Why does this decision matter for a healthcare practice?

Key Takeaways:
  • Choosing the right accounting method helps healthcare practices better understand cash flow, profitability and overall financial health.
  • Cash basis accounting is simple and practical, but it can hide collection issues and operational inefficiencies that impact cash flow.
  • Accrual accounting provides a clearer picture of performance, but practices must closely monitor receivables to avoid paying tax on income they may never collect.

 

Cash basis vs. accrual basis is normally a decision that most practice owners leave to their business advisory and tax professionals. It takes red flags appearing, often in the form of feeling cash-strapped, before many owners begin to see the impact of accounting methods.

Your accounting method determines when income and expenses show up in your reports. For healthcare practices, including dental, medical, veterinary and wellness centers, that timing can affect financial reporting, taxes, cash flow, and day-to-day decisions.

Understanding your accounting method choice and navigating issues as they come up will improve the financial health of your practice.

What is an accounting method?

An accounting method is the set of rules used to recognize revenue and expenses for financial and tax purposes. Think of this as your instruction manual for accounting entries that you will use to create and view reports that will be relied on for management decisions.

Cash basis accounting recognizes revenue when payment is received and expenses when bills are paid.

Accrual basis accounting recognizes revenue when it is earned and expenses when they are incurred, even if the money has not been collected or paid out.

For a healthcare practice, that timing matters. You may provide services this month, wait on insurance reimbursement next month and collect the patient balance even later. Depending on your accounting method, the recording of the revenue is going to be quite different.

Why do many healthcare practices use cash basis accounting?

Many healthcare practices use cash basis accounting because the books and tax return will match up to what’s happening in the bank account.

Money comes in. Money goes out.

As a patient pays at check out, you run payroll for your staff, you pay the monthly rent on your building, these are clear, identifiable cash in and cash out transactions. For many small and mid-sized practices, this is easier for owners to follow.

Cash basis accounting may also have less guesswork when it comes to tax planning. If the practice has a strong cash year, the owner may have more opportunities for tax strategies such as retirement plan contributions, staff bonuses, equipment purchases or other tax planning moves before year-end.

For many healthcare practices, cash basis is the practical starting point.

Where can cash basis accounting fall short?

Cash basis can make tax reporting easier, but it may not tell the whole story.

A practice can have a strong month of appointments, procedures or patient visits, and yet, the owner feels the pinch in their bank account as expenses exceed the income coming in. Insurance reimbursements may be delayed or claims denied. Patient balances may be aging and co-pays not collected consistently. The front office may be short-staffed and overwhelmed, and staff turnover is high and morale low

A cash basis report will show what landed in the bank. But unless the practice is also reviewing accounts receivable, collections, and other metrics, it may not show where the money is stuck or where there are inefficiencies impacting the practice’s financial health.

That is when owners start asking:

  • “Our reports say we made money, so why are we struggling to pay bills?”
  • ”My staff spends all of their time on insurance claims.”
  • “We are busier than ever, but I feel I’m taking home less.”

Cash basis may still be the right accounting method, but it should not be the only way a growing practice measures performance.

Does cash basis mean I can ignore accounts receivable?

No. Healthcare practices using cash basis accounting still need to watch A/R closely.

Accounts receivable tells you whether the practice is actually collecting what it earns. Even on cash basis, healthcare practice owners should review:

  • Net collection rate
  • Days in accounts receivable
  • Insurance aging
  • Patient aging
  • Denied claims
  • Adjustments and write-offs

Other metrics to review that may help a practice owner pinpoint problem areas within the practice operations and can be related to accounts receivable and collections:

  • No Shows
  • Schedule Utilization Rate
  • Average Patient Wait Time

Don’t forget that patient and staff surveys are also a great way to get feedback that may help indicate issues. While feedback from others can sometimes be difficult to hear, it can be an honest perspective from someone with a different point of view.

When does accrual basis accounting make sense?

Accrual basis accounting may make sense when a healthcare practice needs a clearer month-to-month view of performance. Accrual basis accounting can better match revenue and expenses to the period when they happen.

Accrual basis for financial and tax purposes may be useful if the practice has multiple locations, multiple providers, large supply or inventory costs, membership programs, lender requirements, outside investors, regulatory reporting requirements or plans to buy, sell or merge.

A practice may provide a significant amount of care in March. Accrual basis financials would reflect that revenue in March, even if the cash is collected later. All expenses are recorded for the same period, regardless of when they may have been paid.

That can help the owner understand whether the practice actually made money that month instead of only seeing the cash activity for the month.

What is the downside of accrual basis accounting?

For accrual basis, you would recognize and pay tax on income when earned. For tax purposes, that can be a real issue.

Accounts Receivable balances, patient or insurance funds not collected, will be taxed. But what if your aging A/R has been a pain point for your practice? You may have turnover in your front office staff, which has caused an increase in insurance claims being denied or patient co-pays are not pursued at checkout due to inexperienced staff.

Whether you will collect your accounts receivable can be unpredictable. When you determine the uncollectible amount, you will have an expense to offset this income, but until then, your income may be overstated. For tax purposes, this translates to paying tax on income that you may never collect.

Accrual basis can provide a better management picture, but it must be paired with other management reports and use of metrics for the full picture. Otherwise, the practice may look healthier on paper when the reality is much different.

Can my practice use one method for taxes and another for management reports?

In many cases, yes.

A practice may have one primary accounting method, such as cash basis for tax purposes, and implements a routine where accrual basis reports and KPIs are reviewed and monitored so a practice owner has a clear picture of the financial condition of the business.

Keep in mind the added complexity of potentially having two sets of books, one for financials, and one for tax returns. This requires more diligence and a close eye on the impact of entries throughout the year and before making any business decisions. Having accurate accounting is important!

What if my practice chose the wrong accounting method?

If you later find that the method you initially chose isn’t the best fit, or the nature of your business has changed and the method chosen is no longer the best choice, you may file a Form 3115, Application for Change in Accounting Method. This tells the IRS that you want to change accounting methods.

Filing Form 3115 involves calculating the tax impact of the change in accounting methods. While the calculation for the adjustment can be tricky, the intent in filing Form 3115 is to help taxpayers avoid negative tax impacts from making the change in accounting methods.

The calculation and Form 3115 can be technical, so it is not something most owners should try to manage without guidance.

Questions?

If your healthcare practice looks profitable but cash still feels tight, our Adams Brown Healthcare team would be happy to evaluate your accounting method and other management reporting to ensure you have the necessary tools to make decisions with a clear view of your practice’s financial health. Contact an Adams Brown healthcare advisor today.