Consolidated Financial Statements and Report of Independent Certified Public Accountants Methodist Health System September 30, 2012 and 2011

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1 Consolidated Financial Statements and Report of Independent Certified Public Accountants

2 TABLE OF CONTENTS Report of Independent Certified Public Accountants 2 Page Consolidated Financial Statements as of and for the years ended Statements of Financial Position 3 Statements of Operations and Changes in Net Assets 4 Statements of Cash Flows 6 Notes to Financial Statements 8

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4 CONSOLIDATED STATEMENTS OF FINANCIAL POSITION September 30, (In thousands) ASSETS Current assets: Cash and cash equivalents $ 45,602 $ 42,696 Short-term investments 492, ,659 Patient accounts receivable (net of allowance for uncollectible accounts of $90,635 and $89,868 in 2012 and 2011, respectively - Note 2) 139, ,468 Other accounts receivable 22,861 18,981 Other current assets 31,447 30,315 Total current assets 732, ,119 Long-term investments 62,782 34,623 Net property, plant and equipment - Note 3 587, ,479 Assets whose use is limited - Note 1 81,148 58,460 Other assets 12,029 7,438 Total assets $1,475,702 $1,259,119 LIABILITIES AND NET ASSETS Current liabilities: Accounts payable and accrued expenses $ 90,564 $ 85,484 Accrued construction costs 3,530 1,440 Health insurance programs reimbursement payable 1, Current installments of long-term debt - Note 4 11,177 16,465 Total current liabilities 107, ,804 Long-term debt - Note 4 350, ,978 Interest rate swaps liability - Note 4 57,015 54,377 Other liabilities - Notes 6 and 8 25,067 40,348 Total liabilities 539, ,507 Commitments and contingencies - Notes 3 and 6 Net assets - Note 5: Unrestricted net assets attributable to MHS 900, ,660 Unrestricted net assets (deficit) attributable to noncontrolling interests 4,817 (383) Temporarily restricted 26,825 24,751 Permanently restricted 4,113 3,584 Total net assets 935, ,612 Total liabilities and net assets $1,475,702 $1,259,119 The accompanying notes are an integral part of these consolidated financial statements. 3

5 CONSOLIDATED STATEMENTS OF OPERATIONS AND CHANGES IN NET ASSETS For the years ended September 30, (In thousands) Net patient service revenue before provision for bad debts $1,012,419 $960,970 Provision for bad debts (66,915) (81,097) Net patient service revenue - Notes 1 and 2 945, ,873 Other operating revenue Note 11 23,725 24,598 Total operating revenue 969, ,471 Operating expenses - Notes 8 and 10 Salaries, wages and benefit costs 457, ,973 Other operating expenses 338, ,622 Depreciation and amortization 57,043 52,876 Total operating expenses 853, ,471 Income from operations 115,737 90,000 Nonoperating losses, net - Note 1 (8,759) (44,181) Contribution received in the acquisition of assets - Note 12 52,116 - Excess of revenue over expenses 159,094 45,819 Deficit (excess) of revenue over expenses attributable to noncontrolling interests (5,480) 4,606 Excess of revenue over expenses attributable to $ 153,614 $ 50,425 The accompanying notes are an integral part of these consolidated financial statements, including Page 12, containing information on the unreimbursed cost of charity care of approximately $125 million and $83 million provided during 2012 and 2011, respectively. 4

6 CONSOLIDATED STATEMENTS OF OPERATIONS AND CHANGES IN NET ASSETS- CONTINUED For the years ended September 30, (In thousands) Changes in unrestricted net assets: Excess of revenue over expenses $153,614 $ 50,425 Other changes in unrestricted net assets: Unrecognized pension gain (loss) 218 (290) Changes attributable to noncontrolling interests 5,200 (3,202) Net assets released from restrictions used for capital 3, Increase in unrestricted net assets 162,671 47,465 Changes in temporarily restricted net assets: Restricted grants, gifts, and bequests 4,941 4,413 Income (loss) from investments 1,781 (50) Transfer to permanently restricted net assets (500) - Increase (decrease) in net assets of related foundation (371) 2,193 Net assets released from restrictions (3,777) (2,191) Increase in temporarily restricted net assets 2,074 4,365 Changes in permanently restricted net assets: Restricted grants, gifts, and bequests Transfer from temporarily restricted net assets Increase in permanently restricted net assets Increase in net assets 165,274 51,858 Net assets - beginning of year 770, ,754 Net assets - end of year $935,886 $770,612 The accompanying notes are an integral part of these consolidated financial statements. 5

7 CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended September 30, (In thousands) Cash flows from operating activities: Increase in net assets $ 165,274 $ 51,858 Adjustments to reconcile increase in net assets to net cash provided by operating activities: Operating depreciation and amortization 57,043 52,876 Nonoperating depreciation and amortization 7,927 7,106 Provision for bad debts 66,915 81,097 Capitalized interest (259) (111) Loss on retired assets Unrealized loss on interest rate swaps 2,638 14,408 Unrealized and realized losses (gains) on investments (17,411) 8,736 Contribution received in the acquisition of assets (52,116) - Changes attributable to noncontrolling interests - (1,785) Restricted grants, gifts, and bequests and change in interest in the net assets of related foundation (4,599) (6,634) Changes in operating assets and liabilities: Increase in patient accounts receivable (80,870) (97,086) Increase in other accounts receivable (3,543) (5,600) Increase in other current assets (1,132) (2,608) (Increase) decrease in other assets (4,696) 3,835 Increase in accounts payable and accrued expenses 3,039 21,401 Increase (decrease) in health insurance programs reimbursement payable 1,567 (1,656) Increase (decrease) in other liabilities (1,678) 3,439 Net cash provided by operating activities 138, ,276 Cash flows from investing activities: Purchases of investments (459,645) (451,031) Maturities and sales of investments 392, ,530 Purchases of property, plant and equipment (63,763) (104,900) Cash from acquisition of hospital 6,421 2,535 Increase in assets whose use is limited (2,024) (3,951) Net cash used in investing activities (126,451) (203,817) The accompanying notes are an integral part of these consolidated financial statements. 6

8 CONSOLIDATED STATEMENTS OF CASH FLOWS - CONTINUED For the years ended September 30, (In thousands) Cash flows from financing activities: Principal payments on debt $ (22,725) $ (12,473) Issuance of long-term debt 9,195 79,717 Restricted grants, gifts, and bequests and change in interest in the net assets of related foundation 4,599 6,634 Net cash (used in) provided by financing activities (8,931) 73,878 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,906 (663) Cash and cash equivalents, beginning of year 42,696 43,359 Cash and cash equivalents, end of year $ 45,602 $ 42,696 Supplemental disclosure of cash flow information: Cash paid for interest $ 20,266 $ 15,997 Accrued construction costs $ 3,530 $ 1,440 The accompanying notes are an integral part of these consolidated financial statements. 7

9 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Methodist Hospitals of Dallas, a 501(c)(3) tax-exempt corporation doing business as Methodist Health System (MHS), owns and operates four acute care hospitals and is the sole corporate member of a Texas non-profit corporation that owns land, buildings and equipment, as discussed in Note 12, which is leased by MHS. Two of the owned and operated hospitals, Methodist Dallas Medical Center, a 515-licensed-bed tertiary care hospital, and Methodist Charlton Medical Center, a 254-licensed-bed community hospital, are located in Dallas, Texas. The third hospital, Methodist Mansfield Medical Center, a 160-licensed-bed community hospital is located in Mansfield, Texas. The remaining hospital, Methodist Richardson Medical Center (MRMC), is a 209-licensed-bed community hospital located in Richardson, Texas, which was leased and operated by MHSR Medical Center (MHSR) during 2011 and owned by MHSR and leased to MHS effective October 1, MHSR is a 501(c)(3) tax-exempt corporation established by MHS. As the sole corporate member of MHSR, MHS has full power to appoint and remove all board members. In addition, MHS is the majority owner of Methodist Rehabilitation Hospital, LLC (MRH), a 40-bed post-acute hospital located in Dallas, Texas that is a joint venture with Centerre Corporation. MHS is also the majority owner of Methodist McKinney Hospital, LLC (McKinney), a 23-bed surgical hospital located in McKinney, Texas, and Methodist Hospital for Surgery (MHfS), a 32-bed surgical hospital located in Addison, Texas. Both McKinney and MHfS are joint ventures with physicians. The consolidated financial statements include accounts of MHS, MHSR, MRH, MHfS, McKinney, Methodist McKinney Hospital Property, LLC, Foundation (Foundation), and Pavilion Properties. The Foundation is a 501(c)(3) tax-exempt corporation that was established to raise funds to support the operations of MHS. Pavilion Properties is a 501(c)(2) tax-exempt title-holding corporation. All significant intercompany items are eliminated in consolidation. Recent Accounting Pronouncements In July 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) , Health Care Entities (Topic 954): Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities, which is intended to provide greater transparency about a healthcare entity s net patient service revenue and related allowance for uncollectible accounts. The update requires healthcare entities that recognize significant amounts of patient service revenue at the time services are rendered even though they do not assess the patient s ability to pay to change the presentation of their statement of operations and changes in net assets by reclassifying the provision for bad debts associated with patient service revenue from an operating expense to a deduction from patient service revenue (net of contractual allowances and discounts). Additionally, those healthcare entities are required to disclose patient service revenue (net of contractual allowances and discounts) by major payor source as well as qualitative and quantitative information about changes in the allowance for uncollectible accounts. As permitted, MHS adopted the guidance of ASU on October 1, 2011, and retrospectively applied the presentation requirements to all periods presented and prospectively applied the disclosure requirements to the year ended September 30, The change in presentation and additional disclosures are reflected in the consolidated statements of operations and changes in net assets and in Note 2. 8

10 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued U.S. Income Tax Status MHS, MHSR, and the Foundation are exempt from federal income taxes under Section 501(a) of the Internal Revenue Code (IRC), as an organization described in IRC Section 501(c)(3). They each have been classified as an organization that is not a private foundation under IRC Section 509(a)(1), and as such, contributions to them qualify for deduction as charitable contributions. Due to their organization structure, certain of the consolidated entities are taxable under the IRC and some entities are tax exempt but are required to pay income taxes for income generated from activities unrelated to their exempt purpose under IRC Section 511. In addition, certain of the consolidated entities file U.S. partnership income tax returns. The Texas Margin Tax applies to certain partnerships and taxable entities included in the consolidated financial statements. The overall impact of federal income taxes and Texas Margin Taxes to the MHS consolidated financial statements for the years ended September 30, 2012 and 2011 is not significant. MHS has concluded that it does not have any unrecognized tax benefits resulting from current or prior period tax positions. Accordingly, no additional disclosures have been made in the financial statements. MHS does not have any outstanding interest or penalties, and none have been recorded in the consolidated statements of operations and changes in net assets for the years ended. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States (US GAAP) requires estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents Cash equivalents include commercial paper, corporate notes, and U.S. government securities having original maturities, at time of purchase, of 90 days or less. Cash is placed in high credit quality financial institutions. At times such investments may be in excess of the Federal Deposit Insurance Corporation insurance limit. The carrying amounts approximate fair value because of the short maturity of these instruments. Investments Investments include those held by the Foundation. Short-term investments have maturities, measured at balance sheet dates, of less than one year. Long-term investments have maturities greater than one year. 9

11 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Investment income is comprised of the following: Years ended September 30, (in thousands) Interest and dividend income $ 4,521 $ 2,874 Realized gains, net 3,078 1,381 Unrealized gains and (losses), net 14,333 (10,117) Investments are comprised of the following: $21,932 $ (5,862) September 30, (in thousands) U.S. government and agency securities $343,318 $237,234 Corporate bonds 98, ,536 Mutual funds 133,968 92,533 Commercial paper 29,380 33,801 Common stock 3,591 2,662 Certificates of deposit Real property - 18 Other $609,520 $517,425 Short-term investments as defined above total approximately $544,819,000 and $478,385,000 at, respectively. Long-term investments total approximately $64,701,000 and $39,040,000 at, respectively. Short-term investments of approximately $51,823,000 and $41,726,000 as of, respectively, are included in assets whose use is limited. Long-term investments of approximately $1,919,000 and $4,417,000 as of, respectively, are included in assets whose use is limited. The carrying amounts of corporate bonds, mutual funds, marketable securities and investments in real estate trusts and government agency funds approximate fair value based on quoted market prices or that of identical or similar assets in active markets. 10

12 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Debt Repurchase Investments and long-term debt (Note 4) reflect MHS s secondary market repurchase of $150 million of its Series 1998 bonds. The repurchase was made during 2008 with available cash and results in reduced amounts of unrestricted cash and investments. The purchase was made to reduce net interest expense. US GAAP requires that the purchase be reported as a reduction of long-term debt. MHS can reoffer the Series 1998 bonds in the secondary market, but may also choose to refund them depending upon market conditions at a future time. Inventory Inventories are valued at the lower of net realizable value or cost. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is provided on the straight-line method using the estimated economic lives of depreciable assets, ranging from 3 to 40 years. Expenditures that materially increase values, change capacities, or extend useful lives are capitalized. Routine maintenance and repair items are charged to current operations. Assets Whose Use Is Limited Assets whose use is limited include cash and cash equivalents of approximately $1,188,000 and $7,241,000 as of, respectively; short-term investments of approximately $51,823,000 and $41,726,000 as of, respectively; long-term investments of approximately $1,919,000 and $4,417,000 at, respectively, and other assets including pledges receivable and a receivable of $20,866,000 related to the assumption of the Richardson Hospital Authority 2004 bonds (see Notes 4 and 12). Disclosures About Fair Value of Financial Instruments US GAAP requires that investments held in equity securities with readily determinable fair values and all investments in debt securities be reported at fair value with gains and losses included in the consolidated statements of operations and changes in net assets. Adjustments for amortization of premium and accretion of discount are included in interest income. Gains or losses on the sale of securities are recognized upon realization using the specific identification method. All investments with readily determinable fair values are recorded at fair values based on quoted market prices. Investments are considered trading securities. Unrealized gains and losses on investments recorded at fair value are included in the consolidated statements of operations and changes in net assets as increases or decreases in unrestricted net assets unless their use is temporarily or permanently restricted by explicit donor stipulations or law. 11

13 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Variable rate long-term debt carrying values approximate fair value because of the frequency with which the interest rates are reset. Derivative Instruments and Hedging US GAAP requires that derivative instruments be recorded on the consolidated statements of financial position as either an asset or liability, be measured at their fair value, and that changes in the derivative s fair value be recognized currently in earnings, unless specific hedge accounting criteria are met. MHS utilized six (6) interest rate swap agreements to minimize the risks and costs associated with its financing activities (see Note 4). The interest rate swaps were not designated as hedging instruments. Unrealized losses on interest rate swaps are recorded in nonoperating losses on the consolidated statements of operations and changes in net assets. MHS has no other derivative instruments. Investments in Unconsolidated Companies MHS has investments in subsidiaries, affiliates, and joint ventures which are not consolidated. Investments in unconsolidated companies owned 20 percent or more are recorded on an equity basis. Investments in companies less than 20 percent owned, and for which MHS does not exercise significant influence, are carried at cost. While certain of these companies meet the criteria for consolidation, management believes such presentation is not material to the financial statements. Temporarily and Permanently Restricted Net Assets Temporarily and permanently restricted net assets represent those net assets whose use has been limited by donors to a specific purpose. Permanently restricted net assets have been restricted by donors to be maintained in perpetuity and the income to be used for specific purposes. Assets in an endowment fund are donor-restricted assets until appropriated for expenditure by MHS. The portion of a donor-restricted endowment that is not permanently restricted has a time restriction until appropriated and is classified as temporarily restricted net assets. Net Patient Service Revenue Net patient service revenue is reported at the estimated net realizable amounts from patients and thirdparty payors for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Charity Care MHS provides care to patients who meet certain criteria under its charity care policy, without charge or for amounts less than its established rates. The amount by which established rates exceed the amount, if any, expected to be collected from patients receiving charity care is not reported as net patient service revenue. MHS maintains records to identify and monitor the level of charity care it provides under its charity care policy. The unreimbursed cost of charity services provided, including the unreimbursed cost of Medicaid services, was approximately $125 million in 2012 and $83 million in The unreimbursed cost estimate is derived from applying the ratio of costs to charges to serve all patients to charity patient charges and subtracting payments received that are associated with the charity care. 12

14 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Medicare and Medicaid Program Reimbursement Net patient service revenue before provision for uncollectible accounts includes amounts reimbursable by the Medicare and Medicaid programs. Reimbursement for Medicare inpatient services is based on a combination of prospectively determined amounts for operating costs, capital costs, and medical education, and retrospective reimbursement for other costs. Reimbursement for Medicaid inpatient services is based on prospectively determined amounts. Reimbursement for Medicare and Medicaid outpatient services is based on either the hospitals operating costs, as defined, prospectively determined amounts, or a blend of the operating costs and prospectively determined amounts, depending on the services provided. The commercial managed Medicare and Medicaid inpatient and outpatient business is paid on negotiated rates. Those payments that are not prospectively determined under the Medicare and Medicaid programs are reimbursed at tentative rates with final settlement determined after submission of annual cost reports, and audits thereof by the Medicare and Medicaid fiscal intermediary. The difference between final determination after audit and the estimated amount accrued is included in net patient service revenue in the year of determination. Net patient service revenue increased approximately $7,049,000 and $3,720,000 in 2012 and 2011, respectively, due to decreases in allowances required as a result of final settlement and current estimates based on the status of audits that are in process or completed but not final. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation. MHS believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. MHS received funds of approximately $9.2 million and $11.0 million in its fiscal years 2012 and 2011, respectively, from the Texas Health and Human Services Medicaid Disproportionate Share program. The program obtains funding from intra-governmental transfers of public hospital funds that are matched by U.S. government federal funds and distributed to hospitals that serve a disproportionately large share of uninsured and Medicaid program patients. MHS qualifies for funds because the distribution is based upon the percentage of low-income inpatients served. Advertising Costs Advertising costs are expensed as incurred and were approximately $5,029,000 and $4,894,000 for the years ended, respectively. 13

15 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Nonoperating Losses, Net Nonoperating losses, net primarily include interest expense on MHS debt, loss on interest rate swaps, and all investment income. MHS classifies its investments as trading securities and reports investment income, including unrealized gains and losses, within the performance indicator. Interest expense, net of amounts capitalized, was approximately $20.6 million and $15.9 million for 2012 and 2011, respectively. Interest paid was approximately $20.3 million and $16.0 million for 2012 and 2011, respectively. Interest of approximately $0.3 million and $0.1 million was capitalized for 2012 and 2011, respectively. Unrealized losses on interest rate swaps were approximately $2.7 million and $14.4 million for 2012 and 2011, respectively. Nonoperating losses, net also include losses from operations of unconsolidated companies, primarily the Methodist Family Health Centers, of $4.6 million and $6.6 million for 2012 and 2011, respectively; and unrestricted contributions to MHSF of $0.1 million and $0.2 million for 2012 and 2011, respectively. Contributions Contributions are recorded as either temporarily or permanently restricted support if they are received with donor stipulations that limit the use of the donated assets. When expenditures are made that meet the donor specified purpose, temporarily restricted net assets are reclassified as unrestricted net assets and reported in the consolidated statements of operations and changes in net assets as net assets released from restrictions. The carrying amount of pledges receivable approximates fair value as determined by discounting pledges at an appropriate discount rate commensurate with the risks involved. Unconditional promises to give cash and other assets to MHS or the Foundation are reported at fair value when the eligibility requirements established by the donor have been satisfied. Pledges are written unconditional promises to make future contributions which, if all eligibility requirements have been satisfied, are recognized as pledges receivable and contribution income at their discounted present value based on future expected collections. Conditional promises to give and indications of intentions to give are reported at fair value at the date the gift is received or becomes an unconditional promise. Undiscounted pledges receivable at were approximately $3,633,000 and $2,938,000, exceeding their discounted present value by approximately $109,000 and $76,000, respectively. Pledges receivable at September 30, 2012 were discounted using rates ranging from 1.35% to 3.04%. The discount rates used to discount pledges receivable at September 30, 2011 ranged from 1.35% to 4.98%. All pledges receivable are deemed collectible by management; thus, no allowance is required. 14

16 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Pledges receivable are a component of assets whose use is limited. Pledges outstanding are expected to be collected in the following periods: September 30, (in thousands) One year or less $2,091 $1,685 Between one and five years 1,433 1,177 At September 30, 2012, there are two conditional promises to give totaling $183,000. $3,524 $2,862 NOTE 2 - NET PATIENT SERVICE REVENUE AND PATIENT ACCOUNTS RECEIVABLE Net patient service revenue before the provision for uncollectible accounts by major payor source for the years ended, are as follows: September 30, Medicare 32% 31% Medicaid 6 5 Managed care Self-pay and other % 100% MHS provides health care services to patients regardless of their ability to pay. MHS maintains an allowance for uncollectible accounts for estimated losses resulting from a payor s inability to make payments on accounts. The allowance is based on historical write-offs and the aging of the accounts; management continually monitors and adjusts the allowance for uncollectible accounts receivable. Accounts are written off when routine billing and communication with the payor are not expected to result in payment. MHS collection efforts continue, and recoveries of accounts written off are accounted for as reductions in the provision for bad debts. The allowance for uncollectible account decreased to 22.0% of account balances at September 30, 2012 from 27.0% at September 30, The system maintains collection allowances for all major payor categories including governmental, managed care, and all other which is primarily the uninsured. At September 30, 2012, the collection allowance total is composed of 10% for governmental payors, 29% for managed care payors, and 61% for all others, primarily the uninsured. Patient accounts receivable are stated at net realizable value. Concentrations of receivables from patients include: 15

17 NOTE 2 - NET PATIENT SERVICE REVENUE AND PATIENT ACCOUNTS RECEIVABLE - Continued September 30, Managed care providers 70% 67% Government-related programs Self-pay patients and other payors % 100% Receivables from government programs (primarily Medicare and Medicaid) represent the only concentrated group of credit risk for MHS, and management does not believe that there are any significant credit risks associated with these government agencies. Managed care and other receivables consist of receivables from various payors involved in diverse activities and subject to differing economic conditions and do not represent any significant concentrated credit risks to MHS. NOTE 3 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment and the related accumulated depreciation and amortization are as follows: September 30, Accumulated Accumulated depreciation depreciation and and Cost amortization Cost (in thousands) amortization Land $ 52,057 $ - $ 38,047 $ - Land improvements 26,177 18,041 26,148 16,956 Buildings 616, , , ,433 Fixed equipment 71,527 65,622 71,328 64,572 Movable equipment 359, , , ,295 Construction in progress 40,054-17,866 - $1,165,242 $577,828 $1,026,735 $522,256 Net book value $ 587,414 $ 504,479 MHS has several construction and renovation projects in progress for which it has commitments of approximately $3.7 million at September 30, 2012, which are expected to be utilized in the next fiscal year. 16

18 NOTE 4 - LONG-TERM DEBT Long-term debt is as follows: September 30, (in thousands) North Central Texas Health Facilities Development Corporation Flexible Rate Hospital Revenue Bonds Series average interest rate of 1.34% and 1.45% for the years ended, respectively. $ 150,000 $ 150,000 Tarrant County Cultural Education Facilities Finance Corporation Hospital Revenue Bonds Series variable rate demand notes payable weekly with an average interest rate of 3.53% and 3.60% for the years ended, respectively, principal payable through , ,600 Richardson Hospital Authority Series 2004 Hospital Revenue Refunding and Improvement Bonds - interest rates ranging from 4% to 6%, payable in annual installments through ,590 - Capital Lease Obligation at imputed interest rate of 4% payable monthly through Methodist McKinney Hospital Property - Real Estate Loan with an interest rate of 5.16%, payable monthly, principal and interest payments through ,773 31,472 Methodist McKinney Hospital - Equipment Notes with interest rates of 4.89% to 6.50%, payable monthly, principal and interest payments through ,064 7,146 Methodist McKinney Hospital - Line of Credit up to $3,500,000 with an interest rate of 5.00%, payable monthly - 2,376 Methodist McKinney Hospital - Promissory Notes with an interest rates of 5.00% to 6.25%, payable monthly, principal payable through ,761-17

19 NOTE 4 - LONG-TERM DEBT - Continued September 30, (in thousands) Methodist Hospital for Surgery - Related-party capital lease $ 58,123 $ 58,123 Methodist Hospital for Surgery - Equipment Note with a floating interest rate of LIBOR plus 2.50%, payable monthly, principal and interest payments through ,546 12,276 Methodist Hospital for Surgery - Line of Credit up to $5,000,000 with a floating interest rate of LIBOR plus 2.00%, payable monthly, principal payable on or before September 1, ,450 Debt repurchased (Note 1) (150,000) (150,000) 361, ,443 Less current installments (11,177) (16,465) Total $ 350,481 $ 289,978 The aggregate long-term debt maturing during the five years following fiscal 2013 and thereafter is as follows: $11,721,000; $10,370,000; $8,794,000; $5,133,000; thereafter - $314,462,000. In 1998, MHS borrowed the proceeds of the North Central Texas Health Facilities Development Corporation Flexible Rate Hospital Revenue Bonds Series 1998 (Series 1998 Bonds). The Series 1998 Bonds were issued by the North Central Texas Health Facilities Development Corporation pursuant to a Trust Indenture dated March 1, 1991 and a First supplement to Trust Indenture dated August 15, 1998 (Indenture). A portion of the proceeds was used to refund a prior series of bonds. The remainder of the proceeds, and other funds available from operations, were used for a capital improvement program. In 2008, all outstanding Series 1998 Bonds were repurchased by MHS using available cash in an effort to reduce net interest expense. The purchase is reported as a reduction of long-term debt. MHS has the ability to re-offer or refund the Series 1998 Bonds in the secondary market at a future time. The Series 1998 Bonds are issued in a flexible mode and bear interest for interest periods of 270 days or less. The Series 2008 Bonds consist of Series 2008A Bonds which are issued in a daily rate period and Series 2008B Bonds which are issued in a weekly rate period. A remarketing agent selected by MHS determines the interest rates and markets each series of bonds. Additional security for payment of the principal and interest of any Series 2008 Bonds tendered and not remarketed is provided under an irrevocable Letter of Credit issued by a bank. The letter of credit expires October 31,

20 NOTE 4 - LONG-TERM DEBT - Continued In September 2008, MHS borrowed the proceeds of the Tarrant County Cultural Education Facilities Finance Corporation Hospital Revenue Bonds Series 2008 ( Series 2008 Bonds ). The Series 2008 Bonds were issued by the Tarrant County Cultural Education Facilities Finance Corporation pursuant to a Trust Indenture dated June 1, The proceeds were used to refund a prior series of bonds. As part of the purchase of the assets of Richardson Hospital Authority (RHA) by MHSR on October 1, 2011 (see Note 12), MHSR assumed and became an obligor under the bond indenture for the RHA 2004 Hospital Revenue and Refunding Bonds (RHA Bonds) and MHS unconditionally guarantees the obligations of MHSR. While RHA remains obligated under the bonds until no later than March 1, 2014, MHSR provides the funds needed to make the principal and interest payments on the bonds. Further, MHSR provided RHA a security interest in the property conveyed to MHSR in the transaction and allowed RHA to retain $18 million held in a bond reserve fund for the sole purpose of redeeming the bonds or to satisfy any obligation of RHA in the event of a default under the bonds and debt service funds with a balance of $2.9 million at September 30, 2012 (see Note 1). Methodist McKinney Hospital Property, LLC (MMHP JV), is a joint venture limited liability company established to own and construct a surgical hospital that is leased to McKinney. The loan to MMHP JV is irrevocably and unconditionally guaranteed by its members in an amount proportionate to their ownership interest. MHS has a 59.02% interest in MMHP JV. McKinney has equipment loans and a line of credit guaranteed by its members. MHS s portion of the guarantee is 50.5%. MHfS has equipment loans and a line of credit guaranteed by its members. MHS s portion of the guarantee is 50.5%. MHfS has a building lease with MHSS-Addison L.P., a related party, for an initial 20 year period through 2030 with an option to extend for three periods of ten years each. MHSS-Addison L.P. is a joint venture which was formed as a financing vehicle in which MHS holds a minority interest. The lease payments escalate throughout the lease each subsequent year based on 3% of the initial year. Because initial rent payments do not exceed the imputed interest on the lease, the amount owed under this agreement will increase through The increase, totaling $1,209,000 and $598,000 at, respectively, is recorded as deferred interest and included in other liabilities on the consolidated statements of financial position. 19

21 NOTE 4 - LONG-TERM DEBT - Continued Property, plant, and equipment include the following property under capital lease: September 30, (in thousands) Land $10,450 $10,450 Buildings 47,826 47,826 Equipment ,968 58,276 Less accumulated depreciation (5,585) (2,671) $53,383 $55,605 Aggregate scheduled annual payments on the capital lease obligation at September 30, 2012, are as follows: $7,231,000; $7,444,000; $7,663,000; $7,889,000; $8,121,000; thereafter - $129,393,000. The amount representing interest is $108,990,000, and the principal balance at year end is $58,123,000. In 2007, MHS entered into six interest rate swap transactions in order to substantially fix the expected net interest expenses associated with its bonds. MHS is obligated to make payments to the related swap counterparties at fixed rates of 3.7% per annum on a notional amount of $100,000,000 and 3.8% per annum on a notional amount of $100,000,000, and the related swap counterparties are obligated to make reciprocal floating rate payments at a rate equal to 64% of the U.S. dollar one-month LIBOR rate reset weekly, plus 0.2%. The instruments fair value and changes therein must be measured in MHS s consolidated financial statements. The market value of the swaps, included in noncurrent liabilities, is approximately $57.0 million and $54.4 million at, respectively, and the amount included in nonoperating losses related to the change in value of the swaps is a loss of approximately $2.7 million and $14.4 million for the years ended, respectively. The fair value of the interest rate swaps is estimated based on quotes from the market makers of these investments and represents the estimated amounts MHS could expect to receive or pay to terminate the agreements. Assets held by the trustee, included in assets whose use is limited, include reserve funds required by the Series 1998 Indentures. The Series 1998 Bonds had no reserve requirement at September 30, 2012 and MHS is in compliance with all debt covenants as of. 20

22 NOTE 5 - TEMPORARILY AND PERMANENTLY RESTRICTED NET ASSETS Temporarily restricted net assets were approximately $26,825,000 and $24,751,000 as of September 30, 2012 and 2011, respectively. Permanently restricted net assets were approximately $4,113,000 and $3,584,000 as of, respectively. Temporarily restricted net assets are available for the following: September 30, (in thousands) Golden Cross Indigent Care Program $ 4,509 $ 3,671 Specific Purpose Funds: Capital Projects & Equipment 1,128 1,855 Women and Children Services 2,249 3,581 Trauma/Emergency Department 3,249 1,536 Indigent Care Programs 1,450 1,404 Education and Training 1, Pastoral Care Cardiology/Neurology 1, Transplant Research Oncology Other Nursing Scholarships Future Fund General Endowment 1,173 1,173 Specific Purpose Endowments 5,626 4,996 25,003 22,558 Interest in net assets of MRMC Foundation 1,822 2,193 $26,825 $24,751 Methodist Richardson Medical Center Foundation, Inc. (MRMC Foundation) was organized as a Texas non-profit corporation established to operate (i) exclusively for the benefit of MRMC and all of its campuses and health care facilities and programs, (ii) for the support of the community as needed for the benefit of MRMC consistent with historical practices, and (iii) consistent with the intent of the donors making grants or charitable contributions pursuing charitable, benevolent, educational and scientific purposes. MRMC Foundation is exempt from federal income taxes under Section 501(a) of the IRC, as an organization described in Section 501(c)(3). 21

23 NOTE 5 - TEMPORARILY AND PERMANENTLY RESTRICTED NET ASSETS - Continued US GAAP requires MHS to record its interest in the net assets of MRMC Foundation and to adjust that interest for changes in its share of the net assets of the MRMC Foundation. The assets of MRMC Foundation are managed solely by its board of directors. MRMC Foundation s board determines the timing of transfers to MRMC. MRMC maintains an economic interest in MRMC Foundation. Net assets released from restrictions for operations were approximately $138,000 and $1,659,000 for the years ended, respectively. Net assets released from restrictions for capital were approximately $3,639,000 and $532,000 for the years ended, respectively. Permanently restricted net assets, the income from which is restricted to the purposes below, are as follows: September 30, (in thousands) Golden Cross Endowment $2,854 $2,325 General Endowment Nursing Scholarships Specific Purpose Endowments $4,113 $3,584 Permanently restricted net assets consist of donor restricted endowment funds that require the principal be invested in perpetuity and only earnings be expended. NOTE 6 - CONTINGENCIES MHS is a defendant in various legal proceedings arising in the ordinary course of business. Although the results of litigation cannot be predicted with certainty, management believes the outcome of pending litigation will not have a material adverse effect on MHS s financial statements. MHS covers its professional and general liability risks through a program of self-insurance and commercial claims-made insurance policies from unrelated companies. The primary self-insurance coverage has a $5,000,000 retention per claim for all claims incurred after August 31, The self-insurance program is funded in MHS s irrevocable self-insurance trust based upon a third-party actuarial study with projected future payments discounted at a 2% discount rate. Under the trust agreement, trust assets, which are included in assets whose use is limited, can only be used for certain payments, primarily claim indemnity payments, expenses and the cost of administering the trust. MHS has limited its liability for losses incurred prior to September 1, 2002 to $1,000,000 per claim and $5,000,000 in the aggregate through purchase of a tail insurance option in the expiring policy. 22

24 NOTE 7 - UPL PROGRAM MHS has an Indigent Care Affiliation Agreement with Dallas County Hospital District, North Texas Division, Inc. (which owns and operates Medical City Hospital in Dallas), Baylor Health Care System and Texas Health Resources for the purpose of participation in the Private Hospital Medicaid Supplemental Payment Program authorized by Medicaid State Plan Amendment TX (UPL Program) in Dallas County. The private hospitals and health care systems who are parties to the Indigent Care Affiliation Agreement are referred to herein as the affiliated hospitals. As a result of this agreement and others which include UT Southwestern Medical Center at Dallas (UTSW), MHS has recognized receipts and disbursements in its consolidated financial statements. In addition, through contributions received from the affiliated hospitals, Dallas County Indigent Care Corporation (DCICC) provided support to Project Access Dallas in addition to the professional services it arranges to be provided to the indigent through the contractual arrangement in place with UTSW and to pay consulting expenses related to administration of the UTSW contract. DCICC is an entity created by the affiliated hospitals to take over the contract the affiliated hospitals had with UTSW as part of the UPL Program. During 2011, MHS recognized a total of $31.0 million of UPL payments in net patient service revenue and $6.7 million in expense for community benefits provided through the DCICC. During 2012, MHS recognized a total of $26.7 million of UPL payments in net patient service revenue and $15.2 million in expense for community benefits provided through the DCICC. MHS has an Indigent Care Affiliation Agreement with Tarrant County Hospital District, North Texas Division, Inc. (which owns and operates several hospitals in Tarrant County), Baylor Health Care System and Texas Health Resources for the purpose of participation in the UPL Program in Tarrant County. During 2011, MHS recognized a total of $2.7 million of UPL payments in net patient service revenue and $1.8 million in expense for community benefits provided. During 2012, MHS recognized a total of $2.8 million of UPL payments in net patient service revenue and $1.9 million in expense for community benefits provided. During 2012, the Texas Health and Human Services Commission (HHSC) proceeded with implementation of a five-year Section 1115 Waiver, Texas Healthcare Transformation and Quality Improvement Program: Medicaid 1115 Waiver, which was approved by the Centers for Medicare and Medicaid Services (CMS) in December of In part, the waiver replaces the UPL program with two new pools of funding, the uncompensated care pool (UC pool), and the delivery system reform incentive payment pool (DSRIP pool). The UC pool will reimburse hospitals for the cost of care for Medicaid and uninsured patients for which the hospital does not receive payment. The DSRIP pool will provide payments to hospitals and other providers upon their achieving certain goals that are intended to improve the quality and lower the cost of care. 23

25 NOTE 8 - RETIREMENT PLAN The Employees Retirement Plan (Plan) has both defined benefit and defined contribution features. The Plan s defined benefit feature was frozen effective January 1, 1993 and replaced with an enhanced defined contribution feature. Plan participants are required to contribute 2.5% of compensation, which is matched by MHS at amounts ranging from 2.5% to 6.25% of the participant s compensation depending on the participant s length of service. The plan includes an additional 1% match for employees making additional voluntary contributions of at least 1% of compensation to the employee 403b plan. Contributions are invested in tax-sheltered annuities in each participant s name. The participant becomes fully vested in the MHS matching contribution after three years of service. Substantially all Plan assets are invested in fixed income and equity mutual funds managed by open-end investment companies. MHS s contributions for the defined contribution feature of the Plan, reflected in salaries, wages and benefit costs in the accompanying consolidated statements of operations and changes in net assets, totaled approximately $12,006,000 and $11,041,000 for the years ended, respectively. The total accrued pension liability (which represents the unfunded status of the defined benefit feature of the Plan) as of was approximately $123,000 and $499,000, respectively. NOTE 9 - FAIR VALUE OF FINANCIAL INSTRUMENTS US GAAP emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, US GAAP establishes a three-tier hierarchy to distinguish between various types of inputs used in determining the value of the MHS s investments and liabilities. The inputs are summarized in three levels as outlined below: Level 1 Inputs - Quoted prices (unadjusted) in active markets for identical assets and liabilities. Assets include publicly traded securities and mutual funds. Valuations of these instruments do not require a high degree of judgment as the valuations are based on quoted prices in active markets that are readily available. Level 2 Inputs - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities that are not active; and inputs other than quoted prices that are observable, such as models or other valuation methodologies. Assets in this category generally include corporate bonds, real estate trusts, and government agency funds. Liabilities in this category include interest rate swaps. Valuations in this category are inherently less reliable than quoted market prices due to the degree of subjectivity involved in determining appropriate methodologies and the applicable underlying assumptions. Level 3 Inputs - Unobservable inputs for the valuation of the asset or liability. Assets include investments for which there is little, if any, market activity. These inputs require significant management judgment or estimation. MHS has no level 3 assets or liabilities. MHS s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the financial instrument. 24

26 NOTE 9 - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued The schedule below classifies MHS s assets and liabilities carried at fair value at September 30 based upon the three-tier hierarchy: Fair Value Measurements at September 30, 2012 Quoted Prices Significant In Active Markets Other Significant For Identical Observable Unobservable Assets Inputs Inputs Description 2012 (Level 1) ( Level 2) (Level 3) Assets: U.S. government and agency securities $343,318 $169,661 $173,657 $ - Certificates of deposit Corporate bonds 98,401-98,401 - Commercial paper 29,380-29,380 - Common stock 3,591 3, Mutual funds 133, , Other Total investments $609,520 $308,082 $301,438 $ - Liabilities: Interest rate swaps $ 57,015 $ - $ 57,015 $ - Fair Value Measurements at September 30, 2011 Quoted Prices Significant In Active Markets Other Significant For Identical Observable Unobservable Assets Inputs Inputs Description 2011 (Level 1) ( Level 2) (Level 3) Assets: U.S. government and agency securities $237,234 $ 93,201 $144,033 $ - Certificates of deposit Corporate bonds 150, ,536 - Commercial paper 33,801-33,801 - Common stock 2,662 2, Mutual funds 92,533 92, Real Property Other Total investments $517,425 $189,037 $328,388 $ - Liabilities: Interest rate swaps $ 54,377 $ - $ 54,377 $ - 25

27 NOTE 10 - FUNCTIONAL EXPENSES MHS provides general health care services. Expenses related to providing these services are as follows: Years ended September 30, (in thousands) Patient care $545,598 $495,482 General and administrative 233, ,045 Depreciation and amortization 57,043 52,876 Medical education 15,289 14,610 Other 1,980 1,458 $853,492 $814,471 NOTE 11 - ELECTRONIC HEALTH RECORDS The American Recovery and Reinvestment Act of 2009 provides for Medicare incentive payments for eligible acute care inpatient hospitals that are meaningful users of certified electronic health record (EHR) technology upon submission of a successful attestation of meaningful use. The Medicare incentive payment is the result of a defined calculation occurring in the Medicare cost report and is subject to retroactive determination. MHS qualified for incentive payments of $6,588,000 for the fiscal year ended September 30, 2011 and management estimates that it qualifies for incentive payments of $5,913,000 for the fiscal year ended September 30, EHR payments are not related to the provision of care to specific patients so are included in other operating revenue for the years ended September 30, 2012 and 2011 and in other accounts receivable as of. The difference between final determination after audit and the estimated amount will be included in operations in the year of determination. NOTE 12 - PURCHASE OF RICHARDSON HOSPITAL AUTHORITY NET ASSETS On October 1, 2011 MHSR purchased substantially all of the assets previously leased from Richardson Hospital Authority (RHA), and the professional office buildings and certain rental properties not previously leased. As a part of the acquisition transaction, MHSR assumed the outstanding debt of RHA, net of available cash in fulfillment of the purchase price obligation. The assets acquired include all hospital facilities, all hospital equipment, land, and the professional office buildings and parking garage. All hospital facilities and hospital equipment are leased to MHS for the operation of the acute care hospital at the Campbell Road and Bush Renner locations in Richardson, Texas. Additionally, ownership of the professional office buildings and other office property previously leased to MHSR and acquired by MHSR on October 1, 2011 was transferred to and is operated by Pavilion Properties as part of the acquisition transaction. 26