BAYLOR COLLEGE OF MEDICINE FINANCIAL STATEMENTS. Together with Auditor s Report

Transcription

1 BAYLOR COLLEGE OF MEDICINE FINANCIAL STATEMENTS 2012 Together with Auditor s Report

2 Deloitte & Touche LLP Suite Bagby Street Houston, TX USA Tel: Fax: INDEPENDENT AUDITORS REPORT To the Board of Trustees of Baylor College of Medicine Houston, Texas We have audited the accompanying balance sheets of Baylor College of Medicine (the "College") as of June 30, 2012 and 2011, and the related statements of activities and cash flows for the years then ended. These financial statements are the responsibility of the College'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 of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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 College'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, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the College at June 30, 2012 and 2011, and the changes in its net assets and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. October 30, 2012 Member of Deloitte Touche Tohmatsu

3 Baylor College of Medicine Balance Sheets As of June 30, 2012 and 2011 (in thousands) Assets Cash and cash equivalents $ 55,889 $ 41,558 Cash held by bond trustee 29,510 41,584 Bond swap collateral, net - 6,299 Accounts receivable, net 92,868 96,189 Patient receivables, net 27,607 23,439 Contributions receivable, net 166, ,825 Notes receivable 17,267 17,263 Investments 764, ,217 Investments loaned under security lending agreements 46,701 47,137 Security lending collateral 47,905 48,422 Property and equipment, net 552, ,004 Other assets 20,308 19,844 Total Assets $ 1,821,362 $ 1,921,781 Liabilities Net Assets Accounts payable and other liabilities $ 189,272 $ 190,157 Short term line of credit 48,500 49,000 Bond swap liability, net 23,044 - Self-insurance reserves 29,516 31,292 Unexpended current awards 70,768 70,426 Bonds payable 570, ,826 Payable under security lending agreements 47,905 48,422 Total Liabilities $ 979,672 $ 968,123 Unrestricted $ 63,162 $ 212,842 Temporarily restricted 409, ,962 Permanently restricted 369, ,854 Total Net Assets $ 841,690 $ 953,658 Total Liabilities and Net Assets $ 1,821,362 $ 1,921,781 See accompanying notes to financial statements. 2

4 Baylor College of Medicine Statements of Activities For the Years Ended June 30, 2012 and 2011 (in thousands) Operating Revenues Tuition and fees $ 31,341 $ 24,426 Less: Institutional scholarships (16,768) (11,185) Net tuition and fees $ 14,573 $ 13,241 State appropriations 46,278 50,316 Government and private grants and contracts: Direct recoveries 329, ,874 Indirect recoveries 69,100 71,574 Medical services 235, ,687 Affiliated hospital contracts 440, ,351 Investment income distribution and other 39,903 40,527 Equipment acquired through grants and contracts 12,854 12,719 Contributions 16,014 20,323 Net assets released from restrictions 43,350 34,841 Other sources 36,699 44,847 Total Operating Revenues $ 1,284,090 $ 1,234,300 Operating Expenses Salaries, wages and benefits $ 900,255 $ 843,845 Services, supplies and other 313, ,173 Depreciation 70,297 64,226 Interest 17,046 19,649 Total Operating Expenses $ 1,300,915 $ 1,252,893 Expenses in Excess of Revenues $ (16,825) $ (18,593) Non-Operating Activities Contributions $ 1,460 $ 2,912 Investment gain (loss), net of distribution (19,653) 67,705 Unrealized gain (loss) on bond swaps (61,056) 3,762 Non-equipment assets acquired through grants, contracts and gifts and other 4,447 2,543 Losses on disposals and write-downs of property and equipment (2,066) (1,458) Net assets released from restrictions Carrying Costs of McNair Facility - (7,137) Write-off of original bond issue costs - (3,355) Impairment losses on capital projects (56,000) (87,000) Decrease in Unrestricted Net Assets from Non-Operating Activities $ (132,855) $ (21,570) Decrease in Unrestricted Net Assets $ (149,680) $ (40,163) See accompanying notes to financial statements. (Continued) 3

5 Baylor College of Medicine Statements of Activities For the Years Ended June 30, 2012 and 2011 (in thousands) Decrease in Unrestricted Net Assets $ (149,680) $ (40,163) Temporarily Restricted Net Assets Contributions, net $ 92,821 $ 44,789 Net assets released from restrictions (43,362) (35,298) Investment gain (loss) (21,041) 68,386 Increase in Temporarily Restricted Net Assets $ 28,418 $ 77,877 Permanently Restricted Net Assets Contributions $ 10,028 $ 22,580 Investment gain (loss) (734) 2,884 Increase in Permanently Restricted Net Assets $ 9,294 $ 25,464 Increase (Decrease) in Net Assets $ (111,968) $ 63,178 Net Assets, beginning of year 953, ,480 Net Assets, end of year $ 841,690 $ 953,658 (Concluded) See accompanying notes to financial statements. 4

6 Baylor College of Medicine Statements of Cash Flows For the Years Ended June 30, 2012 and 2011 (in thousands) Cash Flows from Operating Activities Increase (Decrease) in Net Assets $ (111,968) $ 63,178 Adjustments to reconcile increase (decrease) in net assets to net cash used in operating activities: Depreciation and loss on disposals and write-downs of property and equipment and other 91,481 66,133 Impairment losses on capital projects 56,000 87,000 Equipment acquired through grants and contracts (12,457) (7,622) Investment income (6,093) (13,609) Change in net unrealized (gains) loss on investments 43,414 (92,507) Net realized gains on sale of investments (21,967) (51,337) Decrease (increase) in accounts receivable 3,321 (11,096) Decrease (increase) in patient receivables (4,168) 5,921 Increase in contributions receivable (33,092) (11,176) Permanently restricted contributions and investment income (10,028) (22,581) Decrease (increase) in other assets (464) 1,322 Increase (decrease) in accounts payable and other liabilities (48) 13,472 Decrease (increase) in bond swap liability 61,119 (2,878) Net Cash Provided By Operating Activities $ 55,050 $ 24,220 Cash Flows from Investing Activities Purchases of investments $ (119,773) $ (366,664) Proceeds from sales of investments 144, ,735 Purchases of property and equipment (53,417) (62,615) Decrease in restricted cash held by bond trustee 12, ,208 Investment income 6,093 13,609 Issuances of notes receivable (3,141) (2,766) Repayments of notes receivable 3,137 3,276 Net Cash Provided by (used in) Investing Activities $ (10,211) $ 291,783 Cash Flows from Financing Activities Proceeds of line of credit $ 14,500 $ 20,000 Repayment of line of credit (15,000) (20,000) Payments to bond swap collateral (31,776) (5,159) Repayment of bonds payable (8,260) (309,485) Permanently restricted contributions and investment income 10,028 22,581 Net Cash Used In Financing Activities $ (30,508) $ (292,063) Net Increase in Cash and Cash Equivalents $ 14,331 $ 23,940 Cash and Cash Equivalents, beginning of year 41,558 17,618 Cash and Cash Equivalents, end of year $ 55,889 $ 41,558 Supplemental disclosures Net interest paid on bonds (excluding capitalized interest) $ 14,237 $ 19,317 Non-cash investing activities: Property and equipment acquisitions in accounts payable and other liabilities $ (2,170) $ (3,046) Increase (decrease) in security lending collateral $ (517) $ 37,942 See accompanying notes to financial statements. 5

7 Baylor College of Medicine Notes to Financial Statements For the Years Ended June 30, 2012 and 2011 (1) ORGANIZATION Baylor College of Medicine (the College or Baylor ) is one of the leading health science universities and biomedical research institutions in the United States. Founded in 1900, Baylor owns and operates educational, research, and patient care facilities. The College is an institution comprised of four separate colleges including a medical school, a graduate biomedical sciences school, an allied health school and a school of tropical medicine. Baylor trains more than 3,000 medical, graduate, nurse anesthesia, and physician assistant students, as well as residents and post-doctoral fellows each year. The College is also among the nation s leading biomedical research institutions and consistently ranks among the top of the country s 137 medical schools. Finally, the College provides extensive patient care services through its wholly owned Baylor Clinic and through faculty physician service agreements primarily with eight independently owned and operated affiliated hospitals. Baylor s main campus is located in the Texas Medical Center, a 700 acre complex of 50 independent institutions in Houston, Texas. The College is the only private medical school in the southwestern United States. The College s McNair Campus is located on 33 acres approximately one mile southeast of its main campus. The McNair Campus includes the Baylor College of Medicine Medical Center (BCM Medical Center) currently under construction and expected to house a hospital and faculty medical clinic, and a medical office building known as the Lee and Joe Jamail Specialty Care Center. While the McNair Campus is located adjacent to the Texas Medical Center, it is not on Texas Medical Center land and accordingly, is not restricted to use for nonprofit medical education, patient care and research. The BCM Medical Center is currently shelled-in, and its interior is not built out. In March 2012, the College s Board of Trustees authorized the first two phases of the build-out which will allow the College to consolidate most of its outpatient and certain inpatient clinical services, including related faculty offices, by The build-out will be completed in two phases, with the first phase consisting of hospital services and office and other non-hospital occupancy. The schedule for completion for phase one is summer 2013, concurrent with the initiation of planning for phase two, which is anticipated to include additional universal licensed inpatient beds, clinics, diagnostic and ancillary services, and faculty offices. The estimated costs of both phases of the project are $200 million, including capital build-out and medical equipment, non-capital facility start-up, marketing and faculty recruitment. Philanthropy, which has been substantially raised, will fund these two phases. The BCM Medical Center will become the College s focal point for its adult private practice when it opens (see Note 11). Development of the remaining portion of the BCM Medical Center is subject to authorization by the Board of Trustees. Currently contemplated possible uses include 6

8 the addition of specialized and incremental general inpatient beds, additional operating rooms, translational research space and incremental clinic and office space. In addition, a clinical research unit and facilities for translational research will be included. Currently, there is no timetable for determining if, or if so, how or when the College will develop the remaining portion of the BCM Medical Center. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting and Reporting The College s consolidated financial statements include the accounts of all entities in which Baylor has a significant financial interest and over which Baylor has control, including the Baylor College of Medicine International Pediatric AIDS Initiative ( BIPAI ) and the Baylor Medical Foundation ( Foundation ). BIPAI is a Texas not-for-profit corporation organized to foster international HIV/AIDS prevention, care and treatment, health professional education, and clinical research. BIPAI s activities are primarily located in the Sub-Saharan region of Africa. The Baylor Medical Foundation is a Texas not-for-profit corporation organized exclusively to aid, support and maintain the College. Governed by a separate Board, in the event of dissolution of the Foundation, any funds or property then owned by the Foundation are to be transferred to the College. In accordance with Accounting Standards Codification (ASC) , Not-for-Profit Entities Financially Interrelated Entities, the College s interest in the net assets of the Foundation is included in the accompanying balance sheets (see Note 4). The consolidated financial statements of Baylor have been prepared on the accrual basis in accordance with accounting principles generally accepted in the United States (GAAP). Based on the existence or absence of donor-imposed restrictions, Baylor classifies resources into three categories: unrestricted, temporarily restricted, and permanently restricted net assets. Unrestricted net assets are free of donor-imposed restrictions. All revenues, gains, and losses that are not temporarily or permanently restricted by donors are included in this classification. All expenditures are reported in the unrestricted class of net assets, since the use of restricted contributions in accordance with donors stipulations results in the release of the restriction. Unrestricted net assets may be designated for specific purposes by the College s Board of Trustees. Temporarily restricted net assets are limited as to use by donor-imposed stipulations that expire with the passage of time or that can be satisfied by action of the College. These net assets may include unconditional pledges, interests in trusts held by others, and accumulated appreciation on donor-restricted endowments which have not yet been appropriated by the Board of Trustees for distribution. Permanently restricted net assets are amounts required by donors to be held in perpetuity. These net assets may include unconditional pledges, donor-restricted endowments (at historical value), and interests in trusts held by others. Generally, the donors of these assets permit the College to use a portion of the income earned on related investments for specific purposes. 7

9 Expirations of temporary restrictions on net assets (i.e., the passage of time along with the annual Board approval of the endowment spending rate and/or fulfilling donorimposed stipulations) are reported as net assets released from restrictions between the applicable classes of net assets in the consolidated statement of activities. Temporarily and permanently restricted net assets as of June 30, 2012 and 2011 are principally restricted for research, education, and capital costs associated with the BCM Medical Center. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses during the reporting period as well as the disclosure of contingent assets and liabilities. Actual results ultimately could differ from management s estimates and assumptions. Cash Equivalents Cash and cash equivalents are liquid assets with minimal interest rate risk and original maturities of three months or less when purchased. Such assets, reported at fair value, primarily consist of depository account balances, money market funds, and short-term U.S. Treasury securities. The College considers all unrestricted demand deposits and short-term managed pooled investments, with original maturities of 90 days or less, to be cash equivalents. Accounts Receivable, net Accounts receivable, net consists primarily of unreimbursed grant and contract expenditures and amounts owed by various affiliated hospitals to which the College provides residents and faculty. Unreimbursed grant and contract expenditures consist of receivables from the Federal Government, principally the National Institutes of Health, and other non-federal sources for payment for research provided by the College. Accounts receivable related to affiliated hospital and grant and contract amounts are reduced by approximately $2.5 and $1.7 million at June 30, 2012 and 2011, respectively, related to allowances for uncollectible accounts. Patient Receivables, net Patient receivables, net consists primarily of unreimbursed physician healthcare services. They are recorded net of an allowance for contractual adjustments and doubtful accounts to report the receivables at their estimated net realizable value. At both June 30, 2012 and 2011, the patient receivables were reduced by approximately $1.6 million related to the allowance for doubtful accounts. Contributions As pledges are made to the College, the intent of the donor, circumstances surrounding the pledge and any action taken by the College in response to the pledge are considered in determining whether the pledge is an unconditional promise to give or a conditional promise. Unconditional promises to give (pledges) are recognized as contributions 8

10 when the donor s commitment is received. Contributions with donor-imposed restrictions are recorded as unrestricted revenue if those restrictions are met in the same reporting period. Otherwise, contributions with donor-imposed restrictions are recorded as increases in temporarily restricted or permanently restricted net assets, depending on the nature of the restriction. Conditional promises (primarily bequest intentions) are not recorded until donor conditions are substantially met. Contributions recorded as temporarily restricted net assets are released from restrictions and recognized as unrestricted net assets after any donor stipulations are met. Contributions for plant facilities are released from restrictions and recognized as a nonoperating item only after resources are expended for the applicable plant facilities. Unconditional promises to give, that are expected to be collected within one year, are recorded at net realizable value. Unconditional promises to give that are expected to be collected in future years are recorded at fair value, which is measured as the present value of their future cash flows. The discounts on those amounts are computed using risk-adjusted interest rates applicable to the years in which the promises are received. Amortization of the discounts is included in contribution revenue. An allowance is made for uncollectible contributions receivable based upon Baylor s analysis of past collection experience and other judgmental factors. Investments The College s investments in marketable equity and fixed income securities are recorded at fair value. Non-marketable securities are securities for which no public market exists; substantially all of these securities are accounted for under the equity method, which approximates fair value. These non-marketable securities include investments in private equity limited liability corporations or partnerships. Other investments are stated at cost or fair value at the date of the acquisition or donation. Realized gains and losses arising from the sale or other disposition of investments have been accounted for as changes in unrestricted net assets unless restrictions have been imposed by the donor. Certain investments are pooled with each fund subscribing to or disposing of units on the basis of the market value per unit, which is computed monthly. Realized gains and losses arising from the sale of securities are determined on an average cost basis. The U.S. and international financial markets have experienced significant volatility that has resulted in substantial fluctuations in equity markets, in which the College invests. Market volatility can affect the value the College receives for its investments in future periods. Securities Lending The College participates in securities lending transactions whereby a portion of its investments are loaned, through its agent, to various parties in return for cash and securities from the parties as collateral for the securities loaned, usually on a short-term basis. Collateral provided by parties is maintained at levels of at least 100% of the fair 9

11 value of the securities on loan and is adjusted for market fluctuations. The fees received for these transactions are recorded as investment income. Property and Equipment Purchased property, plant, and equipment are recorded at cost, including, where appropriate, capitalized interest. Donated assets are recorded at fair value at the date of donation. Repairs and maintenance costs are expensed as incurred. Depreciation is calculated using the straight-line method to allocate the cost of various classes of assets over their estimated useful lives. Property, plant, and equipment are removed from the accounting records at the time of disposal. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An impairment charge is recognized when the fair value of the asset or group of assets is less than the carrying value. See Note 5 for a discussion of impairment charges. Unexpended Current Awards Unexpended current awards represent amounts received from grant and contract sponsors for which the College has not yet fulfilled its obligations. These amounts will be recognized in future periods once the obligations have been satisfied. Fair Value Measurements Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosure (ASC 820) defines fair value, requires expanded disclosures about fair value measurements, and establishes a three-level hierarchy for fair value measurements based on the observable inputs to the valuation of an asset or liability at the measurement date. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. ASC 820 prioritizes the inputs to the valuation techniques used to measure fair value by giving the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to measurements involving significant unobservable inputs (Level 3 measurements). Furthermore, ASC 820 considers certain investment funds that do not have readily determinable fair values including private investments, hedge funds, real estate, and other funds. ASC 820 allows for the estimation of the fair value of investments in investment companies for which the investment does not have a readily determinable fair value using net asset value per share or its equivalent. See Note 8 for further discussion of Fair Value Measurement. Debt Portfolio Financial Instruments Long-term debt is reported at carrying value. The College employs derivatives in the form of fixed payor swaps, primarily interest rate exchange agreements, to help manage interest rate risks associated with variable-rate debt. Derivative financial instruments are reported at fair value with any resulting gain or loss recognized as a non-operating item 10

12 in the consolidated statements of activities. Periodic net cash settlement amounts with counterparties are accounted for as adjustments to interest expense on the related debt. Parties to interest rate exchange agreements are subject to risk for changes in interest rates as well as risk of credit loss in the event of nonperformance by the counterparty. Baylor deals only with high-quality counterparties that meet rating criteria for financial stability and credit worthiness. Additionally, the agreements require the posting of collateral when amounts subject to credit risk under the contracts exceed specified levels. Operating Results Operating results are broadly defined as changes in unrestricted net assets from operating activity. Unrestricted net assets are also affected by non-operating activities, which include endowment earnings and other, net of distributions, changes in the fair value of derivative financial instruments, contributions for plant facilities, and certain other non-recurring items. Revenue Recognition Baylor s revenue recognition policies are: Tuition and fees, net - Student tuition and fees, for training or educating undergraduate medical, research graduate and allied health students, are recorded as revenues during the year the related academic services are rendered. The College s academic year is generally consistent with its fiscal year. Student tuition and fees received in advance of services to be rendered are recorded as deferred revenue. Financial aid provided by Baylor for tuition and fees is reflected as a reduction of tuition and fees. Financial aid does not include payments made to students for services provided to Baylor. State appropriations - The College receives funding in the form of appropriations from the State of Texas Higher Education Coordinating Board (Coordinating Board) for the purpose of training or educating Texas resident undergraduate medical students and graduate medical residents. State of Texas appropriations recognized during fiscal years 2012 and 2011 were $46.3 million and $50.3 million, respectively. The College expended $169.8 million and $166.3 million, respectively, for fiscal years 2012 and 2011 to train and educate undergraduate medical students and graduate medical residents. Expenditures used to satisfy these appropriations are reflected as instruction expenditures and certain amounts related to the instruction of graduate medical residents are included in affiliated hospital programs expenditures in the schedule of Functional Expense (see Note 9). In July 2012, the Coordinating Board approved the transfer of the College s State funding to the Texas Health and Human Services Commission for state fiscal year An agreement is currently being finalized. The purpose of this intergovernmental transfer is to allow the use of the College s State funding to draw down Federal dollars under the Section 1115 Medicaid Waiver Program. Because this is a hospital-based program, the College has signed an agreement to collaborate with Texas Children's Hospital, pursuant to which Texas Children's Hospital will transfer to the College the amounts the College normally would receive from the Coordinating Board. All agreements include a 11

13 provision that the original appropriation will be returned to the College if the Federal match anticipated under the 1115 Waiver does not occur. Government and private grants and contracts - Government and private grants and contracts represents revenue from grants and contracts with federal, state and local governments, private foundations, and corporate sponsors primarily for research and education activities conducted by the College. Direct recoveries are recognized when allowable direct expenditures for salaries and supplies are incurred under the terms of each sponsor s agreement. Indirect recoveries represents reimbursement of the costs of facilities and administrative (F&A) overhead associated with government and private grants and contracts. Indirect recoveries are recognized as revenue as the corresponding allowable direct grant and contract expenses are incurred under the terms of each sponsor s agreement. Baylor s federal F&A costs recovery rate for oncampus research was 56.5% in both fiscal years 2012 and Baylor s federal F&A costs recovery rate for off-campus research was 27.1% in both fiscal years 2012 and Medical services - Medical services revenue, primarily for physician healthcare services, is reported at the anticipated realizable amounts from patients, third-party payors, and others for services rendered before any allowance for bad debt. Medical services revenue is reported at established rates, net of contractual adjustments, and indigent assistance services. Bad debt expense related to medical services in fiscal years 2012 and 2011 was $12.0 million and $17.5 million, respectively. The College has entered into payment agreements with certain commercial insurance carriers, health care maintenance organizations, and preferred provider organizations. The basis for payment to the College under these agreements is primarily prospectively determined rates. In addition, the College provides services to Medicare and Medicaid program beneficiaries in which the College is paid based on prospectively determined rates. Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The College believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing. While no such regulatory inquiries have been made, compliance with such laws and regulations can be subject to future government review and interpretation, as well as significant regulatory action including fines, penalties, and exclusion from the Medicare and Medicaid programs. Changes in the Medicare and Medicaid programs could have an adverse or positive impact on prospective medical services revenues. At June 30, 2012 and 2011, revenue from the Medicare and Medicaid programs accounted for approximately 31% and 33%, respectively, of the College s medical service revenues. The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not limited to, matters such as licensure, accreditation, governmental health care program participation requirements, reimbursement for patient services, and Medicare and Medicaid fraud and abuse. 12

14 Charity Care The College is committed to providing assistance to financially indigent patients in the community who require care and services at reduced or no cost, as determined by its affiliated hospitals. Records are maintained to identify and monitor the level of charity care the College provides. These records include the amount of charges foregone and estimated costs for services and supplies furnished under its charity care policy. Costs incurred are estimated based on a Medicare cost factor applied to total gross charges for indigent patients after reducing costs for any payments received. The level of charity care provided, based on estimated costs, during fiscal years 2012 and 2011, and was $84.2 million and $90.5 million, respectively. Endowment Investments and Income Distribution The College s investments are managed to achieve the maximum long-term return. Investment income distribution and other consists of amounts distributed from the College s endowment funds and from operating investment income. The amount distributed from the endowment funds to support current operation is determined by the Board of Trustees and is based on a 5% distribution rate applied to a trailing 28-quarter average market value of the endowment portfolio. The Board may in its discretion designate additional funds to be used for operating purposes. The primary objective of the 5% endowment distribution methodology is to reduce the impact of capital market fluctuations on operational programs. Operating investment income consists of dividends, interest, and gains and losses on non-endowed investments. Operating investment income consists of dividends, interest, and gains and losses on nonendowed investments. Affiliated Hospital Contracts The College has affiliation agreements with area hospitals, including, but not limited to, Texas Children s Hospital, Harris Health (formerly Harris County Hospital District), St. Luke s Episcopal Hospital, Michael E. DeBakey Veterans Affairs Medical Center, The Methodist Hospital, The Menninger Clinic, MD Anderson Cancer Center and The Institute for Rehabilitation and Research. Under the terms of these agreements, the College conducts administrative, research and educational activities on behalf of these hospitals. In addition, the College provides residents to the affiliated institutions who in turn provide patient care services as part of their medical training. Mutual commitments include sharing of operational and research costs, including physicians salaries. Amounts due to the College from affiliated hospitals included in accounts receivable, net in the accompanying balance sheets as of June 30, 2012 and 2011 were $33.3 million and $29.9 million, respectively. Income Taxes The College is a tax-exempt organization as described in Section 501(c)(3) of the Internal Revenue Code (the Code), and is generally exempt from federal income taxes on related income pursuant to Section 501(a) of the Code. Baylor is, however, subject to federal and state income tax on unrelated business income and files unrelated business income tax and other information returns as required by government authorities. Tax 13

15 positions taken related to the College s tax exempt status, unrelated business income activities taxable income and deductibility of expenses and other miscellaneous tax positions have been reviewed and management is of the opinion that material positions taken by the College would more likely than not be sustained by examination. Accordingly, the College has not recorded an income tax liability for uncertain tax positions as of June 30, Subsequent Events Baylor has evaluated events subsequent to June 30, 2012, and through the date on which the consolidated financial statements were available for issuance, October 25, 2012, and determined that there were no subsequent events requiring adjustment or disclosure in the financial statements, except as described in Notes 2, 6, 7 and 11. New Accounting Standards On January 21, 2010, the FASB issued Accounting Standard Update (ASU) No , Improving Disclosures about Fair Value Measurements, which amended ASC Topic 820, Fair Value Measurements and Disclosures to add new disclosure requirements about recurring and non-recurring fair value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. These new disclosure and clarification on existing disclosures were effective for reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. These disclosures are effective for fiscal years beginning after December 15, The College adopted the new disclosures and clarification that were effective as of December 31, 2009 in the prior year and adopted the remaining disclosures in the year ended June 30, In August 2010, the FASB issued ASU , Measuring Charity Care for Disclosure, which requires that costs be used as the measurement basis of charity care disclosures and that cost be identified as the direct and indirect cost of providing the charity care. The ASU also requires disclosure of the method used to identify the costs. The ASU is effective for fiscal years beginning after December 15, Retrospective application and early adoption are permitted. The College adopted the new disclosures in the year ended June 30, In August 2010, the FASB issued ASU , Health Care Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries (a consensus of the FASB Emerging Issues Task Force), which clarifies that health care entities should not net insurance recoveries against a related claim liability. Further, such entities should determine the claim liability without considering insurance recoveries. The ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, A cumulative-effect adjustment should be recognized in opening retained earnings in the period of adoption if a difference exists between any liabilities and insurance receivables recorded as a result of applying the amendments in the ASU. Retrospective application and early adoption are permitted. The College adopted the 14

16 ASU as of July 1, 2011 and the adoption had no material impact on the financial statements. On July 25, 2011, the FASB issued ASU , Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities (a consensus of the FASB Emerging Issues Task Force), which provides guidance on presentation and disclosure of patient service revenue and the related provision for bad debts and allowance for doubtful accounts. The ASU requires an entity, instead of showing bad debts as an operating expense, to present its patient service revenue net of its provision for bad debts in its statement of activities. In addition, the ASU calls for enhanced quantitative and qualitative disclosures about changes in the allowance for bad debts. The ASU is effective for the first annual period ending after December 15, Early adoption is permitted. The amendments to the presentation of the provision for bad debts related to patient service revenue in the statement of activities should be applied retrospectively to all prior periods presented. The additional disclosure requirements should be applied prospectively. The College did not elect to early adopt and is currently evaluating the impact that will result from adopting ASU to its financial statements. On December 16, 2011, the FASB issued ASU , Balance Sheet (Topic 210) Disclosures about Offsetting Assets and Liabilities, which contains new disclosure requirements regarding the nature of an entity s rights of setoff and related arrangements associated with its financial instruments and derivative instruments. The new disclosures are designed to make financial statements that are prepared under U.S. GAAP more comparable to those prepared under International Financial Reporting Standards (IFRS). Generally, it is more difficult to qualify for offsetting under IFRSs than it is under U.S. GAAP because under U.S. GAAP certain derivative and repurchase agreement arrangements are granted exceptions from the general offsetting model. As a result, entities with significant financial instrument and derivative portfolios that report under IFRSs typically present positions on their balance sheets that are significantly larger than those of entities with similarly sized portfolios whose financial statements are prepared in accordance with U.S. GAAP. To facilitate comparison between financial statements prepared under U.S. GAAP and IFRSs, the new disclosures will give financial statement users information about both gross and net exposures. The new disclosure requirements are effective for annual reporting periods beginning on or after January 1, 2013, and interim periods therein; retrospective application is required. The College did not elect to early adopt and is currently evaluating the impact that will result from adopting ASU to its financial statements. 15

17 (3) CONTRIBUTIONS RECEIVABLE Contributions receivable as of June 30, 2012 and 2011 are expected to be realized as follows (in thousands): In one year or less $ 43,209 $ 31,766 Between one year and five years 105,189 75,255 More than five years 38,966 50,479 Less: present value discount (.72% to 5.09%) (20,447) (23,675) Total $ 166,917 $ 133,825 Included in contributions receivable at June 30, 2012 and 2011 is $55.0 million and $8.8 million, respectively, for the BCM Medical Center. As of June 30, 2012 and 2011, the College had received conditional promises to give and indications of intentions to give of approximately $114.2 million and $153.0 million, respectively, in addition to the amounts recorded as contributions receivable. These conditional promises to give will be recognized in the accompanying financial statements in the periods in which the conditions are substantially met. (4) INVESTMENTS AND ENDOWMENT FUNDS Investments (including amounts for self-insurance) held by the College at June 30, 2012 and 2011, are as follows (in thousands): Pooled investments: Stocks (cost of $197,044 and $210,580) $ 284,031 $ 317,853 Bonds (cost of $62,678 and $75,244) 64,474 76,794 Other short-term investments 42,772 43,083 International equities (cost of $174,545 and $171,189) 157, ,618 Private equity securities (cost of $180,469 and $159,400) 236, ,596 Assets held for State of Texas (cost of $32,655 and $32,689) (28,778) (30,337) Total pooled investments $ 756,339 $ 803,607 Net equity interest in Baylor Medical Foundation 31,194 30,160 Other stocks (cost of $1,475 and $575) 10,730 8,781 Real estate, at cost 2,152 2,152 Assets held in trust (cost of $6,106 and $8,105) and other 10,449 12,654 Total investments $ 810,864 $ 857,354 In fiscal year 2000, the College received $25.0 million to establish a fund for investing a portion of receipts paid to the State of Texas under a judgment rendered in the tobacco settlement (the tobacco funds ). The College is responsible for the administration of the tobacco funds, which are invested along with the College s pooled investments; however, the College does not have title to the assets, and the tobacco funds are not 16

18 recorded in the financial statements. As of June 30, 2012 and 2011, the value of the distributed funds is included in pooled investments and a corresponding reduction to the College s investments has been recorded to reflect that the College does not currently have an ownership interest. The earnings of the tobacco funds are required to be remitted to the State of Texas which, in turn, appropriates the earnings to the College to benefit programs in medical research, health education and treatment. This distribution is included in state appropriations in the statement of activities. Investment performance, including equity earnings, for the years ended June 30, 2012 and 2011, is summarized as follows (in thousands): 2012 Operating Non Operating Temporarily Restricted Net Assets Permanently Restricted Net Assets Total Distribution of endowment earnings and other $ 2,552 $ - $ 91 $ - $ 2,643 Other investment income (loss) - 33 (9) 4 28 Net realized gains (losses) - 46,620 (2,555) ,253 Net unrealized gains (losses) - (28,955) (18,568) (926) (48,449) Total investment return (loss) $ 2,552 $ 17,698 $ (21,041) $ (734) $ (1,525) Investment return, designated for current operations 37,351 (37,351) Total investment return (loss), net of distributions to operations $ 39,903 $ (19,653) $ (21,041) $ (734) $ (1,525) 2011 Operating Non Operating Temporarily Restricted Net Assets Permanently Restricted Net Assets Total Distribution of endowment earnings and other $ 3,317 $ - $ 89 $ - $ 3,406 Other investment income Net realized gains - 60,142 20, ,237 Net unrealized gains - 44,766 47,533 2,542 94,841 Total investment return $ 3,317 $ 104,915 $ 68,386 $ 2,884 $ 179,502 Investment return, designated for current operations 37,210 (37,210) Total investment return (loss), net of distributions to operations $ 40,527 $ 67,705 $ 68,386 $ 2,884 $ 179,502 Included within net unrealized gains (losses) above are approximately $11.1 million and $13.7 million of the College s equity in earnings on private equity securities for the years ended June 30, 2012 and 2011, respectively. Endowment earnings are recorded net of investment management fees, which amounted to approximately $4.2 million and $4.6 million for the years ended June 30, 2012 and 2011, respectively. The College s endowment consists of approximately 688 individual funds established for a variety of purposes. Its endowment includes both donor-restricted endowment funds and funds designated by the College to function as endowments. As required by GAAP, net assets associated with endowment funds, including funds designated by the College 17

19 to function as endowments, are classified and reported based on the existence or absence of donor-imposed restrictions. ASC , Not-for-Profit Entities Presentation of Financial Statements Other Presentation Matters Classification of Donor Restricted Endowment Funds subject to the Uniform Prudent Management of Institutional Funds Act, provides guidance on the net asset classification of donor-restricted endowment funds for a notfor-profit organization that is subject to an enacted version of the Uniform Prudent Management of Institutional Funds Act of 2006 (UPMIFA) and improves disclosures about an organization s endowment funds (both donor-restricted and College-designated endowment funds). Interpretation of relevant law - The College has established policy consistent with UPMIFA as adopted by the state of Texas. The College seeks to preserve the fair value of the original gift as of the gift date of the donor restricted endowment funds absent explicit donor stipulations to the contrary. Accordingly, the College classified as permanently restricted net assets (a) the original value of gifts donated to the permanent endowment, (b) the original value of subsequent gifts to the permanent endowment, and (c) accumulations to the permanent endowment made in accordance with the direction of the applicable donor agreement at the time the accumulation is added to the fund. The remaining portion of the donor-restricted endowment fund that is not classified as permanently restricted net assets is classified as temporarily restricted net assets until appropriated for expenditure by the College in a manner consistent with the standard of prudence prescribed by UPMIFA. In accordance with UPMIFA, the College considers the following factors in making a determination to appropriate or accumulate donor restricted endowment funds: (1) The duration and preservation of the fund (2) The purposes of the College and the donor restricted endowment fund (3) General economic conditions (4) The possible effect of inflation and deflation (5) The expected total return from income and the appreciation of investments (6) Other resources of the College (7) The investment policies of the College 18

20 The College s endowment consists of the following net asset types at June 30, 2012 and 2011 (in thousands): 2012 Temporarily Permanently Unrestricted Restricted Restricted Total Donor-restricted endowment funds $ (5,010) $ 153,221 $ 308,064 $ 456,275 Board-designated endowment funds 330,755 10, ,002 Total endowments at June 30, 2012 $ 325,745 $ 163,468 $ 308,064 $ 797,277 Temporarily Permanently Unrestricted Restricted Restricted Total Donor-restricted endowment funds $ (2,523) $ 175,701 $ 294,289 $ 467,467 Board-designated endowment funds 361,648 10, ,312 Total endowments at June 30, 2011 $ 359,125 $ 186,365 $ 294,289 $ 839, Funds with deficiencies - From time to time, the fair value of the assets associated with the individual donor restricted endowment funds may fall below the level that the donor or UPMIFA requires the College to retain as a fund of perpetual duration. In accordance with GAAP, deficiencies of this nature reported in unrestricted net assets were $5.0 million and $2.5 million, as of June 30, 2012 and 2011, respectively. These deficiencies result from unfavorable market fluctuations and continued appropriation of certain programs that was deemed prudent by the Board of Trustees. Return objectives and risk parameters - The College recognizes the goals of endowment management are preserving the purchasing power of the assets and providing stable support for current programs. The primary focus of the College s endowment investment policy is structuring both the endowment s investment portfolio and its annual spending in order to balance the needs of current and future generations of scholars, scientists, patients and teachers. Current annual spending from the endowment, plus inflation, combines to create a minimum target total return for the portfolio. The College expects its endowment funds, over time, to provide an average rate of return at least equal to the spending policy requirements plus the rate of inflation. Actual rates of returns in any given year may vary from this amount. Strategies employed for achieving objectives - The College employs strategies of investing in equity assets and some illiquid assets, broadly diversifying and investing in assets that are out of favor. The College believes these strategies will help achieve the total return target over the long-term. 19

21 Spending policy and how the investment objectives relate to spending policy - The College s board approved endowment earnings distribution policy, as permitted by the UPMIFA, is based on a 5% distribution applied to a trailing 28-quarter average market value of the endowment assets, for both fiscal years. In establishing this spending policy, the College considered the long-term expected return on its endowment assets and expects the current spending policy to preserve the real purchasing power of the endowment assets, while helping to maintain intergenerational value of the assets, as well as to provide additional real growth through new contributions and investment return. The following endowment-related activities occurred during the years ended June 30, 2012 and 2011 (in thousands): 2012 Temporarily Permanently Unrestricted Restricted Restricted Total Endowment net assets at June 30, 2011 $ 359,125 $ 186,365 $ 294,289 $ 839,779 Investment income, net of expense 22, ,125 Contributions 7,518 (427) 14,649 21,740 Realized & unrealized gains/(losses) (761) (22,063) (874) (23,698) Appropriation of endowment assets for expenditure (37,400) - - (37,400) Other changes: Transfer from board designated endowments within unrestricted net assets (24,862) (407) - (25,269) Endowment net assets at June 30, 2012 $ 325,745 $ 163,468 $ 308,064 $ 797, Temporarily Permanently Unrestricted Restricted Restricted Total Endowment net assets at June 30, 2010 $ 394,618 $ 124,812 $ 273,874 $ 793,304 Investment income, net of expense 105,635 61,516 2, ,899 Contributions 14, ,667 32,599 Appropriation of endowment assets for expenditure (37,258) - - (37,258) Other changes: Transfer from board designated endowments within unrestricted net assets (118,566) (199) - (118,765) Endowment net assets at June 30, 2011 $ 359,125 $ 186,365 $ 294,289 $ 839,779 20