Not long ago, I sat in a room full of attorneys (five for the client and three for the government). I was to review the break-out of consolidated financial statements, isolating the company in question. Collectively, the attorneys pleaded ignorance, something about being liberal arts majors. To this, I replied, “That’s okay, I don’t understand a word of what is in your documents.” Of course, on some level, the attorneys and I were sandbagging one another. But the point is clear, the worlds of accountants and attorneys come together around, “What is the deal, what do the documents say and where does it fit in GAAP?” Drafting of documents in an acquisition and, more particularly, in some form of partnership and joint venture, needs to consider the implications on the respective party’s financial reporting. It isn’t enough to wait until after the dust settles for the accountant to apply GAAP to the deal.
Deals where one party acquires 100% of the other in the form of cash and assumed liabilities can be pretty straightforward. While not to over-simplify the accounting, the biggest challenge for the buyer is the purchase price allocation. For more complex deals, larger players have the resources of a consistent deal team. The challenge is in the lower middle market and among community hospitals or small regional health systems that do a limited number of deals. In these spaces, the deals are fewer and further between. They also tend to be diverse in nature, a physician practice, an imaging center, an outlying hospital and so on.
As health care continues to consolidate, transactions will get done around the various parties’ objectives and interest. How do two not-for-profit hospitals merge? How do for-profit and not-for-profit organizations work together? And how does the accounting get done? Accountants with the help of both auditors, advisors and legal counsel will work through the accounting. But there may be some instances where the goal of either consolidating or not consolidating financial statements and the structure of the deal are at odds with each other.
What follows is a look at the direct impact on accounting treatment of the purchase agreement, operating agreements or a variety of other contracts and, in some cases, simply the details of executing the deal. This article is not a comprehensive look at all possible issues or alternatives. As we have all learned, every deal has its twist. Rather, the article should point out some common issues that may change the intended accounting treatment.
Acquiring Physician Practices
The most active and common transactions, at least in terms of volume, are deals between the hospital and physicians. Physician practice consolidation has some of the most specific direction within the codification of GAAP. Accordingly, it deserves special attention.
Most often, we see physicians end up employed by existing physician organizations established by the hospital. These organizations, when set up properly, are generally very straightforward from an accounting standpoint.
However, there are exceptions. Various states have prohibitions on the corporate practice of medicine or the physicians seek to retain the status of their professional corporation for tax planning or other reasons. In these cases, the ‘buyer’ enters into a management contract to effectively control the practice. The model has been around for years and was refined during the time of PhyCor, MedManagement and others. Most physician management companies that exist today continue to use this model. In the model, the ownership might be reduced to one physician friendly to the ‘buyer’ and he or she may ‘own’ multiple Professional Corporations or other entities engaged in the practice of medicine (PCs) in states where the physician holds a license to practice medicine (the nominee shareholder).
The rules regarding the consolidation of these friendly or captive PCs were first spelled out in 1997 when FASB’s Emerging Issues Task Force (EITF) issued 97-2 concerning physician practice management entities and other contractual management arrangements. EITF No. 97-2 and related language have been superseded. The current guidance is now reflected in the codification of GAAP at Subtopic 810-10-15-22. The guidance considers instances where the physician practice management company (PPMC) cannot own the practice but through contract can control all of the non-clinical aspects of the practice including distributions of profits. The PPMC will usually employ all non-providers, those other than physicians, nurse practitioners and physician assistants. The PPMC funds all expenses and provides systems required to operate the practice.
The PPMC will be seen as having a controlling interest in the physician practice if all the following criteria are met:
- Term of 10+ years or the remaining life of the practice
- Cannot be terminated, except for specific events (g. fraud, gross negligence, bankruptcy of PPMC)
- Exclusive decision making over scope of service, contracts, patient acceptance, financing, pricing but not dispensing of medical services (for example, the PPMC can decide to offer MRI but cannot control the ordering of the MRI).
- Total practice compensation of medical professionals, including hiring and firing. This is typically outlined in an employment agreement at the time the practice is ‘acquired’ and may be amended from time to time.
- The management agreement and its rights are unilaterally saleable or transferable by the PPMC
- Right to receive income as both ongoing fees and proceeds from the sale in an amount that fluctuates based on performance of the practice. Generally, this covers non-provider expenses and the profit of the practice after the providers have been paid.
To make this work, the PPMC will also have control over the nominee shareholder. Specific definition of a nominee shareholder is spelled out in the glossary of Subtopic 810-10. But generally, the PPMC’s power over the nominee shareholder includes the power to establish or change without cause the nominee shareholder by naming anyone qualified to hold the position.
Having reviewed the control requirements, a full-fledged PPMC will monitor and insist on all six of the requirements being met. But it is easy to see on a case by case basis where the ‘buyer’ is a hospital or other local provider not focused on the consolidation of revenue, some of the criteria might be negotiated away to appease the physician group. We have noticed instances where physician groups are consolidated, but when we review the unaudited supplemental data, some practices, designated as PCs, are reported separately from the hospital’s physician organization. Without a review of the facts and circumstances, it is impossible to know if the six criteria have been met. We can envision circumstances where the practice may have retained certain rights such as unilaterally deciding to leave or to change the deal down the road. They may not agree to certain restrictions, term of the agreement, changes to compensation, hiring and firing or other managerial decisions.
Absence of any of the criteria will result in the practice not being consolidated and the intended buyer will record only the management fee and expenses.
Not-for-Profit Health Care Entities
This discussion assumes the entities in question are NOT predominantly supported by contributions but are viable healthcare organizations.
Not-for-profit health care entities present a unique set of variations. There is specific guidance for health care and not-for-profits. Further, these industry guidelines may direct the user back to the specific GAAP topic. For example, when a not-for-profit entity is dealing with a for-profit entity, the user is directed to Subtopic 810-10, for partnerships 810-20 and research and development 810-30 so each of these is consistent with the broader GAAP. Each of these sections also includes tests of control, some of which we address later in the article.
But what about two not-for-profits? Here the issues become more specific to the not-for-profit status and the various ways in which not-for-profits might come together.
For GAAP, a merger is forming a new entity by two not-for-profits, where the new entity is the single member of the two merging parties. In this case, the assets and liabilities transfer over at their carrying value based on what is reported on the financial statements or would have been on the financial statements had they been issued on the date of the transaction. That is, there is no mark-up of asset values or goodwill. The only real changes are for consistency in classification and accounting treatment where there is more than one acceptable answer.
Additionally, a merger may trigger a change in a contract or other agreement. Modifications resulting from a merger would be recognized at the time of the merger. For example, to gain assignment of a contract certain concessions have to be made. Modifications resulting from the renegotiation of the terms other than required by the merger would be reflected in future financial statements.
The first course of action is to determine the acquirer. The acquirer is considered to be the entity able to select or dominate the selection of the governing body. If not obvious, the codification provides for factors to consider in determining the acquirer. The considerations are how the voting board is organized, how future appointments are made and, in the case of a self-perpetuating board, how the initial appointments are made or any supermajority powers of the respective parties.
How will the transaction be recorded on the acquirer’s books?
- One entity acquires another in a bona fide transaction. Assets and liabilities are measured at fair value with certain exceptions. The exceptions generally relate to value which either should already be at an established current fair value, such as contingencies, or was established through prior election, such as the fair value of the promise to give at some date in the future.
- Generally there is a difference in the consideration given and the fair value of the net assets acquired:
- If the consideration given is greater than the fair value of the net assets, it is recorded as goodwill.
- If the value of the net assets is greater than the consideration given, the difference is treated as a contribution and recorded on the date of acquisition classified based on the nature of any donor related restrictions. This differs from a for-profit bargain purchase where the difference would be treated as a gain .
- Special situations where assets may not be transferred directly to the acquirer but will benefit the acquirer. Assets for the ultimate benefit of the acquirer but retained by the ‘seller’ or transferred to a third party are recorded on the acquirer’s books.
- For example, the acquired entity had $10 million allocated for the construction of a new cancer center. At the time of the transaction, the funds are transferred to a third party foundation to be paid over to the acquirer as the new cancer center is built. The acquirer will still record the $10 million as restricted assets even though it does not hold the funds. This is because it will be the sole beneficiary of the funds in the future, so long as it builds the new cancer center.
Controlling an Entity Through Operating Agreements, Contracts or Other Form
Typically, we think of entities as one party having a majority of ownership. Public companies or other for-profit entities focused on growing revenue are very conscious about meeting the criteria for consolidation in joint ventures and partnerships. The not-for-profit on the other hand often straddles the fence between maintaining control and broadening the community reach and integration. It becomes important to the controlling interest to make sure nothing in the governance of the joint venture entity or contract impedes the consolidation. It is equally important to the non-controlling interest that their objectives are met and that they have a level of control as it relates to those objectives. For a tax exempt hospital this might be decisions regarding charity care. (The issue of consolidation of a physician or other professional practice is addressed previously in the article.)
Partnerships or joint ventures typically fall into two groups: Variable Interest Entities (VIEs) and the more traditional voting interest entities. In the case of a VIE, an entity that has effective control and is the primary beneficiary will be required to consolidate the investee entity. The rules around the determination of a VIE are complex and were developed at least in part out of the Enron scandal to require entities to be consolidated because financial consequences (positive or negative) need to be reflected in the financial statements of the primary beneficiary. Historically, one of the more common VIEs was the case in which the owner of a private business owned the real estate integral to the core business separately for a variety of reasons . This is a common theme in the long term care industry where the operations and real estate are in different entities but have common or overlapping ownership. One cannot operate the facility without real estate, and the real estate is not worth as much with the operations.
Not-for-profit entities are not subject to the requirements of VIEs.
Health care organizations are frequently involved in voting interest entities, LLCs, partnerships, etc. The issue of who consolidates arises when the powers of the majority shareholder are restricted by certain approval or veto requirements (refer to 810-10-15-10 of the codification of GAAP). Non-controlling shareholders, members or partners could come into play through supermajority powers found in some agreements, particularly between not-for-profit and for-profit identities. Recent updates to Subtopic 810 were outlined in Accounting Standard Update No. 2015-02, issued in February 2015 that provided more specific language on the issue, including improved definitions of certain key terms.
Key rights to consider in determining control include Kick-Out Rights, Participating Rights and Protective Rights.
- Kick-Out Rights typically allow a limited partner or other party to dissolve the entity or remove the general partner or other entity generally seen as controlling the ordinary course of business.
- Participating Rights allow non-controlling parties to block and/or participate in significant financial and operating decisions occurring in the ordinary course of business. Participating Rights do not necessarily allow the non-controlling party to initiate an action, just to participate in the action.
- Protective Rights provide for protection of the non-controlling party. The approval or veto rights might include increases in debt, purchase of high dollar equipment or other capital commitments or removal of the manager in the case of bankruptcy or breach of duties.
Despite all of the definitions, the ultimate evaluation requires judgements based on the facts and circumstances. In the simplest form, the evaluation requires consideration of questions such as: Does the non-majority owner party have control or protection? Can the non-controlling party effective block certain decisions that occur in the ordinary course of business? Or is the control largely to protect the non-majority owner party?
Let’s assume that in an LLC with a Catholic health care entity (non-majority owner) and another health care entity (majority owner), the Catholic health care entity has the power to block a service or other issue contrary to Catholic Health Directives, but otherwise all business decisions are made by the majority owner entity. In this case, the power is only protecting the Catholic entity and the majority owner entity consolidates.
However, if the non-majority owner entity had a series of rights when viewed on aggregate (veto power of key operating issues, staffing, budgeting or could remove the controlling entity from management), the non-majority owner entity might overcome the majority voting interest. In such a case, the non-majority owner will consolidate. However, in such a circumstance there is likely much discussion by both parties to the agreement and the level of actual control.
Even without a legal transfer of assets or merger, an entity may be required to consolidate financials. One entity may agree to provide support and management if it is given sufficient control over the process. For example, Hospital A agrees to guarantee the debt or obligation to make significant capital improvements (economic interest) if Hospital B will enter into a management contract giving Hospital A substantial control over the ordinary course of business at Hospital B (Control). Hospital A would likely consolidate Hospital B, again subject to a thorough review of facts and circumstances.
In other circumstances, the controlling entity does not have a majority of board votes but has contracted with the other entity as a sponsor or other relationship whereby it controls all of the financial funding and, indirectly, the decision making. The controlling entity would likely consolidate the other entity.
GAAP for governmental entities is governed by the Governmental Accounting Standards Board (GASB). In thinking about GAAP for governmental entities, many fundamentals are the same, as is the goal of reliable reporting. There are differences in the terminology, concepts and the focus on issues common to governmental entities. A government will certainly be judged on its fiscal soundness but it is also judged on how it fulfills its role in the community served. In some cases, GAAP promulgated by GASB may be substantially different from GAAP promulgated by FASB. Governmental health care entities in the form of hospital districts, hospital authorities or county- or municipal-operated facilities compete with for-profit and not-for-profit hospitals. In fact, many governmental hospitals have dual status as a governmental entity and a 501(c)(3) organization. Accordingly, there is a tendency to want to look and act like the competitors. Nevertheless, the financial statements must be prepared in accordance with GAAP for governmental entities, and references in the documents to GAAP may want to specify “as promulgated by GASB.” 
In an acquisition by a governmental hospital, the excess of consideration given over the net position acquired is reported as a deferred outflow of resources. (If we were describing a non-governmental transaction, the excess of the total purchase price over the value of net assets would be reported as goodwill.) The deferred outflow of resources is attributed (amortized) to future periods in a systematic and rational manner, generally based on factors that most closely relate to the goodwill. Guidance for Governmental Combinations can be found in the GASB Codification Co10 and that guidance includes four illustrative examples; unfortunately, none of these examples are health care specific. Generally, the question is, “Over what period of time would a hospital expect to realize the goodwill?” This period might vary based on short and long term plans for the facility, demands for new capital and shifting demographics that may affect the service delivery. For example, a rural hospital transitioning to more outpatient services likely has limited goodwill, but to the extent that it does, it may be very short lived. In general, selection of the amortization period is given more discretion than in non-governmental GAAP.
If consideration given is less than net position achieved, the acquisition value assigned to of non-current assets is reduced, unless the conditions of the acquisition indicate that the seller intended to provide a reduced price as economic aid to the acquirer. For example, if the purchase price is less than acquisition value by $5 million with the understanding that the acquirer will be required to subsidize operations or invest some amount of money in order to insure that the hospital continues to operate in the community. Some portion of the $5 million would likely be reported as contribution revenue. (In a for-profit transaction this would be a gain and in a not-for-profit transaction it would be reported as a contribution.)
In a direct sale of stock, interest or assets, the issues around consolidation are generally straightforward. When one of the large growing health care companies (for-profit or not-for-profit) does a deal, they have the team and the experience to sort out issues around consolidation. However, as the health care industry continues its consolidation, particularly in the form of joint ventures or affiliations, the controls, options or protections afforded the parties will raise issues over who if anyone should consolidate. While more likely to occur in one-off deals or where parties are focused on working together, controlling party complexity can slip into any agreement where the party with the majority ownership interest seeks to assure the non-majority ownership party.
The parties to any agreement should make certain that their respective accounting experts, be they CFOs, controllers, auditors or other consultants, have a good understanding of the key components related to control and the financial reporting consequences.
 Given the complexity of VIEs, we have not attempted to address the full standards on VIEs in this article.
 Recent changes allow private businesses to elect not to consolidate essential leased property with common control. Each instance should be reviewed based on facts and circumstances.
 Prior to the sale of a governmental hospital, it may be important to look at the differences in GAAP and the impact of those differences on the Income Statement and Balance Sheet, so that any prospective acquirer can make an apples to apples comparison.