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III. The Entity and Its Environment
3.1 Industry, Regulatory, and Other External Factors
As the United States’ largest owner and operator of inpatient rehabilitative hospitals, HealthSouth operates its business primarily in the specialty hospitals industry with the NAICS Code of 622310. Business in this industry provide specialized medical, diagnostic and treatment services to people on an inpatient and outpatient basis at health care facilities. The hospital industry is one of the world’s largest and fastest-growing industries, and the United States hospital industry includes over three thousand organizations that operate more than six thousand hospitals across the country. Top companies in this industry includes HAC Holdings, Inc., Fresenius SE & Co. KGaA, and Kaiser Foundation Hospitals. (Hospitals, 2014)
It is fair to say the illness and injury rates along with demographics and advances in medical care and technology are the primary drive of the demand for hospital services. As the developing technology being applied to hospitalization, it appears that the public’s faith of doctors had been on a growing trend. According to Hoovers, as Americans age over 65 being the fastest-growing segment of the population, “health care expenditures are expected to reach more than $4 trillion by 2017, driven partly by the aging population (Hospitals, 2014).” Besides, according to American Hospital Association, about 60 percent of hospital revenue is generated from inpatient services while the rest of revenue is generated from the hospitals’ outpatient services such as emergency room or outpatient clinic services, including same day surgery. This can be a potential threat to the business since the cost of operating and maintaining inpatient services has been going up for the past several years, the medical industry as a whole has reduced the average time patients spend in hospitals. On the other hand, since the outpatient services became a growing portion of hospital revenue, and having patients receiving outpatient services reduces the operating costs, companies may see this trend as a way to shift its business and to provide quality services while efficiently reduce the costs. Overall, whether hospitals are able to take advantage of this trend really depends on the direction the management intended for the business to grow.
Since most hospitals provide similar, if not identical, services to its customers, the competition between hospitals is more heated than the competition in other industries. In terms of competiveness, larger hospitals with more fund appear to have an upper hand as they have more resources in buying supplies, sharing best practice, and negotiating contracts with health insurances. Comparing to smaller hospitals, larger hospitals may be able to provide more efficient and attractive services. However, smaller hospitals do seem to have advantage in terms of serving a limited geographical area or offering specialized services.
According to Hoovers, due to the large number of uninsured customer who use hospitals as their only source of health care, the quality of accounts receivable in the United States hospitals is relatively low. However, by working with insurances programs to large the number of customer covered, hospitals are able to lower the amount of write-offs from their uncollected bills. Therefore, the auditors should be more careful about this type of information and evaluate the reasonableness of write-offs from the company’s books and reports. In addition, cash flow is typically high and because of the high price of medical equipment and buildings, hospitals generally obtain relatively large capital investments.
Because of the sensitivity of the industry and services provided, hospitals are heavily regulated by multiple level of organizations – from federal, states, and local level. From the federal level, for hospitals that are participants in federal Medicare and Medicaid, they must endure by large number of regulations toward their operating, accounting, as well as billing procedure. According to Hoovers, “Medicare has a major influence on the payments hospitals receive, as many other payers use Medicare payment schedules as their benchmark, and legislation has tried to address the rapid growth in national health care costs (Hospitals, 2014).” On the other hand, state regulations can vary from state to state but most states manage a network of regulators to inspect and supervise hospitals for quality of services, working conditions et cetera. In addition, local insurance level. As all Americans know, insurance can be complicated by many factors – state programs being one of them. Because of such complication, hospitals must coordinate with not only state and federal insurance programs but also regulations to make sure both proper care and pay for the services they provide to the customers.
3.2 Nature of the Entity
3.3 Objectives, Strategies and Other Related Business Risks
The auditor obtains an understanding of clients industry, especially company’s objectives, strategies and related business risks. The auditor need to identify those risks could result in material misstatement on financial statements. An objective is a goal or overall plan for the companies, and strategies are operational activities that companies try to achieve its objectives. Other related business risks outcome including events, actions or decisions that could affect companies to achieve objectives. Additional, understanding client’s objectives, strategies and other related business risks are significant because other related business risks often are tied to risks of material misstatement. Several considerations of entity objectives, strategies and related business risks that may be affect financial statements are, expansion of the business, industry developments, regulatory requirements, new products or services, or new accounting requirements.
In health care industry, some potential risks may be associated to material misstatement in the companies’ financial statements. For example, if an entity has difficult time to achieve new drug development, and unable to obtain estimated percentage of revenues from new drug develop, there may have a risk related to revenue recognition. Moreover, sometimes that company may capitalize the “impairment of development costs”, under this situation auditor could related this potential problem with allocation and valuation assertion. Another example of strategies/ business risks that auditor should be concerning is, when company start hiring or firing large number of employees, restructuring organization and replacing management team. Auditor may need to question why company starts replacing large number of people and restructuring organization.
HealthSouth Corporation’s objective is “to be the healthcare company of choice for patients, employees, physicians and shareholders by providing high quality care in the communities we serve.”(Our Values, 2014) The strategies they have are the implementation of service model, successful marketing, and provision of high quality and expansion of network. .”(Our Values, 2014) While achieving their objectives, HealthSouth’s business or operation strategies are subject to different level of risks on financial statements. Developing new products and services is an example of potential business related risk. In January 1995, the company expanded in the surgery center business along with acquisition of surgical corporation and in 1996, the company expanded into diagnostics area. By having new products or services, this could increase company’s product/services liability. A product/service liability is when an unreliable service or defective product causes injury. By developing new product or services, HealthSouth is liable for any defects/unreliable service.
Expansion of business is second strategy that HealthSouth implement; this strategy also could affect company’s financial statements. In 1995, HealthSouth build a new headquarters on U.S highway 280 in Birmingham, and purchased Health Image Inc. In 1997, company acquires Horizon/CMS for $1.8 billion, and 2 years later they purchased Columbia/HCA surgical division. Finally in 2010, HealthSouth purchased two new hospitals. Moreover, when expanding a business, company need to estimate the demand of needs, if the demand has not meet, expanding a business will be a huge business risk for HealthSouth. Therefore, a question HealthSouth should consider before the expansion of business is, will a larger size of business give customer greater efficiency on providing service? On the auditor point of view, the effect on the financial statements is important; auditor needs to concern the financial performance after the expansion of business. (Sharpe, Anita, & Tomsho, 1997)
3.4 Measurement and Review of the Entity’s Financial Performance
Measure and review entity’s financial performance can help check entity’s business and improving the business. It is important to know the entity’s strengths and weaknesses, determine the efficiency of entity’s management. In order to assess the risk of material misstatement, auditor should examine both internal and external information of the company. Such measures an auditor might consider before performing analytical procedures might include, key performance indicators, Key ratios, budgets, or other level performance reports, and comparisons of an entity’s competitors, credit rating reports, analyst reports, and so on. Measuring entity’s profitability is one of the most important areas of measure and review of financial statements. For example, measure gross profit margin to see how much money company made during the year and auditor can also compare financial performance with its competitors.
Some examples of internal risks may be underlying on financial measurement, including inventory measurement, if company has huge leftover inventory, it might cause a company to offer lower pricing in order to sell inventories. However, the auditor should consider whether performance measures might indicate any risk of misstatement in underlying quick decrease in leftover inventory. Company might capitalize some of the manufacturing costs for leftover inventory instead expensed. Moreover, health care industry heavily relied on information system. The data used for measure and reviewing the entity’s financial performance is from the information system; management might not accurate entering the data without any errors exist in the information. Auditor may use some of the data management provide to measure and reviewing the financial performance, we should consider of information risks.
Furthermore, a close look at key ratios of HealthSouth Corporation will help better understanding of how to measure and review of the entity’s financial performance. For fiscal year 2012, HealthSouth Corp. revenue was 2,135 million, at 100% gross margin, and net income was 185 million. In fiscal year 2013, it generate 2,247 million in revenue, at 100% gross margin, and net income was 324 million, a 139 million increase from last year. HealthSouth Corp. main competitor is Hospital Corporation of America (HCA), which is the largest health care company in the world; its facilities are mainly located in the United State and United Kingdom. In fiscal year 2012, its revenue was 33,012 million, at 82.7% gross margin, and net income was 1,605 million. In fiscal year 2013, its revenue was 34,812 million, at 82.5% gross margin and net income was 1,556 million. Although HCA generate more revenue and income than HealthSouth Corp, but if we look close at the number, we can see that HealthSouth Corp. have higher percent gross margin than HCA, and HLS had increased net income from 2012 to 2013, where HCA have lost income from 2012 to 2013. Overall, HealthSouth’s financial performance was in a tremendous growing trend. (HealthSouth Corp, 2014)
On the other hand, although HealthSouth’s revenue was in a growing trend, however, corporation internal management using wrong indicators to measure its performance. For example, Earning Before Interest, Tax, Depreciation and Amortization is not a measure of financial performance under generally accepted accounting principles. Since Earnings Before Interest, Tax, Depreciation and Amortization not a measurement determined with GAAP, thus it cannot be comparable to other similarly companies using Earnings Before Interest, Tax, Depreciation and Amortization. However, HealthSouth management team used Earnings Before Interest, Tax, Depreciation and Amortization to measure financial performance and they believe consolidate Adjusted used Earnings Before Interest, Tax, Depreciation and Amortization are best way to measure. HealthSouth also use adjusted income from continuing operation as key performance indicator to measure. Management believes that adjusted income from continuing operations provides advantageous information for investors. Thus, adjusted income measures are also not defined measures of financial performance under generally accepted accounting principles and should not be considered as key performance indicator for HealthSouth Corporation. Therefore, incorrect performance measures indicator may result in high pressures on management to misstate the financial statements. (Brimmer, 2006)