In the post-Enron alphabet soup, even under GAAP (Generally Accepted Accounting Principals) and bottom-line EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization), financial reporting has deteriorated into a punch line of EBBS, or Earnings Before Bad Stuff. The financial statement has been revealed for what it is — a compilation of numbers that is only as accurate as the assumptions, discretion and application of obscure rules upon which it's based. And although publicly traded firms regularly make the news for reporting distorted financials, these issues permeate even the best-intentioned privately held firms. Even honest errors in accounting judgment and application can undermine the integrity of a firm's financial statements, and more importantly, the strategic decisions based upon them.

Here is a look at where you're most likely to find gremlins hiding in your financial statements. And it's simple enough for even an auditor from Arthur Andersen to follow.

You Say Potato, I Say Revenue

It seems so basic, but the reporting of revenue is extraordinarily ambiguous and discretionary. Conceptually, revenues should be recorded or “matched” with the activities and expenses incurred in generating them. The better the matching, the more meaningful the measure of profits. Recognize revenues too early — recording all the revenues from a contract when it is signed but before services are delivered, for instance — and profits will be overstated. Recognize revenues too late, and profits will be understated.

Unlike the home health prospective payment system, in which companies can conceivably recognize a 60-day episode of revenues on day one, in the home medical equipment business there are few opportunities to post revenues too early. But virtually all companies post revenues too late. The worst violators? Companies that recognize revenues when cash is collected.

With claim turnarounds averaging from 60 to 90 days, this method is woefully inadequate, especially for rapidly growing firms where cash collections will always lag behind the activities and expenses necessary to generate them. Cash may be king, but not when it comes to recognizing revenues.

How about booking revenues when bills are generated — by far the most common method of revenue recognition we see today? Clearly, billings are better matched to expenses than the cash method. But considering the time lag it often takes to bill — an average of 11 days according to industry surveys — billings are far from a perfect accounting match.

So what's the most accurate accounting method of recognizing revenues? Posting when services are delivered at their expected billing rate. Yes, it's risky considering some unbilled services never will get billed. But most will, and that's why reserve accounts exist.

A final comment on revenues: If you still book highly inflated “retail” or gross revenues before contractual allowances to your income statement, where the allowances are standard, substantial and clearly known at the time of billing, please stop the madness. Although the net figure may be accurate after allowances, it still is problematic.

First, unanticipated — and sometimes controllable — adjustments get lost in the often-substantial allowance figures. Second, if you record the allowances when remittance is received — as many companies do — receivables always are overstated. Finally, companies that report inflated gross revenues tend to manage their businesses and perform benchmark comparisons off these numbers. So, if your gross revenues are grossly irrelevant, it may be time to adjust your billing figures to get closer to what you typically expect to get paid. At the very least, make sure that allowances are posted instantly so that only net revenues make it to the income statement and accounts receivable.

In Finance, It's Good to be Reserved

From a financial reporting perspective, the most significant area in which home health care companies err is accounting for uncollectible revenues. Underrecording or underestimating uncollectible revenue leads to inflated net receivables, inflated profit figures and misinformed management decisions. And with so much revenue attributable to third party payers with complex billing procedures, accounting for uncollectibles is as difficult as it is extremely critical in developing accurate financials.

Note that we are talking about uncollectibles — not bad debt. Although the nation's budget surplus is dwindling and state budgets are strained, as far as we know neither Medicare nor Medicaid has gone bust. When Medicare, Medicaid and other third party payers don't pay, they have reasons for doing so, as convoluted and mind-numbing as they may be, other than lack of funds. In fact, true bad debt, or the inability to pay, makes up only a small fraction of uncollectible revenues. The big culprits include billing errors, improper or missing documentation, and negotiated adjustments. These are the real uncollectibles that must be accounted for.

Again, the concept of matching applies. So even though you may not find out until much later that a bill is uncollectible, you want to record it during the period in which the revenue is booked. That's why the direct write-off method, in which a billing adjustment is posted when the company determines that the bill is in fact uncollectible, is unsatisfactory. Although a write-off seems very easy to do, the timing is off, which leaves profits overstated until the write-off actually is posted. And if profits need to be propped up, it can be very tempting to keep chasing dead receivables simply to delay the inevitable write-down.

Accordingly, the preferred method of accounting for uncollectibles is the reserve method, where uncollectible amounts are estimated each month and posted to the income statement before the actual write-off. That way uncollectibles are more closely matched to their associated revenues. For those of you with an accounting background, when the reserve amount is posted to the income statement, the same amount is posted simultaneously to an accounts receivable allowance account on the balance sheet. When a receivable is actually written off, the corresponding entry is posted against the allowance account.

The trick lies in how to determine an appropriate monthly reserve. The most common method is to compare historical cash collections to their associated revenues to determine the average percentage of uncollectibles. This percentage is then applied each month to revenues to calculate that month's estimate of uncollectibility.

The lone drawback to this method is that it is disconnected from the actual aging of receivables. As an alternative, some companies estimate the collectibility of their receivables each month by aging categories — current, 30-60 days, 60-90 days, 90-120, 120 and over — to determine an appropriate total reserve, the theory being that the older the receivable, the less likely it is to be collectible. Therefore, the amount posted to the income statement each month is the adjustment necessary to bring the total allowance to the required level.

Whichever method is used, the key is to use it aggressively and to retest continually whether the key estimates — the percentage of uncollectible revenues or percentage of uncollectible receivables per aged category — still reflect reality. Only then can you begin to assume that income statement profits won't vaporize in a write-off and actually will turn into cash.

The Goods, the Bad, and the Ugly

Calculating the cost of goods sold should be simple. You sell a product, you record the expense of that product. But it's easier said than done. If you have a bar-coded perpetual inventory system where each product dispensed is “wanded” and then captured in COGS, you have a fairly accurate estimate of COGS. But because these systems can be expensive and difficult to set up, most companies calculate the cost themselves, either booking purchases directly to COGS or imputing it by adding purchases to beginning inventory and then subtracting ending inventory.

The direct-purchase method is easy, but because many companies make bulk purchases to get price breaks, COGS goes up and down, and more importantly, is completely unrelated to revenues. The imputed method is designed to solve this problem, but it has its limitations as well: Because the imputed method requires accurate inventory figures, the computation usually is done only at year-end, when inventories typically are performed.

So what is used during the interim periods? Direct purchases or estimates based on historical experience — which obviously are less than precise.

And that's not all. You might be surprised how many companies using the imputed method mysteriously wind up with the same beginning and ending inventory; that is, no inventory was taken. In that case, the calculation comes down to nothing more than — you guessed it — purchases … and back to where we started. So if sales are a big part of your business, a perpetual inventory system is the only way to go.

Leases Lost and Found

Question: What do you get when two companies that are identical in all respects both lease equipment at the same price and terms — except one correctly treats its lease as a capital lease and the other mistakenly treats it as an operating lease? Answer: Companies with very different EBITDA. When a lease is classified as a capital lease, it is considered a financing mechanism. Accordingly, the equipment is actually booked to the firm's balance sheet as an asset and the lease payment is recorded as interest and depreciation. When a lease is classified as an operating lease, it is treated more like equipment rental. The equipment is not booked as an asset and the payment is recorded as a leasing expense.

In calculating EBITDA with a capital lease, the lease payment is “added back” in the form of interest and depreciation. Not so with the operating lease. Now, don't harass your accountant to simply change your operating leases to capital leases. There are rules for this. But know that we've seen more than just a few companies with EBITDA hidden in misclassified leases.

Capital Ideas

Long-term fixed assets such as rental equipment usually are capitalized. That is, when they are purchased, they are recorded as an asset on the balance sheet and, rather than posting the expenses all at once, the costs are spread out over their “useful lives” in the form of depreciation. This makes good sense, but use discretion — there's that word again — when determining whether or not to capitalize an asset.

Consider the purchase of a $750 concentrator. Suppose one company decides that the minimum investment required for capitalization is $1,000 and another decides it should be $500. Company A expenses the entire purchase immediately while Company B capitalizes it and records the expense as depreciation for perhaps five years. Company A takes a big hit in month one and is done. Company B, on the other hand, takes a much smaller hit in the first month but continues to post depreciation expense for 59 more months. Big difference.

Now, suppose the companies are virtually identical and after a two-year increase in activity, they each stop buying concentrators. Company A, which was seemingly much less profitable than Company B during the first two years — when they were expensing purchases — suddenly leapfrogs past Company B in profitability. This happens not because Company A was better, but because of a simple and reasonable difference in accounting policy. This illustrates one of the many reasons to actually read the fine print, or the notes, that accompany financial statements.

Straddle Accounting

It's not uncommon to see discretionary financial decisions made either immediately before or after the end of an accounting period. This happens frequently in publicly traded firms. If your company is in the midst of a bad year, the theory holds that you take all your discretionary write-downs of assets or charges before the year is out and get it over with. If it's a good year, the theory is to finish the year out and hold the adjustments until the next. But these decisions also take place in private firms, albeit for different reasons.

Know anybody who slows down billing or ramps up equipment expenditures in December — especially if they don't capitalize them — to reduce year-end income and taxes? How about someone who holds billings in January so that other health care providers have to bill patients for their Medicare deductibles? Although these and other straddle strategies tend to “even out” over the course of a year, they can significantly distort interim quarterly financials.

In the wake of Enron, the media is all over financial reporting. So when Fox airs “When Good Financials Go Bad,” it's important to remember that many accounting decisions are not a question of right or wrong, but what is most practical — and tax-benevolent — given a company's resources, financial systems, and the needs of its shareholders. The financial statement is a great starting point, but you've got to look beyond the numbers to know what they really mean.

Dexter Braff is president of Pittsburgh-based The Braff Group, a health care merger and acquisition firm with seven offices nationwide. He also has served as a regional director of finance for Foster Medical. Braff can be reached at 412-833-5733 or by e-mail at d.braff@thebraffgroup.com.