How do nonprofit hospitals manage earnings?

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Abstract

We hypothesize that, unlike for-profit firms, nonprofit hospitals have incentives to manage earnings to a range just above zero. We consider two ways managers can achieve this. They can adjust discretionary spending [Hoerger, T.J., 1991. ‘Profit’ variability in for-profit and not-for-profit hospitals. Journal of Health Economics 10, 259–289.] and/or they can adjust accounting accruals using the flexibility inherent in Generally Accepted Accounting Principles (GAAP). To test our hypothesis we use regressions as well as tests of the distribution of earnings by Burgstahler and Dichev [Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99–126.] on a sample of 1,204 hospitals and 8,179 hospital-year observations. Our tests support the use of discretionary spending and accounting accrual management. Like Hoerger (1991), we find evidence that nonprofit hospitals adjust discretionary spending to manage earnings. However, we also find significant use of discretionary accruals (e.g., adjustments to the third-party-allowance, and allowance for doubtful accounts) to meet earnings objectives. These findings have two important implications. First, the previous evidence by Hoerger that nonprofit hospitals show less variation in income may at least partly be explained by an accounting phenomenon. Second, our findings provide guidance to users of these financial statements in predicting the direction of likely bias in reported earnings.

Introduction

Reported earnings in hospitals and other large nonprofit organizations serve a number of important purposes. These include credit evaluation, managerial assessments, donation decisions, contract negotiations, and even the review of tax-exempt status. For example, it is widely thought that many hospitals are currently foreclosed from credit markets in large part due to low reported earnings. Brickley and Van Horn (2002) report a negative relation between earnings and the likelihood a CEO will be terminated. Frank et al. (1990), report that donors consider the hospital's profitability when making donation decisions. Finally, as an anecdotal example of regulatory constraints, the Texas Attorney General's office sued Methodist Hospital soon after Modern Healthcare magazine listed it as the third most profitable nonprofit hospital system in 1991.1

There is an extensive accounting literature documenting that executives manage reported earnings for various contracting reasons (e.g., bonus contracts and debt covenants) and to influence stock prices.2 Several systematic patterns of earnings management have been documented in for-profit organizations. Managers smooth earnings to show steadily increasing earnings patterns, and manage earnings to avoid small losses and to avoid small earnings decreases (Burgstahler and Dichev, 1997). Given the pervasive evidence in the corporate setting and the importance of earnings in the nonprofit hospital industry, a natural question is whether nonprofit hospital CEOs also manage earnings, and whether they do so in a predictable manner.

Nonprofit hospitals, by definition have different objectives, governance, and managerial incentives. These differences naturally give rise to differential predictions in financial reporting strategies. So while we expect earnings management to occur in the nonprofit hospital setting, we expect the form of the earnings management to differ in material ways. We expect that like the executives in the corporate setting, nonprofit hospital CEOs will manage earnings to avoid small losses. That is, if earnings fall just below zero in the initial earnings report, earnings will be managed through accounting adjustments so that the earnings reported to stakeholders (e.g., debtholders, the board of directors, etc.) is nonnegative. This behavior is documented by Burgstahler and Dichev (1997) and Degeorge et al. (1999) in the corporate sector.

The chief differences in earnings management that we expect to find in nonprofit hospitals are as follows. In investor-owned organizations, managers have an incentive to report a pattern of continuous increases in earnings so they engage in income smoothing to show constant growth.3 Firms that show these patterns of growth (even by managing earnings) appear to be rewarded with a price premium in the stock market (Barth et al., 1999). In contrast, we expect that given the various stakeholders, it is optimal for nonprofit hospital CEOs to manage earnings around a fixed point just above zero profits. This prediction is consistent with Hoerger (1991), who predicts and finds that nonprofit hospitals minimize the variance in reported earnings because they attempt to achieve a target level of earnings that satisfies the budget constraint. Similarly, in contrast to for-profit firms, nonprofit hospitals have no incentive to avoid reporting earnings decreases as long as current period earnings are above zero. The motivation for avoiding small losses in the for-profit sector is driven by equity markets, which does not exist in the nonprofit sector. Therefore, in contrast to evidence in the for-profit sector, we do not expect hospital executives to manage earnings in order to avoid earnings decreases.

Hospital CEOs have several ways to manage reported earnings. First, as Hoerger (1991) suggests, managers can increase or decrease discretionary spending near year end to get closer to desired profit levels. However, adjusting discretionary spending in the short-run, often (though not always) has undesirable long-run consequences. For example, cutting back (increasing) services in years where hospitals expect budget shortfalls (surpluses) can lead to inconsistent service and quality. Further, it leads to real economic losses in efficiency. Another limitation of managing real spending to influence reported earnings (the presumed budget constraint in prior research) is that it must occur prior to the end of the reporting period when the final earnings number is not yet known.

Alternatively, managers can take advantage of the subjective nature of certain accounting standards to adjust reported earnings rather than increase or decrease real spending. Consider, for example, the case of third-party settlements which is a liability on hospitals’ financial statements.4 Audits by third-party payers after a hospitals’ fiscal year end can lead to denied or adjudicated claims.5 Further, the ultimate rates paid by Medicare and other insurers are subject to retrospective adjustments. Generally Accepted Accounting Principles (GAAP) require hospitals to reserve for any anticipated adjustments to payments resulting from audits and retrospective rate adjustments by third-party insurers that occur after the year-end. This requires considerable judgment by management because it is difficult to accurately forecast subsequent adjustments, and this liability can be substantial.6 The size of this account coupled with the substantial management judgment required to estimate the settlement amount makes this account highly susceptible to earnings management.7 Furthermore, the subjective nature of accounts such as the third-party allowance account makes it virtually impossible for a financial statement user to “undo” the earnings management for any individual hospital.

In this study, we examine both discretionary accounting adjustments (accruals) and discretionary spending on charity care on a set of 1204 nonprofit hospitals (8179 hospital-years) for the period 1990–2002. Using multiple measures of discretionary accruals (discretionary adjustments to earnings), we find evidence that hospital CEOs (1) manage earnings toward zero, (2) manage earnings to avoid losses and (3) do not manage earnings to avoid negative earnings changes.

In addition to examining CEOs’ discretionary accrual choices, we examine whether discretionary expenditures on charity care are adjusted to report earnings close to zero. We assume that changes in charity care expenditures are discretionary and find that these changes are positively correlated with hospitals’ current income excluding current year changes in charity care. This is consistent with CEOs maximizing philanthropic objectives subject to a zero profit constraint.

Our paper has important implications for both academic researchers and users of financial statements of nonprofit hospitals. Our evidence suggests that researchers should be aware that all reported financial performance embodies a measure of subjectivity that effectively shades the “real” performance of the hospital. Hospital management can use the subjective nature of accounting standards to meet certain profit objectives. Barring the use of accruals, all observed changes in profitability are presumed to be “real” in the sense that the hospital makes actual cuts or increases in spending. For example, Hoerger (1991) finds that hospitals minimize the variance in reported earnings and it is suggested that this is done by adjusting real spending. Making real changes in spending can be costly (e.g., eliminate a position to reduce costs in order to meet a budget constraint). However, our paper suggests that while, we agree with Hoerger (1991) that hospitals do attempt to minimize the variance of earnings, it is likely that at least some of this is accomplished through earnings management via accounting. Earnings management via accounting is likely much less costly than managing real activities.

For users of financial statements in nonprofit hospitals, we provide a model of when nonprofit hospitals are likely to manage earnings up or down. This model is useful for determining the likely direction of any bias in reported earnings. For example, firms with high positive (low negative) profits, likely have higher (lower) profits than those actually reported.

The remainder paper is organized as follows. Section 2 develops hypotheses for incentives to manage earnings in nonprofit organizations. Section 3 presents the empirical model and hypothesis tests. Section 4 presents the data and results, and Section 5 concludes.

Section snippets

Incentives to manage earnings—hypothesis development

We assume that nonprofit hospitals seek to maximize their philanthropic objective function subject to a zero-profit constraint.8 The intuition behind the zero-profit constraint is as follows. Nonprofit hospitals have a social objective, such

Measures of discretionary accruals

To test the zero-profit hypothesis, we analyze specific accounts that are most susceptible to earnings management in the spirit of Guidry et al. (1999), Leone and Rock (2002), and McNichols and Wilson (1988). Based on discussions with the financial officers at numerous nonprofit hospitals, we identified two accounts that are both large in magnitude and require substantial judgment in determining proper balances. These account characteristics afford the greatest opportunity for earnings

Data

The financial data, including balance sheet, income statement, and operating information were obtained from Van Kampen Merritt.20 The database includes only hospitals that issue public debt. We obtain financial data on a set of 8179 nonprofit US hospitals for the period 1990–2002. The Van Kampen Merritt database includes approximately 50% of all nonprofit hospitals in existence for the study period and the original data sources are the

Conclusion

This paper examines the important nonprofit sector of the U.S. economy. In particular, we study the role of earnings in nonprofit hospitals and test whether earnings management occurs in this setting. We find that even though nonprofit hospitals do not have a profit-making objective, earnings play an important role. Various stakeholders including bondholders, the community, regulators and potential donors, as well as the market for CEOs use earnings to evaluate hospital performance. These

Acknowledgments

The authors acknowledge the helpful comments of Bill Baber, Greg Bauer, Mike Barclay, Jim Brickley, David Cutler (editor), Steve Finkler, Scott Keating, Jay Rich, Steve Rock, Cliff Smith, Gerry Wedig, Mike Willenborg, Jerry Zimmerman, two anonymous referees, and workshop participants at the University of Connecticut, George Washington University, University of Michigan, Michigan State and the University of Rochester. Financial support was provided by the John M. Olin Foundation and the Bradley

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