A Guide to Understanding an Orthodontic Practice Financial ...

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A Guide to Understanding an OrthodonticPractice Financial StatementBarry Oliver

The purpose of this article is to help the orthodontic practitioner have a

better understanding of practice financial statements, and what the num-

bers on these financial statements can tell about the financial condition of

the practice. This article explores the basic structure of financial statements,

including an analysis of key performance indicators (KPI). Properly analyzing

financial statements can give a sense of the health of the practice—pointing

out strengths and weaknesses. Not all practices have the same format for

their financial statements as others, and statements will vary from practice

to practice, some providing more information than others. (Semin Orthod

2011;17:320-331.) © 2011 Elsevier Inc. All rights reserved.

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S ome practice financial statements providelittle, if any, meaningful information to the

octor. This can be the result of a lack of detail,oo much detail, or improper grouping of cate-ories. Although there is no one standard in theccounting profession as to how expenseshould be grouped and summarized, there areeveral Certified Public Accountant (CPA) firmscross the country that cater to the orthodonticrofession. One such organization, the Academyf Dental CPAs (ADCPA; http://www.adcpa.rg), is mentioned here because several of theey performance indicators (KPIs) mentionedn this article come from member firms of theDCPA. Firms that specialize in providing ac-ounting and tax services to orthodontists tendo have a better understanding of how an orth-dontic practice operates, and what information

s meaningful to help the doctor make impor-ant decisions about his or her practice.

In this paper, I will examine the financialtatements of an actual practice. The doctor’same has been changed, and a few modifica-

Thomas, Wirig, Doll & Co., CPAs, Walnut Creek, CA.Address correspondence to Barry Oliver, CPA/PFS, Thomas,

Wirig, Doll & Co., CPAs, 165 Lennon Lane Suite #200, WalnutCreek, CA 94598. Phone: (800) 877-0564; E-mail: [email protected]

© 2011 Elsevier Inc. All rights reserved.1073-8746/11/1704-0$30.00/0

320 Seminars in Orthodontics, Vol 17, No

ions have been made for clarification purposesnly.

The analysis assumes that as a practitionernd businessperson the doctor is motivated byoney (that’s a good thing, not a bad thing).therwise, why would he/she be interested in

he financial statements of the practice? It fur-her assumes that the doctor wants to pay theegal minimum in income taxes and retain as

uch income as possible. In addition, for mostractitioners, income taxes are their greatest ex-ense. Most orthodontic practice financial state-ents are driven by income tax considerations.

The Cover Letter

When a practice receives its financial state-ments from the accountant, a cover letter willbe attached. This is usually referred to as theaccountant’s compilation report. Figure 1shows a standard compilation report. The firstparagraph clarifies that the statements havebeen compiled on an income tax basis. This isimportant because the method of accountingchosen can have a significant impact on howmuch, and when, income taxes are paid. Theincome tax basis of accounting for most prac-tices means the same thing as the cash basis ofaccounting with a few allowances for noncashitems. Almost all practices will want to followthis method of accounting to avoid paying

4 (December), 2011: pp 320-331

321Orthodontic Practice Financial Statements

Figure 1. A standard compilation report.

322 Oliver

of accounting should generally be avoided fororthodontic practices.

The second and third paragraphs of the com-pilation report state that the financial statementshave not been reviewed or audited, and that theowner of the practice has elected to omit sub-stantially all disclosures. This is important tounderstand because many doctors think that be-cause their financial statements have been pre-pared by a CPA, that the CPA will look for anddetect fraud and embezzlement. Looking forand detecting fraud or embezzlement is beyondthe scope of a standard engagement of compiledfinancial statements. This is an expensive ser-vice, and most practices will not want to incurthe significant increase of professional fees tohave a review or audit of their financial state-ments.

Although a discussion about detecting fraudand embezzlement in orthodontic practices isbeyond the scope of this article, it is importantto understand a few basic areas in which fraudoften occurs. As we proceed through the finan-cial statements, areas of vulnerability will also bepointed out.

Statements of Assets, Liabilities,and Equity

Figure 2 shows the statement of assets, liabilities,and equity, commonly known as a balance sheet.Notice the date of the balance sheet is “As of.”This means that the balance sheet is as of a pointin time, whereas an income statement (to bereviewed next) is for a period, such as a quarteror 3-month period. Not much time is spent an-alyzing the balance sheet. That’s because mostdoctors want to know how much money theymade and the answer to that is found on theincome statement, known as net income.

A line by-line analysis of the balance sheetshows that as of December 31, 2008, Dr Smileshad US$104,402 in the bank. Many practitionersmanage their practice and measure their successby the amount of cash they have in their bankaccount. Cash is watched closely by most doctorsbecause of the immediate ongoing need to meetthe demands of rent, payroll, supplies, and otheroperating expenses of the practice.

The next line item is Loan To/from Share-holder of US$48,212. Although shareholder

up more frequently, especially for those whosepractice legal entity is an S-Corporation. Thisaccount usually shows up because the doctortook more money from the practice than therewere earnings available, or, if a practice experi-ences a downturn in production and there is notsufficient cash to pay operating expenses, thedoctor sometimes has to put personal funds in totemporarily support the cash account. For inad-equate earnings, this becomes an item that isdriven mainly for income tax purposes.

Next on the balance sheet is the Property andEquipment, which shows the historical actualdollar cost of fixed assets that are still operatingin the practice. This means that Dr SeymourSmiles has spent US$352,203 on things such asfurniture, fixtures, dental chairs, computers,phones, etc. Accumulated Depreciation is theamount of fixed assets that has been written offfor income tax purposes. There is an additionalUS$42,199 of write-offs (against income) in thefuture.

Some doctors have a difficult time under-standing how depreciation deductions work forincome taxes. For example, let’s say the practicepurchased US$75,000 of new equipment thisyear and borrowed US$75,000 on a line of creditto pay for that equipment. Depending on theincome tax circumstance, the practice mightelect under Section 179 of the Internal RevenueCode to expense off the entire US$75,000 ofequipment in year one. That would provide anice tax reduction in the current year. However,in subsequent years when the line of credit ispaid back and cash is flowing out of the practicecash account, there will be no income tax de-duction for the cash outlay because the deduc-tion was taken in year one. Conversely, let’s as-sume that instead of writing off the entireamount in year one, the equipment is written off(depreciated) during a 5-year period. Further-more, let’s assume that a 3-year loan was takenout to purchase the equipment. During the next3 years the cash outlay to pay back the loanwould be greater than your income tax deduc-tions because the depreciation (when it is de-ducted for income taxes) is spread over a 5-yearperiod.

Moving down the balance sheet, we come tothe Noncurrent Assets of Goodwill and Patient

asset

323Orthodontic Practice Financial Statements

chased a practice as opposed to starting fromscratch because this is the only way you can getGoodwill on your balance sheet. These intangi-ble assets are written off (amortized) for income

Figure 2. Statements of

tax purposes during a 15-year period. Doctors

who have purchased Goodwill or other intangi-ble assets know the significance and income taxramifications of an asset that is written off over alonger period than the loan period used to ac-

s, liabilities, and equity.

quire those assets.

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324 Oliver

For example, similar to depreciation de-scribed previously, let us assume that the doctor

orrows money to buy a practice and the loanust be repaid in 7 years. To keep this example

imple, let’s assume the only assets purchased areoodwill and Patient Records for US$450,000.hese 2 intangible assets would be written off dur-

ng the course of 15 years, or US$30,000 per year.onthly payments on a loan of US$450,000, paid

ack in 7 years, at 7% interest, would beS$6791.71 for an annual total of US$81,500.52.

n the later years of the loan, the doctor willrobably ask the CPA how come there is souch owed in income taxes but there is very

ittle money in the bank. One answer is because,s one moves to the end of the loan, more of theonthly payment is going towards principal,hich is not deductible for income taxes. In year, for example, of the US$81,500.52 paid towardhe loan, US$78,492.15 is principal whereas theax deduction is only US$30,000 (the amountne can amortize each year). The good news ishat in years 8 through 15 there will be aS$30,000 income tax deduction without any

ash outlay. The tough part (for income taxesnd cash flow) is making it through the years inhich the principal payments exceed the amor-

ization deduction allowed.The second half of the balance sheet is the

iabilities and stockholders’ equity section. Thisection details the amount of practice debt andetained earnings (RET). Under current liabili-ies it can be seen that Dr Smiles owes US$8,567n a practice credit card. For the current yearhe practice is up-to-date and has fully fundedhe retirement plan obligations so the statementhows that nothing is due at the end of the year.or the previous year, one finds that there aremounts due for the 401(k) and retirementlan. Please note that it is more typical for anmount to be due at the end of the year for theetirement plan because total retirement planontributions are not usually known until afterhe end of the year.

Credit card charges is an area in which fraudan easily, and often, take place. If the officeanager or other office personnel have access

o the doctor’s credit card information, the doc-or must make a detailed review each month toerify that all charges are authorized and for the

The long-term liabilities section shows that DrSmiles owes US$339,684, which is reduced fromUS$448,178 a year earlier. The current portionlong-term debt is used as a standard in the ac-counting profession to distinguish debt that isdue in �1 year. If the doctor’s financial institu-tion is monitoring practice financial statements,the bank will want to know the breakout oflong-term and short-term debt.

As we shift to stockholders’ equity, the paid incapital represents the amount of money the doc-tor used from personal funds to begin the cor-poration. RET represents the amount of practiceearnings that have yet to be distributed (or paidout) to the doctor.

Finally, one can see that total assets and totalliabilities and stockholders’ equity are equal indollar amount. That is why this is called a “bal-ance sheet.” So next time the CPA says “I need tobalance the accounts,” you will know what theCPA is talking about. Accounts are balanced toensure that all banking and lending activity inthe practice has been accounted for on the fi-nancial statements.

Statements of Revenues, Expenses, andRetained or Retained Earnings (RET)

Figure 3 shows supplemental schedules of thestatements of revenues, expenses, and RET earn-ings. The schedule of accounts receivable con-tains important KPI. As noted previously, thispart of the financial statement covers a definitiveperiod. In this example the 2 right-hand col-umns represent an entire year and the 2 left-hand columns represent the most recent quarterfor the years ending December 31, 2008 and2007. Showing 2 years side by side allows com-parisons to be made and see how the practice isdoing compared with the previous year for thesame period. For this analysis, the term AccountsReceivable has the same meaning as ContractsReceivable. Also notice the left-hand columnsrepresent a quarter or a 3-month period. Somepractices like to have their financial statementsprepared monthly. However, one should becareful when using 1-month financial statementsfor key decisions; a practice often has peaks andvalleys from month to month, whereas a quar-terly statement gives a broader snapshot of the

emen

325Orthodontic Practice Financial Statements

Beginning on January 1, 2008, Dr Smiles hadan accounts receivable balance of US$510,131.

Figure 3. Supplemental schedules of the stat

Charges or production for the year were

US$1,209,335 compared with US$1,056,761 forthe previous year. Given the economy during

ts of revenues, expenses, and RET earnings.

2008, this represents a significant increase in

326 Oliver

charges. Adjustments for the year were US$67,673for total net charges of US$1,141,662. Collectionswere US$1,075,234 compared with US$904,720 forthe previous year. The ending accounts receivablebalance at December 31, 2008, was US$576,559. Theschedule flows from top to bottom followingsimple math—beginning accounts receivablesplus charges minus adjustments minus collec-tions equals ending accounts receivable.

The first KPI to notice in Fig. 3 is that thepractice had an increase of US$124,607 of netcharges. Clearly, this is an increase any practicewould like to see, especially given how tough theeconomy was in 2008. The next KPI is the real-ization rate. For both 2007 and 2008 the realiza-tion rate was slightly �94%. The realization ratemeans that for every dollar in patient chargesthe doctor is collecting that percentage ofcharges. In 2008, Dr Smiles collected US$940.80for every US$1,000 charged. Most practices willbe at 95% and above on their realization rate.

Items that affect the realization rate are ad-justments that include cash discounts, sibling orfamily discounts, scheduling discounts, uncol-lectible accounts, professional discounts to col-leagues, or promotional discounts, such as to astaff member of a referring doctor. In thesetough economic times many practices have seentheir realization rate decrease because of pa-tients who are not able to keep up with theirpayments for treatment. If the realization ratedrops much �95%, one may want to reconsiderthe financial policies and the credit worthinessof the patients you accept in the practice.

The accounts receivable of the practice is anarea ripe for fraud and embezzlement. Oneshould periodically check the adjustments to en-sure they are valid. It would be easy for a staffmember to collect the payment, post it as anadjustment (as opposed to a payment), then putthe check or cash payment into his or her ownbank account. Depositing a check made out tothe practice into another account of a differentname would not be difficult and would mostlikely go undetected by the bank.

Another KPI on the Fig. 3 schedule is theaccounts receivable ratio. This ratio measuresthe average amount of time it takes to collect(on average) full payment from the time treat-ment was initiated on a patient. For the periodending December 31, 2008, the accounts receiv-

on average that full (treatment) payment is re-ceived in just a little over 7 months per patient.It is important to watch this ratio because if theratio becomes too low, it could be an indicationthat too many patients are paying up front, tak-ing advantage of a cash discount (that could betoo high). One might find that lowering the cashdiscount will result in more patients using thestandard payment plan.

The question comes up why would one notwant to have as many (if not all) prepayments aspossible? The first obvious answer mentionedpreviously is that if everybody is prepaying, thenthe practice’s cash discount is probably too highand money is being left on the table. Second, asmany practices have experienced in 2008 and2009, when there is a slowdown in patient starts,and cash flow is not maintaining normal levelsfrom new patients, then a robust Accounts Re-ceivable can sustain the practice until thingsturn around. Some doctors have said that theyprefer the prepayment and if things later slowdown they will put money back into the practiceto keep it afloat. In theory that line of thinkingis fine; however, in reality once money leaves thepractice and is paid to the doctor, it is most likelyspent and not available for the practice if thereis a need.

Statements of Revenues, Expenses, andRetained Earnings

Figure 4 shows a standard profit and loss orincome statement. Instead of working from topto bottom, one should first look at the bottomline, operating income (loss) before doctor ex-penses, and then review from top to bottom.Most doctors are more interested in looking atthe bottom line first.

For the 12-month (or 4 quarters ended) pe-riod ending December 31, 2008, Dr Smiles hadoperating income before doctor expenses ofUS$518,992. This is an increase of US$172,031from the previous year’s operating income ofUS$346,961. Going to the top line, net revenues,the practice experienced a substantial increase innet revenues of US$183,896 (from US$891,353 toUS$1,075,249) for a 20% increase from the previ-ous year.

The first main category of expenses on theincome statement is total employee compensa-

and

327Orthodontic Practice Financial Statements

fice staff (including the office manager and/ortreatment coordinator), temporary labor, pay-roll taxes, and employee benefits. It will be no-ticed that the category “employee benefits” has

Figure 4. A standard profit

an asterisk (*) symbol by it. Any time this symbol

is seen, it means that there is a supplementalschedule that provides greater detail for thatcategory. For this article, the author will notanalyze most supplemental schedules but will

loss or income statement.

comment on them as appropriate. For example,

328 Oliver

employee benefits generally consist of thingssuch as health insurance, profit-sharing contri-butions, and flexible spending accounts for em-ployees. No benefits for the doctor owner areincluded here. By separating out these types ofexpenses for the doctor, that are considereddiscretionary and not necessary expenses forrunning the practice, a clearer picture of truepractice overhead is obtained.

One needs to be careful when reviewing totalemployee compensation to ensure that salaryand benefits paid to the doctor’s spouse or chil-dren are removed from the totals unless, ofcourse, the spouse or children provide servicesthat actually benefit the practice. Otherwise, ona percentage basis, the employee costs will beinflated. A typical practice will have employeecosts ranging from 20% to 25% depending onlocation and benefits offered.

Employee compensation is another area thatis oftentimes used to commit fraud. It is easy forhours worked to be overstated. It is also easy forthe person in the office who calls in payroll tothe payroll service to change the pay rate, whichwould be difficult for most doctors to detect.Ghost employees (who do not exist) might alsobe on the payroll. The doctor must be sure tocheck the employee payroll on a regular basis.

Employee expenses are considered fixedcosts. Fixed costs are expenses the practice willincur regardless of practice income. These fixedcosts sometimes become stepped fixed costs. Asa practice grows and needs more capacity, addi-tional employees are added and results in step-ping up the fixed costs of the practice. Con-versely, as many practices have experienced adecline in patient starts and revenues this pastyear, employee costs are stepped down as em-ployee days are cut back and hours are reduced.Because these are fixed costs, their percentage ofoverhead based on revenue will fall as revenuesincrease, and employee costs percentage will in-crease as revenues from the practice decrease.

The next main category shown is total occu-pancy expense. Occupancy expenses are all theitems shown from rent through telephone. Atypical practice will have occupancy expensesranging from 10% to 13%. For rent most prac-tices will range from 6% to 8% or greater if inretail space. Dr Smiles rent expense is 3.52% ofnet revenues, well below the average practice.

efficient practice based on the square footageused by the practice. Interest expense isUS$27,413 down from US$36,609 in the previ-ous year. This decrease would be expected be-cause as the practice pays off its loan, more ofthe payments are going towards principal andless is paid for interest on the loan. Depreciationhas also declined from the previous period asthe practice assets are being written down fromyear to year. It can be noted that the amortiza-tion expense remained the same in both years.This is because the amortization expense relatesto the goodwill purchased when Dr Smilesbought the practice. Goodwill is written off on astraight-line basis over 15 years. The Section 179line shows current year equipment purchasesthat the doctor has elected to expense off thetotal purchase at once for tax purposes as op-posed to depreciating the purchase amount overa longer period. Occupancy expenses are con-sidered fixed expenses for the practice.

The next category to review is supplies andlaboratory, including office expense. These costsare known as variable expenses. Variable ex-penses should remain consistent on a percent-age basis relative to net revenues. In this exam-ple, professional supplies for both years hoverclose to 6% and the laboratory expense is closeto 3%. These expenses can vary widely amongpractices as doctors make individual choices asto the types of brackets (and other professionalsupplies) purchased, the vendor purchasedfrom, whether the practice does their own labo-ratory work, and whether the office has a pan-oramic and cephalometric X-ray machine.

There can also be a wide range in profes-sional supplies and laboratory expenses amongpractices that provide Invisalign (Align Technol-ogy, San Jose, CA), with some not offering it atall and other practices that have a significantportion of their patients using it. In addition,because Invisalign is still relatively new to theprofession, there is not consistency among ac-counting firms, even those who specialize inserving orthodontic practices, as to which cate-gory Invisalign costs are assigned to—either pro-fessional supplies or laboratory. Many practicesare now moving to have a separate line item forInvisalign costs, which is probably how it shouldbe listed for accuracy and clarity. Look for more

329Orthodontic Practice Financial Statements

Invisalign, or it becomes a more significant partof orthodontists’ practices.

Office expense for most practices will rangebetween 2.5% and 3%. Office expense includesmiscellaneous office supplies, postage, bankcharges, and computer expenses.

The next main category of expenses includesmiscellaneous but necessary expenses to run apractice. Contract services might include a man-agement consultant or a professional associate.Merchant fees show the cost incurred when pa-tients use their credit cards or arrange for out-side third-party financing. Care should be takenregarding merchant fees because it is easy to notpay attention to them, resulting in paying 2-3times more than needed. Also, making sure staffmembers are trained to steer patients to less-

Figure 5. The remaining portio

expensive outside payment options without los-ing the patient should be considered. Marketingexpense for most practices should be approxi-mately 2%. It can be seen that the categories ofeducation and meetings, meals and entertain-ment, and automobile expense are not very highin dollar amounts. This is because the expenseson the schedule reflect those relating to staffmembers and not the doctor owner.

The total expense for the practice is now con-sidered. It can be seen that the practice has over-head of 51.73% down from 61.07% in the previousyear. In actual dollars, total expenses only in-creased by approximately US$12,000. The largedecrease in overhead percentage was attributableto increased revenues. Therefore, in most in-stances the best way to reduce the practice’s over-

n of the income statement.

330 Oliver

head percentage is to increase the top revenueline. Most practices will find it difficult to reduceoverhead in a substantial way without reducingstaff or obtaining a rent reduction—expense itemsthat are difficult to run a practice without.

Income Statement Continued

Figure 5 shows the remaining portion of theincome statement. It is noted that Dr Smilestook salary during 2008 of US$230,000. In ad-dition, another US$30,500 was put into thepractice profit-sharing plan for the doctor.Not shown is the doctor’s 401(k) contribution,which is included in the doctor’s salary. Doc-

Figure 6. The Statem

tor expenses of US$44,714 (see Fig. 3) in-cludes items such as payroll taxes on the doc-tor salary, doctor health insurance, doctor lifeinsurance, doctor disability insurance, doctorautomobile expense, meals and entertain-ment, travel and lodging, continuing educa-tion, and other doctor owner expenses thatare discretionary in nature and should not beincluded in determining true practice over-head. Thus, for 2008, Dr Seymour Smilesearned a total of US$474,376, which consistedof his salary of US$230,000, the retirementplan contribution of US$30,500, and the re-maining net income of US$213,876.

ent of cash flows.

331Orthodontic Practice Financial Statements

The Statement of Cash Flows

The statement of cash flows is shown in thisarticle (Fig. 6) not because there is much valueto it but because it is a required disclosure that aCPA must include, as part of the accountingprofession’s standards. This schedule is useful inunderstanding the difference between cash flowand net income. If the doctor owner has morepractice income that required payment of in-come taxes without having the cash available,this schedule helps to explain and reconcile the

Summary

As is evident, the financial statements can berather involved. It is critical for an orthodontistto be able to read and understand the informa-tion presented in the practice financial state-ments to be in a position to make adjustments inpractice management and/or internal controls.A CPA with a sound understanding of orthodon-tics can assist the orthodontist in analyzing thefinancial health of the practice, and advise himor her on potential changes to maximize the