Watch for potential life plan community liabilities
The contracts of life plan communities (also known as a continuing care retirement communities, or CCRCs) can be complex. Poor decisions by providers in designing contracts and the related fees can take decades to reveal themselves, and when they do become apparent, it may be too late to take corrective action. When providers, regulators and prospective and actual residents understand the evolution of generally accepted accounting principles to identify and record all potential liabilities, they should feel more confident in their decisions.
A life plan community is a retirement community in which a resident signs a continuing care agreement, pays an entrance fee and agrees to pay a monthly fee that is subject to periodic adjustment. In consideration, the provider agrees to provide housing and an array of services, usually including housekeeping, maintenance, dining, scheduled transportation, activities and certain healthcare services to the resident, typically for the rest of the person's life.
Life plan communities are all different, both in personality and in resident contract, so that anything said about them must be said generally, with the knowledge that there almost always will be exceptions. That said, accounting for these complex contracts has gone through an evolution over the years. A review of this history helps one understand the nature of the liabilities in providers' financial statements.
In the mid-1970s, some life plan communities still took entrance fees into income when the contract was signed and the entry fee paid. Thus, if a new resident paid an entry fee of $100,000, then the entire amount was taken into income at that time.
The contracts typically have a provision for a refund of a portion of the entry fee under certain circumstances, but the amount of the refund is reduced 2% per month so that the refund disappears after four years.
The accounting industry established a standard (GAAP) in the late 1970s that required entry fees to be deferred and amortized into income over the contractual amortization period. Using our example, this approach let the provider take $25,000 into income each year for the first four years of residency. This refund liability continues to be reflected in providers' financial statements to this day, usually described as the “contractual refund obligation” or something similar.
The next step in the evolution of the accounting for contracts came a few years later when it was recognized that the entry fee was paid for services to be provided over the resident's lifetime, so the entry fee ought to be deferred and amortized over the resident's life expectancy, as determined at the time of entrance using actuarial tables.
In our example, if the new resident had a 10-year life expectancy at move-in, then the provider took $10,000 into income each year for 10 years. If the resident passed during the initial 10 years, the provider took the remaining unamortized balance into income in the year the resident passed. If the resident lived beyond 10 years, say for 15 years, then no entry fee income was recognized in the final five years.
It was pointed out that such an approach, although a step toward matching revenue with expense, could be made even more accurate by updating residents' life expectancies annually, because the longer a person lives, the longer he or she actuarially is expected to live.
The annual calculation of life expectancy became GAAP in the early 1980s. Going back to our example, the provider would take $10,000 into income in the first year, and somewhat less than $10,000 into income the second year, and somewhat less than that in the third year and so on.
The expected life and period of amortization is adjusted annually for each resident. This liability continues to be reflected in most providers' financial statements as “deferred entrance fees,” which represents the unearned balance on nonrefundable entrance fees. In other words, this is the amount the community will earn in the future either through continued amortization or at termination of the contract.
The next step in the evolution came in the mid-1980s, when it was pointed out that continuing care contracts need to be accounted for like all other business contracts. In a construction firm, for example, if a contractor enters into a contract that is going to result in a projected loss, then the estimated projected loss is booked when identified. The same should be true for life plan community contracts.
GAAP was modified to require an annual calculation and booking, if there was one, of the estimated unfunded future service liability. This complex calculation, usually performed by an actuary, looks at the combination of entry fee paid plus monthly fees to be paid over the resident's life expectancy, and compares that with the estimated cost of care and services to the resident assuming they are an average consumer of the community's care and services.
This amount, which is present-value discounted, is then compared with existing deferred or unearned entrance fees and allocated depreciation. If there is a liability, then it will show up in the financial statements as something like “estimated obligation to provide future services.” If there is no obligation, then there should be a footnote stating that the calculation was done and that it resulted in no liability.
It is important to recognize that the nature of the calculation is complex and the presence or lack of a liability cannot be used by itself to evaluate the financial solvency of a CCRC.
Several years ago, the picture was made even more complex when providers began to offer contracts in which a portion of the entrance fee was guaranteed to be refunded.
Going back to our original example, there was no refund due to the resident or his or her estate after four years in the standard contract. In a guaranteed refund contract, a portion, say 50%, of the entrance fee is guaranteed to be paid back to the resident or his or her estate at contract termination. Under GAAP, these liabilities show up as “guaranteed refund liability” or “estate preservation liability,” and they do not amortize into income.
Again, following our example, it is possible that one contract could have the following liabilities on the balance sheet of a provider:
- Guaranteed refund liability for contractually guaranteed refunds of all or a portion of the entry fee,
- Estimated obligation to provide future services for an estimated excess, if any, of contractually obligated costs over the revenue to be contractually provided and as yet unearned deferred entrance fees,
- Deferred entrance fees to recognize the deferred recognition of revenue from prepaid entrance fees to match revenue with expenses over a resident's life and
- Contractual refund obligation to recognize the unamortized contractual obligation of each resident contract. Some providers combine the guarantee refund liability related to refundable contracts with the contractual refund obligation on their balance sheet.
Life plan communities have been around for more than 100 years and provide an incredible service to older adults. We hope this review helps lead to their continued success.