The transformation of China's health care system and accounting methods: Current reforms and developments

THE TRANSFORMATION OF CHINA'S HEALTH CARE SYSTEM AND ACCOUNTING METHODS: CURRENT REFORMS A N D DEVELOPMENTS David K. W. Chu and Kolleen J. Rask

ABSTRACT This paper is a case study of China's recent reforms in hospital accounting. We analyze the Chinese health care system in transition to highlight the changing role and nature of accounting services before and after the recent reforms. Prior to reforms, the accounting system provided data solely for government central planning purposes. Reforms were expected to decentralize hospital decision making, thus signaling a need for a new accounting system that would provide information to managers and resource providers. However, the government continues to maintain control by fixing basic medical service prices at levels below cost while allowing profit margins for pharmaceutical sales and other advanced medical services. This schizophrenic policy of quasi-decentralization~macro-control has resulted in an accounting information system that serves neither the need of managers nor external resource providers. In January 1999, major reforms were instituted in China's hospital accounting system, creating a more streamlined structure. The legacy of the command economy, however, remains clearly evident in the areas of revenue control and state

Advances in International Accounting, Volume 15, pages 13--43. Copyright © 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved. ISBN: 0-7623-0952-0 13

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DAVID K. W. CHU AND KOLLEEN J. RASK

subsidies. Hospital accounting in China is therefore subject to the ongoing evolution of the government's health care policy.

INTRODUCTION China has compiled an enviable record of economic success in nearly two decades of deliberate reform, in sharp contrast to the severe difficulties faced by most other transitional economies. One key to China's success has been its slower pace of reform, giving existing institutions time to adjust to changing conditions (see, for example, Rask et al., 1998; Hoen, 1996; Van Ees & Garretsen, 1994). As China continues to increase her reliance on the market system for making important economic decisions, information services take on an ever more critical role in the economy. Plan directives issued by bureaucrats give way to decentralized, individual decision making based on economic realities. These decisions require reliable flows of information, necessitating an overhaul of many institutions, including the administrative accounting structure previously developed for the socialist economy. The health care system in China faces particular challenges in this transitional period. The experience of currently industrialized market economies suggests that as incomes grow in the world's most populous country, demand for medical services will grow disproportionately. Therefore, hospitals already struggling to evolve into market entities must plan at the same time for tremendous growth in the future. This prospect makes increasing the efficiency of health care provision particularly important. Evaluation of costs and benefits, however, requires a sophisticated accounting system that not only provides the relevant information to decision makers, but is also flexible enough to operate in the rapidly evolving market environment. In addition, declining government tax revenues have resulted in severely curtailed public expenditures on health care, putting further pressure on providers to cover their own costs. Placing these industry-specific concerns within the context of a transitional economy already facing a critical deficit of market-trained accounting professionals yields a gloomy picture of the arduous task ahead for the liberalization of China's health care system. Fortunately, some dramatic changes have recently been instituted in the Chinese accounting system for the health care industry. In particular, the reforms of January 1999 moved China's health care accounting system much closer to those operating in Western market economies. Much work remains to be done, however, particularly in the areas of privatization, state subsidies, and the treatment of pharmaceuticals. The legacy of the centrally planned economy is clearly evident even in the reformed accounting structure; the full transformation of

The Transformation of China's Health Care System and Accounting Methods

15

the system into one that can be used more appropriately within the market context will likely require several incarnations of reforms. STRATEGIC

SERVICES

IN TRANSITIONAL

CONOMIES

The Legacy of Socialism

Strategic services coordinate market activities and include such activities as information, financial, transportation, communications, and retailing services, in addition to accounting services. Health services fulfill a different economic function and therefore evolve under different conditions. Despite the fact that strategic services, such as information services, are at the core of an efficiently operating market system, in a transitional economy they tend to be the least developed sector, receiving the least amount of resources and attention (for further development of the theoretical ideas in this section, see Rask & Rask, 1994a). This deficit in service development and perceived importance comes from the socialist legacy of supplanting essential service functions with the command structure, leading to a significant lag in the development of strategic service industries compared to other sectors. This differential then creates a drag on the further development of these sectors. Economic development in a market environment to a great extent consists of a progressive division of labor throughout production and distribution. This specialization transforms a cohesive whole into various separate operations, which are then coordinated by strategic services, such as communications, transportation, exchange, and information services (Rask & Rask, 1994a, b). Prices convey information regarding relative scarcities and production costs, while services coordinate production and distribution based on these prices. When a command structure is superimposed on the economy, market-based services are no longer needed to coordinate activity. Interactions between producers, suppliers, and distributors are proscribed by the planners rather than governed by prices. Physical quantities of inputs are delivered to the producers, who in turn produce a quota-determined level of output, which is distributed by the state. Market-based strategic services would be largely redundant in this scenario, and therefore do not evolve to fulfill these roles. Sectoral Imbalance During Transition

Given the long suppression of strategic services, dismantling the command structure leaves a void in the coordination of economic activity. While strategic (coordinating) services naturally evolve concurrently with a developing market

16

DAVID K. W. CHU AND KOLLEEN J. RASK

economy, the transitional economy finds itself with a severe imbalance between the technically advanced (albeit inefficient) industrial sector and the nearly nonexistent service sector. The task of bringing services of all kinds (including financial and information services like accounting) into balance is formidable. Those services that did not exist at all under the command structure, such as wholesale and retail trade, must be developed from infancy. Others (communications and transportation services) did exist, but were not governed by market forces and are therefore not yet equipped to provide efficient, price-based service. Still others, such as the financial and accounting services highlighted here, fulfilled entirely different functions under the command system and must be completely reconstructed in order to provide market-based efficient coordination (Rask et al., 1998). The reconstruction of such accounting services within the context of the health care system is the focus of our remaining analysis. STRUCTURE

AND TRANSFORMATION HEALTH CARE SYSTEM

OF CHINA'S

Before Economic Liberalization: 1949-1978 Three-Tiered Health Care System During the period 1949-1978, China's health care system emphasized the control and prevention of infectious diseases. Since 80% of the population lived in rural areas, the rural health care system was given the most attention by policymakers at the time. Govemment health care was organized into the following three-tiered referral system: (1) Village stations, (2) Township health centers, and (3) County hospitals. Village stations, which provided rudimentary diagnosis and prescription, comprised the first point of contact between patients and the health system. These stations were staffed by village doctors ("barefoot doctors") with about three to six months of post-junior high school medical training. More complex cases were referred to township health centers that had between ten and twenty beds and were staffed primarily by a doctor with about three years of medical education at the post-high school level. Patients needing a higher level of care were admitted to the county hospital that had 250 to 300 beds and was staffed primarily by doctors with four to five years of medical training at the post-high school level.

The Transformation of China's Health Care System and Accounting Methods

17

The following parallel three-tiered government structure existed in urban areas: (1) Street health stations, (2) Community health centers, and (3) District hospitals (Hsiao & Liu, 1996). Moreover, state-owned enterprises (SOEs), which were required to provide health care to their workers, either operated their own hospitals or contracted with a government-owned hospital for services (Hsiao, 1995).

Health Care Financing Health care was financed primarily from the following programs: (1) a cooperative system in the rural sector, (2) a government insurance system in the urban sector that covered civil servants, workers in public agencies, universities, handicapped military officers, and university students, and (3) a labor insurance system also in the urban sector that covered SOE employees and their dependents. Patients not covered under these three programs paid for health services outof-pocket. By 1975 the government and labor insurance systems covered almost 100% of the urban population, and the cooperative system covered almost 85% of the rural population. Overall, the three health care financing plans covered almost 90% of China's population in 1975 (World Bank, 1997, p. 1).

Hospital Ownership A selected number of hospitals with the most advanced facilities and personnel were owned by the central government. Rural county hospitals and urban district hospitals were owned by the provincial governments. All these hospitals received their funding through the hierarchical structure of the Ministry of Finance, Ministry of Health, and provincial health bureaus. Accordingly, these hospitals were subject to the jurisdiction of the Ministry of Health. SOE hospitals, however, belonged to their respective parent enterprises and were not subject to directives from the Ministry of Health and the provincial health bureaus (Hsiao, 1995). But in light of the fact that SOEs themselves are state entities, one can generally say that all hospitals prior to reform were de facto state-owned entities. According to Yu (1992), the three-tiered structure that existed from 1949 to 1979 enabled both urban and rural health services to be available to almost everyone, albeit at a low quality level. Large numbers of health care workers were well distributed throughout the country. Health services were priced at affordably low prices and most of the population was eligible for coverage under one of the three health insurance plans.

18

DAVID K. W. CHU AND KOLLEEN J. RASK

Economic Reforms: 1979-Present Reforms in Agriculture, Enterprise Management, and Public Finance China's economic reforms since 1979 are well documented (see Bell et al., 1993; Gottschang, 1995; Ho, 1994; Nolan & Ash, 1995; Rawski, 1995; Tseng et al., 1994; and Walder, 1995). Reforms in the agricultural and industrial sectors shifted the emphasis of production management away from collectivization in favor of individual responsibility. The reformed systems were known formally as the "household responsibility system" and the "contract responsibility system" respectively (see Rask et al., 1998; Tang et al., 1994; Tseng et al., 1994; Bell et al., 1993; and Maschmeyer & Yang, 1990). Major reforms were enacted with respect to public finance. Prior to the reforms, all SOEs were required to remit their profits to the central government, comprising a substantial part of national revenue. In the early 1980s the central government began taxing SOE profits while allowing SOEs to retain their after-tax profits. The intent of this tax policy was to provide incentives for management to improve operational efficiency by allowing more local discretion over the use of after-tax profits. Between 1978 and 1985, "Revenues from Enterprises" had fallen from 50% to 2% of total revenue while taxes comprised 88% in the latter year (SSB, 1994). This fundamental change in policy altered the relationship between the central government and SOEs. First, by giving enterprises more discretion in reporting accounting information, the state lost direct control over financial data. As there was a serious lack of auditors at the time, the state had limited means of examining the integrity of profits and losses reported by enterprises. Second, the reform of fiscal policy resulted in various tax-sharing arrangements between local governments and the central government, significantly eroding the central government's revenue intake. Between 1978 and 1993, government revenue as a share of GNP fell from 31.2% to 15.1% (SSB, 1994). Since 1994 the taxation system has been made more transparent. A uniform tax rate of 33% has been applied to all domestic enterprises. Tax exemptions and pretax deductions have been standardized. These reforms have strengthened the central government's ability to administer taxes. With its post-reform dynamic growth clearly coming from the private sector, China's reform policy continues to emphasize expanding the private sector. In 1999 the leadership endorsed a revision of China's constitution that officially recognized multiple forms of ownership, referring to private enterprises and family-owned businesses as an "important part of the socialist, market economy" (WSJ, 1999, p. A18). Meanwhile, SOE reform continues to proceed slowly along the paths of mergers, privatization, and bankruptcy (WSJ, 1997a).

The Transformation of China's Health Care System and Accounting Methods

19

China's economic reform policy is clearly predicated on two tenets: decentralization and privatization. Decision-making power is decentralized to local governments and enterprises, as they become individually responsible for profits and losses. Private ownership of property is encouraged as a key incentive based on the rationale that individuals work harder and more efficiently when they keep the benefits accruing directly from their own efforts. The reforms have been predominantly of an economic nature and have made notable improvements in many aspects of China's economy. The impact of these economic reforms on China's health care system, however, has been quite different.

Health Care Transformation: 1979-Present Government Financing The two pillars of economic reform, decentralization and privatization, inadvertently created a budget crisis for China. Tax decentralization in the 1980s severely decreased the proportion of central government revenue to total GDP while deficit-ridden SOEs failed to attract private buyers (WSJ, 1997b). In order to continue subsidizing SOEs, the decision was made to severely decrease funding for social services such as health care. Table 1 illustrates the downward trend in central government funding for health care. In a decade and a half of economic reform, the central government's role in financing health care had diminished to half of what it used to be; patient out-of-pocket payments had more than doubled in its share of national health expenditures; and the rural cooperative medical system had virtually ceased to exist. Tab~ 1.

National Health Expenditure for China 1978 and 1993. (millions of 1993 yuan.) 1978

Funding Source Central government budget Government and labor insurance systems Out-of-pocket payments Rural cooperative medical system Other Total Source: World Bank, 1997, p. 74.

1993

Amount

%

Amount

%

7,292 7,689 5,268 5,109 428

28 30 20 20 2

18,878 46,108 56,106 2,243 8,713

14 35 42 2 7

25,786

100

132,048

100

20

DAVID K. W. CHU AND KOLLEEN J. RASK

Privatization Reform also included allowing private ownership of health facilities and clinical practices. Private investment in new hospitals in the form of foreign joint ventures was encouraged. Hospitals were given the freedom to seek additional funding from profit-making activities such as producing and selling medicines and medical equipment, and operating businesses such as stores, hotels, and factories. In fact, hospitals that operated businesses to improve their finances were offered tax relief for the first three to five years (Yu, 1992). Hospital management entered into a contract system whereby service provision and economic targets are preset. Within the hierarchy, individuals are accountable to the department, departments are accountable to the hospital, and hospitals are accountable to the local health bureau. Bonuses are awarded for exceeding contract targets and fines are imposed for failing to achieve such targets (Zheng & Hillier, 1995). Under these incentives, hospital management is now primarily focused on service competitiveness and profitability. Rural Health Care The commune welfare funds that had formed the substance of the cooperative medical scheme were depleted as increasingly affluent households refused to pay into the funds, preferring instead to finance out-of-pocket their specific choice of health care. This resulted in the collapse of the cooperative medical financing scheme along with the dismantling of the three-tiered referral system. Wealthier farmers preferred to bypass the primitive health stations in favor of directly consulting with doctors in the more sophisticated county hospitals. Meanwhile, increasing numbers of village doctors gave up their jobs in the village health stations in order to establish lucrative private practices linked to area hospitals. The collapse of the cooperative medical financing scheme, and the decrease in government funding, shifted rural health care financing to a fee-for-service payment system relying on direct out-of-pocket payments from patients. These phenomena were the main causes of the trends observed in Table 1. Pricing Health Care The Chinese government's price reform policy for health services further transformed the behavior of health care providers. A "two-track" approach to health service pricing was adopted; that is, most prices were still centrally determined while others were liberalized. The Central Pricing Commission, which sets the general guidelines for hospitals, still clings to the socialist tenet that health services should be affordable to all. On one track, fees for basic health services are still based on historical fees established in the 1950s, thus setting prices at a level below current cost. In 1984, for example, the centrally determined price

The Transformation of China's Health Care System and Accounting Methods

21

of an appendectomy charged in major hospitals was only 31% of the average cost of the procedure (Hsiao, 1995, p. 1051). On the other track, prices for medications and new diagnostic and therapeutic procedures are set at a level above current cost, allowing for a profit margin. For example, hospitals are allowed to charge a dispensing fee plus a maximum markup of 15% over the wholesale price for western medicine and 25% for Chinese herbal drugs. The prices of diagnostic and therapeutic services such as CT scans, MRI, and multichannel blood analyzers are based on the average cost per budgeted number of procedures. This pricing method enables hospitals to generate more profits simply by increasing the use of new equipment (Hsiao, 1995, pp. 1051-1052). Two-track pricing created an incentive for hospitals to maximize the prescription and sale of drugs as well as the performance of profit-making medical procedures in order to subsidize losses incurred in providing other basic health services. Pharmaceutical expenditure in 1993 comprised 52% of total Chinese health expenditures compared to an average of 14% in OECD countries for that year (World Bank, 1997, p. 20). The skewed financial incentives created by two-track pricing were further encouraged by a shift in demographics and epidemiology. Over the years increased life expectancy has increased the size of the over-65 population, many suffering from chronic diseases. This shift provided an incentive for health care providers to emphasize curative tertiary care rather than preventive primary care. Moreover, preventive primary care is labor intensive and consists of services priced below current cost. Curative tertiary care, on the other hand, is capital intensive and allows hospitals to perform procedures and dispense medications at profitable prices. The emphasis on curative tertiary care results in an increased shift in funding to the more advanced hospitals as they rush to purchase the latest technology. Since these advanced hospitals are located in urban areas, increasing portions of health care funding have also shifted from the rural to the urban areas. Moreover, as nonagricultural enterprises owned by rural townships continue to prosper, many rural townships have experienced increased urbanization, which has led to a higher level of economic integration between urban and those rural areas (Grogan, 1995). The implication is that more areas are now de facto urban areas and the demand for advanced health facilities will further increase. CHINESE

HOSPITAL

ACCOUNTING

SYSTEM

The Political Superstructure of Accounting Prior to the reforms, Chinese accounting was used as a tool not so much for decision making as it was for state administration, economic planning, and

22

DAVID K. W. CHU AND KOLLEEN J. RASK

financial control. Accounting was used to obtain data suitable for statistical aggregation and summarization. Its design thus tended towards compulsory imposition of rigidly standardized accounting procedures. Through this uniform system, central planners obtained average cost data to perform their task of collective planning. It was neither a management accounting system nor a financial accounting system, both of which would have provided vital information for individual decision making. Reforms in the last two decades have not changed the fundamental political superstructure regulating the accounting system. The Ministry of Finance, in conjunction with the financial departments of other ministries, is ultimately responsible for administering accounting regulations pertaining to each sector of the economy. In the health sector, decisions on the design of a hospital accounting system are made jointly by the Department of Planning and Finance within the Ministry of Health and the Ministry of Finance. Once the overall framework is established, local implementation of accounting regulations is made under the joint supervision of the local Finance Bureaus and the Financial Departments of the local Health Bureaus (for a detailed description of the overall system, see Hu & Marts, 1991).

Developments in Hospital Accounting: 1949-1998 Similar to SOEs during this period, hospitals functioned as self-sufficient units. This meant hospitals not only provided medical services to the public, but also provided housing, meals, and other social welfare benefits to their employees. In the medical realm, hospitals not only performed medical services, but also sold pharmaceuticals at retail prices. In the area of traditional Chinese medicines, hospitals were also engaged in the manufacturing and packaging of Chinese medicine. In other words, the Chinese hospital is a multi-faceted entity engaged in a much wider range of economic activities compared to its Western counterpart.

1950-1980 During this period, hospitals were not considered a separate accounting entity in need of a unique accounting system. The government provided most of the funding and very little revenue was generated independently by the hospital. Hospital accounting, subsumed within the overall government accounting system, operated on the basis of budgetary accounting, which recognized revenue and expenditure on a cash basis and highlighted the changes in the source, application, and balance of governmental funds. The main focus was on tracking fund appropriations and expenditures, and showing that the spending

The Transformation of China's Health Care System and Accounting Methods

23

had been made in accordance with legal requirements. Income determination was not a focus of this accounting system. Accounts were therefore classified into three groups: fund source, fund application, and fund balance. The bookkeeping method was known as the receipt/payment method. In place of "debit" and "credit" sides, each account was divided into a "receipt" and a "payment" side. Increases to fund source accounts were entered in the "receipt" side whereas increases to fund application accounts were entered in the "payment" side (for details on this bookkeeping method, see Tang et al., 1994, pp. 159-181). During this period, budgetary accounting provided a tool for the government to obtain aggregate financial data and perform central hospital planning.

Mixed Signals Amidst a Paradigm Shift: 1980-1998 Economic reforms in the 1980s altered the govemmental budgetary structure. In order to relieve pressure on the budget, the govemment encouraged its subordinate units to generate revenue through the sale of goods and services. These revenues were categorized as off-budget funds and retained by hospitals as discretionary income. Off-budget revenues were included in the overall computation of the state budget, but were not distributed through the central budget appropriation (Tang et al., 1994, pp. 162-164). In this regard, hospitals were in a position to generate large amounts of off-budget revenues through the sale of pharmaceuticals, which was categorized as an off-budget revenue item. However, economic reforms in the 1980s also sent mixed signals to the hospital industry. On one hand, the emphasis on decentralization and the decrease in govemment funding signaled a need for hospitals to utilize financial incentives in their decision-making. There was therefore a paradigm shift from viewing hospitals as being a part of govemment to viewing them as separate entities responsible for their own economic survival. On the other hand, government still controlled key aspects of hospital decision making, the most important of which was price fixing. Prices of most medical procedures remained pegged to outdated indexes. 1994 prices for basic health services were based on a 1989 price index that was nominally adjusted only once in 1990, whereas the average annual inflation rate from 1989 to 1995 was 11.1% (SSB, 1996, p. 225). Making matters worse, while prices of medical services remained fixed, controls on the price of medical inputs (wages, equipment, etc.) were lifted, resulting in systemic operating deficits for the hospitals. Recurring deficits ensured a dependence on some form of government subsidy. Under this arrangement, hospitals were required to report an estimated amount of operating deficit to be subsidized. The government would then provide subsidies on one of three bases: (1) the amount of the deficit; (2) a percentage of

24

DAVID K. W. CHU AND KOLLEEN J. RASK

specified expense items such as wages, facility repairs, etc.; or (3) a fixed monetary amount. Such financial dependence guaranteed a high level of government influence on hospital management amidst the reform rhetoric of operational decentralization. Despite these mixed signals, the paradigm shift was sufficient to indicate a need for a separate hospital accounting system. Such a system should not only provide an accurate financial profile of the hospital, but should also provide information relevant to the new economic milieu of operational optimization and return maximization. After all, in the spirit of economic reform, users of accounting information would no longer just be government planners, but hospital managers and department heads as well.

Hospital Financial Structure and Accounting System: 1980-1998 Hospital business operations were categorized as medical services, retail sale of pharmaceuticals, in-house manufacturing of remedies (Chinese herbal medications and solutions), and miscellaneous services. Government policy during this period was to maintain total control over hospital budgets, subsidize operating deficits, and allow hospitals to retain operating surpluses, if any. Thus all surpluses and deficits arising from each category were combined, and, together with any budgetary deficit subsidies from the government, were retained by the hospital to be allocated into a number of funds designated for specific uses. These funds were collectively defined as Designated Items Funds and were used to: (1) replenish productive assets; (2) further business operations; and (3) reward workers in order to motivate them towards operational excellence. Hospitals also directly obtained funds from the Ministry of Finance and the Ministry of Health that were earmarked for specific uses such as equipment acquisition, repairs, and debt repayment. Separately, resources could also be received from individual donors and investors restricted for the purchase of specific equipment and facilities. Finally, hospitals could obtain bank loans to finance specific capital projects. Figure 1 illustrates the flow of hospital funds. The hospital accounting system used at the time was parallel to the financial structure. The Ministry of Finance and the Ministry of Health jointly developed a chart of accounts specifically applicable to hospitals. However, due to continued dependence on government subsidies, the informational framework was still governmental budgetary fund accounting that focused on the flow of funds rather than income determination. All the accounts were still categorized either as fund source or fund application; and the fundamental accounting equation was still defined as fund source = fund application. In contrast to the previous system the cash basis of accounting was replaced by the accrual basis of accounting and the receipt/payment method of

The Transformation of China's Health Care System and Accounting Methods

b~ I

, ~ q-.

.=. d=

.=.

li°.-

©

".4

25

26

D A V I D K. W. C H U A N D K O L L E E N J. R A S K

bookkeeping was replaced by the debit/credit method of bookkeeping. Moreover, as a separate entity, hospitals were required to produce a set of specific financial statements. The chart of accounts for hospitals is shown in Table 2. One can see from Table 2 that accounts were not listed in the order of assets, liabilities, net assets, revenues, and expenses typical of most Western accounting systems. Since the fundamental accounting equation for this system was fund source = fund application, asset and expense accounts were listed together as fund application accounts whereas liability, revenue, and net asset accounts were listed together as fund source accounts. Although the account categories (i.e. source and application) were different from Western systems, the fundamental nature of the accounts was identical to the Western concept. In Western systems, asset, liability, and net asset accounts

Table 2.

Hospital Chart of Accounts for China, 1980-1998.

Fund Application Accounts 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

Fixed assets Fixed asset losses in process Low Value Consumables Pharmaceutical inventory in storage Pharmaceutical inventory in pharmacy Medical inventory Other inventory Medical inventory losses in process Cash in bank Cash on hand Medical expenses Pharmaceutical expenses Hospital-made remedy expenses Administrative expenses Patient accounts receivable Other receivables Expenses to be amortized Investment in government bonds Specific purpose fund expenses Designated items fund expenses Other specific purpose funds expenses Specific purpose cash in bank Specific purpose receivables Specific purpose inventory Income allocation

Source: Wang, 1988, p. 23.

Fund Source Accounts 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45.

Fixed assets fund Fixed asset gains in process Working capital/subsidies Budgetary deficit subsidy Medical revenues Pharmaceutical revenues Hospital-made remedy revenues Other revenues Medical inventory gains in process Pharmaceutical price differential Unearned medical revenues Accounts payable Accrued expenses payable Patient receivables in process Specific purpose subsidies funds Designated items funds Other specific purpose funds Specific purpose loans Specific purpose payables Income summary

The Transformation of China's Health Care System and Accounting Methods

27

are permanent accounts that reflect a hospital's financial position at a specific point of time (stock), whereas revenue, expense, and subsidy accounts are temporary accounts that summarize the results of operation during a period of time (flow). The concepts of flow and stock were clearly illustrated in two of the six mandatory hospital financial statements - the statement of fund application and fund source (Table 3) and the statement of operating revenues and expenses (Table 4). The statement of fund application and fund source (Table 3) was essentially a balance sheet showing the balance between fund application (fixed assets, current assets, and specific purpose fund assets) and fund source (liabilities and net assets). The statement of operating revenues and expenses was essentially an income statement showing the difference between total revenues and expenses, plus the budgetary deficit subsidy. At the end of an accounting Table 3.

Format for Statement of Fund Application and Fund Source. Balance

FUND APPLICATION Fixed assets Fixed asset losses in process SUBTOTAL Low value consumables Pharmaceutical inventory: In storage In pharmacy Medical inventory Other inventory Medical inven, losses in process Cash in bank

Beg.

End

Balance FUND SOURCE

Other receivables Expenses to be amortized SUBTOTAL Specific purpose inventory Specific purpose cash in bank Investment in government bonds Specific and designated fund exp. Specific purpose receivables SUBTOTAL

Fixed assets fund Fixed asset gains in process SUBTOTAL Working capital/subsidies: Pharmaceuticals Medical inventory Other inventory Low value consumables Advance from government Medical inven, gains in process Unearned medical revenues Accounts payable Accrued expenses payable Patient receivables in process Income summary to be allocated SUBTOTAL Specific purpose subsidies funds Designated items funds Specific purpose loans Other specific purpose funds Specific purpose payables SUBTOTAL

TOTAL FUND APPLICATION

TOTAL FUND SOURCE

Cash on hand Patient accounts receivable

Source: Wang, 1988, p. 432.

Beg.

End

28

DAVID K. W. CHU AND KOLLEEN J. RASK Table 4.

Format of Statement of Operating Revenues and Expenses.

Item

Budgeted Amount

Actual Amount CurrentM o n t h Year-To-Date

Revenues

Medical Pharmaceutical Hospital-made remedy Other Total revenues Expenses

Medical Pharmaceutical Hospital-made remedy Administrative Total expenses Excess of Revenues over (under) expenses Add: Budgetary deficit subsidy Income balance Source: Wang, 1988, pp. 426-431.

period, the revenue, expense, and budgetary subsidy accounts were closed into income summary. The balance in income summary was allocated three ways. (1) an amount identical to the total amount of uncollected patient receivables was closed to the patient receivables in process account (2) an amount computed according to percentages predetermined by the administration was closed to the fund balances of the following specific items funds: routine repairs, capital facilities, business development, welfare, bonus, and hospital superintendent discretionary use (3) any remaining income was allocated to the income summary to be allocated account. The patient receivables in process and income summary to be allocated accounts were disclosed as fund source accounts in the statement of fund application and fund source. Figure 2 illustrates the hospital accounting flow described above. In addition to subsidizing business operations, government subsidies for other specific purposes formed an integral part of hospital funding. Therefore, hospitals were required to prepare a statement of changes in specific purpose fund balances that showed the inflow and outflow of resources among the hospital funds. Table 5 shows the format of this statement, which conforms to the financial structure shown in Fig. 1.

The Transformation of China's Health Care System and Accounting Methods

Medical Revenues t Pharmaceutical Revenues Hospital-made remedyRevenues OtherRevenues MedicalExpenses [ Pharmaceutical I Expenses I Hospital-made I remedyExpensesI OtherExpenses ] Budgetary Deficit Subsidy

Patient Receivables in Process Income Summary

Income Allocation Income Summary to be Allocated

-~

RoutineRepairs FundBalance

t

CapitalFacilities FundBalance

29

_• -• -•

BusinessDevelopment FundBalance WelfareFundBalance BonusFundBalance

_~ HospitalSuperintendent FundBalance Fig. 2. Hospital Accounting Flow in China, 1980-1988. Finally, hospitals were required to prepare a statement of receivables and payables (Table 6), a statement of fixed asset repairs and acquisitions (Table 7), and a statement of hospital statistics (Table 8) as supplementary disclosures of financial information. Reasons for Further Reform The hospital accounting system reflected the fragmented nature of hospital economic reform. The hospital profile illustrated by these financial statements was one that was heavily dependent on government subsidies even though managers were supposedly held accountable for the results of their own operational decisions. Systemic operating deficits from fixed prices practically guaranteed continued reliance on government subsidies, which undercut the discretion of hospital managers. Thus the governmental fund accounting system was designed to show the budgetary nature of hospital financing; that is, it emphasized the flow of funds rather than operational efficiency. The information gave decision makers a basic idea of where the funds came from and how they were used, but not whether the funds were used efficiently to achieve maximum return on investment. Related to the inadequacy of governmental fund accounting was the preponderance of special funds. Special funds obtained to finance certain operating expenses clouded the transparency of operating results in several ways. First,

30

D A V I D K. W. C H U A N D K O L L E E N J. R A S K

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The Transformation of China's Health Care System and Accounting Methods Table 6.

31

Format of the Statement of Receivables and Payables.

Item

Amount

Item

Patient accounts receivable: In-house patients Discharged patients Outpatients

Unearned medical revenues: Outpatients Inpatients

Other receivables: XXX XXX

Accounts payable: XXX XXX

Specific purpose receivables: XXX XXX

Specific purpose payables: XXX XXX

Amount

Source: Wang, 1988, p. 439. important expense items were not disclosed. For example, patient bad debts were not disclosed in the statement of operating revenues and expenses by using an allowance method. Instead, total uncollected patient receivables at year-end was allocated out of the income summary account into the patient receivables in process account (see Figure 2). This account was settled through a convoluted series of journal entries as the uncollected account was either written off and compensated by government subsidies, or paid off by the patient. Provision was not made for uncollectible patient accounts and the current asset patient accounts receivable reflected only the gross amount. Managers were therefore unable to assess the quality of their receivables. Likewise, funding for the replenishment of fixed assets was supplied through specific purpose funds, resulting in the absence of depreciation expense in the statement of operating revenues and expenses. While management was aware of the need to replace equipment due to wear and tear, such a need was met through specific government subsidies. The lack of accounting for depreciation led to gross valuation of fixed assets without accumulated depreciation. These omissions meant that the statement of operating revenues and expenses reported a surplus or deficit that did not convey realistic results of hospital operations. Meanwhile, the statement of fund application and fund source reported assets that were grossly overvalued. The preponderance of special funds also led to distorted reporting in another way. In order to motivate workers, hospitals were ordered to establish a separate welfare fund, bonus fund, and hospital superintendent discretionary fund from which resources were taken either to subsidize living expenses or to reward exemplary performance. The funds received an annual allocation from the surplus generated from operations and government subsidies. During the annual

32

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33

F o r m a t of Statement of Hospital Statistics.

Item

Total

Average

Percent of Previous Year

Basic Statistics Number of employees Salaries and wages Number of retirees Wage subsidy per employee Welfare payment per employee Bonus payment per employee Square footage of property and plant Total number of hospital beds Total number of usable beds Total usable bed days Total bed days used Occupancy rate Hospital bed turnover rate (times) Number of patients discharged Number of outpatients Average dally outpatient visits Total value of fixed assets Financial Analysis Number of outpatients per employee Working capital turnover rate (times) Operating revenue per employee Operating expense per employee Fixed asset turnover Fixed asset value per hospital bed Medical inventory turnover Pharmaceutical markup percentage Average fee per outpatient Average fee per bed day Average government deficit subsidy per hospital bed Government deficit subsidy as percentage of total operating revenue Source: Wang, 1988, pp. 442-443. b u d g e t i n g process, hospital m a n a g e m e n t w o u l d b e g i n by first calculating the a m o u n t they w o u l d like to see allocated into these incentive funds. This a m o u n t w o u l d then determine the b u d g e t e d surplus. M a n a g e m e n t then used the predet e r m i n e d surplus, b u d g e t e d revenues and g o v e r n m e n t subsidies to derive the necessary budgeted expenses ex post. D u r i n g the fiscal year, m a n a g e m e n t w o u l d

34

DAVID K. W. CHU AND KOLLEEN J. RASK

then attempt to stay within an unrealistically tight expense budget by not making necessary repairs and by bypassing essential operations and purchases. Under these incentives, management behavior was driven by short-term financial considerations. Not surprisingly, the budgeted surplus seldom ever materialized in reality, and more government subsidies were frequently relied upon to pay the workers their welfare subsidies and bonuses. Another major problem was the side effect of two track pricing. Under this government policy, hospital managers attempted to cross-subsidize health service deficits with pharmaceutical profits. From 1980 to 1990, pharmacy revenue alone comprised an average of 60% of total off-budget hospital revenues (Yu, 1992, pp. 50-51). Since off-budget revenues are not under complete government control, policy makers were concerned that hospitals were profiteering from excessive pharmaceutical prescriptions, at the expense of the average uninformed consumer. The government thus needed a new system that would make hospitals more accountable to the government for their sale of pharmaceuticals. Aside from its inherent weaknesses and behavioral side effects, the hospital accounting system served neither the needs of external resource providers (financial accounting) nor that of internal management (managerial accounting). The underlying accounting philosophy was still that of a governmental unit operating within the parameters of government funding and its requisite planning.

Policy Shift and New Accounting System: 1999-Present As economic reforms progressed into the mid-1990s, the diminished role of government funding in the health care sector became ever more apparent. Not only was total government funding intentionally and significantly diminished (see Table 1), but also government policy towards the allocation of funding within the health care sector radically changed. The change in policy was summarized by the slogan "three preservations and three sacrifices". First, govemment would preserve funding for preventive medicine and sacrifice funding for hospital services. Second, government would preserve funding for basic health services provided to the rural areas and sacrifice funding for the urban areas. Third, government would preserve funding for the fundamental non-elective medical procedures and sacrifice elective medical procedures. This policy meant that future government funding would be directed away from hospitals and go primarily towards public health services in the rural areas. Hospitals would have to obtain capital and operating revenues through avenues other than government subsidies. Operating within an increasingly market-driven and competitive milieu of the mid-1990s, hospital decision-makers faced the need for information that would

The Transformation of China's Health Care System and Accounting Methods

35

allow them to perform cost-benefit analyses, evaluate operational efficiency, and maximize return on investment. These developments also coincided with the desire of the Chinese government to reform its overall accounting systems so as to "link tracks with international practices". A new accounting system was now needed as never before. Between 1994 and 1996, the Ministry of Health and the Ministry of Finance received funding from the World Health Organization and the World Bank to sponsor a number of hospital accounting workshops. These workshops focused on the U.S. hospital accounting system as a framework for China's new hospital accounting system. Both financial accounting and managerial accounting for hospitals were discussed at these workshops. In 1996, the two ministries sent a visiting delegation to Massachusetts. By visiting six hospital systems, the delegation studied various aspects of U.S. hospital accounting, financing, and management. November 1998 saw the publication of Hospital Accounting Regulations: Accounts and Financial Statements (Ministries of Finance and Health, 1998a) and Hospital Finance Regulations (Ministries of Finance and Health, 1998b). A new hospital accounting and financing system had come into being and was implemented in all state-owned hospitals effective January 1, 1999. In this framework, the fundamental relationship between hospitals and the state has not changed. Hospitals remain state-owned and thus dependent to a certain degree on government subsidies and directives, which means the use of accounting reports to exert government financial control still largely exists. Within this context, however, reforms have altered the financial structure in various ways. The fundamental structure is as follows: Budgetary Structure Revenues - Expenses = Surplus or Deficit --* Assets = Liabilities + Net Assets First, although hospital operations remain defined as providing medical services, selling pharmaceuticals, and other miscellaneous operations, tighter scrutiny is exerted on the off-budget sale of pharmaceuticals. In seeking to restore a rational balance between hospital services and pharmacy sales, the government could have chosen to liberate the prices of medical services. In this way, hospitals would no longer have needed to cross-subsidize systemic medical service deficits with pharmacy sales. However, the government has chosen instead to increase its control over pharmaceutical revenues by putting a limit on the maximum revenue that can be generated from pharmaceutical sales. In other words, pharmacy revenues in excess of a predetermined limit must now be remitted to the government (Ministries of Finance and Health, 1998b, p. 4).

36

DAVID K. W. CHU AND KOLLEEN J. RASK

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Second, the new system is a streamlined version of the old financial structure. Instead of operating within a convoluted array of special funds (see Fig. 1), hospitals now contend only with three major funds: (1) operating fund; (2) fixed assets fund; and (3) specific purpose funds (capital repairs and acquisition, welfare, and endowment). The operating surplus is now defined as being the result of: (1) budgetary subsidies; (2) medical operations; (3) pharmaceutical operations; and (4) other operations. With the exception of budgetary subsidies, which is carried forward into the next accounting period as a separate account, the rest is allocated into only two funds: the welfare fund and the operating fund. Figure 3 depicts the flow of hospital funds within this new structure. Third, to reflect adequately the economic realities of operations, hospitals are required to make provisions for bad debts based on 3-5% of the outstanding balance in patient medical accounts receivable. However, no accounts may be written off until they have been outstanding for three years. In the area of depreciation, hospitals are required to transfer an amount equivalent to a portion of total fixed assets cost from the operating fund into the capital repairs and acquisitions fund. This transfer constitutes a provision for depreciation. Fourth, hospitals are encouraged to engage in more diverse, business type transactions such as seeking resources from outside investors and donors, increased debt financing, engaging in mergers and acquisitions, making equity and debt investments, and extending hospital operations to other cities. Fifth, to manage this new financial structure, the position of chief financial officer has been created whose job is to head a separate hospital finance department. The new hospital accounting system operates on the accrual basis and has been streamlined considerably as seen in Fig. 3. More significant, however, is the fundamental transformation of the accounting equation from a funds flow model (fund application = fund source) to that of assets = liabilities + net assets. Going beyond merely streamlining the number of funds, the Chinese government has moved its hospital accounting system more in line with Western systems. The chart of accounts in Table 9 consists of accounts one would generally use for a private, non-profit entity in the U.S. In fact, the current Chinese system resembles the U.S. hospital accounting system that was in place prior to the Statement of Financial Accounting Standard No. 117 (FASB, 1993) when the AICPA Accounting and Audit Guides for the hospital industry were still in effect. The three mandatory hospital financial statements are the balance sheet (Table 10), statement of revenues and expenses (Table 11), and statement of changes in fund balances (Table 12).

38

D A V I D K. W. C H U A N D K O L L E E N J. R A S K

Table 9.

Hospital Chart of Accounts for China, 1999-Present. REVENUES AND EXPENSES

ASSETS

101 102 109 111 113 114 119 121 122 123 125 131 141 151 153 161 171 181

Cash on hand Cash in bank Other cash deposits Inpatient pharmaceutical accounts receivable Patient medical accounts receivable Allowance for uncollectible accounts Other receivables Pharmaceutical inventory Pharmaceutical price differential Other inventory Hospital-made remedy work in process Expenses to be amortized Investments Property, plant and equipment Construction in progress Intangible assets Organization costs Asset gains and losses in process

401 402 403 404 409 411 412 415 416 419

LIABILITIES

201 202 204 205 207 209 211 221 231 241

Short-term loans Accounts payable Unearned medical revenues Wages payable Social security fees payable Other payables Excess revenues payable to government Accrued expenses payable Long-term loans Long-term payables

NET ASSETS

301 302 303 305

306

Operating fund balance Fixed assets fund balance Specific purpose fund balance Income summary: Budgetary subsidies income summary Medical income summary Pharmaceutical income summary Other income summary Income allocation

Source: Ministries of Finance and Health, 1998a, pp. 3-5.

Budgetary subsidies Non-budgetary subsidies Medical revenues Pharmaceutical revenues Other revenues Medical expenses Pharmaceutical expenses Administrative expenses Specific purpose fund expenses Other expenses

The Transformation o f China's Health Care System and Accounting Methods

Table 10. ASSETS

Beg. Balance

CURRENT ASSETS Cash Inpatient pharmaceutical accounts receivable Patient medical accounts receivable Less: Allowance for

uncollectible accounts Other receivables Pharmaceutical inventory Less: Pharmaceutical price differential Other inventory Hospital-made remedy work in process Expenses to be amortized Current asset gains/losses in process TOTAL CURRENT ASSETS INVESTMENTS

FIXED ASSETS Property, plant and equip. Construction in progress Fixed asset gains/losses in process TOTAL FIXED ASSETS INTANGIBLE ASSETS ORGANIZATION COSTS TOTAL ASSETS

39

Format of the Balance Sheet. Ending Balance

LIABILITIES AND NET ASSETS

Beg. Balance

Ending Balance

CURRENT LIABILITIES Short-term loans Accounts payable Unearned medical revenue Wages payable Social security fees pay Other payables Excess revenue payable to government Accrued expenses payable TOTAL CURRENT LIABILITIES

LONG-TERM LIABILITIES Long-term loans Long-term payables TOTAL LONG-TERM LIABILITIES TOTAL LIABILITIES

NET ASSETS Operating fund balance Fixed assets fund balance Specific purpose fund bal. Budgetary subsidies income summary Accumulated operating deficit TOTAL NET ASSETS TOTAL LIABILITIES AND NET ASSETS

Source: Ministries of Finance and Health, 1998a, p. 40.

The format of these statements reveals the schizophrenic state of economic reforms in the hospital sector. On one hand, the balance sheet is no longer a governmental funds flow statement, but one which depicts assets = liabilities + net assets, which is more in line with market reality. The current assets and liabilities depict the status of hospital working capital; and the fixed assets, long-term liabilities, and net assets show the status of productive assets and their financing. In addition, investments, intangible assets, and organization costs reflect the results of typical market transactions such as external investments, goodwill from consolidations, and costs arising from business startups that are initially capitalized and later amortized.

DAVID K. W. CHU AND KOLLEEN J. RASK

40

Table 11.

F o r m a t o f the S t a t e m e n t o f R e v e n u e s a n d E x p e n s e s .

Item

Month

Year-to-date

REVENUES Budgetary subsidies: Routine subsidies Non-routine specific subsidies Non-budgetary subsidies Medical revenues Pharmaceutical revenues Other revenues Total revenues

EXPENSES Medical expenses Pharmaceutical expenses Non-routine specific subsidies expenses Other expenses Total expenses EXCESS OF REVENUES OVER (UNDER) EXPENSES LESS: Budgetary subsidies income summary Excess revenue remitted to government BALANCE ALLOCATED TO: Welfare fund Operating fund

Source: Ministries of Finance and Health, 1998a, p. 41. Table 12.

F o r m a t o f the S t a t e m e n t o f C h a n g e s in F u n d B a l a n c e s . Specific PurposeFunds

Item

Capital Repairs and Fixed Operating Acquisitions Welfare Endowment Assets Total Fund Subtotal Fund Funds Funds Fund

Beginning balance Additions: Received from government Transferred in Other Total additions Deductions: Expenses Transferred out Other Total deductions Ending balance

Source: Ministries of Finance and Health, 1998a, p. 44.

The Transformation of China's Health Care System and Accounting Methods

41

On the other hand, these three financial statements also show the socialist side of the picture, which is that hospitals are still state-owned and rely on government subsidies for their survival. In the net assets section of the balance sheet, the two accounts "budget subsidies income summary" and "accumulated operating deficit" remind us of the state's hand in hospital financing. This financial dependence is also disclosed in the various budgetary subsidies of the statement of revenues and expenses. In that statement, the line item "excess revenue remitted to the government" reminds the reader of how much control the state still retains in the area of revenue management. Despite these accounting reforms, hospitals still do not have a clearly established cost accounting system. Under the new rules, "administrative expenses" (see Table 9) are considered indirect costs and are allocated to "medical expenses", "pharmaceutical expenses", and "other expenses". Thus the financial statements serve also as a very primitive form of management cost reports. The Ministries of Finance and Health have announced that hospitals should establish cost accounting systems relevant to their respective operating milieu. Although no centralized effort has been made to develop a hospital management accounting system, the mere mention of such a need is an indication of awareness. A well defined management accounting system may emerge in the future. CONCLUSION The new accounting system now resembles the U.S. hospital financial accounting system prior to 1993. It is a fund accounting system structured within the framework of assets = liabilities + fund balance. Compared to the old system, the new one is more streamlined and transparent. The number of special funds have been reduced and more expense accounts have been added to reflect business reality. The new system thus better enables financial statement users to assess the flow of resources and its effect on financial position. In this sense, the new system is better suited for decision making in the current milieu of economic reform. Yet the new accounting system reflects the schizophrenic nature of China's health care reform. On one hand, economic reforms are to empower health care agents to control their own destiny and to be rewarded or punished on the basis of operating results. On the other hand, the state imposes a normative framework of operating values and intervenes whenever management decisions go beyond the boundaries of this value framework. This schizophrenia is evidenced by the budgetary nature of hospital financing. Subsidies, although significantly reduced, still comprise a prominent feature of hospital operations. Hospitals must submit their annual budgets for prior governmental approval even though

42

DAVID K. W. CHU AND KOLLEEN J. RASK

most of their revenues are now derived from off-budget sources. Moreover, the two-track pricing policy remains in place despite price reforms in other sectors of the economy. Faced with distortions caused by differential government regulation - low prices for basic services, higher cost-plus prices for pharmaceuticals - one solution would have been to liberalize basic services, thereby effecting a rational balance. Instead, the government resorted to its traditional behavior of exerting more control by requiring hospitals to remit pharmacy revenues generated above a government-determined ceiling. Underlying this policy schizophrenia is the difficulty of defining the nature of health care. The ongoing debate in the W e s t over whether health care should be viewed as a public good or a private good has also dominated the debate in China. The classification of health care either as a private or a public good would affect the nature of financing, which further affects the nature of hospitals as a business or otherwise. Since health care in China is still considered to be a public good, it is unlikely that hospitals will be given complete freedom over their financial destiny. In light of the current slowdown in SOE reform, and the fact that any further reforms in hospital accounting must be initiated by the Ministries of Finance and Health and be universally applied to all hospitals in China, the current accounting system is likely to remain in effect for the foreseeable future. REFERENCES

Bell, M. W., Hoe, E. K., & Kochhar, K. (1993). China at the threshold of a market economy. Washington, D.C.: International Monetary Fund. FASB (Financial Accounting Standards Board) (1993). Statement of financial accounting standards no. 117." Financial statements of not-for-profit organizations. Stamford, CT: FASB. Gottschang, T. R. (1995). Introduction. In: T. R. Gottschang (Ed.), Reform and Development in Rural China (pp. 1-19). New York: St. Martin's Press. Grogan, C. M. (1995). Urban economic reform and access to health care coverage in the People's Republic of China. Social Science and Medicine, 41, 1073-1084. Ho, S. P. S. (1994). Rural China in transition: Non-agricultural development in rural Jiangsu, 1978-1990. Oxford: Oxford University Press. Hoen, H. W. (1998). 'Shock vs. gradualism' in Central Europe reconsidered. Comparative Economic Studies, 38, 1-20. Hsiao, W. C. L. (1995). The Chinese health care system: lessons for other nations. Social Science and Medicine, 41, 1047-1055. Hsiao, W. C. L., & Liu, Y. (1996). Economic reform and health - lessons from China. The New England Journal of Medicine, 335, 430-432. Hu, Y., & Marts, J. A. (1991). How China's central government administers accounting in industry. Advances in International Accounting, 4, 143-150. Maschmeyer, R. A., & Yang, J. (1990). Responsibility accounting during the economic transformation in the People's Republic of China. Research in Third World Accounting, 1,141-156.

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Ministries of Finance and Health (1998a). Hospital accounting regulations: Accounts and financial statements (in Chinese). Beijing: China Finance and Economics Publishing. Ministries of Finance and Health (1998b). Hospitalfinance regulations (in Chinese). Beijing: China Finance and Economics Publishing. Nolan, P., & Ash, R. F. (1995). China's economy on the eve of reform. The China Quarterly, 144, 980-998. Rask, K. J., Chu, D. K. W., & Gottschang, T. R. (1998). Institutional change in transitional economies: The case of accounting in China. Comparative Economic Studies, 40, 76-100. Rask, K. J., & Rask, K. N. (1994a). The pivotal role of services in transitional economies. The Economics of Transition, 2, 467-486. Rask, K. J., & Rask, K. N. (1994b). The central role of services in economic development. Journal of Economic Development, 19, 139-157. Rawski, T. G. (1995). Implications of China's reform experience. The China Quarterly, 144, 1150-1173.

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