Accounting 101: Basics you need to know

Physicians practice medicine and communicate within the world of medical language, yet there is a lack of awareness and understanding by many health care professionals of the universal language of business, which is accounting. Just as Latin provides the basic framework for medically related terminology, accounting is the standard language used to convey financial information to both internal and external stakeholders.

Accounting principles are important to physicians at any level. Whether you are starting out in private practice, running a clinical department, or working as an executive in a health care system, most decisions are based on the interpretation of financial data using accounting principles. Accounting standards in the United States are developed by the Financial Accounting Standard Board (FASB) and established as a set of principles and guidelines called Generally Accepted Accounting Principles (GAAP).^1–3

Accrual- vs cash-based accounting

There are 2 approaches to recording financial transactions: accrual- and cash-based accounting methods. The main difference between them is in the timing of the recorded financial transactions (when revenue and expenses are recognized on the accounting books). Under GAAP, the matching principle, which is one of the most basic and utilized guidelines of accounting, specifies that accrual accounting be used. In the United States, most businesses (publically traded companies and moderate- to large-sized companies) use accrual accounting, while some individual and smaller businesses, including health care services such as physician practices, use the cash method.^1–4

Accrual-based accounting

Accrual-based accounting specifies that revenues are recorded when they are earned, and expenses are recorded when they occur. A health care business may earn revenue for services on one day, but the cash may not be received or recorded on the accounting books for several weeks or months and at an amount less than billed.

Accrual-based accounting provides a more accurate representation of a business’ financial performance, since it uses the principle in which expenses are matched to revenues in the same time period. This enables a more precise representation of true financial performance during a given time frame.^1–4

Cash-based accounting

Cash-based accounting is the easiest method to understand and implement because financial transactions are recorded in the accounting books when money is received or spent without the need for complex accounting techniques or integration of accounts receivable or payable.

Despite the ease of use and simplicity in tracking cash flow, this method can be deceiving because revenue may be received or expenses may need to be paid at times that are not consistent with when the revenue has been earned or expenses incurred. This can result in misleading information on the business’ health and the accuracy of tracking financial performance over time, since revenue and expenses for a particular transaction may occur at different times.^1–4

Which accounting process to choose?

Even though accrual-based accounting may provide a more accurate financial representation of a business’ performance, many smaller businesses, including physician practices, prefer to use cash-based accounting. In addition, many health care businesses are eligible to use cash-based accounting per Internal Revenue Service (IRS) rules by qualifying for the Gross Receipts Test and being a qualified Personal Service Corporation (PSC):

• The Gross Receipts Test states that if the average annual gross receipts of the business are less than $5 million, the business can use the cash-based accounting method.
• If at least 95% of a business activity involves performing health care services, and at least 95% of the business is owned by employees performing health care services, then the business qualifies as a PSC that may use the cash-based accounting method.

Many physician practices qualify to use cash-based accounting, which reduces the complexity of following accrual-based accounting rules and simplifies overall cash-flow management.⁵

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