninsured patient as required by law, but because of the patient's condition, the medical services must be provided before the hospital can determine whether the patient can commit to pay for the services. The ED services total $10,000 at standard rates. The hospital later finds that the patient's income level disqualifies the patient for charity care, and based on precedents, it expects to collect a lower amount. Historical cash collections from patients in such circumstances suggest that the variable consideration the hospital can expect to collect is only $1,000.

Under this scenario, the hospital must determine whether the $9,000 it does not expect to collect is an implied price concession or bad debt. If it is an implied price concession, then the hospital should record only $1,000 of revenue. If the hospital expects to bill and attempt to collect the full $10,000, then it can record $10,000 of revenue and a $9,000 estimated bad debt expense. This is an example of variable consideration in which, under either an implied price concession or bad debt scenario, the entity ends up reporting only $1,000 of net revenue.

The previous variable consideration of $1,000 may have been computed using a probability-weighted estimate, based on past data for that customer class, as shown in the exhibit below.

Alternatively, the previous variable consideration of $1,000 may have been a most-likely amount if established hospital policy is to charge a maximum of $1,000 for all non-charity care ED visits, regardless of standard rates, wherever patients lack the means to pay standard rates.

The FASB's standard states that the consideration received should be adjusted for the time value of money if the timing of the payments (either explicitly or implicitly) provides the customer with a significant financing benefit.

The new standard requires improved revenue-related disclosures to provide for clearer accounting of reported revenue, thereby helping financial statement users better understand an entity's past performance and future prospects.

a. FASB, Accounting Standards Update, No. 2014-9: Revenue from Contracts with Customers, May 2014.

b. FASB, Accounting Standards Update, 2015-14: Revenue from Contracts with Customers-Deferral of Effective Date; August 2015.

c. FASB, Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, December 1985.

d. FASB, Statement of Financial Accounting Standards No. 5: Accounting For Contingencies, March 1975.

About the author

Thomas E. McKee, PhD, CMA, CIA, CPA (not licensed or practicing in South Carolina), is professor, healthcare leadership and management, College of Health Professions, Medical University of South Carolina, Charleston, S.C., and a member of HFM A's South Carolina Chapter ([email protected]).