132: Accrual Accounting Part 1 - The Why and the When

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You have this natural talent, this unique ability. Hello and welcome to another episode of DSO Secrets. I am Ken Kaufman, your host today and excited to introduce our two guests and really just introduce this amazing topic. It comes up and every conference that we're at, that we're speaking at and every conversation it seems like it's coming up about accrual accounting. And I finally decided along with Mike and Holly that our guest today that we'll intro here in just a second. Finally decided it's time to just unpack this. So we have organized a five part series today being part one of accrual accounting. Everything you need to know to make that switch and along with and today primary focus is going to be the why and the when of that process. So Holly, would you take a quick minute, introduce yourself and then Mike, love to get a quick intro from you as well.

Thank you Ken. My name is Holly Williams and I'm the CFO here at Rodeo Dental and I've been here about a year and a half. Coming up on two years believe it or not. Before that I was the CFO of an oncology practice, a multi site oncology practice for 12 years. Took that practice from cash to accrual and then when I came to Rodeo Dental we actually went from pass through accrual as well. So this is definitely a topic that is very relevant.

Awesome Mike, great. Good morning.

Thank you. I'm Mike Yates, I'm the CFO with Lumio Dental based out of Tulsa, Oklahoma. Been here also about a year and a half and our tracks follow each other pretty closely. Also was in oncology for about 11 years before I came. That was actually one of the very first things I did when I came to Lumio was the cash to accrual conversion. For a lot of the reasons we'll talk about today, but having been through it recently, I just really understand how important it is and some of those big steps to get through.

Yeah, this is great. The primary Reason why I wanted to have both of you with me on this is because of the recent change that both of you led inside your organization and were obviously instrumental really from the ground up. Processes and procedures that had to be changed, mindsets that had to be changed, which we'll touch on throughout this five part series and so many other things. So to get this kicked off, we really wanted to start with the why. What is the 30,000 foot level of why running a cash based business versus accrual based can be not a great idea? And why you can actually be a much better operator of the business when you're on accrual versus on cash. And I know Mike and Holly, I told you that I would sort of take this to start with an experience I had. This dates me all the way back to 2004. I was in my very first CFO role. I walked into the very first executive team meeting. The financial statements were being reviewed by this executive team. And the most fascinating and frustrating, so we'll call it the double F conversation. Fascinating and frustrating conversation ensued. The entire one hour meeting was comprised of everyone trying to explain why the financial statements weren't right. And I had the estimator in there talking about, well, no, we're bidding projects here and here and here. And that margin, there's no way that margin can be right because I'm bidding them here. Unless the field's messing up. Then the guy who ran the field was over field operations. This is a construction company, by the way. He, he said, no, no, my field runs these projects better than you estimate them. And so whatever years say the margin is, the margin should be better. And when we looked back, we were looking at several months and the margins were ranging from 5% to like 34%. And they were just bouncing all over the place from a cost of goods sold perspective. And then the owner chimed in and said, well, wait a minute, didn't we have three payrolls last month? And so isn't that why this is throwing it off? And then we had another director of operations jump in and he said, well, hold on a second. I think didn't our biggest customer, they didn't pay us last month, I think and they ended up sort of double paying us the following month. So isn't that now messing up the storyline and messing our margins up? And so we went through and they went around and around and I just sat there for this hour and as I recall, I didn't actually say anything because I was just fascinated that it was such an unproductive Dialogue and conversation, because you want those conversations to be focused on how do we improve the business, how do we make it better? Instead, it was just a whole series of excuses. So my energy around accrual was day one in my very first CFO role, was how in the world do I change the conversation in this room to talking about how do we actually run the business better, how do we find ways to improve and finance growth and everything that goes with actually running the business the right way? And so that sent me on a journey to get this construction company converted to an accrual basis. A lot of very similar principles apply between industries and how all this works. Mike and Holly, as I share that story, if you have anything you'd like to add to that, any experiences, feel free to.

Mike, you want to chime in?

Yeah. Well, I think we probably all have had a similar conversation or meeting to that very much. There's this much money left in the bank. It must have been a good month or the other alternative. You know, we're out of money in the bank. What happened? And so that's, you know, that's obviously why I think we all look at it originally, is we want the numbers to be real. To your point, that's one of the big focuses I've done over the last year is making the financials an operational document. They're not a historical document. They're an operational tool. And if they're cash basis, you know, you are what your bank statement says you are. Yeah. Regardless of what else happens.

Yep. And to just add to that, the financial statements, when prepared on a cash basis, they are wrong. They're right in terms of explaining what's in your bank account, but they are wrong in terms of what's actually happened functionally and operationally inside your business. Holly, go ahead. I think you've got something to add there.

Yeah. I mean that absolutely correct. I mean, one of the basic things that happens when we go to school is we get taught about the matching principle, where you match your revenues with your expenses. And so when you hear people talking about accrual accounting or gap financials, you'll hear a lot about matching. And what that is is it's where, you know, you think about it. If you're. You're operating a dental clinic and your dentist is in seeing patients that day, and if you want to assume you've only operated for one day, and then you. You open for one day and you close, and you were to do a cash basis financial statement for that day, there's nothing that happened. But you patients were served and you earned money and employees worked and you owe them money, but nothing happened in your bank account that day. And so your cash basis financial statement would just be a big zero. And that's not correct because you are owed money and you owe money. And so when you match it and you accrue for the revenue for that day and you obligate yourself and accrue for the payroll that you're obligated to pay, that you can really see what happened. And that's a lot of times the conversation I have to have with a doctor is just for them to understand that, you know, you activities happen and you are obligated to pay your employees and your patients are obligated to pay you.

Yeah. And you utilize supplies, right?

Yes, exactly.

To some degree I could even argue all those fixed assets and ti build out in that, in that office, like some of that should be appreciated right there. Relative to, relative to that every element, every cost, everything that, that happens in that dental practice on a day by day basis. And I love how you simplified it down. It's that day what, what really happened and what, what was the success of that day irregardless of what happened in the bank account? One thing I'll mention too is I know some very big businesses that have stayed cash basis, but in dentistry and really in multi site healthcare in general, as soon as you have an owner who isn't chairside all day long, seeing every patient, understanding all the financial transactions that happen every day. But if you go to where now there are associates in that practice and you get more and more practice staff that are handling cash and those sorts of things and then you go to a second location and a third location, the more accurate financials become highly relevant and important. Because if you're just looking at cash, how do you really know? Especially if you haven't set foot in that practice this month or this year, based on your size and how you're running your business and how your group is overall organized. Go ahead, Mike. I think you've got a comment to add there.

No, I think that's exactly what you're doing. Where I was headed is just the scope. I mean, a cash basis statement doesn't give you the ability to measure those sites that you're never physically in. And there's a number of reasons for that. I mean, one is just quality of staff, training of staff, you know, just variants in acquired facilities that haven't totally adopted your company policies yet. So you can't assume even if you were on cash basis, you can't assume everybody's doing it the same. You know, our deposits sitting in the safe for two weeks instead of a daily deposit. You know, are we sending out bills or are we forcing patients to pay up front? The bigger you get, cash just becomes less and less relevant. As funny as that sounds, just because there's, there's no guarantee your inputs are all uniform, that you can make safe

assumptions on, well, and cash basis becomes irrelevant. Cash is still king in the business. Right. And we want to understand our cash flow. Just to clarify what you said. I know it's what you meant, Mike. Yeah, but it's really understanding true operational performance and it's the absolute best way to run the business. It gives you the most realistic picture of what's happening. Maybe. Holly, would you comment on when you're accrual versus cash basis, how does that help in your accuracy and forecasting and planning for the future?

Well, one of the things that happens a lot of times when a company is on a cash basis is they're growing and the DSO space is growing very rapidly. And I think that most people who are listening to this podcast are interested because they're looking at growth. But if you keep your financials on a cash basis, you have exponential expenses to fund with growth. And if you're not looking at your forecasted cash flow, if you haven't done the work to understand your gross charges as compared to what your collections are, and understand the timing and then record that appropriately in your financials, you can really find yourself drowning in what I would say. You may be six foot tall, but drown in a six and a half foot wave of all of a sudden I can't see when my cash is going to be short and I can't see when my financing is going to happen. One thing I want to point out is when you move to Gap Financials, your audience may be a little uncomfortable because they're used to looking at a cash basis, P and L, and they're used to seeing exactly like my cash increased or it decreased. But when you have Gap Financials, there's three financial pieces that you look at and one of them is the cash flow statement, which will show you your negative cash from operations or positive cash from operations. But if you, if you, you look at all of this together and then you can forecast out based on the production you've done, when you're going to collect and you understand when your payers pay, you can see those shortfalls before they happen.

Yeah, that's Right. Just want to identify for our listeners. Holly talked about gaap. It's GAAP stands for Generally Accepted Accounting Principles. And you are not compliant with GAAP if you're cash basis. And so when we, the three of us, or you hear others in the industry referencing GAAP financials, it means accrual based financials. Those two are synonymous.

Right.

Well, and that does lead to another thing that I know we're going to talk about is the audit requirements. A true, fully opined audit letter is based on GAAP appropriate financial statements. And you can't get that through cash, no matter how accurate they are, no matter how effective you are as an operator. Cash does not equate to a clean audit opinion. And you've got to get there to satisfy that requirement.

Yeah. And so you're kind of identifying one of the points in time when a company, regardless of size or sophistication or anything else, there's a time when they're going to be required to have an audit. And in order to have audited financial statements, whether it's being required by a board of directors or you're internally just wanting to do it, or you have external banks or private equity or other groups that are requiring an annual audit, you have to make the change. The two are synonymous with each other. You have to go to accrual or GAAP based.

Right. And I think it's important too, not just for those external sources which obviously, I mean, have the ability to mandate an audit, but for the internal sources. You know, in our setting we have numerous partner docs. It's nice to be able to give a partner doc a financial statement that says, you know, look, somebody totally disinterested came in from the outside, they looked at the work we've done and they said, yes, this is a fair representation of your business.

Yep.

You know, and it just gives that extra comfort level for existing partners and potentially recruiting new partners as well.

Yeah. Instills confidence, doesn't it? And we all know we can partner with the best doctors in the world, but if they feel like they've got to question things like relationships can just go bad and sour. I've been in a few situations in my career where because the accuracy or the truthfulness of financial statements were being questioned, it ruined partnerships and it ultimately got close to ruining businesses as a result of a lack of trust. And so to some degree, to instill confidence and trust, you've got to help your organization see and understand the value of Gap. And then, and then have these outside and outside Attestation happen or occur, which the audit would be sort of the premier option there. Yes, that's great. Let's talk for a second about when the audit is mandated. What are the situations that you both have seen in your career where if you weren't already on accrual, you had to get there because you got in a situation or things changed and the audit was being required?

Well, for me, the first time that I had to do it was when, as I mentioned to you, I was with an oncology practice. They were on a cash basis. When I got there. We were seeking funding for growth, we were seeking funding for building out new facilities, bringing on new physicians. And so in speaking to the bank, like, great, I can see your bank account, it's growing. But we really need to see the historical financial statements on accrual basis. And then we also need to see your forecast and your plan for the next five years is so that we can decide to get behind this road and to be on a cash basis. You really just can't accomplish that. We were lucky enough to go through that financing round with accrual based financial statements with just a review. We didn't have to have an audit. But it just depends on how much money you're asking the bank for and the size of your company and whether or not the bank itself will require your financial statements to be audited. But like you said, when you bring in partners or PE groups or any other, you know, large transactions, it's usually, usually definitely required.

Yeah, that's so helpful to understand, Mike, Anything to add to that?

Yeah, the only other situation where I've kind of been forced to do that audit, it was in an internal partnership offering. It was kind of an internal initial offering, you know, versus going out to market. It was strictly for internal employees and higher level people in the company. But again, we wanted to be able to give that qualified opinion of, or that non qualified opinion, I guess I should say, of a third party person that these are appropriate. These are what you can expect to see. These are, you know, the plans are based off of audited or accrual based historical statements. These truly represent the operations that you're looking at getting into.

Outstanding. Good. Well, if the two of you are okay, I wanted to jump to our next topic around this, which is Dr. Pay Timing, how, how we think about and how we calculate it. And I've actually been looking forward to this part of the conversation. So we really have two ways to base how doctors are compensated. We can, I shouldn't say that because if you, if you put some in a straight salary, that would be, that would be a different situation I'm referencing. To the degree you want compensation to be at all tied to the activities that the provider is engaging in or the production that they're generating, you can organize that pay based on either the production that they generate or the collections that come in as a result of that production that they generate. So you've got these two options. Let's talk for a minute about Dr. Pay timing and the calculation of Dr. Pay. And let's get really. Let's talk for a minute about what it means and why a move to accrual could, what impact it could have on the way you want to think about doctor pay timing. Holly, do you want to maybe jump here? Because I know you kind of run Cross grain a little bit because you guys still pay on collections.

We do, we do still pay on collections. And you know, as I mentioned, I came here about a year and a half ago. We were moving from cash to accrual. One of the processes of that is understanding, you know, the bridge between gross and net. So what we've done is we've really created a good understanding and a good bridge. And so we understand all of our write offs, we understand what's happening, the bad debts. And we've brought in a new director of Revenue Cycle. And one of her functions is to speak with the doctors and help them understand their collection rates and understand how to improve those collection rates. And so we actually have training around that for the doctors, we have training around that for our staff, we have training around that for everyone involved in Revenue Cycle. But the doctors have become very engaged in making sure that their collection rates are the best that they, they can be. And so we've made the decision to stay on that basis of compensation just because of the level of engagement we've received from the doctors.

Oh, that's great. So in this case then you've moved to GAP or accrual accounting, but you've stayed cash basis in terms of how you calculate doctor's compensation.

That's correct. So that, that part we calculate provider compensation based on collections and that's how we run the payroll. But we do estimate the provider compensation based on the current month production.

Exactly. Again, coming back to this accrual concept, which is here we are in the month of January, all of the production that's generated in, in February, you're going to look at that and say, okay, I need to book in what we estimate those collections are going to be. And what percentage the doctor is going to be paid of those. And then as those dollars trickle in, then they end up getting paid. And it relieves the accrual that you

create a really complicated spreadsheet. But, you know,

that's our world.

We love complicated spreadsheets. In fact, I have a mug, there's a spreadsheet for that.

I love that. Mike, how do you guys think about doctor pay and how do you think about this impact on accrual?

Yeah, so we're almost exactly, exactly the same as Holly and Rodeo. We do, we do still pay our doctors on collections, which, depending on the site, depending on the maturity of this, of the credentialing of that site. Those are good or bad discussions. You know, we, but again, we are accruing what we're going. We're accruing the expense to match the revenue based on our estimated collections are, you know, our percentages, our adjustments. The one thing, again, somewhat echoing Holly, we are also really focused on those adjustment reports with the doctors. It comes from a compensation level because obviously if collections are down, their compensation goes down. But I'm bubbling that back up to my top line of, okay, you had this type of adjustment, this type of adjustment, this type of adjustment. What of those can we control? What can you as Dr. X control to make these adjustments go down? Detailed conversations, detailed reporting. But end of the day, we're still matching that comp to what the financial statement says is revenue and just paying it a little differently.

Right, that makes sense. The way that we think about it at Community Dental Partners is we actually base all of the Dr. Compensation model on production. And that creates a couple of pressure points. Right. First one is we need to be really good at making sure fee schedules are in the practice management software so that that gross production number is as close to the real collectible number as possible. And then the second thing we do with our doctors is we will take that gross production number and then discount it a little bit to then calculate the compensation to account for the fact that there are adjustments and there are going to be write offs and those sorts of things. And then to try to drive ownership. Holly, because I loved how you talked about the doctors really taking an ownership mindset toward, toward collecting. The way that we drive that mindset is we run reports so that they can see them and, you know, how much were the adjustments during a prior period. And we look at totals as well as one time amounts and, and if they're outside of the general acceptable ranges, then there are discussions that clinicians have with each other about what that means and what opportunities may or may not exist around it. So we do that. And then obviously, since we're calculating doctor Pay on a production basis, we're able to grab those numbers and just drop them in to our accrual as opposed to then waiting. And then it gets relieved the next month automatically because doctor Pay equals what gets accrued versus with you guys as cash trickles in. Now, I realize a lot of it comes in that first month or two, but as it trickles in, then you're relieving that old accrued amount. So that's how we think about it. And those are really kind of the two options that you've got.

Right?

Awesome. Anything else on doctor Pay, Mike or Holly before we jump to our next topic?

No.

All right, so we want to wrap up with this discussion because the purpose of it was the why and the when. So we've talked a lot about the why you would want to do it. Let's talk for a minute about the win and then we'll wrap this one up and I'll give the teaser. Now part two is going to focus in on the profit and loss statement and the ways that you get that accurate from an accrual perspective. And then episode three is going to focus on the balance sheet because when you get into accrual financials, the balance sheet and reconciling those balances becomes extremely critical to making sure your financials are accurate. So we're going to spend time there and I think, Holly, to your point, we should pull in a discussion about the statement of cash flow as well to help those who are making the transition to still feel like, hey, how much cash do I actually generate? And that can be a really powerful place to sort of satiate that need to the degree it's there. And then we're going to jump to expenses and how expenses get accrued, like doctor Pay we just talked about. We'll go into those details and how that hits the P and L and the balance sheet and then we'll have a wrap up episode that's going to say, now how do you go throughout your organization and how do you get aligned? How do you help the doctors understand the switch over that you've made and other stakeholders in your financial statements? So anyways, that's just the quick teaser. Here's the last point we want to hit and that is when should you make the transition to accrual? I get asked this question very often. I'm certain both of you do as well I'm interested to hear your thoughts and let's do a quick powwow on this and then we'll wrap up the episode.

Mike?

Well, sure. So I mean, I think there's a couple of points, you know, in the case of Lumio, obviously it was in conjunction with the PE transaction. You know, I think that is any anybody that's looking for that funding, that PE partner going out to market, this is a non optional step. My opinion is the sooner you can take that step the better, you know, because it's a lot of work to get from A to B and you don't want to necessarily set a timeline of okay, we want to be in market in 90 days, let's get an audit. It's just not going to happen. So, you know, the quicker you can get this change made, start to roll it into your, you know, three or five year plan, you've got all the bugs worked out, you've got your systems generally in place, you're going to be able to stand up to that audit for, you know, testing. And again, you've got good valid financial statements you can refer back to. You've got strong basis for forecasting looking forward because you know you're going to get those questions as well. So the sooner the better when you're leading into a PE transaction is obviously vital for specifically this industry.

Yeah. And it's not a linear path to get there. It's not. In fact, I know in QuickBooks there's an option to run your financials on accrual or cash basis and there is so much that has to happen that it's not, it's not that easy because of dentistry, because of the way we've got disparate technology and because of so many elements that go into it. And so it's not a linear path, it's not a hey, let's do this this month and then we're good to go. It takes some time and some investment, which we're going to dive into all of that. But I appreciate that, Mike. So would you say even, cause I know your switch to accrual was in conjunction with bringing private equity on, what would you say to if somebody said, hey, I think in a couple of years maybe we're going to bring on private equity. Would you recommend they do that? They go ahead and pay the price and get it done before the transaction, or do you think doing it in connection with the transaction is the right way to do it?

Yeah, I would absolutely recommend. The sooner the better, you know, if you can do it on that two year timeline horizon. That's ideal because again, you've got a lot of bumps you're going to have to work through. You want people to be bought in. You want people to understand the why, why are we doing this? What is this telling us? Because in our situation, we did get our cart a little before our horse, but to get us there, there were questions and conversations and meetings with doctors and investors and partners and they need to know what you're doing and why, you know, and the sooner you can get everybody engaged in that process, the better, in my opinion.

Great point, Holly. I'd love to hear your perspective on this.

Well, I would add to that the sooner the better simply because say that you're, you've got one dental practice and you're planning on opening a second and you know that in two to three years you're going to look for a larger financial partner. If you can get your financials while your data is still a little bit manageable, you can get your financials onto accrual basis and then run on accrual basis. Up until that point, you're going to have history to be able to share with that future financial partner because a lot of them are going to look at year over year performance and if you're constantly having to say, well, this year is on accrual basis, last year's on cash basis, so they're not comparable, it's going to make your due diligence and the quality of earnings work a lot harder and a lot more painful. But if you can, if you can, go ahead and move over to the approval basis. And it's not, you just have to find the right person to help you. You know, you know, as you said, the QuickBooks deceptive, you know, it does have that deceptive button up there that says accrual versus cash and that is literally only going to manage your ap. When did you enter the bill? What was the bill date versus what was the check date? It doesn't do anything for you on your revenue side. Yeah. So, you know, it's, it's very important to do it while your data is still manageable. You know, there's no reason to keep letting water run under that bridge.

So that's it. That's a great point. And again, let's remember going to a private equity transaction or a sophisticated enough bank transaction where they're going to acquire it. That's, that's part of the reason. But remember, the absolute most important reason to do it is it's Going to make you a better operator of your business. It's going to help you drive better performance and create better results. And from that perspective, I'll throw this idea out to the two of you. If I make the investment, I get myself converted over to accrual. Would you say that my business becomes more valuable when I'm on accrual versus when I'm on cash basis?

I think it gives you the visibility to see the real levers in your financial statements to make your financial statement, to make your financial performance better. One of the levers, if your financial

performance is better, then that means you are more value. And most likely even if you're getting the same multiple, but most likely you can probably because your forecasting is going to be better. So you probably could justify a higher multiple in a transaction as well. Potentially.

Potentially, yes. I mean, I think to get your accrual based financials in front of you and to really understand what's driving the numbers, you know, the adjustments between gross and net revenue, the expenses, you can see your true EBITDA margin, is that a good margin, you know, according to industry, or is it not? If it's not a good margin, what's happening? And you can really get into the, you know, the KPIs are the key performance indicators underneath those financial statements and make improvements. Otherwise it's just, you know, timing. And you always, anytime you give someone an excuse to not pay attention to a financial statement, they will never pay attention, you know, oh, it's just when the bank deposits came in. Okay, well, I'm not going to pay attention, you know, and it just, it's wrong. Yeah, it's almost like, you know, if it's wrong or if it's too late or any of that, they just don't pay attention.

Great point. Mike, what do you think on this?

Well, yeah, and to kind of bring the discussion full circle back to your original example, I think, you know, not only does it help you make the business more valuable, it helps make you a participant in the operations of the business. Because now you're sitting with your coo, your field operators, your regional managers, and instead of defending why these financial statements are right or wrong, you're talking about margin, you're talking about drops in ratios, you were talking about those KPIs. You know, you're talking real time economic decision making versus defending why cost of goods sold percent went up or down. You know, why, why is, why did we miss it on a three month payroll? Because it wasn't accrued, you know, Those discussions go away and it's true operational decision making.

Mike and Holly, you guys have rocked it today. You guys know, I think, I think the world of both of you, you're amazing and appreciate the way that you're helping to lead this industry and everything that you do. And again, this is just, it's been an amazing discussion today. I can't thank the both of you enough for joining.

Thank you for having me.

Thank you. Yeah, absolutely. So if this has piqued your interest at all as a listener, get ready because there's four more episodes coming. Like I said, our next one is going to focus on the how the P and L gets impacted and what happens to that when we make the switch to accrual from a revenue perspective. And then we're going to go through the balance sheet elements. Then we're going to go through expense recognition and then wrap it up with how to get alignment throughout your organization. So that's, that's what's coming. We've got four more episodes. I think Mike and Holly, we're going to try to get one of these done maybe every three to four weeks. So be prepared. Maybe about once a month should be the mindset. Again, Mike and Holly, the two of you have been amazing and thank you to all of our listeners. This is a wrap for episode number one, or I should say part one of accrual accounting. The why and the when. Happy day.

Foreign.

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