You’re deep into a healthcare acquisition when you suddenly discover their revenue looks off. Way off. Now what do you do?
ant to avoid blowing up your healthcare deal? Look at revenue for the targeted company and identify where the money comes from right from the start.
Every. Single. Penny.
That’s an exaggeration of course — accounting for all revenue in any transaction is notoriously difficult. The point is that giving short shrift to revenue vetting in a healthcare deal can have adverse effects. In an FTI Consulting review of healthcare deals it serviced over the past three years, more than 45 percent had a material* overstatement of revenue and accounts receivables. Revenue recognition was in fact the number one reason a deal was cancelled or repriced. (Number two: Clinical and Compliance issues.)
What’s going on? The problem starts with a few overarching industry issues. For one, the collection cycle for healthcare receivables can be long. It’s not atypical for some collections to extend a full year or more after services were performed. That long cycle can add ambiguity to understanding the true amount of net collectibles. And, it can become a reason — yes, even an excuse — for a company’s inability to estimate actual revenues.
Another issue is inconsistency in audit and diligence approaches, usually linked to a lack of industry expertise. Healthcare companies that have undergone a thorough audit of their revenue and AR may be under the impression that their findings are sound. But by the time errors are discovered they’ve typically been festering for years. Imagine the house-of-cards: the company has an audit team without healthcare expertise, followed by a similarly inexperienced diligence team that relies on the shaky audit findings. (This occurs in both private and public companies, by the way.)
Clearly, one cannot dabble in healthcare.
DIAGNOSING THE PROBLEM
As noted, revenue recognition issues are endemic to the healthcare industry, however, FTI Consulting finds that several recurring themes are prevalent:
Over-reliance on Past History
Many revenue and AR reserve models rely on a “lookback” methodology. That is, they utilize historical collection percentages applied to current revenue and AR. In a status quo environment, that typically wouldn’t be a problem. However, healthcare over the last several years has been anything but status quo. That can open the door to trouble while waiting for the impact of changes to the business to be realized in collection percentages.
Ignoring Changing Business Dynamics
Perhaps more so than other industries, healthcare entities are bombarded by change that can affect business. This includes in-network versus out-of-network contracts, fluctuating reimbursement rates, payor mix changes and regulations from doing business in new states. All these factors can significantly impact go-forward collection rates.
Using One Reserve Approach
Many healthcare entities still rely on either a P&L approach or a balance sheet approach. In our experience, we find that companies that use a more holistic approach are more successful at properly recognizing revenue and recording AR. This includes analyses such as cash adjudication (a combination of historical and projected collection rate), cash-lag analysis, payor mix analysis, DSO trending, and price/volume analysis.
SAVING THE PATIENT
So what areas should you dig into more closely during healthcare diligence to improve revenue recognition and to better assess AR collectability?
• Days Sales Outstanding (DSO) – Check to see if this measure starts trending up and assess the answers management provides. If you’re not satisfied, keep digging!
• Cash Analysis – As simple as this sounds, using cash collections as part of both prospective and retrospective testing is a must. However, it’s not uncommon for auditors or other providers to perform this analysis improperly by not fully comprehending what should be included and excluded from any cash-to-revenue testing. A simple cash lag analysis, when done correctly, can provide an interesting data point, but multiple angles are needed to “triangulate” an answer.
• Lines of Communication – Is there an open dialogue and flow of information between the accounting department and the billing office? Silos in these areas can break a company and a deal. Make sure your diligence includes both accounting and billing for not only current state validation, but to ensure that the future state of the organization can be supported.
WHO DOES YOUR DUE DILIGENCE?
Getting gross to net revenue and AR right is inherently difficult in any deal, and getting it wrong can be catastrophic. But there are usually signs of issues along the way.
That’s why the due diligence process is so crucial and why those doing the vetting must take a holistic approach to the job. Are they experienced in the healthcare industry and is it their primary focus? Is their work relying too much on the auditors? Are they involving the billing office, or does their diligence stay within the “four walls” of the accounting office? Do they understand the forward effects of trends that are noted?
Within healthcare, the focus should be on high risk items like revenue and AR, with multiple tests run to eliminate false negatives and false positives. Once an issue is identified, a large AR write-off may be necessary, which could be related to multiple years. Determining the current year impact is the true baseline for revenue and earnings.
Those who choose to skimp on due diligence — or dabble in healthcare as it were — may find their deal on life support.
* “Material” is defined as requiring an adjustment in the quality of earning analysis.