SOLUTIONS
Multiple Choice Questions:
1. Which of the following statements about finance, accounting, and financial management is most correct?

a. Accounting is of no value in decision making.
b. Accounting provides the theory and concepts necessary to help managers make better decisions.
c. Financial management involves the measurement, in financial terms, of operational events that affect the resources and financing of an organization.
d. The primary role of finance is to plan for, acquire, and use resources to maximize the efficiency and value of the enterprise.
e. Financial management is of no value in decision making.

2. Which of the following statements about the role of finance in healthcare organizations is incorrect?

a. Over time, the finance function has become increasingly focused on strategic issues, such as joint venture decisions.
b. Today, the most critical finance function is cost identification.
c. The finance function often supports cost containment efforts and third-party payer contract negotiations.
d. The primary activities of the finance function can be summarized by the four Cs: costs, cash, capital, and control.
e. In times of high profitability and abundant financial resources, the finance function tends to decline in importance.

3. Which of the following is not a hypothesized benefit of integrated delivery systems?

a. Information systems that track all aspects of patient care can be developed more easily.
b. Integrated delivery systems can provide population-based care, such as chronic disease management, that is often not offered by stand-alone providers.
c. Integrated delivery systems have better access to capital.
d. Integrated delivery systems are easier to manage than stand-alone providers.
e. Integrated delivery systems are able to offer payers "one-stop shopping."

Questions: (NOTE: The responses below are really text book, ideal answers to the question chapters. Your answer might be shorter and still acceptable.)
2.1 The three primary forms of business organization are the proprietorship, partnership, and corporation. A proprietorship, sometimes called a sole proprietorship, is a business owned by one individual. A proprietorship is easily and inexpensively formed, it is subject to few governmental regulations, and the business pays no corporate income taxes.

A partnership is formed when two or more persons associate to conduct a nonincorporated business. Like a proprietorship, the major advantages of the partnership form of organization are its low cost and ease of formation. In addition, the tax treatment of a partnership is similar to that of a proprietorship; the partnership's earnings are allocated to the partners and taxed as personal income, regardless of whether the earnings are actually paid out to the partners or retained in the business.

Proprietorships and partnerships have three important limitations:

1. Selling their interest in the business is difficult for owners. 2. The owners have unlimited personal liability for the debts of the business, which can result in losses greater than the amount invested in the business. In a proprietorship, unlimited liability means that the owner is personally responsible for the debts of the business. In a partnership, it means that if any partner is unable to meet his or her pro rata obligation in the event of bankruptcy, the remaining partners are responsible for the unsatisfied claims and must draw on their personal assets if necessary.
3. The life of the business is limited to the life of the owners.

These three disadvantages—difficulty in transferring ownership, unlimited liability, and impermanence of the business—lead to the fourth and perhaps the most important disadvantage from a finance perspective, the difficulty that proprietorships and partnerships have in attracting substantial amounts of capital.

A corporation is a legal entity that is separate and distinct from its owners and managers. The creation of a separate business entity gives the corporation three main advantages:

1. A corporation has unlimited life and can continue in existence after its original owners and managers have died or left the company.
2. It is easy to transfer ownership in a corporation because ownership is divided into shares of stock that can be easily sold.
3. Owners of a corporation have limited liability.

The corporate form of organization has two primary disadvantages. First, corporate earnings of taxable entities are subject to double taxation: once at the corporate level and then again at the personal level when dividends are paid to stockholders. Second, setting up a corporation, and then filing the required periodic state and federal reports, is more costly and time consuming than that required to establish a proprietorship or partnership.

2.2 There are three key features of investor-owned corporations. First, the owners (the stockholders) of the business are well defined, and they exercise control of the firm by voting for directors. Second, the residual earnings of the business belong to the owners, so management is responsible only to the stockholders for the profitability of the firm. Finally, investor-owned corporations are subject to taxation at the local, state, and federal levels.

If an organization meets a set of stringent requirements, it can qualify for incorporation as a tax-exempt, or not-for-profit, corporation. Tax-exempt corporations are sometimes called nonprofit corporations. Because nonprofit businesses (as opposed to pure charities) need profits to sustain operations, and because it is hard to explain why nonprofit corporations should earn profits, the term “not-for-profit” makes more sense, especially in a finance context. Not-for-profit corporations differ significantly from investor-owned corporations. Because not-for-profit firms have no shareholders, no single body of individuals has ownership rights to the firm's residual earnings or exercises control of the firm. Rather, control is exercised by a board of trustees that is not constrained by outside oversight. Also, not-for-profit corporations are generally exempt from taxation, including both property and income taxes, and they have the right to issue tax-exempt debt (municipal bonds). Finally, individual contributions to not-for-profit organizations can be deducted from taxable income by the donor, so not-for-profit firms have access to tax-subsidized contribution capital.

2.3
a. The primary goal of investor-owned corporations is shareholder wealth maximization.

b. The primary goal of most not-for-profit healthcare organizations generally takes the form of some mission, such as to enhance the health of the communities served.

c. In spite of overall goal differences, there actually is little difference between the finance goals of investor-owned and not-for-profit businesses. In general, the finance function must ensure the financial viability of the organization and support organizational goals.

d. An agency problem exists when one or more individuals (the principals) hire another individual or group of individuals (the agents) to perform a service on their behalf and then delegate a decision-making authority to those agents. Within the healthcare finance framework, the agency problem exists between stockholders and managers, and between debtholders and stockholders.

The agency problem between stockholders and managers occurs because the managers of large, investor-owned firms hold only a very small proportion of the firm's stock, so they benefit very little from stock price increases. On the other hand, managers benefit substantially from such actions as increasing the size of the firm to justify higher salaries and more fringe benefits; awarding themselves generous retirement plans; and spending too much on office space, personal staff, and travel—actions often detrimental to shareholders' wealth. Clearly, many situations can arise in which managers are motivated to take actions that are in their best interests, rather than in the best interests of the firm's stockholders. A similar agency problem exists between the managers and other stakeholders—primarily the communities served—in not-for-profit organizations.

Shareholders (or other stakeholders in not-for-profit organizations) recognize the agency problem and counter it by creating compensation incentives, such as stock options and performance-based bonus plans, that encourage managers to act in shareholders' interests. Additionally, other factors, such as the threat of takeover or removal, are at work to keep managers focused on shareholder wealth maximization.

2.8 (NOTE: this question is particularly important for students new to the U.S. health system)
a. Under cost-based reimbursement, providers are given a “blank check” in regards to acquiring assets and incurring operating costs. If payers reimburse providers for all costs, the incentive is to incur costs. Facilities will be lavish and conveniently located, and staff will be available to ensure that patients are given “deluxe” treatment. Furthermore, as in billed charges reimbursement, services that may not truly be required will be provided because more services lead to higher costs, which means higher revenues. Cost-based reimbursement is the least risky for providers because payers more or less ensure that costs will be covered, and hence profits will be earned.

b. Under charge-based reimbursement, providers have the incentive to set high charge rates, which leads to high revenues. However, in highly competitive markets, there will be a constraint on how high providers can go. Because billed charges are a fee-for-service type of reimbursement, in which more services result in higher revenue, a strong incentive exists to provide the highest possible amount of services. In essence, providers can increase utilization, and hence revenues, by churning—creating more visits, ordering more tests, extending inpatient stays, and so on. Although charge-based reimbursement does encourage providers to contain costs, the incentive is weak because charges can be more easily increased than costs can be reduced. Note, however, that discounted charge reimbursement places additional pressure on profitability, and hence creates an increased incentive for providers to lower costs. In charge-based systems, providers typically can set charges high enough to ensure that costs are covered, although discounts introduce uncertainty into the reimbursement process. Providers bear the cost-of-service risk in that costs can exceed revenues. However, if providers set charge rates for each type of service provided, they can most easily ensure that revenues exceed costs.

c. Under prospective payment reimbursement, provider incentives are altered. First, under per procedure reimbursement, the profitability of individual procedures will vary depending on the relationship between the actual costs incurred and the payment for that procedure. Providers, usually physicians, have the incentive to perform procedures that have the highest profit potential. Furthermore, the more procedures the better, because each procedure generates additional revenue. Prospective payment adds a second dimension of risk to reimbursement contracts because the bundle of services needed to treat a particular patient may be more extensive than that assumed in the payment. However, when the prospective payment is made on a per procedure basis, risk is minimal because each procedure will produce its own revenue.

d. The incentives under per diagnosis reimbursement are similar to those under per procedure reimbursement. Providers, usually hospitals, will seek patients with those diagnoses that have the greatest profit potential, and discourage (even discontinue) those services that have the least potential. Furthermore, to the extent that providers have some flexibility in assigning diagnoses to patients, an incentive exists to upcode diagnoses to another one that provides greater reimbursement. When prospective payment is made on a per diagnosis basis, provider risk is increased relative to cost- or charge-based reimbursement. If, on average, patients require more intensive treatments, and for hospitals, a longer length of stay (LOS), than assumed in the prospective payment amount, the provider must bear the added costs.

e. In all prospective payment methods, providers have the incentive to reduce costs, because the amount of reimbursement is fixed and independent of the costs actually incurred. When per diem reimbursement is used, particularly with hospitals, providers have an incentive to increase length of stay. Because the early days of a hospitalization are typically more costly to the provider than the later days, the later days are more profitable. When prospective payment is made on a per diem basis, even when stratified, one daily rate usually covers a large number of diagnoses. Because the nature of the services provided could vary widely, both due to varying diagnoses as well as intensity differences within a single diagnosis, the provider bears the risk that costs associated with the services provided on any day exceed the per diem rate. Although patients with complex diagnoses and greater intensity tend to remain hospitalized longer, the additional days of stay (and hence reimbursement) may be insufficient to make up for the increased resources consumed. In addition, providers bear the risk that the payer, through the utilization review process, will constrain LOS, and hence increase intensity during the days that a patient is hospitalized.

f. Under global pricing, providers do not have the opportunity to be reimbursed for a series of separate services, which is called unbundling. For example, a physician's treatment of a fracture could be bundled and hence billed as one episode, or it could be unbundled with separate bills submitted for diagnosis, x-rays, setting the fracture, removing the cast, and so on. The rationale for unbundling is usually to provide more detailed records of treatments rendered, but often the result is higher total charges for the parts than would be charged for the entire package. Also, global pricing, when applied to multiple providers for a single episode of care, forces involved providers (e.g., physicians and a hospital) to jointly offer the most cost-effective treatment. Such a joint view of cost containment may be more effective than when each provider separately attempts to minimize its treatment costs, because lowering costs in one phase of treatment could increase costs in another. Under global pricing, a more inclusive set of procedures, or providers, is included in one fixed payment. Clearly, the more services that must be rendered for a single payment—or the more providers that have to share a single payment—the more providers are at risk for intensity of services.

g. Finally, capitation reimbursement totally changes the playing field by completely reversing the actions that providers must take to ensure financial success. Under all prospective payment methods, the key to provider success is to work harder, increase utilization, and hence increase profits; under capitation, the key to profitability is to work smarter and decrease utilization. As with prospective payment, capitated providers have the incentive to reduce costs, but now they also have the incentive to reduce utilization. Thus, only those procedures that are truly medically necessary should be performed, and treatment should take place in the lowest-cost setting that can provide the appropriate quality of care. Furthermore, providers have the incentive to promote health rather than just treat illness and injury, because a healthier population consumes fewer healthcare services. Under capitation, providers assume utilization and actuarial risks that traditionally have been an insurance function. In the traditional fee-for-service system, the financial risk of providing healthcare is shared between purchasers and insurers. Hospitals, physicians, and other providers bear negligible risk because they are paid on the basis of the amount of services provided. Insurers bear short-term risk in that in any year, payments to providers can exceed the amount of premiums collected. However, poor profitability by insurers in one year usually can be offset by premium increases to purchasers the next year, so the long-term risk of financing the healthcare system is borne by purchasers. Capitation, however, places the burden of short-term utilization risk on providers.

Problem:
2.1 a We want to calculate net income. Note the hint that Net Income is income that remains after taxes.

There are TWO ways to solve this problem and arrive at the correct answer:

(1)
Taxable income = $1,000,000 (ALWAYS use the dollar sign)
Tax rate = 30% or .30

Tax = $1,000,000 x .30 = $300,000
Net income = Income - tax
Net income = $1,000,000 – 300,000 = $700,000

(2)
AT = Net income
BT = Taxable income = $1,000,000 Correct
T = tax rate expressed as a decimal = .30 answer with either
AT = BT x (1 – T) approach

AT= $1,000,000 x (1 – 0.30)
AT = $1,000,000 x 0.70
AT = $700,000