Standardizing the financial reporting of dental practices

Jan. 28, 2015
Owing to the difficulty of comparing one dental practice with another, and to the inconsistent and sometimes irrational manner in which line items are compiled on income statements, we need to address financial reporting in dental practice. Specifically, we need to address standardizing methods of financial reporting in dental practices.

Thomas A. Climo, PhD

Owing to the difficulty of comparing one dental practice with another, and to the inconsistent and sometimes irrational manner in which line items are compiled on income statements, we need to address financial reporting in dental practice. Specifically, we need to address standardizing methods of financial reporting in dental practices.

Without an agreeable set of line items for the balance sheet, the income statement, and industry benchmarks, the operating performance of dental practices is more of a matter of guesswork than it is a matter of financial analytics. For example, "supplies" in one practice might mean dental supplies and lab fees, but in another practice, it could refer to dental supplies alone. To cite another example, a second practice might use "wages" as a line item to account for the pay of the entire office staff and associate dentists. The fact that there is no standardization of what to call gross profit also hurts. One practice equates gross profit with total sales or revenues, a second takes off only dental supplies, and a third, although correctly separating the cost of fee services from other costs, fails to separate variable from administrative costs. Standardized line items with standardized names will make redundant that which is currently trial-and-error.

Once a template of line items exists for the income statement (and balance sheet), operating costs as a percentage of total sales can be calculated for each line item, and the median results can be used to create a benchmark for the industry. Benchmarking enables comparisons to be made between practices and against industry standards. When a practice has a line item of operating cost above the benchmark, the cost may need to be trimmed. When a practice has a line item below the benchmark, the accuracy of the bookkeeping may need to be questioned. With the power to keep track of both the operating and the valuation sides of the business, management and financial accounting can be merged.

If the meanings of "net income" and "net income margin" can be agreed on for every dental practice, comparison can become a tool for every owner-dentist and every dentist-consultant. Comparability among practices would finally be at hand. Given the long movement toward standardization in financial reporting for every other industry in the world, two related "why" questions and one "how" question about the U.S. dental industry must be answered:

1. Why is there an absolute lack of standardization in accounting for dental practices?

2. Why is it that no two dental practices are accounted for alike?

3. How can we approach standardizing the financial reporting of dental practices?

On the journey to answering these questions, we will have to learn about the varying interpretations of accounting terminology and thereby the inconsistency of balance sheet and income statement compilations throughout U.S. dental accounting. Cases exist in abundance of poor accountancy and operational results, poor accounting procedures, absent chart review audits, and failure to ensure that internal controls are in place for the correct transfer of software accounting data into financial reporting.

Standardization is not an impossible task to address, but it does take care and dedication. First, we must define accounting terminology and remain consistent with its usage throughout the industry. Second, we must create balance sheet and income statement templates in the exact line item compilation recommended for every dental practice in America. Third, since standardization requires consensus, a white paper must be written and treated as a starter document so that revisions can be made by those who are involved in the practice, operation, accounting, and valuation of dental practices.

To be effective, the white paper would have to convey the following points, which we can compare to "rungs" on a ladder. Each successive rung leads one step closer to the successful transformation of financial reporting for the dental industry.

Rung No. 1: With illustrations, demonstrate the current state of financial reporting with specific reference to its deficiency in helping to manage dental practices and in allowing outside observers to accurately survey the performance of dental practices.

Rung No. 2:Show the need for recalibration that would allow dental practice financial statements to be comparable by: identifying earnings before interest, taxes, depreciation, and amortization (EBITDA); calculating a depreciation expense that matches the economic deterioration of equipment in a dental office; and arriving at a genuine net income number.

Rung No. 3:Find acceptable definitions of all terms - whether they are assets or liabilities, revenues or expenses. List each term in its precise location in a template where the line items should appear defined as an asset, a liability, revenue, or an expense.

Rung No. 4:Show the resulting balance sheet template. Make sure that, if there is an owner's "draw" on the balance sheet, that it only occurs after a compensating expense for the owner's contribution to revenue is established. Using an associate dentist's percentage-of-collections rate against the owner's production is acceptable. In this way, a match of a reasonable expense against the revenue generated by the dentist-owner is guaranteed and will not exaggerate the net income by its absence on the income statement.

Rung No. 5:Show the resulting income statement template. Total sales, EBITDA, EBITDA margin, net income, and net income margin should be prominent.

Rung No. 6:Execute an internal audit to verify that procedures are in order for transferring accounting data into a correct number as conveyed in the template line items. This will consist of cash, receivables, inventory, and billings and collections audit, as well as an examination of the practice's internal control and general recordkeeping capabilities.

Rung No. 7: Assume the net income is repeatable, or, if not, show a pro forma of the rise and fall of revenue, EBITDA, and net income in an appropriate five-year spreadsheet.

Rung No. 8: Find the empirical cost of capital rate prevalent in the market from data available at either the Stern School of Business at New York University or Value Line.

Rung No. 9: Value the dental practice under one of four methods:

Method No. 1 - Net income margin against prior-year sales
Method No. 2 - Net income or the Warren Buffett approach
Method No. 3 - EBITDA or the free cash flow approach
Method No. 4 - Private equity approach using multiple rates on

EBITDA for private pay, Medicaid, or a combination of both Method Nos. 1 and 2 are appropriate for valuing solo practices and small groups. Method No. 4 is appropriate for large group practices with EBITDA of at least $2 million. Method No. 3 is not recommended. I concur with the observation about the shortcoming of EBITDA made by Warren Buffett:

"Trumpeting EBITDA is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a 'non-cash' charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a 'non-cash' expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?"1

In summary, once the dental industry has dental practices reporting accurate and believable net income numbers and net income margins, accurate comparability across practices will follow and a more economically valid method of calculating the business valuation and sales price of dental practices can be instituted. With standardization of its financial reports confirmed by internal audit, dentistry will become part of the mainstream economy and no longer look like a mom-and-pop cottage industry with operating results up for grabs. Uniting the dental industry with the best of modern economics, modern accounting, and business management will guide the future of the business of dentistry in the right direction.

Editor's note: For an in-depth look at this topic, read Dr. Climo's 7,600-word white paper on the importance of dental financial standardization. Find it at DentalEconomics.com. Search: Climo.

Income statement terminology

Cash basis method - Method of bookkeeping by which revenues and expenditures are recorded when they are received and paid. Most dental practices have their income statements performed on a cash basis. This is contrasted with a transaction or accrual basis.

Income (or what I prefer to call "revenue") - Inflow of revenue during a period of time, which is broken down into cash, insurance, or Medicaid payments, and split between dental and hygiene production.

Cost of goods or services sold - Figure representing the cost of buying raw materials and producing finished goods. In a service industry such as dentistry, it is the cost of salaries, employee benefits including health insurance, and payroll taxes.

Variable cost - Total costs that change in direct proportion to changes in productive output or any other measure of volume.

Administrative and fixed cost - Costs that remain constant within a defined range of activity, volume, or time period.

Earnings before interest, taxes, depreciation, and amortization (EBITDA) - A popular measure of cash generated from the operation of a dental practice. Financial analysts, especially those in private equity investment, frequently use EBITDA to evaluate the ability of a company to service its debt obligations. EBITDA is also used as a measure of profitability in valuing a company and in comparing a company's financial performance with other firms. Critics contend EBITDA can be a misleading financial tool, in part because companies have wide discretion in determining the dollar amount of the components used in calculating EBITDA. In addition, EBITDA does not consider the funds a company is likely to require for capital investments. Warren Buffett once famously asked: "Does management think the tooth fairy pays for capital expenditures?" The terms "cash flow" and "free cash flow" are often used interchangeably with EBITDA.

EBITDA margin- EBITDA as defined above, divided by total sales or revenues.

Depreciation - Expense allowance made for wear and tear on a fixed asset over its estimated useful life. This is not a source of funds but an intentional allocation of practice income enabling worn-out fixed assets to be replaced when the time comes.

Net income - Excess or deficit of total revenues and gains, compared with total expenses and losses for an accounting period.

Net income margin- Net income as defined above, divided by total sales or revenues.

References

1. Buffett, W.E. Chairman's letter. 2002 Annual Report. Berkshire Hathaway.

Thomas A. Climo, PhD, writes and consults in dental economics, specializing in organizing practice management groups for solo practitioners and in the standardization of accounting for and valuation of dental practices. Dr. Climo has published twice before in Dental Economics (September 2009/2012). He can be reached at [email protected].

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