S PECIAL P URPOSE C OMBINED F INANCIAL S TATEMENTS AND S PECIAL P URPOSE C OMBINING I NFORMATION

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1 S PECIAL P URPOSE C OMBINED F INANCIAL S TATEMENTS AND S PECIAL P URPOSE C OMBINING I NFORMATION Years Ended December 31, 2008 and 2007 With Report of Independent Auditors

2 Special Purpose Combined Financial Statements and Special Purpose Combining Information Years Ended December 31, 2008 and 2007 Contents Report of Independent Auditors...1 Special Purpose Combined Balance Sheets...3 Special Purpose Combined Statements of Operations and Changes in Net Assets...4 Special Purpose Combined Statements of Cash Flows...5 Notes to Special Purpose Combined Financial Statements...6 Special Purpose Combining Information Special Purpose Combining Balance Sheets...32 Special Purpose Combining Statements of Operations and Changes in Net Assets...36

3 Ernst & Young LLP 99 Wood Avenue South P.O. Box 751 Iselin, New Jersey The Board of Trustees RWJ Health Care Corp. at Report of Independent Auditors We have audited the accompanying special purpose combined balance sheets of RWJ Health Care Corp. at Obligated Group (the Obligated Group ) as of December 31, 2008 and 2007, and the related special purpose combined statements of operations and changes in net assets and cash flows for the years then ended. These financial statements are the responsibility of the Obligated Group s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Obligated Group s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Obligated Group s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1, the accompanying special purpose combined financial statements were prepared for the purpose of complying with the Loan Agreement between the New Jersey Health Care Facilities Financing Authority and the Obligated Group dated July 1, 2005, and are not intended to be a presentation in conformity with U.S. generally accepted accounting principles. In our opinion, the financial statements referred to above present fairly, in all material respects, the combined financial position of as of December 31, 2008 and 2007, and the combined results of their operations and changes in net assets, and their combined cash flows for the years then ended on the basis of accounting described in Note 1. Our audits were conducted for the purpose of forming an opinion on the special purpose combined financial statements taken as a whole. The accompanying special purpose combining information, prepared on the basis of accounting described in Note 1, is presented for purposes of additional analysis and is not a required part of the special purpose combined financial A member firm of Ernst & Young Global Limited 1

4 statements. The special purpose combining information has been subjected to the auditing procedures applied in the audits of the special purpose combined financial statements and, in our opinion, is fairly stated in all material respects in relation to the special purpose combined financial statements taken as a whole. This report is intended solely for the information and use of the Board of Trustees and management of RWJ Health Care Corp. at, the New Jersey Health Care Facilities Financing Authority, Financial Security Assurance, Inc., Radian Assurance Inc. and TD Bank and is not intended to be and should not be used by anyone other than these specified parties. May 29, 2009 ey 2

5 Special Purpose Combined Balance Sheets December Assets Current assets: Cash and cash equivalents $ 17,285,708 $ 13,598,979 Short-term investments 7,279,947 2,977,985 Assets whose use is limited - current portion 5,554,712 5,477,282 Patient accounts receivable, net of allowance for doubtful accounts of $11,119,000 in 2008 and $10,472,000 in ,390,430 29,747,243 Due from affiliates 919, ,077 Prepaids and other current assets 5,736,855 5,995,177 Total current assets 66,166,742 58,682,743 Long-term investments 18,912,524 26,010,428 Assets whose use is limited, less current portion 9,859,391 11,812,244 Property and equipment, net 130,432, ,722,515 Deferred financing costs 4,735,620 5,061,964 Investment in MSO 397, ,647 Assets held by related organization 927,329 2,039,838 Other assets 422, ,747 Total assets $ 231,853,462 $ 240,209,126 Liabilities and net assets Current liabilities: Current installments of long-term debt $ 2,747,564 $ 2,763,345 Accounts payable and accrued expenses 33,306,905 31,343,541 Estimated amounts due to third-party payors 2,008,494 1,089,078 Due to affiliates 590, ,120 Accrued interest payable 1,574,657 1,641,868 Total current liabilities 40,227,634 37,530,952 Estimated amounts due to third-party payors 11,579,098 11,028,344 Long-term debt, excluding current installments 119,526, ,178,598 Other liabilities 1,034,819 1,626,000 Total liabilities 172,368, ,363,894 Commitments and contingencies Net assets: Unrestricted 58,557,756 64,805,394 Temporarily restricted 927,329 2,039,838 Total net assets 59,485,085 66,845,232 Total liabilities and net assets $ 231,853,462 $ 240,209,126 See accompanying notes. 3

6 Special Purpose Combined Statements of Operations and Changes in Net Assets Year Ended December Revenue: Net patient service revenue $ 212,550,799 $ 206,730,521 Other revenue 3,562,147 6,700,123 Net assets released from restrictions for operations 835,000 Total revenue 216,947, ,430,644 Expenses: Salaries and wages 93,833,238 90,625,723 Physicians fees 6,753,673 6,384,521 Employee benefits 20,812,373 19,059,228 Supplies and other 75,241,070 74,785,543 Interest 5,504,418 5,252,010 Depreciation and amortization 10,025,910 8,459,932 Provision for doubtful accounts, net 8,169,246 8,205,113 Total expenses 220,339, ,772,070 (Deficiency) excess of revenue over expenses (3,391,982) 658,574 Other changes in unrestricted net assets: Change in net unrealized gains and losses on non-trading investments (3,655,656) (385,252) Net asset transfer from affiliates 800,000 1,264,500 (Decrease) increase in unrestricted net assets (6,247,638) 1,537,822 Unrestricted net assets at beginning of year 64,805,394 63,267,572 Unrestricted net assets at end of year $ 58,557,756 $ 64,805,394 Change in net assets held by related organization $ (277,509) $ 156,340 Net assets released from restrictions for operations (835,000) Total change to temporarily restricted net assets (1,112,509) 156,340 Temporarily restricted net assets at beginning of year 2,039,838 1,883,498 Temporarily restricted net assets at end of year $ 927,329 $ 2,039,838 See accompanying notes. 4

7 Special Purpose Combined Statements of Cash Flows Year Ended December Cash flows from operating activities (Decrease) increase in net assets $ (7,360,147) $ 1,694,162 Adjustments to reconcile (decrease) increase in net assets to net cash provided by operating activities: Depreciation and amortization 10,025,910 8,459,932 Amortization of deferred financing costs 326, ,098 Provision for doubtful accounts, net 8,169,246 8,205,113 Amortization of premium on long-term debt (104,208) (129,064) Change in net unrealized gains and losses on non-trading investments 3,655, ,252 Change in net unrealized gains and losses on trading investments 105, ,322 Change in equity on alternative investments (1,437,175) 484,112 Realized gains on investments 1,486,581 (758,560) Net loss (gain) on investment in MSO 119,570 (245,015) Net asset transfers from affiliates (800,000) (1,264,500) Changes in operating assets and liabilities: Patient accounts receivable (7,812,433) (9,988,414) Due from/to affiliates, net (136,119) (882,995) Assets held by related organization 1,112,509 (156,340) Investment portfolio classified as trading 1,001,982 (723,763) Other assets 198,403 (977,487) Accounts payable and accrued expenses 1,963,364 3,719,404 Accrued interest payable (67,211) (15,952) Estimated amounts due to third-party payors 1,470, ,083 Other liabilities (591,181) 676,000 Net cash provided by operating activities 11,326,857 9,797,388 Cash flows from investing activities Net (purchase) sale of investments and assets whose use is limited (141,275) 17,269,298 Purchases of property, plant, and equipment (4,735,508) (23,383,438) Retainage payable (2,066,456) Net cash used in investing activities (4,876,783) (8,180,596) Cash flows from financing activities Payments on long-term debt and short-term borrowings (3,563,345) (944,643) Net asset transfers from affiliates 800,000 1,264,500 Net cash (used in) provided by financing activities (2,763,345) 319,857 Net increase in cash and cash equivalents 3,686,729 1,936,649 Cash and cash equivalents at beginning of year 13,598,979 11,662,330 Cash and cash equivalents at end of year $ 17,285,708 $ 13,598,979 Supplemental disclosure of cash flow information Cash paid during the year for interest $ 5,316,642 $ 5,564,936 See accompanying notes. 5

8 Notes to Special Purpose Combined Financial Statements December 31, Organization and Summary of Significant Accounting Policies Organization (the Obligated Group ) prepares special purpose combined financial statements for the purpose of complying with the Loan Agreement between the New Jersey Health Care Facilities Financing Authority (the Authority ) and the Obligated Group dated July 1, 2005 and the Reimbursement Agreement (the Agreements ) between Commerce Bank and the Obligated Group dated July 1, The Agreements allow for Financial Security Assurance, Inc., Radian Asset Assurance Inc. and TD Bank to request additional information such as the preparation of special purpose combined financial statements of the Obligated Group members; accordingly, the accompanying special purpose combined financial statements and related disclosures include only the accounts of RWJ Health Care Corp. at ( RWJHCCH ) and Johnson University Hospital at and Subsidiaries (the Hospital ), in addition to the entities identified below. The Hospital is a not-forprofit, tax-exempt wholly owned subsidiaries of RWJHCCH. The combination of financial statements for only certain entities within a controlled organization differs from U.S. generally accepted accounting principles which would require a consolidation of all of the related entities under common control. RWJHCCH s other subsidiaries which are not included in these special purpose combined financial statements, include: Johnson University Hospital at Foundation, Inc. (the Foundation ), Lakeview Child Center, Inc. ( Lakeview ) and RWJ Medical Services Organization at, Inc. (the RWJ MSO ). All intercompany balances and transactions relating to the combined entities have been eliminated in combination. OB/GYN Associates P.A. is an extension of the Hospital s OB/GYN practice whose office is located in Township. The Hospital has a controlling financial interest over the decisions and operations of the practice and has included its financial position and operating results in these combined financial statements. RWJ Medical Associates at, P.A. was a primary care physician practice owned and operated by an employee of the hospital. The Hospital had a controlling interest over the decisions and operations of the practice and has included its financial position and operating results in the accompanying consolidated financial statements. RWJ Medical Associates at, P.A. discontinued operations on December 1,

9 1. Organization and Summary of Significant Accounting Policies (continued) During 2007, the Hospital acquired RWJ Diabetes & Endocrinology Group, P.A., a for-profit, wholly-owned organization of the Hospital located in Township. As part of the mission to meet the health care needs of the community, this practice provides diabetes, endocrinology and related services. The Hospital has a controlling financial interest over the decisions and operations of the practice and has included its financial position and operating results in these combined financial statements. The purpose of RWJHCCH is to meet the health and social needs of its community through a vertically and horizontally integrated organization consisting of complementary, synergistic, and self-supporting corporations. RWJHCCH has been involved in the development and administration of such activities as hospital and long-term care management, marketing, fundraising, and day care facilities. The Hospital located in Township, New Jersey, is a 284 bed, not-for-profit, tax-exempt hospital. RWJ Health Care Corp. ( RWJHCC ), a New Jersey not-for-profit corporation, is the sole member of RWJHCCH. RWJHCC is also the sole member of Johnson University Hospital, a not-for-profit, tax-exempt academic medical center located in New Brunswick, New Jersey. The following is a summary of the Obligated Group s significant accounting policies: Cash and Cash Equivalents Cash and cash equivalents consist of cash balances, money market funds and certificates of deposit with maturities of three months or less at the date of purchase, excluding amounts held as assets limited as to use and long-term investments. Assets Whose Use is Limited Assets so classified represent assets whose use is limited under terms of a bond indenture agreement, or captive insurer funds. These assets, which consist of investments in cash, cash equivalents, and U.S. Government obligations, are recorded at fair value determined by quoted market price. The current portion of assets whose use is limited are held by trustees under bond indenture, and will be used to satisfy current principal and interest obligations under long-term debt agreements. 7

10 1. Organization and Summary of Significant Accounting Policies (continued) Investments Investments represent both trading and non-trading investment funds maintained by the Obligated Group. The Obligated Group has the ability to direct all trade activity on the investments classified as non-trading. Unrealized gains and losses on these investments are excluded from the (deficiency) excess of revenues over expenses, unless an other-than-temporary impairment in value has occurred, and are recorded as an increase or decrease in net assets. Investments classified as trading represent the managed portion of the portfolio. Unrealized gains on investments classified as trading of approximately $105,596 and $214,000 are included in the (deficiency) excess of revenues over expenses for the years ended December 31, 2008 and 2007, respectively. Investments in equity securities with readily determined fair value and all investments in debt securities are measured at fair value in the special purpose combined balance sheets. Investment income or loss (including unrealized gains and losses on trading investments, realized gains and losses on investments, interest and dividends) of marketable securities is included in the (deficiency) excess of revenues over expenses, unless the income or loss is restricted by donor or law. Alternative investments are defined as nontraditional, not readily marketable asset classes. Alternative investment holdings are structured as limited partnership interests or other corporate forms. The alternative investments are recorded using the equity method of accounting. For the years ended December 31, 2008 and 2007, the Obligated Group recorded (loss) income on alternative investments of approximately $(1,437,000) and $484,000, respectively, which is included in other revenue in the special purpose combined statements of operations and changes in net assets. Individual investment holdings of the Obligated Group within the alternative investments may include investments in both non-marketable and market-traded securities. Valuations of investments not readily marketable may be determined by the investment manager or general partner. Fund of funds investments are primarily based on financial data supplied by the underlying investee funds. Values may be based on historical cost, appraisals, or other estimates that require varying degrees of judgment. Generally, reported value reflects net contributions to the investee and an ownership share of realized and unrealized investment income and expenses. The investments may indirectly expose the Obligated Group to securities lending, short sales of securities, and trading in futures and forwards contracts, options and other derivative products. While these financial instruments may contain varying degrees of risk, the Obligated Group s risk with respect to such transactions is limited to its capital balance in each 8

11 1. Organization and Summary of Significant Accounting Policies (continued) investment. The financial statements of the investees are audited annually by independent auditors. At December 31, 2008, the Obligated Group has future commitments to invest in alternative investments totaling $810,911. Amounts with maturities of twelve months or less are classified as current assets. Supplies Supplies are carried at the lower of cost (first-in, first-out method) or market. Supplies totaling approximately $2,542,000 and $2,432,000 are included with other current assets in the special purpose combined balance sheets at December 31, 2008 and 2007, respectively. Property and Equipment Property and equipment are recorded at cost, except donated assets which are recorded at fair value at date of donation. Depreciation is provided over the estimated useful life of each class of depreciable asset and is computed using the straight-line method. Capitalized leases are recorded at the fair value at the inception of the leases. Equipment under capital leases is amortized over the shorter period of the lease term or the estimated useful life of the equipment. Amortization is included in depreciation and amortization expense in the accompanying statements of operations. Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of In accordance with Statement of Financial Accounting Standards ( SFAS ) No. 144, long-lived assets, such as property, plant, and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future net cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the special purpose combined balance sheets and reported at the 9

12 1. Organization and Summary of Significant Accounting Policies (continued) lower of the carrying amount or fair value less costs to sell, and would no longer be depreciated. The assets and liabilities of a disposed group classified as held for sale would be presented separately in the appropriate asset and liability sections of the special purpose combined balance sheets. Deferred Financing Costs Deferred financing costs include the costs of obtaining financing and are amortized using the effective interest method over the life of the related debt. During 2005, in connection with the issuance of the New Jersey Health Care Facilities Financing Authority ( NJHCFFA ) Series 2005A and 2005B revenue bonds, a portion of which refinanced the existing NJHCFFA Series 1994 bonds (see Note 7), the Obligated Group capitalized deferred financing costs of $6,156,000. At December 31, 2008 and 2007, the accumulated amortization for deferred financing costs was approximately $1,420,000 and $1,094,000, respectively. Investment in MSO The MSO is not part of the Obligated Group and is being accounted for as an unconsolidated Subsidiaries of RWJHCCH using the equity method of accounting. Although this method of accounting differs from generally accepted accounting principles which require consolidation of the MSO with RWJHCCH, such difference is not material to the special purpose combined financial statements. Estimated Malpractice Costs The provision for estimated medical malpractice claims, included in other expenses in the special purpose combined statements of operations, includes estimates of the ultimate costs for both reported claims and claims incurred but not reported. The estimated liability for medical malpractice costs is included with other liabilities in the combined balance sheets (see Note 9). Employee Health Benefit Plan During 2006, the Hospital established a self-insured employee health benefit plan. The Hospital contracts with a preferred provider organization to assist in the administration of the health plan. The liabilities of the health plan, both reported and unreported, are included in accrued expenses in the accompanying special purpose combined balance sheets. 10

13 1. Organization and Summary of Significant Accounting Policies (continued) Unrestricted and Temporarily Restricted Net Assets The Obligated Group separately accounts for and reports upon donor restricted and unrestricted net assets. Unrestricted net assets are not externally restricted for identified purposes by donors or grantors. Unrestricted net assets include resources that the governing board may use for any designated purpose. Temporarily restricted net assets are those whose use by the Obligated Group has been limited by donors to a specific time frame or purpose. When donor restrictions expire, that is, when a time restriction ends or a purpose restriction is accomplished, temporarily restricted net assets are recorded as net assets released from restrictions. These funds have been restricted for the following purposes: December Capital projects $ 606,919 $ 1,728,505 Research 104, ,719 Hospital programs 215, ,614 $ 927,329 $ 2,039,838 In accordance with SFAS No. 136, Transfers of Assets to a Not-for-Profit Organization or Charitable Trust that Raises or Holds Contributions for Others, the Obligated Group recognizes its interest in the net assets of the Foundation. Changes in the Obligated Group s interest in the Foundation s temporarily restricted net assets are included in the accompanying special purpose combined statements of changes in net assets. The interest is reflected in assets held by related organization in the accompanying special purpose combined balance sheets and represents the temporarily restricted net assets recorded by the Hospital. In 2007 the construction of the patient tower was completed. The Foundation had raised funds for construction of the tower which were included as capital projects in temporary restricted net assets. Upon completion of the tower, the restrictions were released and amounts were reclassified to unrestricted net assets. During 2008, the Foundation contributed $835,000 to the Hospital for use in operations. 11

14 1. Organization and Summary of Significant Accounting Policies (continued) Patient Accounts Receivable and Net Patient Service Revenue Patient accounts receivable result from the health care services provided by the Hospital. Additions to the allowance for doubtful accounts result from the provision for bad debts. Accounts written off as uncollectible are deducted from the allowance for doubtful accounts. The amount of the allowance for doubtful accounts is based upon management s assessment of historical and expected net collections, business and economic conditions, trends in Medicare and Medicaid health care coverage and other collection indicators. Net patient service revenue is reported at the estimated net realizable amounts from patients, third-party payers, and others for services rendered and includes estimated retroactive adjustments due to future audits, reviews and investigations. Retroactive adjustments are considered in the recognition of revenue on an estimated basis in the period the related services are rendered, and such amounts are adjusted in future periods as final settlements and adjustments become known or as years are no longer subject to such audits, reviews, and investigations. The Hospital has agreements with third-party payors that provide for payments at amounts different from their established rates. A summary of the payment arrangements with major thirdparty payors includes, but is not limited to, the following: Medicare Inpatient acute care services rendered to Medicare program beneficiaries are paid under the Prospective Payment System ( PPS ) at prospectively determined rates per discharge. These rates vary according to a patient classification system that is based on clinical, diagnostic, and other factors. Outpatient services are paid under the Outpatient Prospective Payment System ( OPPS ) at prospectively determined rates per ambulatory payment classification ( APC ). The Hospital is reimbursed for capital-related costs under the fully prospective payment methodology. The Hospital s classification of patients under the Medicare program and the appropriateness of their admission are subject to an independent review by a peer review organization under contract with the Hospital. Medicaid Inpatient acute care services rendered to Medicaid program beneficiaries are paid under a prospective methodology which, similar to Medicare, is based on predetermined rates per discharge. Outpatient services are paid based upon a cost 12

15 1. Organization and Summary of Significant Accounting Policies (continued) reimbursement methodology. The Hospital is reimbursed at a tentative rate with final settlement determined after submission of annual cost reports and audits thereof by the Medicaid fiscal intermediary. Commercial Insurance The Hospital has entered into payment agreements with certain insurance carriers, health maintenance organizations, and preferred provider organizations which cover health benefits and workers compensation for commercial, Medicare and Medicaid members. The basis for payment to the Hospital under these agreements varies by payor, but typically includes prospectively determined rates per discharge, discounts from established charges, prospectively determined daily rates, and/or cost pass-through reimbursement for certain high cost items. Income Taxes RWJHCCH and the Hospital are organizations described in Section 501(c)(3) of the Internal Revenue Code and, therefore, are exempt from Federal income taxes pursuant to Section 501(a) of the Code. In addition, RWJHCCH and the Hospital are exempt from State income taxes. The RWJ Diabetes & Endocrinology Group P.A. and OB/GYN Associates P.A. are forprofit organizations subject to both Federal and State income taxes. No income taxes have been provided in 2008 or 2007 due to carry forward net losses that are not material for disclosure. Charity Care The Hospital provides care to patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Hospital does not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. Advertising Costs The Obligated Group expenses advertising costs as incurred. For the years ended December 31, 2008 and 2007, advertising costs totaled approximately $595,000 and $715,000, respectively. 13

16 1. Organization and Summary of Significant Accounting Policies (continued) Performance Indicator The special purpose combined statements of operations and changes in net assets include (deficiency) excess of revenue over expenses as the performance indicator. Changes in unrestricted net assets which are excluded from (deficiency) excess of revenue over expenses, consistent with industry practice, include changes in net unrealized gains and losses on nontrading investments, permanent transfers of assets to and from affiliates for other than goods and services, and contributions of long-lived assets, including net assets released from restriction for capital projects. Use of Estimates The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, including estimated uncollectibles for accounts receivable for services to patients, and liabilities, including estimated net payables to third-party payors, malpractice insurance liabilities and medical claims payable, and disclosure of contingent assets and liabilities as of the date of the financial statements. Estimates also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Recent Accounting Pronouncements In September 2006, the Financial Accounting Standards Board ( FASB ) issued FASB Statement No. 157, Fair Value Measurements ( SFAS No. 157 ), which defines fair value as the price 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 and establishes a framework for measuring fair value. SFAS No. 157 establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. SFAS No. 157 expands disclosures about instruments measured at fair value. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements and, accordingly, SFAS No. 157 does not require any new fair value measurements. Adopting SFAS No. 157 did not have a material impact on the Obligated Group s financial position and results of operations, although it provides for increased disclosures (see Note 11). 14

17 1. Organization and Summary of Significant Accounting Policies (continued) As noted above, SFAS No. 157 establishes a three-level valuation 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 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. Level 3 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. In February 2007, the FASB issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financials Liabilities, including an amendment of FASB Statement No. 115 ( SFAS No. 159 ), which among other things, provides an option to elect fair value as an alternative measurement for selected financial assets and liabilities not previously recorded at fair value. As a result of adopting SFAS No. 159, the Obligated Group did not elect fair value accounting for any asset or liabilities that are not currently required to be measured at fair value. Consequently SFAS No. 159 did not affect the accompanying combined financial statements. 15

18 2. Charity Care The Hospital provides care to patients who meet the strict charity care criteria of the New Jersey State Department of Health (the Department ) without charge or at amounts less than its established rates. In accordance with guidelines established by the Department, the Hospital maintains records to identify and monitor the level of charity care it provides. These records include, among other things, the amount of charges forgone for services furnished under the Hospital s charity care policy. The estimated charges forgone under these guidelines, based on established rates, were approximately $41,044,000 and $55,311,000 for the years ended December 31, 2008 and 2007, respectively. The strict state eligibility criteria and the difficulty in obtaining the required data from patients limits the number of patients who qualify for charity care in New Jersey. It is management s belief that the present charity care guidelines understate the Hospital s charity care amounts and overstate the level of bad debts reported, because of the difficulties involved with obtaining patient cooperation. The Hospital provides additional charity care to the community which includes the following: child health program, fireman pulmonary testing, hepatitis screening, breast screening, lead screening, flu vaccine program, and Special Olympics physicals. The Hospital also provides free community programs including Adult Health Education Programs, Health Education Programs for elementary and pre-school children, as well as safety programs for children and various support groups. These services are not recognized by the Department as charity care. 3. Third-Party Payor Programs As described above, the Hospital provides care to patients under Medicare, Medicaid and other contractual arrangements. The Medicare and Medicaid programs pay for all inpatient and most outpatient services on a combined prospective/retroactive basis. Certain outpatient services and specified expenses are reimbursed on a reasonable cost basis. Regulations require annual retroactive settlements for these amounts based on cost reports filed by the Hospital. These retroactive settlements are estimated and recorded in the special purpose combined financial statements in the year in which they are estimated. The estimated settlements recorded at December 31, 2008 and 2007 could differ from actual settlements based on the results of cost report audits. Medicare and Medicaid cost reports for all years through 2004 have been audited and settled at December 31, However, during 2006, the Medicare fiscal intermediary sent notices of intent to reopen previously settled cost report years (2000 through 2004) for potential repayment of Medicare disproportionate share payments made to the Hospital. This action may have a similar impact on 2006 through In the opinion of management, adequate provision has been made for any adjustment, which may result from final settlement of these reports or appeal items. In April 2009 the Hospital received a letter from the Medicare fiscal intermediary 16

19 3. Third-Party Payor Programs (continued) stating that the 2004 cost report was final settled and that $1,254,000 was required to be repaid. Such amounts were included in the estimated amounts to third-party payors in the balance sheet at December 31, Cost reports related to 2000 through 2003 remain open for this issue. Included as an increase to net patient service revenue in 2008 is approximately $625,000 related to changes in estimated amounts due to third-party payors attributable to prior years. There were no such amounts in Revenue from the Medicare and Medicaid programs accounted for approximately 35% and 39% of the Obligated Group s net patient service revenue for the years ended December 31, 2008 and 2007, respectively. There are various proposals at the federal and state levels that could, among other things, significantly reduce reimbursement rates or modify reimbursement methods. The ultimate outcome of these proposals and other market changes cannot presently be determined. Future changes in the Medicare and Medicaid programs and any reduction of funding could have an adverse impact on the Obligated Group. Laws and regulations governing the Medicare and Medicaid programs are extremely complex and subject to interpretation. As a result, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term. Actions for noncompliance includes fines, penalties and exclusion from the Medicare and Medicaid programs. The Obligated Group believes that it is currently in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrong doing, except as described in Note 9. The New Jersey Health Care Subsidy Fund was established for various purposes including the distribution of charity care payments to hospitals statewide. During 2008 and 2007, the Obligated Group received approximately $1,373,000 and $1,589,000, respectively, which is included in net patient service revenue. The components of net patient service revenue for the years ended December 31, 2008 and 2007 follow: Year Ended December Gross charges $ 1,591,645,772 $ 1,615,168,644 Contractual and other allowances (1,379,094,973) (1,408,438,123) Net patient service revenue $ 212,550,799 $ 206,730,521 17

20 4. Investments and Assets Whose Use is Limited Investments The composition of investments at December 31, 2008 and 2007 is as follows: Certificates of deposit $ 6,814,060 $ 5,697,242 U.S. Government obligations 461,908 2,387,227 U.S. corporate bonds 3,587,163 2,851,099 Fixed income funds 4,636,502 4,874,958 Equity funds 4,585,758 7,205,687 Alternative investments 4,125,083 5,602,518 Money market funds 1,844, ,188 Accrued interest 137, ,494 26,192,471 28,988,413 Less: short-term investments 7,279,947 2,977,985 Long-term investments $ 18,912,524 $ 26,010,428 Assets Whose Use is Limited Assets whose use is limited that are required to satisfy obligations classified as current liabilities are reported in current assets. The composition of assets whose use is limited at December 31, 2008 and 2007 is as follows: Under bond indenture agreements held by trustees: U.S. Government obligations $ 12,438,106 $ 14,348,339 Held by captive insurer fund: Cash and cash equivalents 2,975,997 2,941,187 Total assets whose use is limited 15,414,103 17,289,526 Less assets whose use is limited current portion 5,554,712 5,477,282 Noncurrent assets whose use is limited $ 9,859,391 $ 11,812,244 18

21 4. Investments and Assets Whose use is Limited (continued) The assets held by trustees under bond indenture agreements, at fair value, are maintained for the following at December 31, 2008 and 2007: Project and construction fund $ 2,179,040 $ 3,928,135 Cost of issuance fund 2,704 Debt service for principal and interest 2,714,064 2,872,498 Debt service reserve fund 7,545,002 7,545,002 $ 12,438,106 $ 14,348,339 Investment income is included in other revenue and is comprised of interest of approximately $1,991,000 and $2,960,000 and realized (losses) gains of approximately $(1,487,000) and $759,000 for the years ended December 31, 2008 and 2007, respectively. The following table summarizes the unrealized losses on non-trading investments aggregated by investment category and length of time these investments have been in a continuous unrealized loss position at December 31, 2008, which consist of 8 securities: Less than Twelve Months Fair Unrealized Value Losses Continuous Loss Position Twelve Months or Longer Fair Unrealized Value Losses Non-trading Investments with Gross Unrealized Losses Fair Unrealized Value Losses Mutual funds $ 7,726,235 $ (2,138,562) $ 1,496,025 $ (437,087) $ 9,222,260 $ (2,575,649) Total $ 7,726,235 $ (2,138,562 $ 1,496,025 $ (437,087) $ 9,222,260 $ (2,575,649) In accordance with accounting principles generally accepted in the United States, the Obligated Group is required to review its investment holdings for indicators of other than temporary decline in fair value of investments. The securities noted above which have been in a continuous unrealized loss position for greater than twelve months began to experience significant unrealized losses during the fourth quarter of 2008 consistent with the downturn in the financial markets. 19

22 4. Investments and Assets Whose use is Limited (continued) The following table summarizes the unrealized losses on non-trading investments aggregated by investment category and length of time these investments have been in a continuous unrealized loss position at December 31, 2007, which consist of 2 securities: Continuous Loss Position Less than Twelve Months Twelve Months or Longer Fair Unrealized Fair Unrealized Value Losses Value Losses Non-trading Investments with Gross Unrealized Losses Fair Unrealized Value Losses Mutual funds $ 1,559,685 $ (32,152) $ 505,854 $ (4,146) $ 2,065,539 $ (36,299) Total $ 1,559,685 $ (32,152) $ 505,854 $ (4,146) $ 2,065,539 $ (36,299) At December 31, 2008 and 2007, the unrealized losses were not deemed to be other than temporary based on the Obligated Group s ability and intent to hold the funds until recovery in addition to the extent and length of significant impairment. 5. Property and Equipment Property and equipment at December 31, 2008 and 2007 consists of the following: Useful Lives Land $ 87,255 $ 87,255 Land improvements 5,158,676 5,126, Buildings 125,217, ,683, Fixed equipment 21,914,301 21,656, Major movable equipment 68,273,255 65,960, ,651, ,514,610 Less accumulated depreciation (92,271,919) (82,243,491) 128,379, ,271,119 Construction in progress 2,052,711 1,451,396 $ 130,432,113 $ 135,722,515 20

23 5. Property and Equipment (continued) During 2008 and 2007, the Obligated Group capitalized $71,000 and $493,000 of interest expense net of $289,000 of interest income in 2007 (none in 2008). Additionally, the Obligated Group capitalized $155,000 and $165,000 of computer software costs in 2008 and 2007, respectively. Estimated costs to complete the projects classified as construction in progress at December 31, 2008 approximated $2 million. 6. Related Party Transactions Due from affiliated companies at December 31, 2008 and 2007 consist of the following: RWJ Medical Services Organization at, Inc. $ 770,824 $ 756,199 Johnson University Hospital at Foundation, Inc. 136, ,314 Lakeview Child Center, Inc. 12,210 19,564 Due from affiliates $ 919,090 $ 886,077 Due to affiliated companies at December 31, 2008 and 2007 consist of the following, including loans referred to below: RWJ New Brunswick $ (590,014) $ (693,120) Due to affiliates $ (590,014) $ (693,120) RWJHCCH provided management services to the Foundation and Lakeview at a cost of approximately $105,000 and $112,000 in 2008 and 2007, respectively. Lakeview rents space from the Hospital. Total annual rent expense was $73,000 in 2008 and In 2008, Lakeview permanently transferred $800,000 to the Hospital. In 2007, Lakeview and the Foundation permanently transferred $1,000,000 and $264,500, respectively, to the Hospital. 21

24 6. Related Party Transactions (continued) In addition, in 2008 net assets held by the Foundation were released from restrictions for use in operations of $835, Long-Term Debt Long-term debt at December 31, 2008 and 2007 consists of the following: December New Jersey Health Care Facilities Financing Authority ( NJHCFFA ) Revenue and Refunding Series 2005A Bonds, $30,300,000 Auction Rate Bonds, maturing July 1, 2024, bears interest at a weekly auction rate (4.5% at December 31, 2008 and 3.75% at December 31, 2007). These bonds are insured by Financial Security Assurance Inc. ( FSA ). $ 27,400,000 $ 28,425,000 NJHCFFA Revenue Series 2005B Bonds, $16,035,000 Serial Bonds maturing through July 1, 2020, $49,340,000 Term Bonds, maturing through July 1, 2035 with interest rate ranging from 3% to 5%. These bonds are insured by Radian Asset Assurance Inc. 64,460,000 65,375,000 NJHCFFA Revenue Series 2002 Bonds, due serially to July 1, 2032, bears interest at variable rates (1.25% and 3.62% at December 31, 2008 and 2007, respectively). These bonds are secured by an irrevocable direct pay letter of credit provided by a bank. 27,910,000 28,930,000 Total bonds payable 119,770, ,730,000 Obligations under capital leases (Note 9) 666,019 1,269,364 Unamortized premium 1,838,371 1,942,579 Total long-term debt 122,274, ,941,943 Less current portion 2,747,564 2,763,345 Total long-term debt, net of current portion $ 119,526,826 $ 123,178,598 In 2005, the Obligated Group, through NJHCFFA issued $30,300,000 Revenue and Refunding Bonds (Series 2005A) and $65,375,000 Revenue Bonds (Series 2005B). The net proceeds of the 2005A bonds were used to refund all of the Series 1994 bonds and to fund a Debt Service Reserve Fund relating to the Series 2005A bonds and payment of the costs of issuance of the Series 2005A bonds. The Series 1994 bonds were called upon their optional redemption and paid to the bondholders in

25 7. Long-Term Debt (continued) The net proceeds from the Series 2005B bonds were used to pay the construction and equipment costs for a new 4-story tower on the hospital campus (1st floor of which houses utilities and loading docks and the remaining floors of which include 32-bed inpatient beds), additional radiology capacity and a new dietary area and cafeteria as well as various building improvements. In connection with the issuance of the 2002 bonds, the Obligated Group has entered in to a $31,561,000 Irrevocable Direct Pay Letter of Credit Agreement. The letter of credit expires on August 31, The Obligated Group is required to maintain certain financial ratios in connection with the NJHCFFA Series 2002, 2005A and 2005B revenue bonds and the letter of credit as described in the agreements. At December 31, 2008 and 2007, the Obligated Group was in compliance with the amended financial ratios, except for the long-term debt to capitalization ratio as required under the Amended Series 2005A agreements. Although this is not an event of default, it allows the bond insurers to require the Obligated Group to retain an independent consultant to make recommendations to remedy the noncompliance. In addition, the Obligated Group was not in compliance with the covenant contained in the agreements relating to the submission of audited financial statements for the year December 31, 2007 within 150 days of the fiscal year end. This is not an event of default until after 30 days of written notice of such failure from the Master Trustee and the letter of credit bank. After the 30 days written notice, the Obligated Group would have been in default and the bond insurers and the letter of credit bank would have the rights, among other things, to accelerate scheduled payments. On July 22, 2008, the Obligated Group received written notice from the Master Trustee regarding the late submission of the audited financial statements for 2007; however, within 30 days of that date the Obligated Group submitted the required financial statements and, therefore, was not in default. 23

26 7. Long-Term Debt (continued) Future principal payments (including required sinking fund deposits) on long-term debt, excluding capital leases at December 31, 2008, are as follows: 2009 $ 2,260, ,360, ,465, ,580, ,720,000 Thereafter 107,385,000 $ 119,770,000 Amounts anticipated to be deposited in the debt service funds for the purpose of sinking fund requirements and interest on the Series 2005A bonds over the next five fiscal years and thereafter are as follows: Principal Sinking Fund Requirements Total Debt Service Requirements Interest Year Ending June 30: 2009 $ 1,100,000 $ 749,951 $ 1,849, ,150, ,726 1,868, ,225, ,811 1,910, ,300, ,469 1,952, ,375, ,715 1,988,715 Through ,250,000 Total principal sinking fund requirements $ 27,400,000 Monthly payments must be made to the trustee in amounts sufficient to pay principal and interest to the bondholders. 24

27 7. Long-Term Debt (continued) Amounts anticipated to be deposited into the debt service funds for the purpose of sinking fund requirements and interest on the Series 2002 bonds over the next five years and thereafter are as follows: Principal Sinking Fund Requirements Total Debt Service Requirements Interest Year Ending June 30: 2009 $ 220,000 $ 920,456 $ 1,140, , ,005 1,134, , ,208 1,127, , ,129 1,121, , ,278 1,113,278 Through ,810,000 Total principal sinking fund requirements $ 27,910,000 Monthly payments must be made to the bank in the amounts sufficient to pay principal and interest to the bondholders. Capital Leases The Hospital has two lease agreements which have been capitalized. The carrying value of assets under the capital leases is approximately $522,330 at December 31, 2008 and $1,081,000 at December 31, The following is a schedule of future minimum lease payments under the capital leases at December 31, 2008: Year Ending December 31: 2009 $ 498, ,787 Total minimum lease payments 677,944 Less amount representing interest at 6.0% (11,925) $ 666,019 25

28 8. Employee Benefit Plans The Obligated Group has a noncontributory defined contribution pension plan covering all eligible employees. Employees become eligible to participate upon attaining 21 years of age and completing one year of service with the Obligated Group. At least 1,000 hours must be worked during a calendar year in order to qualify as a service year. No amounts were contributed to the plan in 2008 or During 2002, the Obligated Group established a supplemental executive retirement plan for certain key individuals. The plan is unfunded. The amount of accrued liability at December 31, 2008 and 2007 is $50,000 and $18,000 respectively, and is included in accrued expenses in the accompanying special purpose combined balance sheets. 9. Commitments and Contingencies In October 2005, the Hospital received a subpoena for documents from the United States Department of Health and Human Services, Office of Inspector General. Among other items, the subpoena requested information relating to reimbursements received by the Hospital for Medicare outlier patients and to the Hospital s charge setting practices. The subpoena seeks documents dating back to January 1, Based on communications with the government, the subpoena was served in connection with the government s investigation of actions filed under seal against the Hospital under the qui tam provisions of the False Claims Act, alleging that the Hospital raised charges to obtain additional Medicare outlier reimbursement. The Hospital is fully cooperating with the government s requests in response to the subpoena. In April 2008, the United States Department of Justice filed a formal complaint in the United States District Court for the District of New Jersey, for action based on the false claims for outlier payments submitted to the Medicare program. The United States seeks damages and civil penalties for each claim for an outlier payment submitted to the Medicare program for inpatient stays with discharge dates from January 1, 1998 through April 30, On June 30, 2008, the Hospital filed a motion to dismiss the government s complaint. On March 31, 2009, the Court issued an Order denying the Hospital s motion to dismiss, though it did not issue an opinion giving the reasons for its ruling. On April 14, 2009, the Hospital filed a motion seeking an interlocutory appeal from the Court s Order pursuant to 28 U.S.C. 1292(b) (the Motion ). While the Motion was being briefed, the Court issued an opinion explaining its Order on May 7, The Motion now has been fully briefed and is pending before the Court. If the Motion is granted, the Hospital will be able to appeal the Court s Order directly to the Third Circuit. If the Motion is denied, the Hospital will not have an opportunity for an immediate appeal and the case will proceed. 26