Texas Children s. Combined Interim Financial Statements (Unaudited) June 30, Texas Children's 1

Transcription

1 Texas Children s Combined Interim Financial Statements (Unaudited) June 30, 2012 Texas Children's 1

2 HARRIS COUNTY HEALTH FACILITIES DEVELOPMENT CORPORATION HOSPITAL REVENUE BONDS (TEXAS CHILDREN S HOSPITAL PROJECT) SERIES 1999B MATURITY CUSIP NO. 10/01/ PN2 10/01/ PP7 SERIES 2008 MATURITY CUSIP NO. 10/01/ RU4 10/01/ RV2 10/01/ RW0 HARRIS COUNTY CULTURAL EDUCATION FACILITIES FINANCE CORPORATION HOSPITAL REVENUE BONDS (TEXAS CHILDREN S HOSPITAL PROJECT) SERIES 2009 MATURITY CUSIP NO. 10/01/ BW9 10/01/ BX7 10/01/ BY5 10/01/ BZ2 10/01/ CA6 10/01/ CB4 10/01/ CC2 10/01/ CD0 10/01/ CH1 10/01/ CE8 10/01/ CF5 10/01/ CG3 Texas Children's 2

3 HARRIS COUNTY CULTURAL EDUCATION FACILITIES FINANCE CORPORATION HOSPITAL REVENUE BONDS (TEXAS CHILDREN S HOSPITAL PROJECT) SERIES 2010 MATURITY CUSIP NO. 10/01/ DN7 10/01/ DP2 10/01/ DQ0 10/01/ DR8 10/01/ DS6 10/01/ DT4 10/01/ DU1 10/01/ DV9 10/01/ DW7 10/01/ DZ0 10/01/ EA4 10/01/ DX5 10/01/ DY3 Texas Children's 3

4 Contact information: Ben Melson Executive Vice President and Chief Financial Officer Texas Children s 6621 Fannin Houston, TX Telephone: (832) bbmelson@texaschildrens.org Rachel Shupe Controller Texas Children s 1919 S. Braeswood Blvd. Houston, TX Telephone: (832) rmshupe@texaschildrens.org Texas Children's 4

5 Disclaimer This document is marked with a dated date and speaks only as of that dated date. Readers are cautioned not to assume that any information has been updated beyond the dated date except as to any portion of the document that expressly states that it constitutes an update concerning specific recent events occurring after the dated date of the document. Any information contained in the portion of the document indicated to concern recent events speaks only as of its date. The information contained in this document may include "forward looking statements" by using forward-looking words such as "may," "will," "should," "expects," "believes," "anticipates," "estimates," or others. You are cautioned that forward-looking statements are subject to a variety of uncertainties that could cause actual results to differ from the projected results. Those risks and uncertainties include general economic and business conditions, receipt of funding grants, and various other factors that are beyond our control. Because we cannot predict all factors that may affect future decisions, actions, events, or financial circumstances, what actually happens may be different from what we include in forward-looking statements. Texas Children's 5

6 Combined Balance Sheets (Dollars in thousands) Assets June 30, September 30, (unaudited) (audited) Current assets: Cash and cash equivalents $ 113,055 $ 246,943 Patient receivables, net of allowances of $159,507 and $137,537, respectively 142, ,601 Other current assets 75,854 77,067 Assets limited as to use, current 26,271 19,377 Total current assets 357, ,988 Assets limited as to use 110,721 94,036 Investments 1,526,079 1,412,625 Property and equipment, net 1,550,384 1,483,098 Other assets 94,077 78,489 Total assets $ 3,638,490 $ 3,522,236 Liabilities and Net Assets Current liabilities: Accounts payable and accrued expenses $ 179,041 $ 257,507 Current portion of long-term debt 12,935 12,480 Current portion of capital lease obligation 2,903 2,903 Long-term debt subject to remarketing agreements 272, ,875 Total current liabilities 467, ,765 Long-term debt 415, ,801 Long-term capital lease obligation 25,284 27,266 Loss reserves 47,310 43,379 Other long-term liabilities 109, ,806 Total liabilities 1,065,672 1,159,017 Net assets: Unrestricted 2,314,163 2,108,157 Temporarily restricted 155, ,222 Permanently restricted 103,549 94,840 Total net assets 2,572,818 2,363,219 Total liabilities and net assets $ 3,638,490 $ 3,522,236 See accompanying notes to combined interim financial statements. Texas Children's 6

7 Combined Statements of Operations and Changes in Net Assets (Unaudited) (Dollars in thousands) Three Months Ended June 30, June 30, Nine Months Ended Changes in unrestricted net assets: Operating revenues: 316, ,188 Patient service revenue (net of contractuals and discounts) 918, ,693 (11,138) (9,732) Provision for doubtful accounts (31,616) (30,342) 304, ,456 Net patient service revenue less provision for doubtful accounts 887, , , ,939 Premium revenue 500, ,416 4,541 12,438 Disproportionate share income 16,688 23,430 5,080 3,566 Grants 14,882 14,450 9,749 10,740 Other 32,971 29,433 6,296 4,008 Net assets released from restrictions for operations 13,710 11, , ,147 Total operating revenues 1,466,309 1,282,557 Operating expenses: 192, ,193 Salaries and benefits 558, ,662 44,047 36,228 Supplies 119, , ,414 79,626 Medical and hospital 330, ,651 67,261 58,178 Professional fees 201, ,478 20,100 18,386 Operation of plant 52,461 47,880 23,846 20,597 Outside purchased services 67,639 56,183 17,793 14,807 General and administrative 48,567 42,735 32,909 24,779 Depreciation and amortization 82,582 70,294 5, Interest 6,028 3, , ,231 Total operating expenses 1,467,118 1,209,981 (18,084) 18,916 Operating income (loss) (809) 72,576 Nonoperating gains (losses): 3,951 13,725 Investment return 157, ,364 (6,180) (3,087) Change in interest rate swap valuation 639 8,341 (1,117) 179 Other (2,047) 719 (3,346) 10,817 Net nonoperating gains (losses) 156, ,424 Revenues and gains in excess (deficit) of expenses and losses, (21,430) 29,733 carried forward 155, ,000 See accompanying notes to combined interim financial statements. Texas Children's 7

8 Combined Statements of Operations and Changes in Net Assets (Unaudited), continued (Dollars in thousands) Three Months Ended Nine Months Ended June 30, June 30, Revenues and gains in excess of expenses and losses, (21,430) 29,733 brought forward 155, ,000 Net assets released from restrictions for purchases of property 5,717 1,821 and equipment and other 49,753 50,904-3,965 Other changes in net assets 777 3,583 (15,713) 35,519 Change in unrestricted net assets 206, ,487 Changes in temporarily restricted net assets: 3,587 7,359 Donor restricted contributions 36,303 23,300 1,859 1,566 Investment return 8,906 5,837 (8,548) (6,226) Net assets released from restrictions (58,514) (62,778) Change in beneficial interest in net assets of donor-restricted (361) (285) foundations 8,189 1,561 (3,463) 2,414 Change in temporarily restricted net assets (5,116) (32,080) Changes in permanently restricted net assets: 34 1,070 Donor restricted contributions 315 1, ,409 Investment return 8,394 3, ,479 Change in permantly restricted net assets 8,709 4,590 (18,322) 40,412 Change in net assets 209, ,997 2,591,140 2,446,869 Net assets at beginning of period 2,363,219 2,272,284 2,572,818 2,487,281 Net assets at end of period 2,572,818 2,487,281 See accompanying notes to combined interim financial statements. Texas Children's 8

9 Combined Statements of Cash Flows (Unaudited) (Dollars in thousands) Three Months Ended Nine Months Ended June 30, June 30, Cash flows from operating activities: (18,322) 40,412 Change in net assets $ 209,599 $ 214,997 Adjustments to reconcile change in net assets to net cash provided by operating activities: Change in beneficial interest in net assets of supporting organizations (8,189) (1,561) 2 (11,423) Net realized and unrealized losses (gains) on investments (152,988) (92,353) 32,890 24,513 Depreciation of property and equipment 82,257 69, Amortization of intangible assets 325 1,160 6,180 3,087 Change in interest rate swap valuation (639) (8,341) (189) (63) (Gain) loss on disposal of assets ,138 9,732 Provision for doubtful accounts 31,616 30,342 (6,170) (6,304) Temporarily and permanently restricted contributions (35,203) (39,211) Changes in assets and liabilities: (30,955) (9,435) Increase in patient accounts receivable (63,065) (42,518) 4,836 (63) Decrease (increase) in other assets (14,903) 13,275 (27,418) (5,868) Decrease in accounts payable and accrued expenses (78,466) (29,555) 1,966 - Increase in loss reserves 3,931 3,736 (13,493) (17,353) Decrease in other long-term liabilities (5,414) (9,943) (20,833) (12,557) Total adjustments (240,454) (105,503) (39,155) 27,855 Net cash (used in) provided by operating activities (30,855) 109,494 Cash flows from investing activities: 57,431 16,894 Sales (purchases) of investments, net 15,751 (158,913) (57,030) (65,354) Purchases of property and equipment (149,827) (215,351) 401 (48,460) Net cash provided by (used in) investing activities (134,076) (374,264) Cash flows from financing activities: (92) (109) Principal payment on long-term debt (12,757) (8,715) 68 - Deferred financing costs (24,530) - Payments on line of credit, net - - 6,170 6,304 Temporarily and permanently restricted contributions 35,203 39, ,409 Permanently restricted investment return 8,394 3,157 (17,564) 7,604 Net cash (used in) provided by financing activities 31,043 33,653 (56,318) (13,001) Decrease in cash and cash equivalents (133,888) (231,117) 169, ,344 Cash and cash equivalents at beginning of period 246, , , ,343 Cash and cash equivalents at end of period $ 113,055 $ 287,343 See accompanying notes to combined interim financial statements. Texas Children's 9

10 Notes to the Combined Interim Financial Statements (Unaudited) June 30, 2012 (Dollars in thousands) 1. ORGANIZATION In fiscal year 2012, Texas Children s changed its corporate structure in that Texas Children s Hospital (the Hospital), Texas Children s Pediatric Associates (TCPA), Texas Children's Health Plan, Inc. (TCHP), TCH Insurance Company, Ltd. (TCHICO), Texas Children's Hospital Foundation (TCHF), Texas Children s Women s Specialists (TCWS) and Texas Children s Physician Group (TCPG) (Other Affiliates) are wholly owned subsidiaries of Texas Children s (formerly known as TCH System, Inc. (TCHS)). Prior to fiscal year 2012, Other Affiliates and TCHS were subsidiaries of the legal entity Texas Children s Hospital. The legal structure change did not result in any financial statement impact. All significant intercompany balances and transactions have been eliminated in combination. The Hospital is comprised of a 555 licensed-bed comprehensive tertiary care pediatric facility and a 105 licensed-bed facility providing obstetrics and gynecological care, both located in Houston s Texas Medical Center and a 48-licensed-bed full service pediatric facility located in West Houston. The Hospital primarily provides direct patient care and conducts educational and research activities within Houston and its surrounding communities. The Hospital is exempt from federal income taxes under Section 501(c)(3) of the Internal Revenue Code (the Code). TCPA is organized to acquire, manage, and affiliate with pediatric practices, primarily in Houston and its surrounding counties, and to conduct educational and research activities. The sole corporate member of TCPA is the Hospital. TCPA is exempt from federal income taxes under Section 501(c)(3) of the Code. TCHP is operated to improve the quality, cost, and access of pediatric services delivered to health care members in its service area. TCHP has a Certificate of Authority from the Texas Department of Insurance and operates a health maintenance organization (HMO). The sole corporate member of TCHP is the Hospital. TCHP is exempt from federal income taxes under Section 501(c)(3) of the Code. TCHICO, a taxable for-profit entity, is operated to issue insurance policies to the Hospital and its affiliated entities. TCHICO provides primary and excess professional malpractice and general liability coverage. The sole shareholder of TCHICO is the Hospital. TCHF is a Texas nonprofit corporation operated for charitable, scientific and educational purposes, and in accomplishment of such purposes, is administered solely for the benefit of the Hospital. TCHF is exempt from federal taxes under Section 501(c)(3) of the Code. TCWS is organized to provide obstetric and gynecological services, education and research as the Hospital develops its new Pavilion for Women. The sole corporate member of TCWS is the Hospital. TCWS is exempt from federal taxes under Section 501(c)(3) of the Code. TCPG is organized to provide services in support of the Hospital and Baylor College of Medicine (Baylor) pediatric subspecialists affiliated with the Hospital. TCPG began operations in fiscal year The sole corporate member of TCPG is the Hospital. TCPG is exempt from federal income taxes under Section 501(c)(3) of the Code. Texas Children's 10

11 Notes to the Combined Interim Financial Statements (Unaudited), continued 2. BASIS OF PRESENTATION The accompanying unaudited combined financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The statement of operations and changes in net assets have been retrospectively adjusted in accordance with the adoption on October 1, 2011 of ASU , Health Care Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries, and ASU , Health Care Entities (Topic 954): Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities. In the opinion of management, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature. Operating results for the nine months ended June 30, 2012 are not necessarily indicative of the results expected for the year ending September 30, For further information, refer to the audited combined financial statements and notes thereto for the year ended September 30, USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the combined financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 4. FINANCIAL STATEMENT PRESENTATION Texas Children s funding sources include donors that have placed specific restrictions on the use of donated assets and, in certain instances, the use of the income derived from those assets. Net assets and revenues, expenses, gains, and losses are classified based on the existence or absence of donor-imposed restrictions. Accordingly, net assets of Texas Children s and changes therein are classified and reported as follows: Unrestricted net assets net assets that arise as a result of the operations of Texas Children s for its stated purposes and reported as revenues and gains in excess of expenses and losses, donations that are not subject to donor imposed restrictions, and unrealized gains and losses on investments. Temporarily restricted net assets net assets that are subject to donor-imposed restrictions based on the passage of time or the occurrence of a specific event. Permanently restricted net assets net assets required to be maintained in perpetuity, with only the income to be used for the Hospital s activities, due to donor-imposed restrictions. Temporarily restricted net assets are restricted to fund certain operating expenses, provide charity assistance to patients, and to purchase property and equipment. Permanently restricted net assets are restricted to investment in perpetuity, the income and appreciation from which are restricted for the aforementioned purposes in accordance with donor restrictions. The Hospital has a beneficial interest in the net assets of The Gordon and Mary Cain Pediatric Neurology Research Foundation, which is restricted for pediatric neurology programs and is included in temporarily restricted net assets. Texas Children's 11

12 Notes to the Combined Interim Financial Statements (Unaudited), continued 5. INVESTMENTS AND INVESTMENT RETURN Investments consist of fixed income securities, marketable equity securities, and interests in mutual funds, common trust funds, and exchange traded funds, which in turn invest in marketable securities. Additionally, the Hospital and TCHF hold ownership interests in certain limited liability partnerships and corporations that hold investments in hedge funds, private equity, real estate, managed futures, natural resources, and other investment categories (alternative investments). Investments are reflected in the combined balance sheets as investments or assets limited as to use. Assets limited as to use represent investments limited for specific purposes. Investments and assets limited as to use are classified as noncurrent assets, except for those required for current obligations, which are classified as current assets. Investments in marketable securities, fixed income securities, certain mutual funds, and exchange-traded funds with readily determinable fair values are reported at fair value. Investments in common trust funds and limited liability partnerships and corporations do not have readily determinable fair values and are recorded based on Texas Children s share of the underlying value of portfolio securities held by these funds, as reported to Texas Children s. For certain alternative investments, positions are recorded at amounts as reported by the related investment managers. The investments in limited liability partnerships and corporations are accounted for under the equity method of accounting. Under this method, the equity in earnings includes changes in reported values in the underlying investments. Generally, the underlying investments are not readily marketable and the alternative investments may not be redeemable except in certain circumstances. As a result, reported values cannot be validated by the management of Texas Children s, reported values may not be reliable, and there can be no assurance such reported amounts will be ultimately realized. As of June 30, 2012, management has utilized the best available data for reported investment values, which in some instances are valuations as of September 30, Investment return includes interest and dividend income, realized and unrealized investment gains and losses, and earnings from investments accounted for under the equity method. Investment income on assets held by bond trustee and assets held for Texas Children s insurance program is included in other revenue. All other investment return is recorded as nonoperating gains and is included in revenues and gains in excess of expenses and losses, unless investment return is restricted by donor or law. Investment return is initially recorded as unrestricted, temporarily restricted, or permanently restricted based on donor-imposed restrictions, if any. Restricted amounts are reflected as net assets released from restrictions in the combined statements of operations and changes in net assets to the extent they become available for use during the period. At June 30, 2012, and September 30, 2011, Texas Children s had $510,734 and $447,998, respectively, in alternative investments and other investments. These funds are invested with external investment managers who invest primarily in various alternative categories, including real estate, long and short equity positions, natural resources, private equity, managed futures, emerging markets, distressed enterprises and arbitrage positions. These investments are domestic and international in nature, are illiquid, and may not be realized for a period of several years after the investments are made. The risks associated with these investments are numerous and include liquidity risk, market risk, event risk, foreign exchange risk, interest rate and investment manager risk. Texas Children s has committed approximately $86,864 of future funding to various alternative investments as of June 30, Texas Children's 12

13 Notes to the Combined Interim Financial Statements (Unaudited), continued These funds are subject to numerous risks as outlined above resulting in greater likelihood of losing invested capital. The risks include the following: Non-regulation risk they are not required to register with the SEC and are not subject to regulatory controls. Managerial risk fund managers may fail to produce the intended returns and are not subject to oversight. Minimal liquidity many funds impose lock-up periods that prevent investors from redeeming their shares or impose penalties to redeem. Limited transparency as unregistered investment vehicles, funds are not required to disclose the holdings in their portfolios to investors. Investment strategy risk the funds often employ sophisticated, risky investment strategies and are speculative and may use leverage, which could result in volatile returns. 6. FAIR VALUE OF FINANCIAL INSTRUMENTS Texas Children s uses various inputs in determining the fair value of its investments and measures these assets on a quarterly basis. Financial assets and liabilities recorded at fair value in the combined balance sheet are categorized by the level of objectivity associated with the inputs used to measure their fair value. Authoritative guidance establishes a three-level hierarchy for disclosure of fair value measurements. The valuation hierarchy is based on the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows: Level 1 Inputs to the valuation methodology are quoted prices for similar assets and liabilities in active markets. Level 2 Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. Level 3 Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Texas Children's 13

14 Notes to the Combined Interim Financial Statements (Unaudited), continued The inputs or methodology used for valuing securities are not necessarily an indication of the credit risk associated with investing in those securities. The following tables present the financial instruments carried at fair value as of June 30, 2012 and September 30, 2011, by caption by the valuation hierarchy (as described above). The following tables do not include alternative investments and other investments as they are accounted for using the equity method of accounting: Financial Assets and Liabilities at Fair Value as of June 30, 2012 Level 1 Level 2 Level 3 (in thousands) Assets Cash and cash equivalents $ 26,271 $ - $ - U.S. government fixed income securities - 490,193 - Corporate fixed income securities - 2,867 - Domestic equity securities 599,330 International equity securities 33,676 Total Assets at fair value $ 659,277 $ 493,060 $ - Liabilities Interest rate swap agreement $ - 29,595 - Total liabilities $ - 29,595 - Financial Assets and Liabilities at Fair Value as of September 30, 2011 Level 1 Level 2 Level 3 (in thousands) Assets Cash and cash equivalents $ 19,377 $ - $ - U.S. government fixed income securities - 482,934 - Corporate fixed income securities - 44,097 - Domestic equity securities 441,873 International equity securities 89,759 - Total assets at fair value 551, ,031 - Liabilities Interest rate swap agreement $ - 30,234 - Total liabilities $ - 30,234 - The fair value of the Hospital s long-term debt is estimated based on the quoted market prices for the same issues. Expenses that would be incurred in an actual settlement are not taken into consideration. The estimated fair value of long-term debt is $724 million at June 30, 2012 based on the quoted market prices for the same issues. Settlement at the reported fair value may not be possible or may not be a prudent business decision. Texas Children's 14

15 Notes to the Combined Interim Financial Statements (Unaudited), continued 7. NET PATIENT ACCOUNTS RECEIVABLE AND ACCRUED THIRD-PARTY PAYOR LIABILITIES Patient accounts receivable and related allowances for contractual adjustments and doubtful accounts are recorded on an accrual basis at estimated billing rates to report patient accounts receivable at net realizable value in the combined balance sheet. The allowance for doubtful accounts is recorded based primarily on the aging of accounts receivable and historical collection experience by major payor. Texas Children s regularly reviews data about these major payor sources of revenue in evaluating the sufficiency of the allowance for doubtful accounts. For receivables associated with services provided to patients who have third-party coverage, Texas Children s analyzes contractually due amounts and provides an allowance for doubtful accounts and a provision for bad debts. For receivables associated with self-pay patients (which includes both patients without insurance and patients with deductible and copayment balances due for which third-party coverage exists for part of the bill), Texas Children s records a significant provision for bad debts in the period of service on the basis of its past experience, which indicates that many patients are unable or unwilling to pay the portion of their bill for which they are financially responsible. The allowance for doubtful accounts represents the difference between the standard rates (or the discounted rates negotiated or provided by policy) and the amounts expected to be collected after all reasonable collection efforts have been exhausted. Texas Children s allowance for doubtful accounts for self-pay patients was 72% of self-pay accounts receivable at June 30, 2012 and write-offs totaled approximately $36.1 million for the nine months ended June 30, Amounts receivable or payable under the Hospital reimbursement agreements with the Medicaid and Medicare programs are subject to examination and retroactive adjustment. Provisions for estimated retroactive adjustments under such programs are provided in the period the related services are rendered and adjusted in future periods as final settlements are determined. Final settlement has been made for both Medicaid and Medicare through PLEDGES AND CONTRIBUTIONS Pledges, less a provision for uncollectible amounts, are recorded as other assets in the year made. Unrestricted pledges are recorded as contributions within other operating revenues and restricted pledges are recorded as increases in temporarily or permanently restricted net assets depending on the donor restrictions received with the pledge. Pledges receivable represent unconditional promises to give and are primarily restricted for specific capital campaigns. Noncurrent pledges receivable have been discounted to their present value. Pledges receivable, net of discounts and allowances, are included in other current or noncurrent assets in the combined balance sheets. Texas Children s records unconditional contributions, including promises to contribute, as revenue when the commitment is received. Conditional contributions are recognized as revenue when the conditions on which they depend have been substantially met. Texas Children s reports gifts of cash and other assets as restricted support if they are received with donor restrictions that limit the use of the donated assets. When a donor restriction expires, that is when a time restriction ends or purpose restriction is accomplished, temporarily restricted net assets are reclassified to unrestricted net assets and reported in the combined statements of operations and changes in net assets as net assets released from restrictions. At June 30, 2012, temporarily restricted net assets included $41.5 million restricted for capital expansion, of which $41.2 million relates to pledges that have not yet been received. Texas Children's 15

16 Notes to the Combined Interim Financial Statements (Unaudited), continued Pledges receivable as of June 30, 2012 and September 30, 2011 are expected to be realized as follows: June 30, 2012 September 30, 2011 In one year or less $ 12,637 $ 26,515 Between one year and five years 49,644 33,686 More than five years 8,573 8,573 Total pledges 70,854 68,774 Less present value discount (3.5%) (5,666) (4,366) Less allowance for doubtful pledges (1,417) (1,373) Net pledges receivable $ 63,771 $ 63, LOSS RESERVES The reserve for losses and loss adjustment expenses related to professional malpractice and general liability is based on case-basis estimates for reported claims and on actuarial estimates for unreported claims and loss adjustment expenses. The reserve for losses and loss adjustment expenses has been established to cover the net cost of self-insured losses. The amounts are based on estimates of future rates of inflation and other factors. 10. DERIVATIVE FINANCIAL INSTRUMENTS Texas Children s periodically utilizes an interest rate swap agreement to manage its interest rate exposure. Changes in the fair value of Texas Children s swaps are recorded as non-operating gains (losses) and included in revenues and gains in excess of expenses and losses. During 2007, the Hospital and a financial institution entered into a LIBOR-based interest rate swap agreement with a notional amount of $100 million, which expires on October 1, Under the agreement, the Hospital agreed to pay the financial institution a fixed rate of 3.657% on the notional amount and receive payments of 67% of the U.S. dollar one-month LIBOR rate, reset monthly. The Hospital has an option to terminate this transaction in whole or in part with cash settlement. The Hospital may be required to post collateral to secure obligations that would be owed to the counterparty under such transaction if terminated, regardless of whether such transaction is actually terminated. The Hospital has complied with these provisions as required. The Hospital does not offset the fair value of the derivative financial instrument and fair value of any collateral posted. The Hospital has posted collateral of $10.8 million and $3.7 million at June 30, 2012 and September 30, 2011, respectively. At June 30, 2012, the fair value of the swap agreement was a liability of approximately $29.6 million and is included in other long-term liabilities in the combined balance sheet. Texas Children's 16

17 Notes to the Combined Interim Financial Statements (Unaudited), continued 11. NET PATIENT SERVICE REVENUE Amounts reimbursed for services rendered to patients covered under the Medicaid and Medicare programs are generally less than the established billing rates. The Hospital, TCPA, and TCPG also provide services to beneficiaries of certain other third-party payor programs at amounts less than their established billing rates based on contractual arrangements. Differences between the established billing rates and amounts reimbursed are contractual adjustments. A summary of the payment arrangements with major third-party payors is as follows: Medicaid and Medicaid Managed Care Programs Certain Hospital services rendered to Medicaid beneficiaries are reimbursed under a cost-based reimbursement methodology, subject to regulatory reductions. The Hospital is reimbursed at a tentative rate, with final settlement determined after submission of annual cost reports by the Hospital and audits thereof by the fiscal intermediaries. The remaining hospital services and all TCPA and TCPG services rendered to Medicaid beneficiaries are reimbursed under prospectively determined rates according to a patient classification system that is based on clinical, diagnostic, and other factors. For fiscal year 2011, approximately 20% of gross patient service revenues were derived from the Medicaid program. In addition to the cost-reimbursed Medicaid program described above, certain Medicaid recipients are required to enroll in selected HMOs that contract with the Medicaid program to provide primary and acute care services to enrolled Medicaid recipients. The Hospital has contracted with these HMOs to provide services to pediatric Medicaid recipients and is reimbursed at a discount from established charges. For fiscal year 2011, approximately 27% of gross patient service revenues were derived from Medicaid managed care programs. Managed Care The Hospital, TCPA, and TCPG have entered into payment agreements with certain commercial insurance carriers, HMOs, and preferred provider organizations. The basis for payment under these agreements includes discounts from established charges, agreed-upon fees per procedure, prospectively determined per diem rates, and case rates. For fiscal year 2011, approximately 45% of gross patient service revenues were derived from managed care programs. Texas Children s recognizes revenue for uninsured patients that do not qualify for charity care based on standard rates for services provided. A significant portion of the uninsured patients will be unable or unwilling to pay for the services provided. Thus, Texas Children s records a provision for bad debts related to uninsured patients in the period the services are provided. Patient service revenue, net of contractual allowances and discounts (but before the provision for bad debts), recognized in the nine months ended June 30, 2012 by payor, was approximately: Medicaid $ 135,849 Medicaid Managed Care 119,463 Managed Care 564,030 Commercial 47,148 Self-Pay and Other 52,251 Total All Payors $ 918,741 Texas Children's 17

18 Notes to the Combined Interim Financial Statements (Unaudited), continued 12. CHARITY CARE AND COMMUNITY BENEFIT In accordance with its vision and mission, Texas Children s commits significant resources to promote the health of and well being of children. In support of this endeavor, Texas Children s recognizes that some of its most fragile constituents are children whose families are financially or medically indigent. To that end, Texas Children s provides medical treatment to children whose family or custodians are unable to pay for such treatment. Texas Children s ensures that charity care, indigent care, education, research and other sponsored community programs benefit all children, regardless of economic status. Therefore, Texas Children s maintains charity and community benefits programs, within limits, that are available to the entire community with equal consideration for those who are poor and underserved. The categories included as programs and services for the poor and the underserved are as follows: Charity Care represents the unreimbursed cost of providing, funding, or otherwise financially supporting health care services to a patient classified as financially indigent or medically indigent. In accordance with Texas Children s established policy and procedure, a patient classified as medically indigent or financially indigent will not be required to pay for the designated portion of the care received. Services designated as charity and provided to these patients are not reported as revenue in the combined statements of operations and changes in net assets. Unreimbursed Cost of Government Sponsored Indigent Health Care - represents the cost of providing services to beneficiaries of public programs, including State Medicaid and indigent care programs, in excess of any payments received from all sources. Community Benefits - represent the unreimbursed cost of providing services for the benefit of the entire community. These benefits include philanthropy, education, research and various other community-based healthcare programs. The majority of these benefits are for graduate medical education and academic research. Other benefits for the community target the poor and underserved and include Project Medical Home, immunizations for children and various community-based health educational resources. These programs are not intended to be financially self-supporting. 13. PREMIUM REVENUES Premium revenue is recorded for products for which TCHP is the primary HMO and is recognized as revenue during the coverage period of the subscriber agreement. Under these agreements, TCHP receives monthly payments based on the number of participants regardless of actual medical services performed. Premiums received prior to the coverage period are reflected as unearned premiums. Unearned premiums are included in accounts payable and accrued expenses in the combined balance sheets. TCHP earns premium revenue from state-funded programs such as the Children s Health Insurance Program (CHIP) and the Medicaid STAR program. At June 30, 2012 and September 30, 2011, TCHP s premium revenue was derived 81% and 81% from its Medicaid STAR contract, respectively, and 19% and 19% from its CHIP contract, respectively. TCHP is subject to an experience rebate if net income as a percentage of revenues is greater than the percentage set forth by the state. TCHP s estimated experience rebate liability was $585 and $23.3 million at June 30, 2012 and September 30, 2011, respectively. The fiscal year 2011 liability has been paid as of December 31, Texas Children's 18

19 Notes to the Combined Interim Financial Statements (Unaudited), continued 14. MEDICAL AND HOSPITAL EXPENSES TCHP contracts with various health care providers for the provision of pediatric medical care to its members. TCHP compensates hospitals on either a discounted fee-for-service or per diem basis and compensates physicians and other health care providers on a capitated basis or a discounted fee-forservice basis. The cost to TCHP for health care services provided by contracted providers is accrued in the period in which it is provided to a member, based in part on estimates, including accruals for medical services provided but not billed, and estimates of claims incurred but not yet reported to TCHP, based on actuarial valuations. The methods utilized in determining estimates are continually reviewed, and any changes in estimates are reflected prospectively. At June 30, 2012 and September 30, 2011, recorded accruals were $22 million and $21 million, respectively, included in accounts payable and accrued expenses in the combined balance sheets. 15. ASSOCIATED ORGANIZATIONS Under the terms of the affiliation agreement the Hospital has with Baylor, Baylor conducts research and educational activities and its physicians provide patient care services while utilizing the Hospital s facilities in the practical application of the teaching process. Mutual commitments include sharing of operational and research costs, including residents and physicians salaries. In addition, TCPG has an agreement with Baylor relating to overhead operating costs of the adult surgical subspecialty departments that manage pediatric components. During the nine months ended June 30, 2012 and 2011, Texas Children s recorded expense of $200,543 and $166,115 related to these agreements, respectively, which is included in professional fees in the accompanying combined statements of operations and changes in net assets. Amounts due to Baylor of approximately $24,502 and $21,156 are included in accounts payable and accrued expenses in the combined balance sheets at June 30, 2012 and September 30, 2011, respectively. The Gordon and Mary Cain Pediatric Neurology Research Foundation (Cain Foundation) is operated to support research, teaching, treatment, and related activities with respect to pediatric neurological disorders and is administered solely for the benefit of the Hospital. The assets held by the Cain Foundation include primarily investments in debt and equity securities. The Hospital and the Cain Foundation are financially interrelated organizations in that the Cain Foundation manages assets for the sole benefit of the Hospital; therefore, the Hospital has a beneficial interest in the net assets of the Cain Foundation. The beneficial interest in the net assets of the Cain Foundation was $16,705 and $14,458 at June 30, 2012 and September 30, 2011, respectively and is included in assets limited as to use in the combined balance sheets. 16. RELATED-PARTY TRANSACTIONS Texas Children s Boards of Trustees include members from the financial services, legal, and business communities who provide valuable assistance in the development of policies and programs. All transactions with organizations with which Board members are affiliated have, in the opinion of management, been entered into in the normal course of business at prevailing market rates. Texas Children's 19

20 Notes to the Combined Interim Financial Statements (Unaudited), continued 17. PROPERTY AND EQUIPMENT Property and equipment, by major category, at June 30, 2012 and September 30, 2011 are as follows: June 30, 2012 September 30, 2011 Land and land improvements $ 90,858 $ 72,116 Buildings 924, ,026 Building under capital lease obligation 38,471 38,471 Fixed equipment 643, ,962 Movable equipment 504, ,603 2,201,506 1,638,178 Less accumulated depreciation (730,082) (652,985) 1,471, ,193 Construction in progress, including $3,153 and $23,864, respectively, in capitalized computer software costs 78, ,905 Net property and equipment $ 1,550,384 $ 1,483,098 Interest cost is capitalized until the property under construction is placed in service. Interest costs of $10,405 and $14,849, net of interest income on respective bond proceeds, were capitalized during nine months ended June 30, 2012 and 2011, respectively, and are included in construction in progress. The Hospital has remaining commitments of approximately $84 million on open construction and equipment contracts as of June 30, COMMITMENTS AND CONTINGENCIES Insurance Program Texas Children s is self-insured for professional and general liability and maintains excess insurance coverage at varying levels. A provision is made for estimated losses and related expenses on risk not covered by insurance. This provision includes estimated amounts for asserted claims, reported incidents for which a claim has not been asserted, and claims incurred but not reported. The provision is based on specific claim loss estimates by management and on estimates of total annual losses by an independent consulting actuary using Texas Children s experience and similar industry experience. TCHICO is a captive insurance company that provides primary coverage for professional and general liability exposures of Texas Children s and also provides excess liability coverage for amounts in excess of the primary policy limits. The Hospital funds TCHICO s required insurance reserves. Funding amounts are based on actuarial recommendations. The assets of TCHICO and the estimated liability for self-funded losses, which is based on a discount rate of 3.4% at June 30, 2012 and September 30, 2011, are reported in the combined balance sheets. Investment income from the assets and the provision for estimated self-funded losses and administrative costs are reported in the combined statements of operations and changes in net assets. Texas Children s has certain pending and threatened litigation and claims incurred in the ordinary course of business; however, management believes that the probable resolution of such contingencies will not exceed insurance coverage and self-insurance reserves and will not materially affect the combined financial position of Texas Children s or the results of its operations. Texas Children's 20

21 Notes to the Combined Interim Financial Statements (Unaudited), continued Regulatory Compliance Laws and regulations governing the Medicare and Medicaid programs and certain other third-party programs are complex and subject to interpretation. The U.S. Department of Justice and other federal agencies are increasing resources dedicated to regulatory investigations and compliance audits of health care providers. Texas Children s is subject to these regulatory efforts and has a corporate compliance committee that monitors and responds to regulatory changes and any issues that may arise. Texas Children s intent is to be in compliance with all applicable laws and regulations, and it is not aware of any significant pending or threatened investigations involving allegations of potential wrongdoing. 19. NEW ACCOUNTING PRONOUNCEMENTS In August 2010, the FASB issued Accounting Standards Update (ASU) No , Health Care Entities (Topic 954): Measuring Charity Care for Disclosure. ASU is intended to reduce the diversity in practice regarding the measurement basis used in the disclosure of charity care. ASU requires that cost be used as the measurement basis for charity care disclosure purposes and that cost be identified as the direct and indirect costs of providing the charity care, and requires disclosure of the method used to identify or determine such costs. This ASU was effective for Texas Children s on October 1, The adoption had no impact on its financial position and results of operations and the required disclosures will be included in the financial statements for the year ending September 30, In August 2010, the FASB issued ASU No , Health Care Entities (Topic 954): Presentation of Insurance Claims and Related Insurance Recoveries. The amendments in the ASU clarify that a health care entity may not net insurance recoveries against related claim liabilities. In addition, the amount of the claim liability must be determined without consideration of insurance recoveries. This ASU is effective for Texas Children s on October 1, Texas Children s recorded a receivable included in other current assets and an offsetting liability included in loss reserves of $8.4 million at June 30, 2012 and September 30, There was no impact on the results of operations from the adoption of this guidance. In July 2011, the FASB issued ASU , Health Care Entities (Topic 954): Presentation and Disclosure of Patient Service Revenue, Provision for Bad Debts, and the Allowance for Doubtful Accounts for Certain Health Care Entities. The amendments in the ASU require Texas Children s to change the presentation of its combined statement of operations and changes in net assets by reclassifying the provision for bad debts associated with patient service revenue from an operating expense to a deduction from patient service revenue (net of contractual allowances and discounts). Additionally, the ASU requires enhanced disclosure about Texas Children s policies for recognizing revenue and assessing bad debts, patient service revenue (net of contractual allowances and discounts), and qualitative and quantitative information about changes in the allowance for doubtful accounts. This ASU is effective for Texas Children s on October 1, 2012, with early adoption permitted. Texas Children s early adopted this ASU on October 1, The statement of operations and changes in net assets were modified to present the provision for bad debts as a deduction from patient service revenue. Additionally, Texas Children s enhanced disclosures about its policy for recognizing revenue, changes in allowance for doubtful accounts and assessing bad debts. 20. SUBSEQUENT EVENTS Texas Children s evaluated events and transactions occurring subsequent to June 30, 2012 through August 23, 2012, the date of issuance of the financial statements. During this period, there were no subsequent events requiring recognition in the combined financial statements. Additionally, there were no nonrecognized subsequent events requiring disclosure. Texas Children's 21

22 Management s Discussion of Financial Results (Unaudited) (Dollars in thousands) Texas Children s exists to support excellence in patient care, education and research with a commitment to quality service and cost-effective care to enhance the health and well-being of children locally, nationally and internationally. The following information should be read with the unaudited combined interim financial statements and related notes included elsewhere in this report, as well as Texas Children s fiscal year 2011 audited financial statements. Operating Results For the nine months ended June, the Texas Children s operating results were a loss of $800,000 on a budget of $23.7 million. For the same time period income from operations before depreciation and interest was $88 million on a budget of $117 million. The budgeted operating margin is being exceeded for Texas Children s Health Plan, Texas Children s Pediatrics, West Campus and the Neurological Research Institute and the Pavilion for Women is within 1% of its operating margin. The unfavorable operating margin variance is within the Main Campus of the Hospital. Excess Margin For the nine months ended June, Texas Children s excess margin, including non-operating activity, was $155 million on a budget of $92 million. Combined investment returns fiscal year- to-date was 10.6%. Texas Children s Hospital The Hospital s operating performance has not met budget expectations due to the Main Campus which had an operating loss of $1.6 million for the third quarter. For the nine months ended June, the Main Campus had an operating margin of $20 million on a budget of $63 million. The primary factors driving the financial performance of the Main Campus were 1) salaries and benefits 2) increase in investment in Baylor faculty 3) reductions in disproportionate share payments from the state and 4) a shift in patient services provided. Salaries and Benefits Fiscal year-to-date salary growth at the Main Campus has exceeded budget by $16 million. The increase in salaries expense relates to the increased utilization of premium labor, specifically contract labor for the final stages of EPIC implementation and for clinical staffing. EPIC has been installed successfully and labor costs related to the project are falling dramatically. Texas Children's Hospital - Salary Expense by Location For the nine months ended June 30, 2012 Favorable Increase Actual Budget (Unfav) Prior Year (Decrease) Main Campus 311, ,565 (16,302) 276,596 35,271 West Campus 18,973 18,381 (592) 11,268 7,705 Neurological Research Institute Pavilion for Women 31,343 30,617 (726) 11,756 19,588 Texas Children's Hospital Salary Expense 362, ,242 (17,563) 300,195 62,610 Texas Children's 22