Quarterly Disclosure Report. For Six Months Ended December 31, (Unaudited)

Transcription

1 Quarterly Disclosure Report For Six Months Ended December 31, 2008 (Unaudited) Contacts: Mark Amiri Frederick Savelsbergh Vice President and Treasurer Senior Vice President of Hospital Finance and Interim Chief Financial Officer

2 Quarterly Disclosure Report for December 31, 2008 TABLE OF CONTENTS Organization Page 1 Key Operating and Financial Indicators Page 1 Financial Operations Summary Page 2 Management Discussion and Analysis: Page 3 Net Operating Income Page 3 Net Operating Revenue Page 3 Operating Expenses Page 4 Nonoperating Gain (Loss) Page 5 Utilization Statistics Page 5 Liquidity Page 6 Foundations Net Assets Page 7 Combined Balance Sheets Page 8 Combined Statements of Operations Page 9 Combined Statements of Cash Flows Page 10 Notes to Combined Financial Statements Page 11

3 Quarterly Disclosure Report for December 31, 2008 Organization Baylor Health Care System (BHCS) is a Texas 501(c) (3) non-profit corporation operating an integrated health care delivery system with over 2,300 beds serving the health care needs of the ten county Dallas-Fort Worth metroplex. Its affiliates include the System s flagship Baylor University Medical Center, eight community hospitals, four specialty limited service hospitals, one research institute, two philanthropic foundations and Health Texas Provider Network (HealthTexas), a physician practice organization. The combined financial statements, which are unaudited, also include partnerships through Texas Health Ventures Group, LLC ( THVG ) that operate six short-stay surgery hospitals with one additional hospital under development and fifteen ambulatory surgery centers. The Baylor Health Care System Foundation and the All Saints Health Foundation foster support from the Dallas and Fort Worth metroplex to further Baylor's mission within the communities they serve. HealthTexas is a Texas non-profit corporation that owns and operates primary care and specialty practices in the Dallas-Fort Worth metroplex. HealthTexas provides physician recruiting services to BHCS and as of December 31, 2008, employed 436 physicians and physician extenders. Baylor s credit ratings are Aa2 Stable with Moody s Investors Service and AA- Stable by Standard and Poor s. Key Operating and Financial Indicators The information contained in this document represents the preliminary and unaudited financial condition and results of operations of the System for the six months ended December 31, The six months ended December 31, 2007 has been restated to conform with the 2008 fiscal year end audit. Key Operating and Financial Indicators ($ Thousands) December 31, Total Operating Revenue $ 1,512,763 $ 1,663,667 Operating Margin (net of realized investment income and minority interest) 2.8% 3.8% Adjusted EBITDA* $ 202,349 $ 170,240 Cash and Investments $ 1,535,647 $ 1,225,248 Days in Patient Accounts Receivable Days Cash on Hand (including restrictred funds) *EBITDA has been modified to exclude unrealized gain/loss on investments. 1

4 Quarterly Disclosure Report for December 31, 2008 Financial Operations Summary Combined Statements of Operations ($ Thousands) Audited June 30, December 31, Total operating revenue $ 2,848,717 $ 3,110,864 $ 1,512,763 $ 1,663,667 Total operating expenses 2,631,493 2,906,492 1,441,756 1,557,070 Income from operations 217, ,372 71, ,597 Non-operating gain (loss) 168,752 (186,639) 28,722 (240,534) Excess of revenues over expenses before minority interest 385,976 17,733 99,729 (133,937) Less: Minority interest 65,213 79,037 34,233 52,093 Excess (deficit) of revenues over expenses $ 320,763 $ (61,304) $ 65,496 $ (186,030) Summary Financial Information ($ Thousands) Audited June 30, December 31, Cash Flow: Cash flow from operating activities $ 333,346 $ 239,170 $ 59,685 $ 79,900 Adjusted EBITDA (1) $ 439,153 $ 277,793 $ 202,349 $ 170,240 Capital expenditures for property and equipment $ 309,317 $ 338,631 $ 142,986 $ 95,783 Financial Ratios: Operating margin 7.6% 6.6% 4.7% 6.4% Adjusted EBITDA (1) 14.9% 9.1% 12.9% 10.2% Days in patient accounts receivable Unrestricted days cash on hand Days cash on hand (including restricted funds) Debt to capitalization (2) 33.4% 33.5% 33.6% 36.8% Debt to cash flow (3) 2.10x 3.60x 2.40x 2.80x (1) Adjusted EBITDA is revenue in excess of expenses after minority interest plus depreciation, amortization, taxes, loss from extinguishment of debt and unrealized gain/loss on investments. (2) Long term debt plus current maturities/(long term debt plus current portion) plus unrestricted net assets. (3) Long term debt plus current maturities/excess of revenues over expenses plus depreciation and amortization less unrealized gain/loss on investment plus long term debt and current portion. 2

5 Quarterly Disclosure Report for December 31, 2008 Management Discussion and Analysis of Financial Condition and Results of Operations Net Operating Income In the first six months of fiscal year 2009, BHCS continued to have the strong financial performance exhibited in the fiscal year ended June 30, The operating margin for the first six months was $106.6 million (6.4% of net operating revenue), compared to $71.0 million (4.7%) for the first six months of fiscal year Operating margin, net of joint venture minority interest, was $54.4 million (3.8%) compared to $37.1 million (2.8%) for the same period of fiscal year At December 31, 2008, EBITDA was a positive $216.8 million (13.0%) of net total revenue versus $202.3 million (12.9%) for the six months ended December 31, The positive operating performance was primarily attributable to several factors including acquisitions of certain surgical facilities through THVG during fiscal year 2008 and higher than anticipated patient volumes at most of the acute care facilities for the six months ended December 31, Net Operating Revenue The combined year-to-date operating revenue for fiscal year 2009 was $1,663.7 million, an increase of $150.9 million or 10.0% over the same period of fiscal year Net patient care revenue was $1,587.8 million for the first six months of fiscal 2009, an increase of $150.9 million or 10.5% over the first six months of fiscal year The increase in net patient revenue reflects the impact of higher patient volumes and the THVG acquisitions previously mentioned above. Charity care increased $7.2 million or 7.4% to $103.7 million in the first six months of fiscal year 2009 compared to $96.5 million in the same period in fiscal year 2008 and remained consistent as a percentage of net patient revenue for both the first six months ended December 31, 2008 and 2007, respectively. Operating Data (1), (2) Audited June 30, December 31, Beds in Service 2,412 2,431 2,446 2,389 Inpatient Admissions (1), (2) 108, ,881 54,156 56,633 Patient Days 595, , , ,064 Averange Length of Stay (Days) Emergency Room Visits 278, , , ,742 Outpatient Registrations 579, , , ,997 Gross Outpatient Revenue as a Percent of Total Revenues 45.3% 48.2% 47.7% 50.4% (1) Admissions include adult and special care nursery. (2) Reporting for The Heart Hospital Baylor Plano began January, 2007 upon opening of the facility. Net assets released from restrictions for operations decreased $398,000 or 2.0% to $19.0 million in fiscal year 2009 compared to $19.4 million in

6 Operating Expenses Quarterly Disclosure Report for December 31, 2008 Combined operating expenses for the first six months of fiscal year 2009 were $1,557.1 million, an increase of $115.3 million or 8.0% over the first six months of fiscal year Bad debt expense increased $5.1 million or 4.6% to $116.7 million in the first six months of fiscal year 2009, but decreased as a percentage of net patient care revenue to 7.3% from 7.8%. The increase in bad debt expense between fiscal years was primarily driven by higher patient volumes as previously mentioned above. The change in the percentage of net patient care revenue was a result from unfavorable shifts in payor mix at several of the acute care facilities during the first six months fiscal year Salaries, wages, and employee benefits increased $55.9 million or 8.3% to $727.4 million in fiscal year 2009 compared to $671.5 million in 2008 and decreased as a percentage of net patient care revenue to 45.8% from 46.7% as of fiscal year Salaries and employee benefits represented approximately 46.7% and 46.6% of total operating expenses in the first six months of fiscal year 2009 and 2008, respectively. Supplies and other operating expenses increased $45.0 million or 8.1% in fiscal year 2009 to $602.8 million compared to $557.8 million in fiscal year 2008 and represented approximately 38.0% and 38.8% of net patient care revenue as of fiscal years 2009 and 2008, respectively. Supplies and other operating expenses as a percentage of total operating expenses represented approximately 38.7% for both fiscal years 2009 and Depreciation and amortization increased $7.8 million or 9.6% to $88.2 million in fiscal year 2009 compared to $80.5 million in fiscal year The increase in depreciation expense was primarily attributable to the expansion of the emergency department at the System s flagship affiliate, Baylor University Medical Center, during fiscal year 2008 and the System entering into a capital lease to support expansion of a medical center through its investments in joint ventures. Interest expense increased $1.5 million or 7.5 % in fiscal year 2009 to $22.0 million compared to $20.5 million in fiscal year Operating Expenses ($ Thousands) Audited June 30, December 31, Salaries, wages, and employee benefits $ 1,254,059 $ 1,387,215 $ 671,474 $ 727,369 Supplies & other operating expenses 1,018,883 1,093, , ,826 Bad debt expense 176, , , ,653 Depreciation and amortization 149, ,062 80,480 88,246 Interest expense 32,689 39,432 20,450 21,976 Total operating expenses $ 2,631,493 $ 2,906,492 $ 1,441,756 $ 1,557,070 4

7 Nonoperating Gain (Loss) Quarterly Disclosure Report for December 31, 2008 BHCS recorded unrealized losses on investments of $263.8 million for the first six months of fiscal year 2009, compared to losses of $41.9 million for the same period in fiscal year 2008, related to the ongoing issues in the financial markets. Realized investment gains were $2.4 million for the first six months of fiscal year 2009, a decrease of $50.2 million or 95.4% over the same period in fiscal year Other nonoperating gains of $2.4 million were recorded for the first six months of fiscal year 2009, compared to gains of $12.0 million for the same period in fiscal year 2008, primarily due to the write-down of BHCS equity investment in Children's Medical Center of Dallas ( CMC ). The joint membership agreement relating to CMC was terminated effective June 30, 2008 and the investment in CMC was written down to zero with a corresponding adjustment in nonoperating (losses) gains as of June 30, Equity in earnings of unconsolidated entities relating to BHCS investment in CMC was approximately $7.1 million for the first six months ended December 31, Utilization Statistics BHCS derives its patient revenue from managed care companies, Medicare, Medicaid, commercial insurers, self paying patients and other sources. Self pay and other sources include workers compensation, CHAMPUS, and other government programs. The following table approximates the percentages of both gross and net patient revenue by payor based on available information: Gross Patient Revenue Payor Mix Audited June 30, December 31, Medicare 39.0% 38.8% 37.8% 38.4% Medicaid (including Medicaid Managed Care) 7.2% 7.8% 7.3% 8.0% Managed Care/Commerical Insurance 45.0% 44.2% 45.1% 44.1% Self Pay and Other 8.8% 9.2% 9.8% 9.5% 100.0% 100.0% 100.0% 100.0% Net Patient Revenue Payor Mix Audited June 30, December 31, Medicare 31.5% 29.1% 28.9% 28.4% Medicaid (including Medicaid Managed Care) 6.0% 6.0% 5.4% 6.6% Managed Care/Commerical Insurance 59.9% 62.7% 63.9% 62.6% Self Pay and Other 2.6% 2.2% 1.8% 2.4% 100.0% 100.0% 100.0% 100.0% 5

8 Quarterly Disclosure Report for December 31, 2008 Adult and Pediatric Operating Beds December 31, 2008 Baylor All Saints Medical Centers (includes two Fort Worth Hospitals) 421 Baylor Heart and Vascular Hospital 64 Baylor Institute for Rehabilitation 87 Baylor Medical Center at Garland 214 Baylor Medical Center at Irving 202 Baylor Medical Center at Waxahachie 57 Baylor Regional Medical Center at Grapevine 218 Baylor Regional Medical Center at Plano 104 Baylor Specialty Hospital 61 Baylor University Medical Center 838 Our Children's House 55 The Heart Hospital Baylor Plano 68 Total 2,389 Liquidity Unrestricted cash and investments (excluding (loss) gain on trading investments, net, and unrealized (loss) gain on investments from other than trading securities totaling approximately ($263.8) million) increased by $54.9 million after capital expenditures of $95.8 million since June 30, The debt to capitalization ratio increased from 34.5% to 36.8% for the six months ended December 31, 2008 as compared to June 30, 2008, as total assets decreased 5.9% to $3,529.1 million from June 30, Unrestricted days cash on hand decreased from at June 30, 2008 to days as of December 31, Including restricted funds, days cash on hand totaled days at June 30, 2008, compared to days at December 31, The decrease in total days cash on hand was driven primarily by the capital expenditures mentioned above as well as unrealized investment income related to the ongoing issues in the financial markets. Cash and Investments (1), (2), (3) ($ Thousands) Audited June 30, December 31, Cash and short-term investments $ 171,626 $ 148,463 $ 124,936 $ 156,692 Long-term investments Unrestricted 1,032,965 1,054,519 1,058, ,383 Restricted 193, , , ,576 Investments of insurance operations (2), (3) 106,516 69, ,911 75,492 Funds held by trustee 73,197 19,078 43,607 3,105 Total $ 1,578,302 $ 1,482,784 $ 1,535,647 $ 1,225,248 (1) Baylor maintains an invesment policy that governs all investment assets. Current policy allocations for assets are 45% equity, 46% fixed income and cash, and 9% Hedge Funds. (2) FY2007 have been restated to conform with the FY2008 audit. (3) December 31, 2007 and 2008 includes $119,812 and $72,603, respectively, in self insurance trust (reflected in assets whose use is limited on the balance sheet) and $3,099 and $2,889 respectively, in insurance subsidiaries. 6

9 Quarterly Disclosure Report for December 31, 2008 Foundations Net Assets December 31, 2008 The Baylor Health Care System Foundation and the All Saints Health Foundation foster support from the Dallas and Fort Worth metroplex to further Baylor's mission within the communities they serve. Net assets of the Foundations are as follows: Value of Foundations Net Assets ($ Thousands) Audited June 30, December 31, Unrestricted $ 70,947 $ 60,199 $ 68,652 $ 35,692 Temporary Restricted 105,193 93, ,848 77,434 Permanently Restricted 118, , , ,368 Total $ 295,124 $ 281,404 $ 297,378 $ 237,494 7

10 Quarterly Disclosure Report for December 31, 2008 Baylor Health Care System Combined Balance Sheets ($ Thousands) Audited June 30, December 31, 2007* * 2008 Assets Cash and cash equivalents $ 127,763 $ 104,055 $ 56,878 $ 120,077 Short-term investments 43,863 44,408 68,058 36,615 Accounts receivable, net 421, , , ,295 Assets held as collateral-securities lending program 131, , ,120 64,901 Other current assets 55,536 59,883 58,323 66,835 Total current assets 780, , , ,723 Long-term investments 1,226,963 1,245,420 1,244, ,959 Assets whose use is limited 183,534 92, ,343 81,417 Property and equipment, net 1,278,180 1,454,452 1,350,756 1,465,219 Contributions receivable, net 36,684 39,789 34,319 38,918 Investments of insurance subsidiary 3,005 3,156 3,099 2,889 Interest in related foundation 10,832 10,037 10,833 9,946 Other assets 302, , , ,071 Total assets $ 3,821,687 $ 3,748,907 $ 3,884,624 $ 3,529,142 Liabilities and Net Assets Current liabilities $ 435,917 $ 430,331 $ 406,150 $ 400,149 Long-term debt, less current maturities 831, , , ,060 Payable under securities lending program 131, , ,120 64,901 Other liabilities 342, , , ,286 Total liabilities 1,740,822 1,714,744 1,731,013 1,721,396 Net assets: Unrestricted 1,658,568 1,599,604 1,719,678 1,404,618 Temporarily restricted 302, , , ,025 Permanently restricted 119, , , ,103 Total net assets 2,080,865 2,034,163 2,153,611 1,807,746 Total liabilities and net assets $ 3,821,687 $ 3,748,907 $ 3,884,624 $ 3,529,142 *FY2007 have been restated to conform with the FY2008 audit 8

11 Quarterly Disclosure Report for December 31, 2008 Baylor Health Care System Combined Statements of Operations ($ Thousands) Audited June 30, December 31, 2007* * 2008 Operating Revenue Net patient care revenue $ 2,686,684 $ 2,966,709 $ 1,436,928 $ 1,587,780 Other operating revenue 128, ,756 56,413 56,863 Net assets released from restrictions for operations 33,667 42,399 19,422 19,024 Total operating revenue 2,848,717 3,110,864 1,512,763 1,663,667 Operating Expenses Salaries, wages, and employee benefits 1,254,059 1,387, , ,369 Supplies & other operating expenses 1,018,883 1,093, , ,826 Bad debt expense 176, , , ,653 Depreciation and amortization 149, ,062 80,480 88,246 Interest expense 32,689 39,432 20,450 21,976 Total operating expenses 2,631,493 2,906,492 1,441,756 1,557,070 Income from operations 217, ,372 71, ,597 Nonoperating Gain (Loss) (Loss) gain on trading investments, net 149,362 (48,106) 13,142 (239,763) Other nonoperating gain (loss) 20,338 (127,003) 17,868 2,413 Loss from extinguishment of debt - (4,678) - - Income tax benefit (expense) (948) (6,852) (2,288) (3,184) Excess (deficit) of revenues over expenses before minority interest 385,976 17,733 99,729 (133,937) Less minority interest 65,213 79,037 34,233 52,093 Excess (deficit) of revenues over expenses 320,763 (61,304) 65,496 (186,030) Other changes in unrestricted net assets (10,593) 2,340 (4,386) (8,956) Increase (decrease) in unrestricted net assets 310,170 (58,964) 61,110 (194,986) Temporarily Restricted Net Assets Contributions 41,636 43,263 18,616 23,903 Investment income, net of unrealized gains (losses) 15,745 (1,404) 2,667 (19,224) Net assets released for operations (33,667) (42,399) (19,422) (19,024) Transfer of Irving net assets from unrestricted net assets 37,760 17,934 8,997 (11,935) Other (7,868) (15,666) (2,238) (2,287) Increase (decrease) in temporarily restricted net assets 53,606 1,728 8,620 (28,567) Permanently Restricted Net Assets Contributions 3,095 7,541 2, Investment income, net of unrealized gains (losses) 4,595 (1,170) 398 (3,523) Other (3,649) 4, (82) Increase (decrease) in permanently restricted net assets 4,041 10,534 3,016 (2,864) Increase (decrease) in net assets 367,817 (46,702) 72,746 (226,417) Net assets, beginning of year 1,713,048 2,080,865 2,080,865 2,034,163 Net assets, end of year $ 2,080,865 $ 2,034,163 $ 2,153,611 $ 1,807,746 *FY2007 have been restated to conform with the FY2008 audit 9

12 Quarterly Disclosure Report for December 31, 2008 Baylor Health Care System Combined Statements of Cash Flows ($ Thousands) Audited Fiscal Year Ended June 30, December 31, Cash Flows From Operating Activities: 2007* * 2008 Increase (decrease) in net assets $ 367,817 $ (46,702) $ 66,869 $ (226,417) Adjustments to reconcile increase (decrease) in net assets to net cash provided by operating activities: Loss from extinguishment of debt - 4, Unrealized (gain) loss on investments (82,967) 147,403 44, ,644 Restricted contributions received (11,064) (8,405) (20,871) (24,644) Bad Debt expense 176, , , ,653 Depreciation and amortization 149, ,062 80,480 88,246 Children's Medical Center write-off and equity earnings (16,207) 142,930 (5,877) - Loss on sale of assets, net 185 4,051 1, Change in value of split-interest agreements (3,212) (3,245) (690) (329) Deferred rent 2,240 6,154 1,120 3,078 Changes in operating assets and liabilities (net of acquisition): Increase in net patient accounts receivable (205,582) (230,559) (120,568) (128,733) (Increase) decrease in other accounts receivable (29,455) 38,074 (19,810) (40,632) Increase in trading investments (54,288) (173,069) (85,046) (26,714) Increase (decrease) in interest in net assets of related foundation (859) 795 (1) 91 (Increase) decrease in other assets (18,409) (29,001) 9,833 (31,170) Increase (decrease) in trade accounts payable and accrued liabilities 66,558 (14,109) (47,176) (29,213) (Decrease) increase in other liabilities (7,273) 14,163 43, ,441 Net cash provided by operating activities 333, ,170 59,685 79,900 Cash Flows From Investing Activities: Purchases of property and equipment, net (309,317) (338,631) (142,986) (95,783) Cash proceeds from sales of assets, net of selling expense 2,615 3, Net assets acquired - THVG, net of cash acquired (23,449) (6,331) (16,244) - (Increase) decrease in other than trading investments (13,517) 9,909 2,432 21,653 Decrease (increase) in investments of insurance subsidiaries 1,351 (151) (94) 267 Decrease in assets whose use is limited 66,334 91,368 13,191 10,749 Net cash used in investing activities (275,983) (240,663) (143,701) (63,114) Cash Flows From Financing Activities: Principal payments on long-term debt (35,992) (263,357) (20,211) (28,617) Proceeds from issuance of long-term debt 14, ,737 12,471 3,209 Proceeds from restricted contributions 11,064 8,405 20,871 24,644 Net cash (used in) provided by financing activities (9,956) (22,215) 13,131 (764) Net Increase (Decrease) In Cash And Cash Equivalents 47,407 (23,708) (70,885) 16,022 Cash And Cash Equivalents, beginning of year 80, , , ,055 Cash And Cash Equivalents, end of year $ 127,763 $ 104,055 $ 56,878 $ 120,077 *FY2007 have been restated to conform with the FY2008 audit 10

13 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying unaudited combined financial statements are prepared on the accrual basis of accounting in accordance with the U.S. generally accepted accounting principles. They do not include all of the information and notes required by United States generally accepted accounting principles for complete financial statements of Baylor Health Care System ( the System ). Eliminations and reporting adjustments have been made to present the information in accordance with United States generally accepted accounting principles. The data should be read in conjunction with the audited combined financial statements for the fiscal years ended June 30, 2008 and Information for the six months ended December 31, 2008 and 2007 is not based upon audited information but, in the opinion of management, is presented on a basis consistent with the audited combined financial statements and includes adjustments consisting of normal recurring adjustments necessary for a fair presentation therein. The results of operations for the six months ended December 31, 2008 are not necessarily indicative of the operating results to be expected for the entire fiscal year ending June 30, The combined balance sheet at June 30, 2008 has been derived from the audited combined financial statements at that date, but does not include all of the information and notes required by United States generally accepted accounting principles for complete financial statements. SIGNIFICANT ACCOUNTING POLICIES Cash and Cash Equivalents Cash equivalents are defined as investments which have original maturities of three months or less. Cash equivalents consist primarily of securities issued by the United States government or its agencies, certificates of deposit, commercial paper and overseas investments. Investments The System has designated all of its investments as trading except for those investments held at the Baptist Foundation of Texas (BFT) for the benefit of Baylor Health Care System Foundation, which have been designated as other than trading. For all trading investments, the interest and dividends, realized and unrealized (losses) gains are included in (loss) gain on trading investments, net, in the accompanying statements of operations and changes in net assets. For other than trading, interest and dividends and realized (losses) gains are included in (loss) gain on trading investments, net, unless restricted by donor or law. Unrealized (losses) and gains, net, for other than trading investments are included in other changes in unrestricted net assets, also unless restricted by donor or law. 11

14 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 As of December 31, 2008 Interest and Dividends Unrealized and Realized gains gains (losses) Total (in thousands) Nonoperating gains (losses) $ 2,426 $ (242,189) $ (239,763) Other changes in unrestricted net assets - (21,653) (21,653) Changes in temporarily restricted net assets 3,618 (22,842) (19,224) Changes in permanently restricted net assets 98 (3,621) (3,523) $ 6,142 $ (290,305) $ (284,163) As of December 31, 2007 Interest and Dividends Unrealized and Realized gains gains (losses) Total (in thousands) Nonoperating gains (losses) $ 52,654 $ (39,512) $ 13,142 Other changes in unrestricted net assets - (2,432) (2,432) Changes in temporarily restricted net assets 3,565 (898) 2,667 Changes in permanently restricted net assets 1,867 (1,469) 398 $ 58,086 $ (44,311) $ 13,775 12

15 Securities Lending Program BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 The System participates in securities lending transactions with The Northern Trust Company, investment custodian, whereby a portion of its investments is loaned to selected established brokerage firms in return for cash and securities from the brokers as collateral for the investments loaned, usually on a short-term basis of 30 to 60 days. Collateral provided by brokers is maintained at levels approximating 103% of the fair value of the securities on loan and is adjusted for daily market fluctuations. Cash collateral received in connection with these loans is invested in a short-term pooled fund maintained by the lending agent. As of December 31, 2008 and June 30, 2008, the market value of securities on loan was $65,757,000 and $111,728,000, respectively, and is included in long-term investments in the accompanying combined balance sheets. The market value of collateral held for loaned securities was $64,901,000 and $117,120,000 as of December 31, 2008 and June 30, 2008, respectively, and is reported as assets held as collateral securities lending program. This collateral is reported as a payable under securities lending program in the accompanying combined balance sheets to reflect the System s obligation to repay the collateral upon settlement of the lending transactions. Net Patient Care Revenue Federal Regulations require the submission of annual cost reports covering medical costs and expenses associated with services provided to program beneficiaries. Medicare and Medicaid cost report settlements are estimated in the period services are provided to beneficiaries. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation. As a result, there is a reasonable possibility that recorded estimates may change by a material amount as interpretations are clarified and cost reports are settled. These initial estimates are revised as needed until the final cost report is settled. During the six months ended December 31, 2008 and 2007, certain of the System s prior year third-party cost reports were audited and settled, or tentatively settled, by third-party payors. Adjustments resulting from such audits and management reviews are reflected as adjustments to revenue in the period that the adjustment becomes known. The effect of cost report settlements was a decrease of $2,817,000 and an increase of $6,394,000 in net patient care revenue for the six months ended December 31, 2008 and 2007, respectively. Income Taxes Due to their organizational structure, certain of the System s entities are taxable under the Internal Revenue Code or are required to pay taxes for unrelated business activity. The overall impact of taxes to the System s combined financial statements is not significant. During May 2006, significant changes were made to the current Texas franchise tax, including but not limited to, modifications to the tax base and tax rate which now applies to most legal entities including partnerships. The Texas franchise tax now applies to certain of the System's entities for any tax reports filed on or after January 1, Under the new law, the tax is 13

16 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 calculated on a margin base and is therefore reflected in the System s statements of income for the six months ended December 31, 2008 and 2007 as income tax expense. In July 2006, the Financial Accounting Standards Board issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes- an interpretation of FASB Statement No. 109, Accounting for Income Taxes, or FIN 48, which is effective for the fiscal years beginning after December 15, FIN 48 creates a single model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Under the requirements of FIN 48, tax-exempt organizations could be required to record an obligation as the result of a tax position they have historically taken on various tax exposure items. Prior to FIN 48, the determination of when to record a liability for a tax exposure was based on whether a liability was considered probable and reasonably estimable in accordance with FASB Statement No. 5, Accounting for Contingencies. On July 1, 2007, the System adopted FIN 48. The cumulative effect of initially applying FIN 48 of $1,607,000 has been recognized as a change in accounting principle in the accompanying combined statements of operations and changes in net assets for the six months ending December 31, Contributions and Gifts When received or pledged, unrestricted gifts are reported as contributions, and donor-restricted items are reported as contributions to temporarily or permanently restricted net assets. These donor-restricted contributions are restricted as to use and, when applicable, are transferred from temporarily restricted net assets to unrestricted net assets when the restrictions are satisfied. Interest in Net Assets of Related Foundation The System accounts for its interest in the Irving Healthcare Foundation under Statement of Financial Accounting Standards No. 136, Transfers of Assets to a Not-For-Profit Organization or Charitable Trust That Raises or Holds Contributions for Others, or SFAS No The Irving Healthcare Foundation is a separate and distinct legal entity that is controlled by its own Board of Directors, and is not controlled by Irving, BHCS, or their Boards of Trustees. The information is being disclosed for financial reporting purposes only, in accordance with SFAS No In April 2003, the American Institute of Certified Public Accountants issued a Technical Practice Aid (TPA) for the implementation of SFAS No The TPA requires a not-for-profit organization to determine whether it can influence the financial decisions of a foundation to the extent that it can determine the timing and the amount of distributions from a foundation to a not-for-profit organization. The System made the determination that the Irving Healthcare Foundation ultimately determines the timing and the amount of the distributions thus the System s interest in the net assets of the Irving Healthcare Foundation have been classified as temporarily or permanently restricted. Nothing herein is intended to expose the assets of the Irving Healthcare Foundation to the creditors of the System. The System s interest in the Irving 14

17 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 Healthcare Foundation is approximately $9,946,000 and $10,037,000 at December 31, 2008 and June 30, 2008, respectively. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Accounting Pronouncements In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements, or SFAS 157, which became effective for fiscal years beginning after November 15, This statement provides a single definition of fair value, establishes a framework for measuring fair value, and expanded disclosures concerning fair value measurements. In February 2008, the FASB agreed to a oneyear deferral of the effective date for nonfinancial assets and liabilities that are recognized or disclosed at fair values in the financial statements on a nonrecurring basis. The System adopted the provisions of SFAS 157 on July 1, The adoption did not have a material impact on the System s results of operations or financial position. See Note 3, Fair Value Measurements, for information about assets and liabilities measured at fair value. The System does not expect that the adoption of the provisions for other nonfinancial assets or liabilities will have a material impact on the results of operations or financial position. In February 2007, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, or SFAS 159, which is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. The statement permits entities to choose to measure many financial instruments and certain other items at fair value. The unrealized gains and losses on items for which the fair value option has been elected would be reported in earnings. The objective of SFAS 159 is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The System adopted SFAS 159 on July 1, Since the System has not utilized the fair value option for any allowable items, the adoption of SFAS 159 did not have a material impact on the System s results of operations or financial position. However, in the future, the System may elect to measure certain financial instruments at fair value in accordance with this standard. In December 2007, the Financial Accounting Standards Board issued Statement No. 141R, Business Combinations, or SFAS 141R, which broadens the guidance of SFAS No. 141, extending its applicability to all transactions and other events in which one entity obtains control over one or more other businesses. It broadens the fair value measurement and recognition of 15

18 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 assets acquired, liabilities assumed, and interests transferred as a result of business combinations; and stipulated that acquisition related costs be expensed rather than included as part of the basis of the acquisition. SFAS 141R expands required disclosures to improve the ability to evaluate the nature and financial effects of business combinations. SFAS 141R is effective for all transactions entered into, on or after January 1, The System has not evaluated all of the provisions of SFAS 141R, but does not anticipate a material impact on the results of operations or financial position from the adoption of SFAS 141R and will be effected by the level of transactions and acquisitions entered into by the System. In December 2007, the Financial Accounting Standards Board issued Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements an amendment of ARB No. 51, or SFAS 160, which is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, SFAS 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the financial statements within the equity section but separate from the company s equity. It also requires the amounts of consolidated net income attributable to the parent and to the noncontrolling interest to be clearly identified and presented on the face of the consolidated statement of operations; changes in ownership interest to be accounted for as equity transactions; and when a subsidiary is deconsolidated, any retained non-controlling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary must be measured at fair value. The System has not evaluated all of the provisions of SFAS 160, but does not anticipate a material impact on the results of operations or financial position from the adoption of SFAS 160. In March 2008, the Financial Accounting Standards Board issued Statement No. 161, "Disclosure about Derivative Instruments and Hedging Activities-an amendment of FASB statements No. 133, or SFAS 161, which is effective for fiscal years beginning after January 1, SFAS 161 provides revised guidance for enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133, and how derivative instruments and the related hedged items affect entity's financial position, financial performance and cash flows. The System has not evaluated all of the provisions of SFAS 161, but does not anticipate a material impact on the results of operations or financial position from the adoption of SFAS 161. In August 2008, the Financial Accounting Standards Board issued Staff Position No , Endowments of Not-for-Profit Organizations: Net Asset Classification of Funds Subject to an Enacted Version of the Uniform Prudent Management of Institutional Funds Act, and Enhanced Disclosures for All Endowment Funds, or FSP 117-1, which is effective for fiscal years ending after December 15, FSP provides guidance on the net asset classification of funds that are subject to an enacted version of the Uniform Prudent Management of the Institutional Funds Act of 2006 (UMIFA). UPMIFA is a model act approved by the Uniform Law Commission that serves as a guideline for states to use in enacting legislation. FSP enhances disclosures about an organization s endowment funds (both donor-restricted 16

19 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 endowment funds and board-designated endowment funds), whether or not the organization is subject to UPMIFA. Under FSP 117-1, a not-for-profit organization shall disclose information to enable users of financial statements to understand the net asset classification, net asset composition, changes in net asset composition, spending policies and related investment policies of its endowment funds (both donor-restricted and board-designated). The System has not evaluated all of the provisions of FSP 117-1, but does not anticipate a material impact on the results of operations or financial position from the adoption of FSP Other Certain reclassifications were made to the financial statements for the six months ended December 31, 2007 to conform to the 2008 audit presentation. Reclassifications were made to the combined statements of operations and changes in net assets and were the result of reclassing realized investment income from operations to gain (loss) on trading investments, net, to conform with industry practices. 3. FAIR VALUE MEASUREMENTS The System adopted the methods of measuring fair value described in SFAS 157 on July 1, As defined in SFAS No. 157, fair value is based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, SFAS 157 establishes a three-tier fair value hierarchy for disclosure of fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows: Level 1 Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 Level 3 Inputs to the valuation methodology include quoted prices for similar assets or liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Inputs to the valuation methodology are unobservable and significant to the fair value measurement. A financial instrument s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The carrying amount reported in the combined balance sheets for cash and cash equivalents approximates its fair value which is based on quoted market prices or Level 1. 17

20 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 Fair values of short-term investments, long-term investments, assets limited as to use, and investments of insurance subsidiaries are generally based on quoted market prices. This valuation methodology represents Level 1 and applies to investments such as domestic equities, U.S. treasuries, exchange-traded mutual funds, and agency securities and is measured on a recurring basis. The investments in marketable alternative investments are valued by management at fair value utilizing the net asset valuation provided by the underlying investment companies unless management determines some other valuation is more appropriate. Alternative investments are comprised of private equity investments, real estate investments and hedge funds, collectively referred to as alternative investments, and are included in long-term investments in the accompanying combined balance sheets. This valuation methodology represents Level 3 and is measured on a recurring basis. Substantially all of the System s endowment funds investments and certain temporarily restricted assets are held in trust by the Baptist Foundation of Texas (BFT) and are included in long-term investments in the accompanying combined balance sheets. A significant portion of these investments is held in collective investment funds. Collective investment funds are assets of eligible trust accounts that are pooled to achieve greater diversification of investments and to provide stability of income and/or to satisfy other investment objectives. Fair value of these funds is determined by the custodian based on quoted market prices thus are considered Level 1 and are measured on a recurring basis. For charitable gift annuities, the donor transfers assets to the Foundation, and in return, the Foundation agrees to pay a certain dollar amount to designated beneficiaries for life. The Foundation records the assets at fair market value based on quoted market prices and are included in long-term investments in the accompanying combined balance sheets and are measured on a recurring basis thus are considered Level 1. Under various interest rate swap agreements, the System pays a fixed rate and receives a percentage of LIBOR. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. To comply with the provisions of SFAS 157, the System incorporates credit valuation adjustments to reflect both the System s nonperformance risk and the respective counterparty s nonperformance risk in the fair value measurements. Although the System has determined that the majority of the inputs used to value derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with derivatives utilize Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by the System and its counterparties. However, as of December 31, 2008, the System assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivative positions and has determined that the credit valuation adjustments are not significant 18

21 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 to the overall valuation of the derivatives. As a result, the System determined that its derivative valuations in their entirety apply to the Level 2 fair value hierarchy and are measured on a recurring basis. The System holds a beneficial interest in the net assets of the Irving Healthcare Foundation. The fair value of the net assets is based on the present value of the estimated future cash receipts from the Irving Healthcare Foundation s net assets. The System does not have access to any existing markets in which its beneficial interests could be bought or sold. As there is no principal or most advantageous market, the fair value hierarchy Level 3 applies to the interest in net assets of the Irving Healthcare Foundation and is measured on a recurring basis. The table below sets forth, by level, the financial assets and liabilities that were accounted for at fair value as of December 31, The table does not include cash and cash equivalents, shortterm investments, excluding alternative investments, assets held as collateral securities lending program, restricted investments, assets whose use is limited and investments of insurance subsidiaries as they are measured on quoted market prices and are categorized as Level 1 assets. The table also does not include assets and liabilities that are measured at historical cost or any basis other than fair value. Assets and Liabilities Measured at Fair Value on a Recurring Basis Total Level 2 Level 3 Assets: Long-term investments alternative investments $ 219,564 $ - $ 219,564 Interest in net assets of related foundation 9,946-9,946 Total assets at fair value $ 229,510 $ - $ 229,510 Liabilities: Interest rate swap agreements $ 111,291 $ 111,291 $ - Total liabilities at fair value $ 111,291 $ 111,291 $ - 19

22 BAYLOR HEALTH CARE SYSTEM Notes to Combined Financial Statements (Unaudited) For the Six Months Ended December 31, 2008 The following table is a roll forward of the financial instruments classified by the System within Level 3 of the valuation hierarchy defined above: Level 3 Fair value June 30, 2008 $ 235,896 Realized and unrealized gains 5,203 Unrealized losses (21,572) Purchases, issuances, and settlements, net 10,075 Other (92) Fair value December 31, 2008 $ 229, RETIREMENT BENEFITS Effective January 1, 2002, a 401(k) defined contribution plan administered by ING was made available to all eligible employees. Employees are eligible to contribute to the plan immediately with no minimum service or age requirement. The System matches amounts contributed by employees, up to five percent of the employee s base compensation. Employees vest in the System s matching contribution over five years. Retirement benefits equal the amounts accumulated to the employee's individual credit at the date of retirement. Prior to January 1, 2002, the System offered a 403(b) defined contribution plan through a contract administered by the Annuity Board of the Southern Baptist Convention to all eligible employees. Employees were eligible to participate in the 403(b) plan immediately. The System matched contributions of up to five percent of the employee s base compensation beginning after one year of continuous service during which the employee was credited with 1,000 or more hours of service, as defined. Retirement benefits under the 403(b) contract equal the amounts accumulated to the employee's individual credit at the date of retirement. On December 31, 2001, the System froze the 403(b) defined contribution plan to discontinue all future employee and employer contributions to this plan. Two defined contribution retirement plans administered by ING were provided for employees of All Saints Health System prior to the purchase by the System. These plans were frozen to employee and employer future contributions as of January 1, 2002, with the purchase by the System and all accounts were immediately vested. All Saints Health System employees now participate in the plans offered through the System. 20