Accounting for Bad Debt: Charity Care, IRS Form 990, and ARM

As a sign of things to come for the not-for-profit sector of the healthcare industry, the Service Employees International Union (SEIU) recently drafted a letter to several members of the board of directors at Beth Israel Deaconess Medical Center in Boston, asking them to restate the hospital’s 2005 and 2006 financial statements to exclude bad debt expenses from its provisions for charity care.

The SEIU claims that Beth Israel Deaconess reported $67.6 million in charity care expenses in 2005, but asserts that roughly $11 million of that amount was in fact bad debt, according to a recent article in The New York Times.

The SEUI’s letter attempts to circumscribe Beth Israel Deaconess between two federal laws—the Sarbanes-Oxley Act and IRS Form 990 Schedule H—with the aid of a tenuous interpretation of Massachusetts law. The problem for the SEIU, the largest union of healthcare workers in North America with more than 1 million healthcare members, is that neither of the federal laws actually applies to Beth Israel Deaconess. The problem for the hospital is that at least one of the laws will soon apply to it, and the SEIU’s highly visible action means that Beth Israel Deaconess will likely have to address the issue sooner rather than later, regardless of its legal standing.

Consider the two regulatory standards the SEIU appealed to in its letter to Beth Israel Deaconess:

Sarbanes-Oxley, enacted in 2002 in the wake of major U.S. accounting scandals involving Enron, Tyco, and WorldCom, among others, set new standards for corporate governance, audit procedures, and financial transactions at publicly traded U.S. firms. The law, however, does not apply to private and not-for-profit corporations, which the SEIU recognized in its letter to the Beth Israel Deaconess board. But the union’s argument to apply Sarbanes-Oxley in this case is advanced by its interpretation of Massachusetts state law. SEIU claims in The New York Times article that under the Massachusetts statute, “directors of nonprofits who also work for corporations must ‘use the specialized knowledge they have from their position in the for-profit world’ in governing the nonprofit.” Some of the Beth Israel Deaconess directors also hold positions on the boards of for-profit companies; as such, the union argues that their knowledge of Sarbanes-Oxley from those contexts should have been applied to the hospital’s valuation of its charity care.

The major impediment to validating the SEIU’s use of Sarbanes-Oxley via the Massachusetts law is that deciphering the meaning of opaque phrases like “use the specialized knowledge” is easier said than done. What is transparent, however, is that the Massachusetts law does not require nonprofits to strictly adhere to Sarbanes-Oxley.

The second regulation invoked by the SEIU’s letter is the recent revision to IRS Form 990, “Return of Organization Exempt from Income Tax”. The form, which had not been subject to a major overhaul in almost 30 years, takes effect in tax year 2008, so most not-for-profit hospitals will be required to file the new Schedule H in 2009 or 2010. Among its many changes, Form 990 explicitly requires not-for profit hospitals to clearly report charity care, un-reimbursed costs from financial assistance programs, and bad debt. Uncompensated care can no longer be reported as a portion of a hospital’s charity care unless it is justifiably documented.

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Unfortunately for the SEIU, changes in the Tax Code related to Form 990 are not retroactive; Beth Israel Deaconess’ 2005 and 2006 financial statements are exempt from the IRS mandate to separate bad debt from charity care.

If we assess the SEIU’s charges against Beth Israel Deaconess according to the letter of the law, it would appear that the hospital’s accounting practices for the years in question are legitimate; the first standard—Sarbanes-Oxley—does not apply, and the second—a gesture to the revised Form 990—has yet to take effect. But despite its unsound legal footing, the SEIU letter raises several important issues about the financial constancy of U.S. hospitals and their capacity to deal with bad debt.

Whatever its actual bad debt expense in 2005–$67.6 million or $55.6 million–Beth Israel Deaconess, like many other hospitals, is plainly struggling to confront the impact of uninsured volume increasing at a much faster rate than insured volume. And nonprofits are not alone in this battle to combat bad debt. Some analysts predict that the for-profit hospital sector will see total bad debt expense surpass $14.5 billion in 2008.

Thus, while Beth Israel Deaconess’ financials may pass legal muster, the decision to merge bad debt and charity care expenses reveals a deeper lack of effective collection strategies for patient payments—either at the point of sale or once they reach delinquency status late in the revenue cycle. Moreover, Beth Israel Deaconess, like all hospitals, operates in a community and speculation about a disparity between its stated and actual contributions to that community by means of charity care is likely to be heavily scrutinized.

These circumstances provide accounts receivable management (ARM) companies an opportunity to grow their businesses in a market desperately in need of their services. Collection agencies and debt buyers with healthcare receivables experience are best positioned to step in and relieve hospitals inundated by bad debt. Additionally, first party providers—or agencies with expertise in a broad range of ARM services—may be poised to bundle their back office or collection products with consulting services related to regulatory compliance, particularly in the tax and audit arenas.

Discussions of healthcare reform, a hot-button topic this election year, are often focused exclusively on universal insurance coverage for all Americans. The SEIU’s letter to Beth Israel Deaconess, even if it falls short of achieving its stated goals, underscores the need to open up calls for a revitalized U.S. healthcare system to include strategies for more efficient receivables management.

As an analyst at Kaulkin Media, Michael conducts custom research projects and writes publications focusing on the healthcare sector of the accounts receivable management industry. Contact Michael by email or at 240-499-3836.