Revenue Recognition Third-Party Settlements Scenario 2

April 26, 2019 | Article

Revenue recognition guidance under FASB is effective for public businesses and nonprofits that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market for fiscal years beginning after Dec. 15, 2017 (that’s now!). This means Jan. 1, 2018, for organizations with a Dec. 31 year-end and July 1, 2018, for organizations with a June 30 year-end. For all other entities, the guidance is effective for fiscal years beginning after Dec. 15, 2018.

If you find yourself in the first wave of implementors, you’ve likely read the standard and the published implementation guidance. If you haven’t, you can start with four key matters considered to have the greatest potential impact.

As you move from the theoretical world of accounting standards to your financial reporting system, we’ve created four scenarios to illustrate common applications of a few healthcare-specific nuances of the standard and implementation guidance.

General Hospital, a critical access hospital, accepts Medicare interim rates during the fiscal year as payment. After year-end, the hospital submits its annual cost report. Once reviewed and finalized, a notice of final settlement is issued to close out the cost report year. It is common for this process to take multiple years between the fiscal year when services are rendered and the notice of final settlement, and generally a minimum of 12 to 18 months. Management of General Hospital utilizes a Medicare cost report model and has had historical success estimating final settlements with a high degree of accuracy. General Hospital accrues a third-party settlement asset or liability to adjust the estimated revenue for that fiscal year.

Since the Medicare reimbursement system is set up under a retroactive model for critical access hospitals, the actual amount of consideration received is generally not known for several years. Because of the uncertainty, revenue recognition related to Medicare beneficiaries represents variable consideration. In addition, Medicare payments are determined under complex government rules and regulations; therefore, a high level of potential variability exists in estimating these settlements. In situations involving variable consideration, organizations can select either the Most Likely Outcome method or the Expected Value method in determining the transaction price.

Management of General Hospital determined the Most Likely Outcome method (derived from the single most likely amount in a range of possible consideration amounts) is the best method to predict the variable consideration for services provided to Medicare beneficiaries because of management’s long history of Medicare cost report settlements.

Most Likely Outcome Method

  • Step 1: The contract with Medicare is explicit in providing care to program participants.
  • Step 2: The performance obligations are the procedures provided to eligible patients during the year.
  • Step 3: General Hospital estimates the transaction price for its contracts with Medicare beneficiaries, considering variable consideration, as follows:
Possible settlement amounts Probability of occurrence Estimated settlement
$(50,000) 15%  
$0 25%  
$35,000 60% $35,000

Management also concludes it is probable that a significant reversal of revenue will not occur once the cost reports are settled. In accordance with topic 606, General Hospital has not applied a constraint to the amount recorded. Accordingly, an estimated third-party settlement receivable of $35,000 was recorded at the end of the fiscal year.

During the year, General Hospital began participating in the Disproportionate Share Hospital (DSH) program. As this is the first year of participation, management does not have a history of these settlements and, as such, has determined the Expected Value Method (a probability weighted approach) is the best predictor of the variable consideration.

Possible Settlement Amounts Probability of occurrence Estimated settlement
$0 5% $0
$150,000 10% $15,000
$300,000 40% $120,000
$450,000 45% $191,250

Each possible settlement amount is multiplied by the probability of occurrence to determine a probability-weighted amount. The probability-weighted amounts are aggregated to determine the estimated settlement of $326,250.

Management evaluated if it is probable that a significant reversal of revenue will occur and if a constraint to the amount recorded should be applied. In this case, given the lack of history estimating DSH settlements, management estimated that a constraint of $26,250 should be applied to reduce the amount of revenue recorded to an amount that it is considered probable it will not result in a significant reversal of revenue. This amount is determined based on a cumulative probability of possible settlement amounts of $300,000, $150,000, and $0, which represent a cumulative probability of 55 percent.  In other words, it is more likely than not that the actual settlement will be $300,000 or less, based on this assessment, General Hospital constrained the estimated settlement and recorded an estimated third-party settlement receivable of $300,000.

Most Likely Outcome & Expected Value

  • Step 4: The Hospital considers the performance obligations to be providing care under the Medicare and DSH programs during the year as noted in Step 2. Accordingly, the transaction price is recognized as revenue in the period care is provided.
  • Step 5: The performance obligations are considered satisfied upon completion of the fiscal year.

After a couple of years, both transactions above were settled final. The critical access hospital cost report final settlement amount was $30,000 payable to General Hospital. The DSH program final settlement amount was $450,000. The differences between the original estimates and final settlements are considered changes in estimates and recorded in the year of finalization. Accordingly, in the year of settlement, General Hospital recorded additional revenue of $145,000 ($150,000 for DSH program, less $5,000 difference for critical access hospital cost report).

Implementation guidance related to these two issues are included in the May 1 online edition of the AICPA Audit and Accounting Guide, “Revenue Recognition.” For more information on this guidance, including details not addressed in detail within the scope of this article, please contact Tyler Bernier or your local Eide Bailly representative.

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