The Impact of New Bad Debt Accounting on Covenants

HFA Partners  |  June 27, 2012

The new ASU 2011-07 reclassification of bad debt will buy hospitals more breathing room with days’ cash on hand, but other covenants may not fare as well. CFOs should review their covenants to determine how they may be affected.


In A Nutshell...
 
  • Bond ratings: ASU 2011-07 should have no effect, as ratio medians will eventually reflect the changes
  • Bond covenants: ASU will help days’ cash on hand, but may hurt revenue-based covenants
  • Hospitals should review their covenants to avoid surprises.

Background

Uncompensated care is nothing new for healthcare providers, but in the current economy and high unemployment environment, properly accounting for bad debt has become a major concern for rating agencies and investors alike.

The concern has not been lost on FASB, and starting with fiscal years beginning after 12/15/2011, healthcare providers are now required to adopt Accounting Standards Update No. 2011-07 that reclassifies bad debt expense as a reduction to net revenue, rather than an operating expense.

Fitch Ratings said in a report last week that they view the ASU as an improvement on the prior reporting standard: providers will report a net patient service revenue number closer to what they actually expect to collect. This will enhance the comparability of metrics like operating margins, revenue growth, and revenue per admission.

Impact on Key Ratios

The key rating agency ratios impacted by the ASU include Days’ Cash On Hand (positive impact), EBITDA Margin (positive impact), and Maximum Annual Debt Service/Total Operating Revenues (negative impact). Note that this assumes positive ratios; in the case of distressed providers with negative ratios prior to the change, these ratios will actually worsen so the ASU impact will be negative.

The good news is, since most rated hospitals are affected by the reclassification, median ratios can be expected to adjust across the board, so that the ASU reclassification should have no impact on how a specific hospital stacks against medians, or its implied bond ratings.

Impact on Covenants

The major covenants impacted by the ASU include Days’ Cash On Hand, and various debt to revenue covenants. The impact of the ASU varies depending on the covenant:

  • Minimum Days' Cash On Hand: positive impact.
    DCOH is calculated as cash divided by operating expenses, times 365. Since bad debt runs around 5% of revenue, by moving bad debt out of expenses, the average not-for-profit provider stands to add about 10 days.

  • Maximum Debt to Total Revenues: negative impact.
    This is a relatively common covenant used as one of the tests prior to issuing additional debt. Moving bad debt will reduce revenue and bring the hospital closer to the maximum.

Covenant formula definitions are usually very specific, so there is little chance that the reclassification may be adjusted by bond counsels or bond trustees.




Next Steps

ASU 2011-07 illustrates the need for hospitals to understand bond documents and the restrictive covenants they contain. Debt financings often generate reams of documents with convoluted, overlapping definitions. These paper jungles keep attorneys employed, but can be confusing, even for the most seasoned hospital financial executives.

To stay on top of their capital structure, some hospitals choose to develop a comprehensive covenant inventory. What seems to work best is for the financial advisor to draft something in plain English and have the hospital’s in-house counsel review for accuracy. This can take a little bit of time, but is far more preferable to finding out at the eleventh hour that a financing or an important transaction cannot proceed because of covenants.


This material is intended for general information purposes only and does not constitute legal advice. For legal issues, readers should consult legal counsel. To discuss this article or municipal advisory services, email info@hfapartners.com or call 888-699-4830. HFA Partners, LLC is an Independent Registered Municipal Advisor registered with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.
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