Children s Hospital of Chicago Medical Center and Affiliated Corporations Consolidated Financial Statements August 31, 2012 and 2011

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1 Children s Hospital of Chicago Medical Center and Affiliated Consolidated Financial Statements

2 Index Page(s) Report of Independent Auditors...1 Consolidated Financial Statements Consolidated Balance Sheets...2 Consolidated Statements of Operations and Changes in Net Assets Consolidated Statements of Cash Flows Supplemental Information Consolidating Balance Sheet Consolidating Statement of Operations and Changes in Unrestricted Net Assets...37

3 Report of Independent Auditors To the Board of Directors of Children s Hospital of Chicago Medical Center In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and changes in net assets and of cash flows present fairly, in all material respects, the financial position of Children s Hospital of Chicago Medical Center and its subsidiaries (the Medical Center ) at, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Medical Center s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Our audits were conducted for the purpose of forming an opinion on the consolidated financial statements taken as a whole. The consolidating information on pages is presented for purposes of additional analysis of the consolidated financial statements rather than to present the financial position and results of operations of the individual entities. Accordingly, we do not express an opinion on the financial position and results of operations of the individual entities. However, the consolidating information has been subjected to the auditing procedures applied in the audit of the consolidated financial statements, and in our opinion, is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole. December 5, 2012 PricewaterhouseCoopers LLP, One North Wacker, Chicago, IL T: (312) , F: (312) ,

4 Consolidated Balance Sheets The accompanying notes are an integral part of these consolidated financial statements Assets Current assets Cash and cash equivalents $ 20,602,291 $ 18,274,095 Current portion of self-insurance trust 28,500,000 12,600,000 Accounts receivable, net of allowance for uncollectible accounts of $11,155,000 and $8,792,000 in 2012 and 2011, respectively 112,723,462 33,220,474 Other current assets 53,132,133 42,652,669 Total current assets 214,957, ,747,238 Investments 866,501, ,502,360 Property and equipment, at cost Land 42,280,998 42,280,998 Buildings and improvements 1,098,308, ,481,903 Equipment 263,980, ,028,256 Construction in progress 14,723, ,191,260 Total property and equipment, at cost 1,419,293,954 1,382,982,417 Less: Accumulated depreciation 357,351, ,573,282 Property and equipment, net 1,061,942, ,409,135 Other assets Pledges receivable restricted by donors, net 91,471,095 95,284,016 Unamortized bond issuance costs 8,643,412 8,659,223 Other 20,061,247 18,307,540 Total other assets 120,175, ,250,779 Total assets $ 2,263,577,729 $ 2,087,909,512 Liabilities and Net Assets Current liabilities Accounts payable and accrued expenses $ 166,142,330 $ 113,773,948 Current portion of self-insurance liability 28,500,000 12,600,000 Due to third-party payors 11,715,904 5,234,793 Total current liabilities 206,358, ,608,741 Other liabilities Self-insurance liability 74,270,343 92,742,973 Other noncurrent liabilities 74,242,196 21,695,616 Total other liabilities 148,512, ,438,589 Long-term debt 563,987, ,962,183 Total liabilities 918,858, ,009,513 Commitments and contingencies Net assets Unrestricted 1,006,616, ,225,923 Temporarily restricted 195,155, ,048,649 Permanently restricted 142,947, ,625,427 Total net assets 1,344,719,205 1,275,899,999 Total liabilities and net assets $ 2,263,577,729 $ 2,087,909,512

5 Consolidated Statements of Operations and Changes in Net Assets Years Ended Operating revenue Net patient service revenue $ 608,795,590 $ 564,349,456 Net assets released from restrictions Contributions and philanthropy used for program purposes 22,813,068 21,854,821 Grants and other restricted income used for program purposes 38,317,163 38,243,716 Board-designated endowment income 4,063,890 4,761,810 Other operating revenue 47,798,076 33,650,449 Total operating revenue 721,787, ,860,252 Operating expenses Salaries, wages, and employee benefits 400,697, ,588,168 Supplies and services 232,794, ,380,134 Depreciation 44,812,808 42,115,266 Provision for bad debts 9,177,365 7,149,732 Total operating expenses 687,481, ,233,300 Income from operations before interest and amortization 34,305,939 32,626,952 Interest and amortization of financing costs 8,541,378 4,593,041 Income from operations 25,764,561 28,033,911 Nonoperating income (expense) Investment return 39,194,165 59,844,582 Unrestricted contributions and bequests 20,283,359 19,433,135 Fund-raising expense (19,517,468) (14,758,078) Other general purpose releases from restrictions 7,500,000 7,500,000 Unrestricted net assets redesignated by the donors from temporarily and permanently restricted net assets - 38,446,842 Other (1,315,169) (6,041,810) Total nonoperating income 46,144, ,424,671 Excess of revenue over expenses $ 71,909,448 $ 132,458,582 The accompanying notes are an integral part of these consolidated financial statements. 3

6 Consolidated Statements of Operations and Changes in Net Assets Years Ended Unrestricted net assets Excess of revenue over expenses $ 71,909,448 $ 132,458,582 Net assets released from restrictions used for purchase of and construction of property and equipment 224,937, ,427 Retirement plan-related change other than net periodic retirement plan expense (35,763,062) 14,000,336 Other 306, ,425 Increase in unrestricted net assets 261,390, ,431,770 Temporarily restricted net assets Contributions 52,316,890 41,003,890 Grants and other restricted income 39,997,292 39,522,324 Investment return 8,882,547 16,053,907 Pledge receivable write-offs, net of change in allowance (2,413,997) (1,591,361) Net assets released from restrictions Contributions and philanthropy used for program purposes (22,813,068) (21,854,821) Grants and other restricted income used for program purposes (38,317,163) (38,243,716) Other general purpose releases (7,500,000) (7,500,000) Purchase of property and equipment (224,937,859) (666,427) Transfers (61,671) (1,057,281) Temporarily restricted net assets redesignated by the donors to unrestricted net assets - (11,276,088) Other (46,559) (242,013) (Decrease) increase in temporarily restricted net assets (194,893,588) 14,148,414 Permanently restricted net assets Contributions 1,353,886 3,114,183 Change in fair value of perpetual trusts 860,224 2,423,336 Transfers 61,671 1,057,281 Permanently restricted net assets redesignated by the donors to unrestricted net assets - (27,170,754) Other 46, ,194 Increase (decrease) in permanently restricted net assets 2,322,340 (20,334,760) Increase in net assets 68,819, ,245,424 Net assets Beginning of year 1,275,899,999 1,134,654,575 End of year $ 1,344,719,205 $ 1,275,899,999 The accompanying notes are an integral part of these consolidated financial statements. 4

7 Consolidated Statements of Cash Flows Years Ended Cash flows from operating activities Increase in net assets $ 68,819,206 $ 141,245,424 Adjustments to reconcile change in net assets to net cash provided by operating activities Realized and unrealized gains on investments (39,194,165) (59,844,582) Restricted contributions and restricted investment return (42,193,994) (50,217,922) Receipt of contributed securities (3,893,224) (3,283,516) Retirement plan - related change other than net periodic retirement plan expense 35,763,062 (14,000,336) Depreciation and amortization 45,534,071 42,606,546 Provision for bad debts 9,177,365 7,149,732 Net changes in assets and liabilities Accounts receivable, net (88,680,353) (13,166,875) Accounts payable and accrued expenses 17,367,443 (4,652,900) Due to third-party payors 6,481,111 (5,691,981) Self-insurance liability (2,572,630) 2,734,321 Other assets and liabilities 7,468,609 8,770,795 Net cash provided by operating activities 14,076,501 51,648,706 Cash flows from investing activities Capital expenditures (197,508,071) (226,544,272) Sale of investments 652,799, ,378,300 Purchases of investments (499,278,252) (838,519,218) Net cash used in investing activities (43,986,740) (74,685,190) Cash flows from financing activities Principal payments under long-term debt obligations (114,100,000) - Proceeds from long-term debt financing 112,000,000 - Debt issuance costs 473,444 - Proceeds from restricted contributions and restricted investment income 33,864,991 33,334,961 Net cash provided by financing activities 32,238,435 33,334,961 Increase in cash and cash equivalents 2,328,196 10,298,477 Cash and cash equivalents Beginning of year 18,274,095 7,975,618 End of year $ 20,602,291 $ 18,274,095 Supplemental disclosures of cash flow information Cash paid during the year for interest, net of amounts capitalized $ 4,987,000 $ 1,367,000 Noncash additions to property and equipment 47,793,000 12,793,000 The accompanying notes are an integral part of these consolidated financial statements. 5

8 1. Organization and Nature of Operations Children s Hospital of Chicago Medical Center, formerly Children s Memorial Medical Center (the Medical Center ), an Illinois not-for-profit corporation, is the sole member of Ann & Robert H. Lurie Children s Hospital of Chicago (the Hospital ), formerly Children s Memorial Hospital, a not-forprofit corporation. The Hospital, the first member of the Medical Center, was founded in 1882 by Julia Foster Porter to provide medical care for all children. Today, the Medical Center remains an independent, freestanding academic institution dedicated to the health and well being of all children. The Medical Center is also the sole member of Ann & Robert H. Lurie Children s Hospital of Chicago Research Center ( Research Center ), formerly Children s Memorial Research Center; Ann & Robert H. Lurie Children s Hospital of Chicago Foundation, Inc. (the Foundation ), formerly Children s Memorial Foundation; and the Pediatric Faculty Foundation, Inc. ( PFF ), all Illinois not for-profit corporations. Lurie Children s Medical Group, LLC ( LCMG ), formerly Children s Memorial Medical Group, a controlled affiliate of the Medical Center, is an Illinois limited liability company. The Medical Center is also the parent of CMMC Insurance Co. Ltd. ( CMMC Insurance ), a captive, offshore insurance entity. It is an organization described under the laws of the Cayman Islands. The Hospital owns and operates a pediatric hospital with a licensed capacity of 288 beds in Chicago, Illinois. The Hospital provides a complete range of pediatric health services, including pediatric inpatient medical and surgical care, tertiary care services, and emergency services. The Hospital also operates more than 50 specialty and primary care outpatient clinics at its main campus in the Streeterville neighborhood and other Chicago area locations, as well as two ambulatory care facilities and five outpatient specialty centers. The Research Center was established to improve pediatric health and health services through research and education. The Foundation carries out fund-raising and other related development activities in support of the Medical Center and its affiliated corporations. PFF provides physician services to a broad pediatric population in Chicago, surrounding counties, and across the State of Illinois and totals more than 370 pediatric care and subspecialty physicians. LCMG provides professional pathology, medical imaging, psychiatry, and dentistry services to the Hospital and its patients with more than 50 employed physicians. CMMC Insurance is a captive, offshore insurance entity whose sole function is to purchase reinsurance for the purpose of reducing risk and costs. It does not retain risk. CMMC Insurance has no employees and is managed on behalf of the Hospital by an independent Cayman Islandsbased management company. In April 2008, construction began on the Ann & Robert H. Lurie Children s Hospital of Chicago, which opened in June The Medical Center issued $380,000,000 of debt in May of 2008 (Note 9) primarily to support the project, with the remaining funding sources coming from philanthropy and hospital equity included in the board designated new hospital planning fund. As of August 31, 2012, total commitments on the project were approximately $839,631,000, of which approximately $779,129,000 has been expended. The old Lincoln Park Facility was closed as of June 2012 and is currently being decommissioned and prepared to be sold in the upcoming year. 6

9 Consolidation The accompanying consolidated financial statements of the Medical Center include the accounts of the Medical Center, the Hospital, the Research Center, the Foundation, PFF, LCMG, and CMMC Insurance. Intercompany transactions and accounts have been eliminated. 2. Summary of Significant Accounting Policies New Accounting Pronouncements In August 2010, the Financial Accounting Standards Board ( FASB ) updated guidance for healthcare entities regarding the presentation of insurance claims and related recoveries. The amendments in this update clarify that a healthcare entity should not net insurance recoveries against a related claim liability. Additionally, the amount of the claim liability should be determined without consideration of insurance recoveries. This update was adopted as of August 31, 2011 (refer to Note 11). In August 2010, the FASB issued ASU , Measuring Charity Care for Disclosure (ASU ). The provisions of ASU are intended to reduce the diversity in how charity care is calculated and disclosed across healthcare entities that provide it. Charity care is required to be measured at cost, defined as the direct and indirect costs of providing the charity care. Funds received to offset or subsidize the cost of charity care provided, for example from gifts or grants restricted for charity care, should be separately disclosed. As a healthcare entity does not recognize revenue when charity care is provided, this update will only require enhanced disclosures and will have no effect on the statements of operations and changes in net assets. This new guidance is effective for fiscal years beginning after December 15, 2010, with retrospective application required and with early application permitted. The Medical Center adopted this guidance as of August 31, In June 2011, the FASB Emerging Issues Task Force amended guidance for healthcare entities regarding the presentation and disclosure of the provision for bad debts and the allowance for doubtful accounts. The amendments in this update require certain healthcare entities to change the presentation of their statement of operations by reclassifying the provision for bad debts associated with patient service revenue from an operating expense to a deduction from patient service revenue. Additionally, healthcare entities are required to provide enhanced disclosure about the policies for recognizing revenue, assessing bad debts, and qualitative and quantitative information about changes in the allowance for doubtful accounts. This update will be effective for the Medical Center as of August 31, The updated guidance is not expected to have a material impact on the Medical Center s financial statements. 7

10 Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management of the Medical Center to make assumptions, estimates, and judgments that affect the amounts reported in the consolidated financial statements, including the notes thereto, and related disclosures of commitments and contingencies, if any. The Medical Center considers critical accounting policies to be those that require more significant judgments and estimates in the preparation of its consolidated financial statements, including the following: recognition of net patient service revenue, which includes contractual allowances and third-party payor settlements; provisions for bad debt; reserves for losses and expenses related to health care professional and general liabilities; valuation of alternative investments; and risks and assumptions for measurement of pension liabilities. Management relies on historical experience, on other assumptions believed to be reasonable under the circumstances, and recommendations made by the Medical Center external advisors and actuaries in making its judgments and estimates. Actual results could differ from those estimates. Cash and Cash Equivalents Cash and cash equivalents include unrestricted, undesignated marketable securities with original maturities of three months or less that are held for short-term cash management. Cash and cash equivalents are reported at their approximate fair value. Other Current Assets Other current assets for fiscal year 2012 and 2011 are as follows: Outreach Hospitals and Practice Plan Receivables $ 12,100,927 $ 6,219,343 Prepaids 11,873,201 7,692,432 Inventory 5,866,553 4,027,088 Insurance recoverables 14,459,495 10,578,392 Other 8,831,957 14,135,414 Total other current assets $ 53,132,133 $ 42,652,669 Investments The Medical Center pools its donor restricted, self-insurance, and undesignated and boarddesignated investments. Investment returns are allocated among unrestricted, temporarily restricted, and permanently restricted net assets based on the pro-rata share of the balances in each fund to the total investment pool. Investment income earned, at a fixed rate, on certain funds that are board-designated for patient care and education and on self-insurance trust assets is reported as other operating revenue. All other investment income and losses (including interest and dividends, realized gains and losses, and unrealized gains and losses) are reported as nonoperating income (loss) unless the income or loss is restricted by donor or law. Investment returns on permanently restricted net assets are allocated to the purposes specified by the donor or state law, either as temporarily restricted or unrestricted, as applicable. 8

11 Fair Value of Financial Instruments Financial instruments consist primarily of cash and cash equivalents, investments, accounts receivable, pledges receivable, accounts payable, accrued expenses, estimated third party payor settlements, and long-term debt. Except as otherwise disclosed, the fair value of financial instruments approximates their financial statement carrying amount. Inventories Inventories, which primarily consist of medical supplies and pharmaceuticals used for patient care, are stated at the lower of cost (first-in, first-out) or market value. Property and Equipment Property and equipment is recorded at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. One-half year s depreciation is taken in the year of acquisition, except for the new hospital project which is being depreciated based on the actual date placed into service. The useful lives of the major asset classifications are as follows: Buildings years Building improvements Equipment 5-20 years Computer hardware and software years 3-5 years In 2012 and 2011, The Medical Center disposed of approximately $196,193,000 and $112,000, respectively, of fully depreciated equipment and software that was no longer in use. The Medical Center continually evaluates whether circumstances have occurred that would indicate the remaining estimated useful life of long-lived assets may warrant revision or that the remaining balance of such assets may not be recoverable. When factors indicate that such assets should be evaluated for possible impairment, the Medical Center uses an estimate of the undiscounted cash flows over the remaining life of the asset in measuring whether the asset is recoverable. In connection with the selection of the new hospital site, the useful lives of the existing assets were evaluated for impairment. While no impairment adjustment was deemed necessary, the Medical Center has been recognizing accelerated depreciation compared to original estimates over reduced estimated useful lives to fully depreciate the buildings, leasehold improvements, and equipment which were not utilized by the Hospital. During the years ended August 31, 2012 and 2011, the Medical Center recognized $7,615,000 and $6,906,000, respectively, of accelerated depreciation on these assets. In 2012 and 2011, the Medical Center capitalized net interest expense of $16,736,000 and $20,130,000, respectively, in connection with the new hospital project. 9

12 Pledges Restricted by Donors As of August 31, 2012, approximately 41% of pledges restricted by donors are receivable within one year, 53% between two and five years, and 6% receivable beyond five years. Pledges are recorded at present value of their estimated future cash flow, net of allowances for uncollectible pledges of approximately $2,422,000 and $1,411,000 at, respectively, and present value discounts of approximately $13,462,000 and $11,582,000 at August 31, 2012 and 2011, respectively. Estimated future cash flows due after one year are discounted using interest rates ranging from 5% to 6% commensurate with estimated collection risks. Unamortized Bond Issuance Costs Bond issuance costs are deferred and amortized using the effective interest method over the life of the related debt. Self-Insurance Trust The self-insurance trust is reviewed annually by an independent actuary. The Medical Center contributes to the self-insurance trust amounts determined by the actuary to be sufficient to pay for expected future losses. Accruals related to the estimated self-insurance liability and the corresponding charge to expense are based on management s analysis of asserted and unasserted claims and management utilizes the actuary to assist in assessing these liabilities. Other Noncurrent Liabilities Other noncurrent liabilities for fiscal year 2012 and 2011 are as follows: Accrued pension liabilities $ 60,138,618 $ 17,772,947 Lease obligations 10,599, ,100 Other 3,503,656 3,428,569 Total other noncurrent liabilities $ 74,242,196 $ 21,695,616 Net Assets Net assets are classified based upon donor restrictions, if any, as follows: Unrestricted Net assets which are free of donor-imposed restrictions, all revenue, expenses, gains, and losses that are not changes in permanently or temporarily restricted net assets. Temporarily Restricted Net assets whose use is limited by donor-imposed stipulations that expire with the passage of time, that are restricted based on state laws or that can be fulfilled or otherwise removed by actions of the Medical Center pursuant to those stipulations. Temporarily restricted net assets held outside the endowment fund primarily relate to pledges receivable, grants, program support and new hospital funds. Permanently Restricted Net assets whose use is limited by donor-imposed stipulations that neither expire with the passage of time nor can be fulfilled or otherwise removed by actions of the Medical Center. 10

13 During fiscal year 2012, $224,938,000 of temporarily restricted funds were released to unrestricted net assets as a result of the completion of the new hospital consistent with the donor s intent. During fiscal year 2011, $38,447,000, which includes $27,170,000 of restricted endowments, $9,781,000 of related earnings and $1,496,000 of appropriated spend rate allocation, were redesignated to unrestricted as a result of the donors releasing the original restrictions. The Executive Board of the Hospital authorized the funds to be designated for a purpose consistent with the interests of the respective donors. Refer to Note 6 for further disclosure on endowments and related investment and spending policies. Net Patient Service Revenue Substantially all of the Medical Center s net patient service revenue in fiscal 2012 and 2011 was derived from third-party payors that provide for payments to the Medical Center at amounts different from its established rates. Payment arrangements include reimbursed costs (as contractually defined), discounted charges, and per diem payments. Reimbursement from certain programs is subject to audit. Settlements under these programs are accrued on an estimated basis in the period the related services are rendered and adjusted in subsequent periods as final settlements are determined. Provision is made on a current basis for the difference between charges for services rendered and the expected payments under these agreements and programs and are adjusted in future periods as final settlements are determined. As a result of the complex laws and regulations governing third-party payor programs, there is at least a reasonable possibility that recorded estimates will change by a material amount in the near term. Approximately 32% and 33% of the Medical Center s net patient service revenue in fiscal 2012 and 2011, respectively, was derived from the Illinois Medicaid program. In December 2008, the Centers for Medicare and Medicaid Services approved the Illinois Hospital Assessment Program to improve Medicaid reimbursement for Illinois hospitals. The Provider Assessment and Medicaid Program payments are in effect for the state fiscal years ended June 30, 2009 through December 31, During the year ended August 31, 2012, the Medical Center recorded a net benefit of $21,193,000, of which $17,661,000 related to state fiscal year 2012 and $3,532,000 related to state fiscal year Due to the tax assessment provisions contained in the legislation, implementation of the program affected both operating revenues and expenses in the consolidated statement of operations and changes in net assets. For the years ended, the Medicaid payment of $34,922,000 was included in net patient service revenue and the tax assessment of $13,729,000 was included in supplies and services expense. The amount of disproportionate share and other special payments from Medicaid, if any, that will be made to hospitals in the future, is uncertain. The absence of such payments could have a material adverse effect on the Medical Center s operating results. In fiscal 2012 and 2011, the Medical Center received approximately $8,399,000 and $7,898,000, respectively, in graduate medical education reimbursement. This Children s Hospital Graduate Medical Education ( CHGME ) program provides federal funds to freestanding children s hospitals to help them maintain graduate medical programs that train resident physicians. The program is administered by the HealthCare Resource Service Administration, a branch of the U.S. Department of Health and Human Services. The amount of future graduate medical education reimbursement funding that will be made to children s hospitals is uncertain. 11

14 Statement of Operations All activities of the Medical Center deemed by management to be ongoing, major and central to the provision of healthcare services are reported as operating revenues and expenses. Other activities deemed to be nonoperating include, unrestricted gifts, fundraising expenses and certain investment income (including realized gains and losses). The Medical Center recognizes changes in accounting estimates related to patient service revenue reserves and third-party payor settlements as more experience is acquired. Adjustments to prior year estimates for these items resulted in an increase in net patient service revenues of approximately $1,781,000 in fiscal year In fiscal year 2011, the adjustments resulted in an increase in net patient service revenue of approximately $8,500,000 and a reduction for the provision for bad debts of $2,000,000. The consolidated statements of operations and changes in net assets include excess of revenue over expenses. Changes in unrestricted net assets, which are excluded from the excess of revenue over expenses, consistent with industry practice, include contributions of (and assets released from restrictions for purposes of acquiring) long-lived assets, and pension benefit changes other than net periodic expense. Grants and Contributions Unrestricted contributions are included in nonoperating income (expense) when received. Unrestricted pledges of amounts to be received in future periods are recorded as temporarily restricted net assets and reflected as changes in unrestricted net assets when received. Grants and contributions restricted for a specific operating purpose are recorded as temporarily restricted net assets and reflected in unrestricted revenue when the funds are expended in accordance with the specifications of the grantor or donor. Contributions for capital expenditures, recorded as temporarily restricted net assets when received, are recorded as net assets released from restrictions when expended and placed into service. Interest in Trustee-Held Funds The Hospital recognizes an interest in trustee-held funds held at various financial institutions in which the Hospital has a beneficial interest. Annually, the financial institutions distribute a portion of the income earned on these funds to the Hospital to be used in support of operations. At, the Hospital s interests in these trustee-held funds at fair value totaled approximately $25,364,000 and $24,504,000, respectively, and are included in permanently restricted net assets. The change in fair value of these funds amounted to a gain of $860,000 and $2,423,000, for the years ended, respectively, and is included in permanently restricted net assets. Income Taxes The Internal Revenue Service has determined that the Medical Center, the Hospital, the Research Center, the Foundation, and PFF are all not-for-profit organizations under Section 501(c) (3) of the Internal Revenue Code (the Code ) and are exempt from federal income taxes on related income. LCMG is described as a disregarded entity and is treated as a branch or division of the Medical Center. Therefore, financial and other information applicable to LCMG is reported under the Medical Center. Reclassification Certain amounts in the 2011 financial statements have been reclassified to conform to the 2012 presentation. 12

15 3. Community Benefit Consistent with its mission, the Medical Center maintains a policy that sets forth the criteria pursuant to which health care services are provided free of charge or at a reduced rate to children whose families are unable to pay for the charges associated with their medical care. These services represent charity care and are not reported as revenue. The Hospital also provides a broad range of services and activities to support its charitable mission. These services include the following: Participation in the Medicaid program at a loss (net reimbursement less allocated cost incurred); Support of community medical needs through a variety of outreach programs and educational programs; Comprehensive research programs specifically targeted toward pediatric health to advance knowledge about the causes, treatment, and prevention of childhood diseases; and Training of medical students, pediatric residents, fellows and subspecialists. Funding for these services comes from Hospital income from operations, philanthropy raised by the Foundation, CHGME, and grants. The Medical Center has an established charity care policy and maintains records to identify and monitor the level of charity care it provides. These records include the estimated cost of unreimbursed services provided under its charity care policy and the excess of cost over reimbursement for Medicaid patients. The Medical Center also monitors the unreimbursed cost of patient bad debts. Because the Illinois All Kids program provides coverage for most Illinois uninsured children, the Medical Center has a relatively low number of requests for charity care. The Medical Center determines the costs associated with providing charity care by aggregating the overall cost to charge ratio, including salaries, wages, benefits, supplies, and other operating expenses, based on data from its financial results. The cost to charge ratio is applied to the charity care charges to calculate the charity care costs amount reported below. 13

16 Costs of unreimbursed charity care and community benefit programs for fiscal 2012 and 2011 are as follows: Excess of allocated cost over reimbursement for services provided to Medicaid patients $ 97,023,138 $ 86,158,709 Net benefit under the Illinois Hospital Assessment Program (21,192,658) (21,192,658) Excess of allocated cost over reimbursement for services provided to hospital Medicaid patients, net of net benefit under the Illinois Hospital Assessment Program 75,830,480 64,966,051 Estimated costs and expenses incurred to provide charity care 1,163,893 1,235,611 Unreimbursed cost of charity care 76,994,373 66,201,662 Estimated cost of patient bad debts 3,487,554 3,648,104 Funds allocated to research from unrestricted funds 7,138,246 7,078,166 Resident and fellows expense 15,369,682 15,493,437 Community clinic support 2,948,269 2,882,415 Child advocacy programs 5,495,460 2,644,229 Family support and interpretation services 6,525,590 6,605,020 Transplant patient family housing 169, ,901 Total cost of unreimbursed charity care and community benefit programs $ 118,128,374 $ 104,738,934 The Medical Center also reports community benefits on the IRS Form 990 and the Beneficial Activities for the Property Affidavit. As a result of differences in criteria and definitions between these reports the amounts calculated will vary. 4. Investments The Medical Center maintains a diversified asset allocation that places a greater emphasis on equity-based investments to achieve its long-term return objectives within prudent risk constraints. As of, investments consisted of the following, which includes the current portion of the self-insurance trust of $28,500,000 and $12,600,000, respectively: Short-term investments $ 69,863,113 $ 200,229,326 Common and preferred stock 342,590, ,432,278 Alternative investments 273,322, ,191,017 U.S. Government and agency securities 80,196,051 76,409,407 Corporate and municipal bonds 128,735, ,112,551 U.S. Government guaranteed fixed income - 2,034,062 Net receivable (payable) from investments sold (purchased) (631,598) (352,286) Accrued interest 925,660 1,046,005 Total investments $ 895,001,915 $ 997,102,360 14

17 The decrease in total investments from fiscal 2011 to fiscal 2012 was principally due to planned capital expenditures for the construction of the Hospital (Note 1). Short-term investments include cash and cash equivalents, certificates of deposit, money market funds, and securities with short-term maturities. Common and preferred stock includes public equities traded in both domestic and international markets excluding those investments classified as alternatives. Alternative investments include hedge funds, some publicly traded equities held in limited partnerships, and private equity investments. These include credit-oriented strategies, multistrategy funds where the manager has a broad mandate to invest opportunistically, and event driven funds where managers seek opportunity in various forms of arbitrage strategies as well as in corporate activities such as mergers and acquisitions. The Medical Center s investment in private equity is committed under contract to periodically advance additional funding as capital calls are exercised (Note 14). At August 31, 2012, $7,650,000 had been advanced against a total commitment of $15,000,000. All Medical Center investments are invested with external managers. The Medical Center pools its unrestricted, board-designated and donor-restricted investments. As of, donor-restricted and unrestricted investments are as follows: Donor - restricted investments and other assets limited as to use Project and capital funds $ 14,538,169 $ 14,546,968 Endowments 116,839, ,227,891 Specific purpose 105,683,580 92,319,643 Self-insurance trust 90,321,168 86,444,089 Interest in trustee-held funds 25,363,981 24,503,757 Total restricted investments 352,746, ,042,348 Unrestricted investments Undesignated and board-designated investments 531,274, ,278,674 New hospital-unrestricted 10,980, ,781,338 Total unrestricted investments 542,255, ,060,012 Total investments $ 895,001,915 $ 997,102,360 15

18 The composition and presentation of investment return as reflected in the accompanying consolidated statements of operations and changes in net assets for the years ended August 31, 2012 and 2011 are as follows: Unrestricted investment return Interest and dividend income $ 9,170,879 $ 9,782,994 Realized gains (losses) on sales of investments 13,393,897 (7,673,432) Unrealized gains on investments 9,915,583 46,382,413 Alternative investment gains 15,884,152 20,561,881 Total unrestricted investment return $ 48,364,511 $ 69,053,856 Reported as Board-designated endowment income $ 4,063,890 $ 4,761,810 Other operating investment return 5,106,456 4,447,464 Nonoperating investment return 39,194,165 59,844,582 Total unrestricted investment return 48,364,511 69,053,856 Temporarily and permanently restricted investment return Interest and dividend income 1,413,768 1,594,282 Net realized and unrealized gains on investments 8,329,003 16,882,961 Total restricted investment return 9,742,771 18,477,243 Total investment return $ 58,107,282 $ 87,531,099 Details on typical redemption terms by asset class and type of investments are provided below: Redemption Remaining Redemption Redemption Restrictions Restrictions in Investments Life Terms and Terms Place at year end Short-term investments N/A Daily None None Common and preferred stock N/A Daily to monthly with None None notice periods of 1 to 10 days Alternative investments N/A Quarterly to annually Lock-up provisions Approximately $1.6 million with varying notice ranging from 0 to 3 of investments are in periods years, Private Equity liquidating funds investments and a portion of some hedge funds are in sidepockets with no redemptions permitted U.S. Government and agency securities N/A Daily None None Corporate and municipal bonds N/A Daily None None U.S. Government guaranteed fixed income N/A Daily None None Accrued interest N/A Daily None None 16

19 5. Fair Value Measurements The Medical Center follows the provisions of the Financial Accounting Standards Board (FASB) official pronouncement on Fair Value Measurements for financial instruments. The pronouncement establishes a hierarchy of valuation inputs based on the extent to which the inputs are observable in the marketplace. Observable inputs reflect market data obtained from sources independent of the reporting entity and unobservable inputs reflect the entities own assumptions about how market participants would value an asset or liability based on the best information available. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value. The following describes the hierarchy of inputs used to measure fair value and the primary valuation methodologies used by the Medical Center for financial instruments measured at fair value on a recurring basis. The three levels of inputs are as follows: Level 1 Level 2 Level 3 Quoted prices in active markets for identical assets or liabilities. Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the same term of the assets or liabilities. Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The financial instrument s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The following table presents the investments carried at fair value as of August 31, 2012, by caption, including the current portion of the self-insurance trust of $28,500,000, by the valuation hierarchy defined above: Level 1 Level 2 Level 3 Total Assets Investments Short-term investments $ 69,863,113 $ - $ - $ 69,863,113 Common and preferred stock 271,123,469 71,466, ,590,375 Alternative investments - 23,252, ,070, ,322,978 U.S. Government and agency securities 10,804,727 69,391,324-80,196,051 Corporate and municipal bonds 17,529, ,206, ,735,336 Net receivable (payable) from investments sold (purchased) (631,598) - - (631,598) Accrued interest - 925, ,660 Total assets at fair value $ 368,688,809 $ 276,242,456 $ 250,070,650 $ 895,001,915 17

20 The following table presents the investments carried at fair value as of August 31, 2011, by caption, including the current portion of the self-insurance trust of $12,600,000, by the valuation hierarchy defined above: Level 1 Level 2 Level 3 Total Assets Investments Short-term investments $ 200,229,326 $ - $ - $ 200,229,326 Common and preferred stock 218,424,219 91,008, ,432,278 Alternative investments - 57,352, ,838, ,191,017 U.S. Government and agency securities 6,663,504 69,745,903-76,409,407 Corporate and municipal bonds 3,411, ,700, ,112,551 U.S. Government guaranteed fixed income - 2,034,062-2,034,062 Net receivable (payable) from investments sold (purchased) (352,286) - - (352,286) Accrued interest - 1,046,005-1,046,005 Total assets at fair value $ 428,376,548 $ 335,886,919 $ 232,838,893 $ 997,102,360 The following is a description of the Medical Center s valuation methodologies for assets and liabilities measured at fair value. Fair value for cash equivalents, corporate stocks, international stocks, U.S. Government bonds, corporate bonds, municipal bonds and mortgage and asset backed securities are measured using quoted market prices at the reporting date multiplied by the quantity held. Interests in trustee-held funds are valued at the fair value of the Hospital s interests at year-end based upon current market value of the underlying securities. The Medical Center has certain investments, principally limited liability corporations, partnerships, and absolute return strategy funds for which a portion of quoted market prices are not available. These investments are considered alternative investments. Because of the inherent uncertainty of valuations, values may differ from the values that would have been used had a ready market existed. The value of these alternative investments represents the ownership interest in the net asset value (NAV) of the respective partnership. The fair values (NAV) of the securities held by limited partnerships that do not have readily determinable fair values are determined by the general partner and are based on appraisals, or other estimates that require varying degrees of judgment. Investments included in Level 3 consist of the Medical Center s ownership in alternative investments. During 2012 and 2011, there were no transfers between investment Levels 1 and 2 which are considered material to the financial statements. 18

21 The following table is a rollforward of the 2012 balance sheet amounts for financial instruments classified by the Medical Center within Level 3 of the fair value hierarchy defined above: Level 3 Assets Alternative Investments Assets Beginning balance September 1, 2011 $ 232,838,893 Total net unrealized gains 20,809,493 Purchases 16,838,144 Sales (20,415,880) Ending balance August 31, 2012 $ 250,070,650 Of the total net unrealized gains related to alternative investments reflected above, $15,291,000 represents the unrestricted portion. This is reflected in the accompanying statements of operations and changes in net assets. The following table is a rollforward of the 2011 balance sheet amounts for financial instruments classified by the Medical Center within Level 3 of the fair value hierarchy defined above: Level 3 Assets Alternative Investments Assets Beginning balance September 1, 2010 $ 219,019,557 Total net unrealized gains 21,807,842 Net purchases, sales, issuances and settlements (7,988,506) Ending balance August 31, 2011 $ 232,838,893 Of the total net unrealized gains related to alternative investments reflected above, $16,798,000 represents the unrestricted portion. This is reflected in the accompanying statements of operations and changes in net assets. The methods described above may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Medical Center believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. The significant unobservable inputs used in the fair value measurement of the Medical Center s partnership investments include a combination of cost, discounted cash flow analysis, industry comparables and outside appraisals. Significant increases (decreases) in any inputs used by investment managers in determining net asset values in isolation would result in a significantly lower (higher) fair value measurement. 19

22 6. Endowments The Medical Center s endowment fund consists of individual donor-restricted endowment funds and funds designated by its Board to function as endowments. The net assets associated with endowment funds, including those funds designated by the Board to function as endowments, are classified and reported based on the existence or absence of donor-imposed restrictions. Illinois passed Uniform Prudent Management of Institutional Funds Act ( UPMIFA ). The Medical Center has interpreted UPMIFA as sustaining the preservation of the original gift as of the gift date of the donor-restricted endowment funds absent explicit donor stipulations to the contrary. As a result of this interpretation, the Medical Center classifies 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 gift instrument at the time the accumulation is added to the fund. The remaining portion of the donor-restricted endowment fund that is not classified in permanently restricted net assets is classified as temporarily restricted net assets until those amounts are appropriated for expenditure by the Medical Center in a manner consistent with the donor intent and standard of prudence prescribed by UPMIFA. Where the Board designates unrestricted funds to function as endowments they are classified as unrestricted net assets. The Medical Center had the following board-designated and donor-restricted endowment balances during the year ended August 31, 2012 delineated by net asset class: Board Designated Temporarily Permanently Unrestricted Restricted Restricted Total Endowment net assets at beginning of year $ 175,471,242 $ 57,837,843 $ 140,625,427 $ 373,934,512 Investment return Investment income - 1,413,768-1,413,768 Realized and unrealized gains - 7,468, ,224 8,329,003 Total investment return - 8,882, ,224 9,742,771 Contributions 150-1,353,886 1,354,036 Spend rate allocation 5,287, ,287,776 Appropriation of endowment assets for expenditure (2,926,230) (5,075,554) - (8,001,784) Other (2,113,428) (132,083) 108,230 (2,137,281) Endowment net assets at end of year $ 175,719,510 $ 61,512,753 $ 142,947,767 $ 380,180,030 20

23 Description of Amounts Classified as Permanently Restricted Net Assets and Temporarily Restricted Net Assets (Endowments Only): Temporarily Permanently Restricted Restricted Total Restricted for Research $ 16,431,555 $ 13,658,383 $ 30,089,938 Restricted for Pediatric Programs 45,081, ,289, ,370,582 $ 61,512,753 $ 142,947,767 $ 204,460,520 The Medical Center had the following board-designated and donor-restricted endowment balances during the year ended August 31, 2011 delineated by net asset class: Board Designated Temporarily Permanently Unrestricted Restricted Restricted Total Endowment net assets at beginning of year $ 137,856,982 $ 56,258,485 $ 160,960,187 $ 355,075,654 Investment return Investment income - 1,594,282-1,594,282 Realized and unrealized gains - 14,459,625 2,423,336 16,882,961 Total investment return - 16,053,907 2,423,336 18,477,243 Contributions 255,134-3,114,183 3,369,317 Spend rate allocation 2,855, ,855,158 Appropriation of endowment assets for expenditure (2,495,025) (4,571,260) - (7,066,285) Redesignation by donor from temporarily and permanently restricted to unrestricted net assets 36,951,609 (9,780,855) (27,170,754) - Other 47,384 (122,434) 1,298,475 1,223,425 Endowment net assets at end of year $ 175,471,242 $ 57,837,843 $ 140,625,427 $ 373,934,512 Description of Amounts Classified as Permanently Restricted Net Assets and Temporarily Restricted Net Assets (Endowments Only): Temporarily Permanently Restricted Restricted Total Restricted for Research $ 15,490,277 $ 13,658,383 $ 29,148,660 Restricted for Pediatric Programs 42,347, ,967, ,314,610 $ 57,837,843 $ 140,625,427 $ 198,463,270 21