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Third-Party Reserves & the Importance of Working Together

Hospitals should not wait until year-end to start reconciling third-party reserves, and collaborative communication is key. Read on for details.
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Those of us who attended Forvis Mazars’ three-day 2022 Hospital Cost Report Virtual Training this summer learned about the history of Medicare, the purpose of the Medicare cost report, and the ins and outs of preparing the cost report. One specific offshoot of the training that is worth delving into is what happens behind the scenes prior to the cost report’s preparation. Many readers may know that the Medicare cost report is typically prepared following the completion of the audited financial statements. If a hospital does not require an audit and does not have audited financial statements, that’s certainly acceptable, too—but for most hospitals, the cost report is prepared subsequent to the finalization of the audited financial statements.

Where hospitals often find their biggest pain points in the audited financial statement and cost report preparation process is a lack of synergy and insufficient communication between the accounting department, reimbursement department, and cost report preparers. This article will delve into how improving this line of communication and focusing on more consistent interim recording of revenue and third-party reserve activities during the year can do wonders for a hospital in terms of relieving the cost report deadline crunch and helping confirm that no errors are filed on the cost report as a result of last-minute adjusting audit journal entries.

As mentioned earlier, many hospitals only finalize the Medicare cost report after the audited financial statements are complete. Many readers—whether they are cost report preparers, those involved in reimbursement, those involved in other administrative functions in the hospital, or those who don’t even work for a hospital—may wonder, how does a hospital or any organization obtain audited financial statements? It’s not as easy as one may think, as it is really a full-year process. The accounting department reconciles its books ideally monthly, or in some cases a little less frequently throughout the year, with the goal of softening the load prior to the rigorous and demanding year-end close.

At some time shortly after year-end, once the year’s activity has been reconciled, the hospital’s accountants close out their respective areas of the books that they each worked on during the year and combine each of these sections into the final client-prepared financial statements. Only then is the hospital ready to go through an even more rigorous audit where all of its material financial statement line items are tested and audited to help confirm the numbers are materially correct. Then, finally, once the audit is complete, most hospitals are able to finalize the Medicare cost report. Oh, and the deadline to file the Medicare cost report is five months after your hospital’s year-end—so if you’re lucky enough to be involved in the financial close, audit, and Medicare cost report preparation processes, you may just want to book most of your annual vacation time during the other seven months of the year.

One of the key high-risk areas of a hospital’s financial statement audit and one that the Medicare cost report significantly affects is third-party reserves, otherwise known as third-party liability, or estimated amounts due to third parties. There are numerous reasons why this is almost always a significant risk on a hospital audit. First, many hospitals tend to have a very large third-party reserve liability each year. Secondly, as we will discuss more later, this liability in many cases is an estimate and just that. Often there are limited resources to trace amounts directly back to, and, as a result, third-party reserves are considered to be an inherently risky financial statement line item. During an audit, auditors consider a host of factors in determining significant risk areas to hone in on and perform extensive audit procedures on to help confirm the balance reported on the client-prepared financial statements is reasonable. Inherently risky areas such as third-party reserves and other estimates such as net accounts receivable are typically considered to be higher risk areas than other line items such as cash and fixed assets, for example, even if cash and fixed assets have similarly material balances as compared to third-party reserves. Therefore, third-party reserves for a hospital will typically be a significant audit risk.

As it pertains to the healthcare industry, there are many uncertainties in the revenue recognition and the related reserve due to the third-parties process regarding the sufficiency of evidence that often gives hospitals trouble in trying to determine the most materially accurate liability to record on the books. Luckily for hospitals, the American Institute of CPAs (AICPA) gives guidance (see below) to help best determine the appropriate liability to record on the books. But before we go into that specific guidance, first let’s consider a typical situation that some hospitals have that would result in needing to record a third-party reserve.

Many hospitals receive payments from various payment programs that pay less than full charges for services rendered. For instance, some cost-based programs retrospectively determine the final amounts reimbursable for services rendered to their beneficiaries based on allowable costs. With increasing frequency, even noncost-based programs (such as the Medicare Prospective Payment System) have become subject to retrospective adjustments, e.g., billing denials and coding changes. Often, such adjustments are not known for a considerable period of time after the related services were rendered. This time difference between when services are performed and when the final settlement is reached makes it difficult to estimate the revenue and the associated third-party reserve to record for these programs, especially given the complexities of reimbursement regulations surrounding these programs.

So, what is the AICPA guidance in regard to recognition of revenues and related liabilities? In a March 10, 2000 article, “Auditing Health Care Third-Party Revenues and Related Receivables,” the AICPA requires that patient revenues be reported net of provisions for contractual and other adjustments. As amounts ultimately realizable will not be known in many instances for years after the period in which the services were rendered, the estimate has to be made when the money is received, regardless of whether all the amount received is recognizable or whether a portion should be reserved as a third-party liability. Then, once the final settlement is complete, any differences between the amount settled for and the amount recorded as revenue will then be recorded as a third-party receivable/liability.

As it pertains to hospitals working with Medicare or other governmental payors such as Medicaid specifically, there are often unique risks that can further complicate the amount the hospital estimates as its third-party reserve. Some of these risks are:

  • A hospital’s revenues may be subject to adjustment as a result of examination or audit by governmental agencies or contractors. The audit process and the resolution of significant related matters (including disputes based on differing interpretations of the regulations) often are not finalized until several years after the services were performed.
  • Different Medicare Administrative Contractors (entities that contract with the federal government to assist in the administration of the Medicare program) may interpret governmental regulations differently.
  • Valid claims may be determined to be nonallowable after the fact due to differing opinions on medical necessity, or on the contrary, claims originally considered nonallowable may be changed to allowable if deemed to be a medical necessity.
  • Governmental agencies may make changes in program interpretations, requirements, or “conditions of participation,” some of which may have implications for amounts previously estimated.

Ultimately, what these various factors mean is that there will probably be retrospective adjustments to interim payments. To avoid recognizing revenue that the hospital will not ultimately realize, management must record reasonable estimates for these retrospective adjustments during the year. This is a critical part of the third-party revenue recognition process, and it’s essential that management maintain sufficient documentation for all of their third-party reserves, as well as justifiable explanations for their reserve calculations to provide their auditors. Auditors will rely on the client’s backup and explanations to support this estimate.

As mentioned above, a hospital has five months from its year-end to close its books, complete an audit of its financial statements, and prepare and file its Medicare cost report. A common pitfall that hospitals fall into is taking a significant amount of time to close their books, which results in a high-stress, rushed audit and potentially incorrect revenue amounts filed on the cost report, if these amounts were previously entered by the preparer on the cost report prior to any audit adjustments made late into the audit. Revenues and third-party receivables/liabilities are often the last sections to be closed for the year given their complexities. The best thing a hospital can do to try to reduce this delay is to keep track of its third-party activity during the year, and complete monthly or at least quarterly reconciliations on all material balance sheet accounts.

This is where communication between all team members and more consistent interim recording of activities become critical. If the hospital’s audit is set to begin at the end of February, the accounting team should communicate with the reimbursement team throughout the year on a recurring basis to discuss current-year activity and then, after year-end, obtain the year-end reimbursement data on potential third-party reserves in early February so that all needed journal entries can be posted prior to the audit. The accounting team also must remember to communicate with the cost report preparer to firstly confirm that all prior-year settlement amounts have been recorded and to check that any liabilities related to prior-year settlements not yet paid out are accrued for correctly.

In addition, teams should discuss and see if any current-year expected settlement amounts can be estimated and, if so, the accounting department should obtain proper support and a calculation for this amount and reserve the liability to confirm that sufficient third-party reserves are in place. Once this communication has occurred, make sure the activity for that interim period has been recorded on the books. There is no need to wait until after the year is over to begin recording interim activity. Recording interim activity throughout the year will create a smoother process for getting to post-fiscal year-end. If this communication and interim recording of activity is not occurring, and instead the various departments rely on reconciling these accounts annually, you’re setting your hospital up for severe deadline crunches.

For Prospective Payment System (PPS) hospitals that can reasonably pinpoint the factors that go into their yearly reimbursement, the recommendation would be for the cost report preparer to estimate their reserves for the year on a quarterly basis. For a critical access hospital (CAH) whose revenue is cost based and, therefore, will have a more difficult time estimating its interim reserves, the suggestion would be, time permitting, for the cost report preparer to attempt to complete an interim cost report halfway through the hospital’s fiscal year. This is a more time-demanding challenge for CAHs than for PPS hospitals and does require a significant time commitment. However, by preparing interim calculations or interim cost reports, a hospital will be better prepared to manage cash flows throughout the year by requesting Medicare interim rate changes and settlements as needed, and the preparation will help the hospital internally track what its correct third-party reserve should be by the time the year-end comes.

With ample preparation from the entire fiscal staff, a process can be created and occur each year as seamlessly as possible. The key takeaways are to begin the reconciliation of third-party reserves throughout the year and avoid waiting until year-end. Collaborative communication between the accounting department, reimbursement department, and cost report preparer during the year is key. Early and often after the fiscal year has ended and throughout the year, consistent recording of interim revenue and third-party reserve related activities is critical. Keeping these key takeaways top of mind will go a long way in relieving some of the post-year-end stress in finalizing audited financial statements and filing the Medicare cost report just a few months after year-end.

If you have any questions or need assistance, please reach out to a professional at Forvis Mazars or use the Contact Us form below.


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