HBSP Product Number TCG161

THE CRIMSON PRESS CURRICULUM CENTER

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THE CRIMSON GROUP, INC.

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Brookstone Ob-Gyn Associates (A)
In January, Mark Amsted, M.D., Chair of Obstetrics and Gynecology at Brookstone Medical
School, Chief of Ob-Gyn at Brookstone Medical Center, and President of Brookstone Ob-Gyn
Associates (BOGA), was preparing to meet with the Harris National Bank. He planned to present a

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request for a $300,000 line of credit, the approval of which was critical to BOGA’s continued op-
erations. He had discussed the need for the line of credit with the Dean of the Medical School, and
had obtained approval to make the request to the bank, but he was by no means certain that the bank
would agree to the loan. A great deal depended upon the bank’s reaction to the financial informa-
tion that he and his business manager, Randy Weber, planned to present.
BACKGROUND
BOGA was a faculty practice plan comprised of university faculty physicians in obstetrics and

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gynecology (Ob-Gyn). All BOGA physicians were on the staff of Brookstone Medical Center
(BMC), one of the city’s major teaching hospitals. The hospital was affiliated with the Brookstone
Medical School, and all of BOGA’s physicians held faculty appointments in the medical school.
BOGA had been organized several years earlier as a nonprofit educational trust. Initially, its
offices had been located in the hospital, and it had grown slowly. During its first few years of exis-
tence, BOGA’s physicians saw mainly Medicaid, Medicare, and self-pay (or uninsured) patients in
the hospital’s outpatient department.
Several years ago, Brookstone Medical Center began to experience declining Ob-Gyn admis-
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sions due to competition from some nearby community hospitals. As a result, BMC offered to con-
tribute $1 million to BOGA if it would open offices in a nearby building. The idea was to make
BOGA’s facilities more attractive to patients with private insurance, in the hope that these patients
would use its services. If the idea worked, BMC would reverse the declining trend in its Ob-Gyn
admissions, and would do so with fully insured patients. After discussing BMC’s proposal with
his colleagues, Dr. Amsted accepted the offer.
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Dr. Amsted supplemented the $1 million contribution from the medical center with a long-term
note from the Harris National Bank. The funds were used to purchase new medical and office
equipment, renovate the space, and furnish the offices in the new facility.
The surrounding community responded positively to BOGA’s move. The reputation of
BOGA’s physicians and the attractiveness of the new facilities led to increases in the number of
private insurance patients treated. In each of the last two years, BOGA’s revenue had increased by
about 20 percent over the previous year.
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PROBLEMS
Despite the growth in revenues, BOGA’s profitability was becoming an issue. Indeed, as he
began to prepare for his meeting with the bank, Dr. Amsted was quite perplexed. He commented:

It’s crazy. Despite our rapid rate of growth, we’re losing money, and I don’t understand why. Our salaries are
competitive and our physicians see as many patients per hour as Ob-Gyn physicians in other places. Our
scheduling is good, so we don’t have a lot of downtime. All our other costs seem quite reasonable. Yet, the
figures speak for themselves. Last year, we lost $850,000!
According to Randy, if we don’t get the line of credit from the bank, we won’t be able to meet some of
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our payroll and other expenses next month. Even if the bank gives us the loan, I’m sure they’ll ask me to
either cut expenses or increase our charges so we’ll be profitable. The problem is that the charges are re-
stricted by our third parties, and I can see no place to cut expenses other than by laying people off. I’m re-
luctant to do that, though, since everyone seems overworked.
_____________________________________________________________________________________________
This case was prepared by Professor David W. Young. It is intended as a basis for class discussion and not to illus-
trate either effective or ineffective handling of an administrative situation.
Copyright © 2014 by The Crimson Group, Inc. To order copies or request permission to reproduce this document,
contact Harvard Business Publications (http://hbsp.harvard.edu/). Under provisions of United States and interna-
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Permissions@hbsp.harvard.edu or 617.783.7860
 TCG161 • Brookstone Ob-Gyn associates (A) 2 of 5
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MODIFIED CASH ACCOUNTING

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BOGA used what was called a modified cash form of accounting. Under this system, with only
one exception, revenue is recorded when cash is received, and expenses are reported when cash is

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paid out. The exception is equipment and other fixed assets, where the cash payment associated
with a purchase is not treated as an expense. Rather, because each asset has a relatively long service
life (usually five to ten years for equipment), an annual depreciation figure is computed by dividing
the cost of the equipment by its estimated service life. This depreciation figure is shown as an ex-
pense on the operating statement even though it is not represented by an actual cash payment (the
cash payment is made when the equipment is purchased).

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Exhibit 1 contains financial information for BOGA’s operations during the prior year. As it
shows (Table C), although BOGA billed patients for $6.3 million, it received only $3.9 million in
cash during the year. The difference, less Mr. Weber’s estimate of $1.3 million of contractual al-
lowances and bad debts on the $6.3 million, went into its accounts receivable. Accounts receivable
grew from $648,400 at the beginning of the year to $1.8 million as of the end of the year (Table
D). Exhibit 1 also shows BOGA’s operating statement for the year (Table A). With revenue of
$3.9 million and expenses of $4.7 million, BOGA’s operating deficit slightly exceeded $850,000
for the year.

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ACCRUAL ACCOUNTING
Alice Tanshel, the Harris Bank’s lending officer, had asked Dr. Amsted to come to the meeting
with financial statements prepared on both a modified cash and an accrual basis. In accrual ac-
counting, revenue is recognized when it is earned (usually when the bill is sent out) rather than
when the cash is collected. Similarly, expenses are recorded when they are incurred, rather than
when the associated cash is paid out.
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The main difference between the two approaches for BOGA was in the amount of revenue. The
switch to an accrual basis would require Mr. Weber and BOGA’s accountants to record revenue
when services were delivered to a patient, rather than when cash was received. Because of this, Mr.
Weber needed to estimate the portion of revenue that would not be collected. Contractual allow-
ances by third party payers, as well as the fact that some patients would never pay their bills, meant
that not all revenue that was billed actually would be collected. This was not a problem with the
modified cash basis, since cash payments and revenue were the same. However, the switch to an ac-
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crual basis required Mr. Weber to make estimates of the allowances and bad debts. “Net revenue”
was the difference between billings and these estimates.

Mr. Weber commented on the task that lay before him:

I remember learning about accrual accounting in school. Even then, it wasn’t clear to me why it’s advanta-
geous to use it. With the modified cash system, life is quite simple. When we get a check, we’ve earned
revenue. We don’t have to worry about estimating bad debts formally, we just need to know about how
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much we can expect to collect. When we pay out cash, except for equipment, we have an expense. What
could be easier to understand?
Preparing a set of accrual statements is going to be a nightmare. I’ve spoken with our accountants, and
they tell me that to prepare the statements for the bank, I’m going to have to estimate more than just reve-
nues. Inventory, for example. Under the modified cash system, when we buy some medical supplies, we
have an immediate expense. With the accrual system, we need to create an inventory, and we only incur an
expense when we use an item, rather than when we buy it. Insurance is just like inventory. With an accrual
system, we record the expense when we use the insurance, not when we pay the premium to the insurance
company. That’s a bit of a complication since we pay our premiums for several months in advance; it leads
to what the accountants call a Prepaid Insurance account.
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Accounts payable is just the opposite. Our vendors let us charge our supply purchases, and under the
modified cash system we incur an expense when we pay a vendor. Not with the accrual system. But this is
really tricky. When we buy some medical supplies, the goods go into inventory, and, as I said, we incur an
expense when we use the inventory. But this means we can incur an expense even if we haven’t paid the
vendor yet. This is not just complex; it’s layers of complexity!
Finally, the accountants tell me that after we deduct our estimates of allowances and bad debts from
billings, we owe the Dean 11 percent of this “net revenue,” as they call it. Although the Dean doesn’t ask
us to pay him until we receive the cash, the accountants tell me we need to keep track of the difference. Let
me give you an example. Last year, our net revenue was $5,078,320 [see Table D of Exhibit 1]. At the
11% rate, we owed the Dean $558,615. By contrast, on a modified cash basis, we owed (and paid) the Dean
This document is authorized for educator review use only by YOUSEF HASSAN, Birzeit University until Jun 2021. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 TCG161 • Brookstone Ob-Gyn associates (A) 3 of 5
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$428,511, or 11 % of our $3,895,553 in cash receipts [see Table A in Exhibit 1]. That’s a difference of

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$130,104. The accountants tell me that this amount is a liability—we owe it to the Dean. Even though we
don’t have to pay him until we collect the cash, we still have to show the liability on our balance sheet.

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PREPARING FOR THE MEETING
To prepare for the meeting with the bank, Dr. Amsted asked Mr. Weber to construct both an
operating statement and a balance sheet using the accrual method. The operating statement would
be for the entire calendar year, whereas the balance sheet would be as of December 31.

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The accountants had provided Mr. Weber with a worksheet (Exhibit 2) to use in preparing the
two statements. They also had given him their assessment of some of the account balances as of
December 31. These are shown in Table B of Exhibit 1. With this information in hand, Mr. Weber
began to prepare a set of financial statements on an accrual basis.
Assignment
1. U sing an accrual system, prepare an operating statement for the year and a balance sheet as of December 31.

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What do these statements tell you about BOGA’s profitability?

2. In the absence of the bank’s stipulation that accrual be used, which type of system—modified cash or
accrual—would you recommend that Dr. Amsted use for BOGA? Why?
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No
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Permissions@hbsp.harvard.edu or 617.783.7860
 BROOKSTONE OB/GYN ASSOCIATES (A)
EXHIBIT 1

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FINANCIAL INFORMATION FOR THE PRIOR YEAR

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Table A. Operating Statement Table C. Accounts Receivable Activity
Modified Cash Basis
Billings Receipts
Revenue: January $ 423,200 $ 199,916
Receipts from patients and February 437,800 222,129
3rd parties $3,895,553 March 453,400 246,810

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April 470,200 274,234
Expenses: May 488,300 304,704
Physician payments $1,124,000 June 507,800 338,560
Administrative salaries 684,000 July 529,000 350,240
Benefits 293,200 August 552,000 362,720
Medical supplies 95,200 September 577,100 376,160
Rent and utilities 436,000 October 604,600 390,640
Billing/collection fees (a) 507,832 November 636,300 406,240

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Equipment depreciation 24,000 December 668,200 423,200
Office expense 50,000
Liability insurance (b) 952,185 Total $ 6,347,900 $ 3,895,553
Contracted services 106,000
Other 45,000 Table D. Accounts Receivable Activity for the Year
Contribution to Dean (c) 428,511
Total expenses $4,745,928 Beginning balance $648,400
Billings 6,347,900
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Surplus (Deficit) ($850,375) Less: contractual allowances
and bad debts (d) 1,269,580
Equals: net revenue 5,078,320
Table B. Account balances Subtotal 5,726,720
As of December 31 Less: collections (e) 3,895,553
Cash $ 110,000 Equals ending balance $1,831,167
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Medical supply inventory 125,000

Prepaid insurance 250,000 Notes
Equipment (net) 1,250,000
Accounts payable 75,000 a. 8 percent of billings
Payable to Dean 130,104 b. Computed on a per-physician basis. 15 percent of
Long-term note payable 630,000 billings is used here as an approximation.
c. 11 percent of collections
d. Allowances and bad debts are expected to be
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20 percent of billings
e. Collections come with a 5 month time lag from
when the patient was billed
Example: January billings = $423,200. Expected collections
are 423,200 - (.2*423,200) = $338,560
In June (5 months later) $338,560 is received.
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 BROOKSTONE OB/GYN ASSOCIATES (A)
EXHIBIT 2. WORKSHEET (ACCRUAL BASIS)

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(In thousands of dollars)

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OPERATING STATEMENT For the
Calendar Year Notes
Revenue:
Professional services Same as billings
Less: allowances and bad debts 20 percent of billings
Net revenue

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Expenses:
Physician payments Same as on modified cash
Administrative wages Same as on modified cash
Benefits Same as on modified cash
Medical supplies Same as on modified cash (assumes purchases = uses)
Rent and utilities Same as on modified cash
Billing/collection fees Same as on modified cash

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Equipment depreciation Same as on modified cash
Office expense Same as on modified cash
Liability insurance Same as on modified cash (assumes purchases = uses)
Contracted services Same as on modified cash
Other Same as on modified cash
Contribution to Dean 11 percent of net revenue
Total expenses
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Surplus (Deficit)

BALANCE SHEET As of
December 31 Notes
Assets
Cash Given
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Accounts receivable Given

Medical supply inventory Given
Prepaid insurance Given
Total current assets
Equipment (net) Given
Total assets

Liabilities and Equity

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Liabilities
Bank loan (line of credit) Not needed as of end of the year
Accounts payable Given
Payable to Dean Given
Total current liabilities
Note payable Given
Equity
Start-up contribution Given
Retained earnings To be calculated
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Total liabilities and equity

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Permissions@hbsp.harvard.edu or 617.783.7860