NANTICOKE HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION YEARS ENDED JUNE 30, 2016 AND 2015

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1 NANTICOKE HEALTH SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION YEARS ENDED

2 TABLE OF CONTENTS YEARS ENDED INDEPENDENT AUDITORS' REPORT 1 CONSOLIDATED FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS 3 CONSOLIDATED STATEMENTS OF OPERATIONS 5 CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS 6 CONSOLIDATED STATEMENTS OF CASH FLOWS 7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9 SUPPLEMENTARY INFORMATION CONSOLIDATING BALANCE SHEET 33 CONSOLIDATING STATEMENT OF OPERATIONS 35 CONSOLIDATING STATEMENT OF CASH FLOWS 36 SUPPLEMENTARY DESCRIPTION OF ELIMINATING ENTRIES 37 INDEPENDENT AUDITORS' REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING AND ON COMPLIANCE AND OTHER MATTERS BASED ON AN AUDIT OF FINANCIAL STATEMENTS PERFORMED IN ACCORDANCE WITH GOVERNMENT AUDITING STANDARDS 38 INDEPENDENT AUDITORS REPORT ON COMPLIANCE FOR EACH MAJOR FEDERAL PROGRAM AND REPORT ON INTERNAL CONTROL OVER COMPLIANCE REQUIRED BY THE UNIFORM GUIDANCE 40 SCHEDULE OF EXPENDITURES OF FEDERAL AWARDS 42 NOTES TO SCHEDULE OF EXPENDITURES OF FEDERAL AWARDS 43 SCHEDULE OF FINDINGS AND QUESTIONED COSTS 44

3 CliftonLarsonAllen LLP CLAconnect.com INDEPENDENT AUDITORS REPORT Board of Directors Nanticoke Health Services, Inc. and Subsidiaries Seaford, Delaware Report on the Financial Statements We have audited the accompanying consolidated financial statements of Nanticoke Health Services, Inc. (a Delaware not for profit corporation) and Subsidiaries, which comprise the consolidated balance sheets as of June 30, 2016 and 2015, and the related consolidated statements of operations, changes in net assets, and cash flows for the years then ended, and the related notes to the financial statements. Management s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of the consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America and the standards applicable to the financial audits contained in Government Auditing Standards, issued by the Comptroller General of the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. An independent member of Nexia International (1)

4 Board of Directors Nanticoke Health Services, Inc. and Subsidiaries Opinion In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nanticoke Health Services, Inc. and Subsidiaries as of June 30, 2016 and 2015, and the results of their operations, changes in net assets and cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Other Matters Our audits were conducted for the purpose of forming an opinion on the consolidated financial statements as a whole. The supplemental consolidated information in the consolidating statements and description of eliminating entries on the table of contents is presented for purposes of additional analysis of the consolidated financial statements and is not a required part of the consolidated financial statements. The schedule of expenditures of federal awards, as required by Title 2 U.S. Code of Federal Regulations Part 200, Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards, is also presented for purposes of additional analysis and is not a required part of the consolidated financial statements. The consolidating statements, description of eliminating entries on the table of contents, and the schedule of expenditures of federal awards are the responsibility of management and were derived from and relate directly to the underlying accounting and other records used to prepare the consolidated financial statements. Such information has been subjected to the auditing procedures applied in the audit of the consolidated financial statements and certain additional procedures, including comparing and reconciling such information directly to the underlying accounting and other records used to prepare the consolidated financial statements or to the consolidated financial statements themselves, and other additional procedures in accordance with auditing standards generally accepted in the United States of America. In our opinion, the information is fairly stated, in all material respects, in relation to the consolidated financial statements as a whole. Other Reporting Required by Government Auditing Standards In accordance with Government Auditing Standards, we have also issued our report dated September 22, 2016 on our consideration of Nanticoke Health Services, Inc. s internal control over financial reporting and on our tests of its compliance with certain provisions of laws, regulations, contracts, and grant agreements and other matters. The purpose of that report is to describe the scope of our testing of internal control over financial reporting and compliance and the result of that testing, and not to provide an opinion on internal control over financial reporting or on compliance. That report is an integral part of an audit performed in accordance with Government Auditing Standards in considering Nanticoke Health Services, Inc. s internal control over financial reporting and compliance. a CliftonLarsonAllen LLP Baltimore, Maryland September 22, 2016 (2)

5 CONSOLIDATED BALANCE SHEETS ASSETS CURRENT ASSETS Cash and Cash Equivalents $ 12,196,786 $ 14,918,168 Patient Accounts Receivable, Net of Allowance of Doubtful Accounts of Approximately $12,868,000 in 2016 and $11,944,000 in ,057,545 15,654,859 Inventories 3,716,098 3,596,152 Prepaid Expenses and Other 2,798,323 3,058,220 Promises to Give, Current Portion 506, ,118 Total Current Assets 37,275,307 37,588,517 ASSETS LIMITED AS TO USE Board Designated Funds 47,217,315 51,801,469 Other Investments 10,307,703 10,243,299 Debt Service Reserve Fund 3,734,421 3,748,617 Interest Sinking Fund 1,096,037 1,472,225 Principal Sinking Fund 1,645,000 1,188,750 Total Assets Limited as to Use 64,000,476 68,454,360 PROPERTY AND EQUIPMENT 147,525, ,827,375 Less: Accumulated Depreciation and Amortization (84,416,499) (78,467,726) Property and Equipment, Net 63,109,187 53,359,649 OTHER ASSETS Security Deposits 28,525 28,525 Deferred Financing Costs, Net 832, ,791 Deferred Compensation 501, ,081 Investment in Joint Venture 225, ,741 Promises to Give, Net of Current Portion 1,074, ,372 Total Other Assets 2,662,773 2,724,510 Total Assets $ 167,047,743 $ 162,127,036 See accompanying Notes to Consolidated Financial Statements. (3)

6 LIABILITIES AND NET ASSETS CURRENT LIABILITIES Current Portion Long Term Obligations $ 3,604,114 $ 3,315,425 Accounts Payable and Accrued Expenses 12,974,143 12,791,229 Accrued Salaries and Payroll Taxes 3,861,305 3,285,289 Accrued Vacation 2,414,986 2,190,155 Accrued Interest Payable 1,044,275 1,075,975 Estimated Third Party Payor Settlements 300, ,955 Total Current Liabilities 24,198,823 23,270,028 LONG TERM OBLIGATIONS Bonds and Loan Payable, Net of Current Portion 52,349,988 46,682,215 Capital Lease Obligation, Net of Current Portion 2,058,235 2,019,863 Total Long Term Obligations 54,408,223 48,702,078 ACCRUED PENSION AND OTHER RETIREMENT BENEFITS 8,282,440 3,867,735 OTHER LIABILITIES 944,119 1,051,423 Total Liabilities 87,833,605 76,891,264 COMMITMENTS AND CONTINGENCIES NET ASSETS Unrestricted 74,308,080 81,330,764 Temporarily Restricted 4,906,058 3,905,008 Total Net Assets 79,214,138 85,235,772 Total Liabilities and Net Assets $ 167,047,743 $ 162,127,036 (4)

7 CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED UNRESTRICTED REVENUES Net Patient Service Revenues $ 154,007,742 $ 149,815,965 Provision for Bad Debts (10,769,230) (9,339,118) Net Patient Service Revenues, Less Provision for Bad Debts 143,238, ,476,847 Other Revenues 4,352,906 5,263,264 Interest Income 362, ,528 Net Assets Released from Restrictions, Used for Operations 492, ,908 Total Unrestricted Revenues 148,446, ,334,547 EXPENSES Salaries and Wages 49,550,317 45,931,767 Employee Benefits 16,422,927 15,055,463 Contract Labor 6,808,531 6,628,710 Physician Fees 14,946,552 11,094,229 Professional Fees 739, ,695 Purchased Services 15,768,344 14,823,375 Medical Supplies 17,253,204 16,287,712 Drugs 7,929,028 6,257,669 Repairs and Maintenance 1,083,132 1,194,521 Rental and Lease Expenses 1,336,810 1,169,224 Utilities 2,227,044 2,197,422 Insurance 1,412,803 1,922,771 Other Expenses 5,269,984 4,201,137 Depreciation 6,603,550 5,964,424 Interest and Amortization Expense 2,152,741 2,190,057 Total Expenses 149,504, ,661,176 OPERATING INCOME (LOSS) (1,058,300) 10,673,371 OTHER INCOME Investment Return 1,328,796 2,783,991 Changes in Net Unrealized Losses on Investments (2,400,971) (2,069,189) Total Other Income (1,072,175) 714,802 EXCESS (DEFICIT) OF REVENUES OVER EXPENSES (2,130,475) 11,388,173 Pension and Postretirement Adjustment (4,892,209) 1,337,797 INCREASE (DECREASE) IN UNRESTRICTED NET ASSETS $ (7,022,684) $ 12,725,970 See accompanying Notes to Consolidated Financial Statements. (5)

8 CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS YEARS ENDED UNRESTRICTED NET ASSETS Excess (Deficit) of Revenues over Expenses $ (2,130,475) $ 11,388,173 Pension and Postretirement Adjustment (4,892,209) 1,337,797 Increase (Decrease) in Unrestricted Net Assets (7,022,684) 12,725,970 TEMPORARILY RESTRICTED NET ASSETS Net Assets Released from Restrictions, Used for Operations (492,873) (211,908) Contributions 1,493,923 3,159,011 Increase in Temporarily Restricted Net Assets 1,001,050 2,947,103 INCREASE (DECREASE) IN NET ASSETS (6,021,634) 15,673,073 Net Assets Beginning of Year 85,235,772 69,562,699 NET ASSETS END OF YEAR $ 79,214,138 $ 85,235,772 See accompanying Notes to Consolidated Financial Statements. (6)

9 CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED CASH FLOWS FROM OPERATING ACTIVITIES Increase (Decrease) in Net Assets $ (6,021,634) $ 15,673,073 Adjustments to Reconcile Increase (Decrease) in Net Assets to Net Cash Provided by Operating Activities: Pension and Postretirement Adjustment 4,892,209 (1,337,797) Depreciation 6,603,550 5,964,424 Provision for Bad Debts 10,769,230 9,339,118 Loss from Investment in Joint Venture 81,688 30,406 Loss on Sale of Property and Equipment 144, ,475 Net Amortization of Bonds Premium (91,539) (91,539) Restricted Contributions (1,493,923) (3,159,011) Changes in Net Unrealized Gain on Investments 2,400,971 2,069,189 Change in Assets Limited As To Use 1,676,725 (3,937,973) Change in Deferred Compensation 121, ,988 Amortization of Deferred Financing Costs 49,042 49,042 Changes in Operating Assets and Liabilities, Net (12,894,478) (11,878,079) Net Cash Provided by Operating Activities 6,238,395 12,998,316 CASH FLOWS FROM INVESTING ACTIVITIES Net Cash Used for the Purchases of Property and Equipment (15,181,035) (10,335,113) Proceeds from Sale of Property and Equipment 33, ,375 Contributions to Investment in Joint Venture (42,000) (20,000) Net Cash Used by Investing Activities (15,189,374) (9,940,738) CASH FLOWS FROM FINANCING ACTIVITIES Restricted Contributions 1,493,923 3,159,011 Proceeds from Delaware Economic Development Loan 750,000 Proceeds from USDA Loan 7,500,000 Repayments of Revenue Bonds Payable and Capital Lease Obligations (2,764,326) (3,081,768) Net Cash Provided by Financing Activities 6,229, ,243 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (2,721,382) 3,884,821 Cash and Cash Equivalents Beginning of Year 14,918,168 11,033,347 CASH AND CASH EQUIVALENTS END OF YEAR $ 12,196,786 $ 14,918,168 See accompanying Notes to Consolidated Financial Statements. (7)

10 CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) YEARS ENDED CHANGES IN OPERATING ASSETS AND LIABILITIES, NET Change in Operating Assets: Patient Accounts Receivable, Net $ (13,171,916) $ (7,878,091) Inventories (119,946) (1,795,386) Prepaid Expenses and Other Assets 259,897 (814,208) Promises to Give (293,999) (922,490) Other Trustee Funds 376, ,284 Total Change in Operating Assets (12,949,776) (11,156,891) Change in Operating Liabilities: Accounts Payable and Accrued Expenses 182,914 (434,359) Accrued Salaries and Payroll Taxes 576, ,137 Accrued Vacation 224,831 48,791 Accrued Interest Payable (31,700) (15,201) Accrued Pension and Other Postretirement Benefits (477,504) (394,703) Estimated Third Party Payor Settlements (311,955) (110,091) Other Liabilities (107,304) 37,238 Total Change in Operating Liabilities 55,298 (721,188) CHANGES IN OPERATING ASSETS AND LIABILITIES, NET $ (12,894,478) $ (11,878,079) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Cash Paid for Interest $ 2,135,399 $ 2,156,216 Purchases of Equipment with Capital Lease Obligations $ 1,350,699 $ 2,206,212 See accompanying Notes to Consolidated Financial Statements. (8)

11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Nanticoke Health Services, Inc. was formed in January 1986 as a Delaware not for profit corporation to be governed by its Board of Directors. Nanticoke Health Services, Inc. is a membership corporation without capital stock and is exempt from federal income taxes under Section 501(c)(3) of the Internal Revenue Code (IRC). A brief description of the activities and operations of Nanticoke Health Services, Inc. and Subsidiaries (collectively known as the Organization ) follows: Nanticoke Health Services, Inc. (Health Services) Nanticoke Health Services, Inc. coordinates and supports health care delivery by establishing system wide policy and directing strategic planning for the subsidiaries. In addition, Health Services coordinates the community fundraising functions for the subsidiaries. Nanticoke Memorial Hospital, Inc. (the Hospital) The Hospital provides acute care patient services on an inpatient and outpatient basis. It is the most significant operating entity of the consolidated group. The Hospital is exempt from federal income taxes under Section 501(c)(3) of the IRC. Mid Sussex Medical Center, Inc. d/b/a Nanticoke Physician Network (the Physician Network) The Physician Network provides outpatient medical care in clinics located in Georgetown, Laurel, Bridgeville, Delmar and Seaford, Delaware as well as Federalsburg and Hurlock, Maryland. The Physician Network is exempt from federal income taxes under Section 501(c)(3) of the IRC. Nanticoke Insurance Corporation, Ltd. (NIC) NIC is a captive insurance entity established in the Cayman Islands, which was created to provide professional and general liability insurance to Health Services and professional liability coverage to physicians in the community. The accompanying consolidated financial statements include the accounts of each of the aforementioned corporations. All significant inter company accounts and transactions have been eliminated through consolidation. Use of Estimates The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (9)

12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Change in Accounting Policies During the year ended June 30, 2016, the Organization early adopted a provision of Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) , Financial Instruments Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. This provision eliminates the requirement for entities, other than public business entities, to disclose the fair values of financial instruments carried at amortized cost, as previously required by Accounting Standards Codification (ASC) As such, the entity has omitted this disclosure for the years ended June 30, 2016 and The early adoption of this provision did not have an impact on the entity s financial position or results of operations. Revenue from Contracts with Customers In May 2014, the Financial Accounting Standards Board (FASB) issued amended guidance to clarify the principles for recognizing revenue from contracts with customers. The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The guidance also requires expanded disclosures relating to the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required regarding customer contracts, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. The guidance will initially be applied retrospectively using one of two methods. The standard will be effective for the entity for annual reporting periods beginning after December 15, Management is evaluating the impact of the amended revenue recognition guidance on the entity s financial statements. Cash and Cash Equivalents Cash and cash equivalents include certain investments in highly liquid debt instruments with original maturities of three months or less. Patient Accounts Receivable, Net The Organization s policy is to perform in house collections procedures for approximately 90 days. A determination is made at that time as to what additional collection efforts to pursue. An allowance for doubtful accounts is recorded for accounts not yet written off that are anticipated to become uncollectible in future periods. The allowance for doubtful accounts was approximately $12,868,000 and $11,944,000 as of June 30, 2016 and 2015, respectively. Insurance coverage and credit information are obtained from patients when available. No collateral is obtained for accounts receivable. Accounts receivable from third party payors have been adjusted to reflect the difference between charges and estimated reimbursable amounts. (10)

13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Inventories Inventories, which primarily consist of medical supplies and drugs, are carried at the lower of cost or market. Cost is determined using the first in, first out method. Assets Limited as to Use In accordance with Accounting for Certain Investments Held by Not for Profit Organizations, the Organization accounts for all investments in debt and marketable equity securities (except those accounted for under the equity method of accounting) at fair value. The fair values of individual investments are based on quoted market prices of individual securities or investments or are estimated using quoted market prices of similar investments. Investment income (including realized gains and losses, unrealized gains and losses and interest and dividends) is reported as other income (expense) unless the income is restricted by donor or law. The cost of securities sold is based on the specific identification method. All investment balances are principally uninsured and subject to normal credit and market risk. Other investments consists of debt and marketable equity securities that are held by NIC. The Organization has designated its investment portfolio as trading with unrealized gains and losses included in excess of revenues over expenses. All other assets limited as to use primarily include assets held by trustees under indenture agreements and designated assets set aside by the board of directors for future capital improvements, over which the Board retains control and may at its discretion subsequently use for other purposes. Property and Equipment Property and equipment acquisitions are recorded at cost. Improvements that materially extend the useful lives of the assets are capitalized, while routine maintenance, repairs, and minor replacement costs are charged to operations when incurred. The Organization capitalizes all expenditures for property and equipment costing $5,000 or more and having useful lives greater than one year. Depreciation is provided over the estimated useful life of each class of depreciable asset and is computed using the straight line method. Equipment under capital lease obligations is amortized on the straight line method over the shorter period of the lease term or the estimated useful life of the equipment. Such amortization is included in depreciation and amortization in the consolidated statement of operations. Interest costs incurred on borrowed funds during the period of construction of capital assets is capitalized as a component of the cost of acquiring those assets. The Organization records impairment losses on property and equipment when events and circumstances indicate that it is probable that the assets are impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. Based on management s estimation process, no impairment losses have been recorded as of June 30, 2016 and (11)

14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Property and Equipment (Continued) Gifts of long lived assets such as land, buildings, or equipment are reported as unrestricted support, and are excluded from the deficit of revenues over expenses, unless explicit donor stipulations specify how the donated assets must be used. Gifts of long lived assets with explicit restrictions that specify how the assets are to be used and gifts of cash or other assets that must be used to acquire long lived assets are reported as restricted support. Absent explicit donor stipulations about how long those long lived assets must be maintained, expirations of donor restrictions are reported when the donated or acquired long lived assets are placed into service. Deferred Financing Costs Deferred financing costs are being amortized using the straight line method over the period the related bonds are outstanding, which approximates the effective interest rate method. The Organization incurred financing costs in the amount of $968,349 related to the issuance of the Series 2013 bonds (see Note 6). Investment in Joint Venture On June 9, 2011 the Hospital entered into a joint venture agreement with two other organizations to form Peninsula Home Care at Nanticoke, LLC. The Hospital owns 33 percent of the entity, as well as a 33 percent share in the income or losses according to the joint venture agreement. The following sets forth the investment in joint venture activity: Balance at July 1, 2014 $ 275,147 Contributions 20,000 Loss (30,406) Balance at June 30, ,741 Contributions 42,000 Loss (81,688) Balance at June 30, 2016 $ 225,053 Estimated Professional Liabilities The provision for estimated professional liability claims includes estimates of the ultimate costs for both reported claims and incurred but not reported claims. Due to uncertainties inherent in the claims estimation process, it is at least reasonably possible that actual claims paid could differ materially from the amounts accrued in the accompanying consolidated balance sheets. (12)

15 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Net Assets Unrestricted net assets consist of investments and otherwise unrestricted amounts that are available for use in carrying out the Organization s mission and include those expendable resources which have been designated for special use by the board of directors. Temporarily restricted net assets are those whose use has been limited by donors to a specific time period or purpose. Permanently restricted net assets have been restricted by donors to be maintained in perpetuity. The Organization did not have any permanently restricted net assets at June 30, 2016 and Net Patient Service Revenues The Organization has agreements with third party payors that provide for payments to the Organization at amounts different from its established rates. Payment arrangements include prospectively determined rates per discharge, reimbursed costs, discounted charges, and per diem payments. Net patient service revenue is reported at the estimated net realizable amounts from patients, third party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in future periods as final settlements are determined. Contributions Contributions from donors are classified as unrestricted, temporarily restricted, or permanently restricted net assets. Unrestricted contributions are reflected in the accompanying consolidated statements of operations. Temporarily restricted contributions are those limited by donors for specific uses. Such contributions are reflected as increases in unrestricted net assets when qualifying expenditures are made, thus releasing the restriction. Charity Care The Organization provides care without charge or at amounts less than its established rates to patients who meet certain criteria under its charity care policy. Because the Organization does not pursue collection of amounts determined to qualify as charity care, those amounts are not reported as revenues. The Organization provides care to patients who meet certain criteria under its financial assistance policy without charge. Key elements used to determine eligibility include a patient s demonstrated inability to pay based on family size and household income related to federal income poverty guidelines. (13)

16 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Charity Care The Organization s charity care guidelines were amended as of June 30, 2013 to be for families below 250% of the Federal Poverty Guidelines as published. The Organization has estimated its direct and indirect costs of providing care to indigent patients under its credit and collections policy. In order to estimate the cost of providing such care, management calculated a cost to charge ratio from internal financial data to the Organization s gross charge rate. The cost to charge ratio is applied to the charity care charges foregone to calculate the estimated direct and indirect cost of providing charity care. The total estimated cost of the aforementioned programs and services that benefit the community was approximately $2,175,000 and $2,617,000 for the years ended June 30, 2016 and 2015, respectively. Excess of Revenues over Expenses The consolidated statements of operations include excess of revenues over expenses and changes in net assets. Changes in unrestricted net assets, which are excluded from excess of revenues over expenses, consistent with industry practice, include the pension adjustment, the effect of discontinued operations and contributions received and used for additions to long lived assets. Other Revenues Other revenues include a loss on the sale of property previously owned by the Hospital of $144,985 for the year ended June 30, 2016 and a loss of $17,906 for the year ended June 30, In accordance with Accounting for Impairment or Disposal of Long Lived Assets, as the property did not meet the definition of a component of an entity, the loss has been included in other revenue in the accompanying consolidated statements of operations. Workers' Compensation Insurance The Organization has Workers' Compensation Insurance that covers all employees. This insurance is backed by letters of credit totaling $555,000 and $580,000 as of June 30, 2016 and 2015, respectively, as required by the insurance administrator. Income Taxes The Organization follows the standard of accounting for uncertainty in income taxes recognized in an entity s financial statements. The standard prescribes recognition and measurement of tax provisions taken or expected to be taken on a tax return that are not certain to be realized. The application of the standard had no impact on the Organization s consolidated financial statements. The Organization s tax returns are subject to review and examination by federal and state authorities. (14)

17 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Reclassifications Certain items in the prior year consolidated financial statements have been reclassified to conform to the current year s presentation. These reclassifications had no effect on total assets, net assets of the Organization, or the increase in net assets. Subsequent Events In preparing these consolidated financial statements, the Organization has evaluated events and transactions for potential recognition or disclosure through September 22, 2016, the date the consolidated financial statements were issued. The results of this evaluation indicated that there are no subsequent events or transactions that are required to be disclosed in these consolidated financial statements. NOTE 2 NET PATIENT SERVICE REVENUE The Organization has various agreements with third party payors that provide for payments to the Organization at amounts different from its established rates. A summary of the payment arrangements with major third party payors follows: Medicare Substantial portions of the Hospital s net patient service revenues are for services provided to patients participating in the Medicare and Medicaid programs. Under the Medicare Inpatient Prospective Payment System (PPS), the Organization is reimbursed a fixed amount per inpatient discharge based on a national rate adjusted for regional variation in wages and the diagnosis of the patient. These rates are adjusted annually by the Medicare program. Outpatient services at the Hospital are reimbursed by Medicare under the outpatient PPS. Outpatient services are reimbursed based on a national rate per service adjusted for regional variations in wages. These rates are adjusted annually by Medicare. Medicaid The Delaware Medicaid program utilizes the services of a Managed Care Organization (MCO) to administer the program for hospital services. Reimbursement from the MCO for inpatient services is based on a fixed reimbursement per case, and outpatient services are reimbursed either on a fixed fee basis or a percentage of charges based on cost, depending on the nature of the service. The difference between Medicare/Medicaid reimbursement and the Hospital s standard billing rates is recorded as a component of contractual allowances in determining net patient service revenues in the accompanying consolidated statements of operations. (15)

18 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 NET PATIENT SERVICE REVENUE (CONTINUED) Blue Cross Blue Shield A significant portion of the Hospital s net patient service revenues are for services provided to subscribers of Blue Cross Blue Shield of Delaware (Blue Cross) and other commercial insurers. The Hospital is reimbursed by Blue Cross and these other third party payors based on approved rates, less contractual discounts. These discounts are recorded as a component of contractual allowances in determining net patient service revenues in the accompanying consolidated statements of operations. The Physician Network Medicare/Medicaid The Physician Network is also a provider of health care services to Medicare and Medicaid patients. The Physician Network is reimbursed based on a fixed fee for service. Any difference between the payment amount and established rates is recorded as a component of contractual allowances in determining net patient service revenues. Net patient service revenues are reported at the estimated net realizable amounts from patients and third party payors for services rendered, including estimated retroactive adjustments and regulatory discounts under reimbursement agreements with third party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered, and adjusted in future periods, as final settlements are determined. In evaluating the collectability of accounts receivable, the Organization analyzes past results and identifies trends for each major payor source of revenue for the purpose of estimating the appropriate amounts of the allowance for doubtful accounts and the provision for bad debts. Data in each major payor source are regularly reviewed to evaluate the adequacy of the allowance for doubtful accounts. Specifically, for receivables relating to services provided to patients having thirdparty coverage, an allowance for doubtful accounts and a corresponding provision for bad debts are established for amounts outstanding longer than 90 days and for third party payors experiencing financial difficulties; for receivables relating to self pay patients, a provision for bad debts is made in the period services are rendered based on experience indicating the inability or unwillingness of patients to pay amounts for which they are financially responsible. Actual write offs are charged against the allowance for doubtful accounts. For the fiscal year ended June 30, 2016 and 2015 net patient service revenue increased approximately $312,000 and $110,000, respectively, due to changes in management s estimate of Medicare program settlements. The Medicare program s administrative procedures preclude final determination of certain amounts due to the Organization until after the various cost reports are audited or otherwise reviewed and settled upon by the respective administrative agencies. The cost reports have been finalized by Medicare through the June 30, 2014 filed report. (16)

19 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 NET PATIENT SERVICE REVENUE (CONTINUED) A summary of patient service revenue and contractual adjustments for the fiscal years ended June 30, 2016 and 2015 is as follows: Gross Patient Service Revenues: Medicare $ 156,437,619 $ 152,204,643 Medicaid 79,978,107 76,015,023 Commercial and Other 88,969,710 79,349,352 Self Pay 17,650,299 16,891,998 Revenue Deductions: Charity Care 5,605,251 6,548,661 Provision for Bad Debts 10,769,230 9,339,118 Contractual and Other Allowances 183,422, ,096,390 Net Patient Service Revenues $ 143,238,512 $ 140,476,847 The Organization recognizes patient service revenue associated with services provided to patients who have third party payor coverage on the basis of contractual rates for the services rendered. For uninsured patients that do not qualify for charity care, the Organization recognizes revenue on the basis of its standard rates for services provided (or on the basis of discounted rates, if negotiated or provided by policy). On the basis of historical experience, a significant portion of the Organization s uninsured patients will be unable or unwilling to pay for the services provided. Thus, the Organization records a significant provision for bad debts related to uninsured patients in the period the services are provided. NOTE 3 REGULATORY ENVIRONMENT 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 necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, and reimbursement for patient services. Recently, government activity has increased with respect to investigations and allegations concerning possible violations of fraud and abuse statutes and regulations by health care providers. (17)

20 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 REGULATORY ENVIRONMENT (CONTINUED) Violations of these laws and regulations could result in expulsion from government health care programs, together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations can be subject to future government review and interpretation. Also, future changes in federal and state reimbursement funding mechanisms and related government budgetary constraints could have an adverse effect on the Organization. The Organization is currently reviewing various aspects of its compliance with laws and regulations which include transactions which occurred in prior periods. Based upon its review thus far, management has not identified any significant violations which would have a material adverse effect on the accompanying consolidated financial statements. However, the ultimate determination of whether any contingent liabilities exist will not be finalized until this review is completed. NOTE 4 ASSETS LIMITED AS TO USE Assets limited as to use primarily include assets held by trustees under indenture agreements and designated assets set aside by the Board of Directors. Board Designated Funds Board designated funds represent investments designated by the Board of Directors for future capital replacements and other identified purposes. These investments consisted of the following as of June 30, 2016 and 2015: Cash and Certificates of Deposit $ 1,206,162 $ 9,207,003 Equity Securities and ETFs 27,054,921 23,403,606 U.S. Government Securities 12,431,030 13,826,848 Corporate Bonds 6,525,202 5,364,012 Board Designated Funds $ 47,217,315 $ 51,801,469 Trustee Funds Trustee funds include the interest fund, principal sinking fund, debt service reserve fund, and regulatory deposit. These funds are available to reimburse or directly pay costs associated with certain Hospital projects. Debt service reserve funds represent investments to be segregated and held pursuant to the terms of the revenue bond indentures (see Note 6). These funds will be utilized to fund debt service payments in the later years of the revenue bonds. These investments are stated at fair value and consist of the following as of June 30, 2016 and 2015: (18)

21 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 ASSETS LIMITED AS TO USE (CONTINUED) Cash and Certificates of Deposit $ 6,475,458 $ 6,409,592 Debt Service Reserve Fund $ 3,734,421 $ 3,748,617 Interest Sinking Fund 1,096,037 $ 1,472,225 Principal Sinking Fund 1,645,000 $ 1,188,750 Total $ 6,475,458 $ 6,409,592 Other Investments Other investments include funds held by NIC, which was formed to provide professional liability insurance (see Note 8) and consist of the following as of June 30, 2016 and 2015: Cash and Certificates of Deposit $ 297,598 $ 418,102 Equity Securities 3,523,337 3,488,415 U.S. Government Securities 2,582,241 1,985,307 Corporate Bonds 3,904,527 4,351,475 Other Investments $ 10,307,703 $ 10,243,299 NOTE 5 PROPERTY AND EQUIPMENT Property and equipment consist of the following as of June 30, 2016 and 2015: Land $ 1,250,429 $ 1,380,076 Buildings and Improvements 78,120,792 68,241,971 Fixed and Movable Equipment 66,502,463 59,592,321 Construction in Progress 1,652,002 2,613,007 Property and Equipment 147,525, ,827,375 Less: Accumulated Depreciation and Amortization (84,416,499) (78,467,726) Property and Equipment, Net $ 63,109,187 $ 53,359,649 Construction in progress as of June 30, 2016 consists of various on going projects at Nanticoke, including office building renovations, new HVAC systems, as well as construction of a new Clinical Decision Unit. (19)

22 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 LONG TERM OBLIGATIONS Long term obligations consist of the following: Description Delaware Health Facilities Authority Revenue Bonds, Series 2013, maturing in varying annual amounts, principal due annually on July 1, 2014 through 2032, interest due semi annually, effective interest rates ranging from 1.59% to 4.85% $ 42,540,000 $ 44,125,000 Unamortized Portion of Bond Premium 1,548,530 1,640,069 Sub Total 44,088,530 45,765,069 Delaware Economic Development Authority Strategic Fund Loan, maturing in varying annual amounts through 2019, no stated interest rate 3,240,241 3,226,084 United States Department of Agriculture Note Payable, principal due monthly on June 25, 2016 through 2056, at an annual rate of interest of 2.875% 7,491,988 Various Capital Lease Obligations 3,191,578 3,026,350 Long Term Obligations 58,012,337 52,017,503 Less: Current Portion of Long Term Obligations 3,604,114 3,315,425 Long Term Obligations, Net of Current Portion $ 54,408,223 $ 48,702,078 Series 2013 Bonds In June 2013, the Delaware Health Facilities Authority (the Authority) issued $45,645,000 Revenue Bonds (Nanticoke Memorial Hospital Project) Series 2013 (Series 2013 Bonds) at a premium of $1,830,775. The proceeds of the issue, after the payment of deferred financing costs, were issued for the purposes of paying off the Series 2002A and 2002B bond issuances and funding a deposit to the Debt Service Reserve Fund. The Hospital entered into a loan agreement with the Authority for the proceeds of the 2013 Bonds. Under the terms of the loan agreement and Series 2013 Bonds, the Hospital is required to maintain certain deposits with a trustee. Such deposits are included within assets limited as to use. The loan agreement also places limits on the incurrence of additional borrowings and requires that the Hospital satisfy certain measures of financial performance, including a liquidity covenant, as long as the Series 2013 Bonds are outstanding. (20)

23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6 LONG TERM OBLIGATIONS (CONTINUED) Series 2013 Bonds (Continued) As security for the debt service requirements of the Series 2013 Bonds, the Hospital has granted to the Authority a mortgage lien on certain of its health care facilities in Seaford, Delaware, a security interest in all of the Hospital s gross revenues, certain fixtures and in the funds held under the bond indenture. The terms of the bond indenture restrict the Hospital s ability to create additional indebtedness and its use of the facilities, and require the Hospital to maintain stipulated insurance coverage and a rate structure in each year sufficient to meet certain covenant requirements, including a debt service coverage requirement and days cash on hand requirement. United States Department of Agriculture In May 2016, the United States Department of Agriculture loaned the Hospital $7,500,000. The proceeds of the loan were used to fund the construction of the Medical Pavilion Center. The loan has a stated interest rate of 2.875% and is scheduled to mature on May 25, Delaware Economic Development Authority In February 2009, the Delaware Economic Development Authority loaned the Hospital $4,489,729. The proceeds of the loan was used to decrease the some of the existing debt at the time of the loan as well as assisting in the seamless delivery of health care to both the insured and uninsured population of Delaware. The loan has no stated interest rate, and is scheduled to mature in Capital Lease Obligations The Organization has entered into various capital lease agreements for certain medical equipment. As of June 30, 2016 and 2015 the gross amount of the equipment and related accumulated amortization recorded under these leases is as follows: Equipment $ 9,231,586 $ 8,442,131 Less: Accumulated Amortization (5,749,972) (5,770,927) Leased Equipment, Net $ 3,481,614 $ 2,671,204 Scheduled principal payments on all long term obligations and payments on capital lease obligations at June 30, 2016 are as follows: Series Delaware Economic USDA Capital Lease Year Ending June 30, 2013 Bonds Development Authority Loan Obligations 2017 $ 1,645,000 $ 723,938 $ 101,833 $ 1,194, ,725, , , , ,810, , , , ,905, , , , ,000, , ,205 76,504 Thereafter 33,455,000 6,952,885 Total $ 42,540,000 $ 3,240,241 $ 7,491,988 3,317,392 Less: Amounts Representing Interest 125,814 Present Value of Net Minimum Lease Payments $ 3,191,578 (21)

24 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 OPERATING LEASES The Organization leases medical equipment and office space under operating leases. These leases expire on various dates with renewal options on many of the leases. Scheduled lease payments for the next five years on operating lease obligations at June 30, 2016 are as follows: Year Ending June 30, Amount 2017 $ 869, , , , ,801 Thereafter 1,240,338 Total $ 4,686,396 Rent expense for the years ended June 30, 2016 and 2015 for all operating leases was $1,425,099 and $1,225,186, respectively, and has been included within purchased services and other in the accompanying consolidated statements of operations. NOTE 8 PROFESSIONAL LIABILITY INSURANCE AND SELF INSURANCE In May 2004, NIC was formed to provide professional liability insurance for the Organization and, if required, for qualifying medical practices in the Organization s communities. NIC is a wholly owned subsidiary of Health Services. For the policy periods ended June 30, 2016 and 2015, the Hospital s coverage for Professional Liability was $2,000,000 per medical incident with a $6,000,000 annual aggregate limit. Health Services liability limit on the General Liability coverage was $2,000,000 per occurrence with a $6,000,000 annual aggregate limit. Effective July 1, 2014, an excess umbrella policy was also written with limits of $15,000,000 per occurrence with a $15,000,000 annual aggregate limit. All risks covered by the excess umbrella policy are reinsured by third party reinsurers. Primary coverage is insured under a retrospectively rated claims made policy; premiums are accrued based upon an estimate of the ultimate cost of the experience to date of each participating member institution. The basis for loss accruals for unreported claims under the primary policy is an actuarial estimate of asserted and unasserted claims including reported and unreported incidents and includes costs associated with settling claims. As of June 30, 2016 and 2015, estimates of losses and loss assessment expenses were approximately $4,989,000 and $4,590,000, respectively, and are principally recorded within accounts payable and accrued expenses in the accompanying consolidated balance sheets. Projected losses were estimated on an undiscounted basis at an expected level as their best estimate for both fiscal years ended June 30, 2016 and (22)

25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 9 RETIREMENT PLANS The Hospital has a qualified noncontributory defined benefit plan (Pension Plan) covering substantially all employees of the Hospital. The Hospital s funding policy is to make sufficient contributions to the Pension Plan to comply with the minimum funding requirements of the Employee Retirement Income Security Act (ERISA). At June 30, 2016 and 2015, the accrued pension liability is included in accrued retirement benefits in the accompanying consolidated balance sheets. The measurement date of the Pension Plan is June 30. Effective January 1, 2009, the Pension Plan was frozen and was replaced with augmentations to the Tax Sheltered Annuity Plan described in the following pages. The following table summarizes information about the Pension Plan for the fiscal years ended June 30, 2016 and 2015: Changes in Benefit Obligations Projected Benefit Obligation Beginning of Year $ 21,493,712 $ 22,748,733 Interest Cost 998, ,875 Actuarial (Gain) Loss Assumption Changes and Plan Experience 3,988,400 (1,233,892) Benefits Paid (1,009,128) (984,004) Projected Benefit Obligation End of Year $ 25,471,408 $ 21,493,712 Accumulated Benefit Obligation at End of Year $ 25,471,408 $ 21,493,712 Changes in Plan Assets Fair Value of Plan Assets Beginning of Year $ 18,661,654 $ 18,305,578 Actual Return on Plan Assets 127, ,080 Employer Contributions 500, ,000 Benefits and Expenses Paid (1,009,128) (984,004) Fair Value of Plan Assets End of Year $ 18,280,119 $ 18,661,654 Accrued Benefit Cost $ (7,191,289) $ (2,832,058) Employers are required to recognize the over funded or under funded status of a defined benefit postretirement plan as an asset or liability in its consolidated balance sheets and to recognize changes in that funded status in the year in which the change occurs through unrestricted net assets. The under funded status of the Pension Plan of $7,191,289 and $2,832,058 at June 30, 2016 and 2015, respectively, is recognized in the accompanying consolidated balance sheets as accrued pension and other retirement benefits. For the fiscal year ended June 30, 2016, net assets decreased for Pension Plan related changes other than periodic costs of $4,752,944. For the fiscal year ended June 30, 2015, net assets increased for Pension Plan related changes other than periodic costs of $1,290,924. (23)