Note 1. Summary of Significant Accounting Policies

Use of Estimates in Preparing Financial Statements

Preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the date of the financial statements. Estimates and assumptions also affect the revenues and expenses accrued and reported in the financial statements. Actual results may differ from those estimates.

Entity and Non-Entity Assets

Entity assets are assets that the reporting entity has authority to use in its operations, i.e., management has the authority to decide how the funds are used, or management is legally obligated to use the funds to meet entity obligations.

Non-entity assets are those assets held by the reporting entity but not available for use. An example of a non-entity asset is the interest accrued on overpayments and cost settlements reported by the Medicare contractors.

Entity and non-entity assets are combined into one line on the face of the balance sheet as required by OMB Circular No. A-136.

Fund Balance with Treasury

The HHS maintains its available funds with the Department of the Treasury (Treasury or U.S. Treasury) except for the Medicare Benefit accounts maintained at commercial banks. The Fund Balance with Treasury is available to pay current liabilities and finance authorized purchases. Cash receipts and disbursements are processed by Treasury, and the HHS’ records are reconciled with those of the Treasury on a regular basis.

Investments, Net

Investments consist of Treasury securities including the CMS par value securities that represent the majority of the HHS earmarked funds carried at face value, and other securities carried at amortized cost. Section 1817 for the Hospital Insurance Trust Fund (HI) and Section 1841 for the Supplementary Medical Insurance Trust Fund (SMI) of the Social Security Act require that trust investments not necessary to meet current expenditures be invested in interest-bearing obligations of the U.S. Government, or in obligations guaranteed as to both principal and interest by the U.S. Government.

The FASAB Statement of Federal Financial Accounting Standard (SFFAS), No. 27, Identifying and Reporting Earmarked Funds, prescribes certain disclosures concerning earmarked investments. The Federal government does not set aside assets to pay future benefits or other expenditures associated with the HI or SMI trust funds. The cash receipts collected from the public for an earmarked fund are deposited in the U.S. Treasury, which uses the cash for general government purposes. Treasury securities are issued to the HI and SMI trust funds as evidence of their receipts. The Treasury securities are an asset to the HI and SMI trust funds and a liability to the U.S. Treasury. Because the HI and SMI trust funds and the U.S. Treasury are part of the Federal government, these assets and liabilities offset each other from the standpoint of the Federal government as a whole and are eliminated from presentation in the consolidation of the U.S. Government-wide financial statements.

The Treasury securities provide the HI and SMI trust funds with authority to draw upon the U.S. Treasury to make future benefit payments or other expenditures. When the trust funds require redemption of these securities to make expenditures, the government finances the expenditures out of accumulated cash balances, by raising taxes, by raising the Federal match of SMI premiums or other receipts, by borrowing from the public or repaying less debt, or by curtailing other expenditures. This is the same way that the government finances all expenditures.

No provision is made for unrealized gains or losses on these securities since it is the Department’s intent to hold investments to maturity. Interest income is compounded semiannually in June and December.

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Accounts Receivable, Net

Accounts receivable consist of the amounts owed to the HHS by other Federal agencies and the public as the result of the provision of goods and services. Intragovernmental accounts receivable arise generally from the provision of reimbursable work to other Federal agencies and no allowance for uncollectible accounts is established as they are considered to be fully collectible. Accounts receivable also include interest due to the HHS that is directly attributable to delinquent accounts receivable.

Accounts receivable from the public are primarily composed of provider and beneficiary overpayments, Medicare Secondary Payer overpayments, Medicare Premiums, and Medicaid Audit Disallowances. They are presented net of an allowance for uncollectible accounts. The allowance for uncollectible accounts is determined based on past collection experience and an analysis of outstanding balances.

Direct Loans and Loan Guarantee Receivables and Liabilities

Direct Loans:

The Health Care Infrastructure Improvement Program was enacted into law as part of the Medicare Modernization Act of 2003. This loan program provides loans to hospitals or entities that are engaged in research in the causes, prevention, and treatment of cancer; and are designated as cancer centers by the National Cancer Institute, or are designated by the State legislature as the official cancer institute of the State, and such designation by the State legislature occurred prior to December 8, 2003, for payment of the capital costs of eligible projects. The HHS reasonably expects any loans made under this program to be forgiven as it is anticipated that the borrowers will meet the requirements for forgiveness.

Loan Guarantees:

The HHS administers guaranteed loan programs for the Health Center and the Health Education Assistance Loans (HEAL) programs. Loans receivable represent defaulted guaranteed loans, which have been paid to lenders under this program. Loans receivable also include interest due to the HHS on the defaulted loans. The loans guarantee liabilities are valued at the present value of the cash outflows from the HHS less the present value of related inflows.

As required under the Federal Credit Reform Act (FCRA) of 1990, for loan guarantees committed on or after October 1, 1991, guaranteed loans are reduced by an allowance for subsidy representing the present value of the amounts not expected to be recovered and thus having to be subsidized by the government for loan guarantees. The FCRA also requires that the subsidy cost estimate be based on the net present value of the specified cash flows discounted at the interest rate of marketable Treasury securities of similar maturities. The liability for loan guarantees committed on or after October 1, 1991, is reported at present value.

For loan guarantees committed prior to October 1, 1991, loan guarantee principal and interest receivable are reduced by an allowance for estimated uncollectible amounts. The allowance is estimated based on past experience and an analysis of outstanding balances. The liability for loan guarantees committed prior to October 1, 1991, is established based upon an average default rate. The liability is adjusted each year for the change in default rates.

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Advances to Grantees/Accrued Grant Liability

The HHS awards grants to various grantees and provides advance payments to grantees to meet their cash needs to carry out their programs. Advance payments are recorded as “Advances to Grantees” and are liquidated upon grantees’ reporting expenditures. In some instances, grantees incur expenditures before drawing down funds that, when claimed, would reduce the “Advances to Grantees” account. An accrued grant liability occurs when the accrued grant expenses exceed the outstanding advances to grantees, resulting in a negative balance in the “Advances to Grantees” account. The HHS grants are classified into two categories: “Grants Not Subject to Grant Expense Accrual” and “Grants Subject to Grant Expense Accrual.” Progress payments on work in process are not included in grants.

Grants Not Subject to Grant Expense Accrual: These grants represent formula grants (also referred to as “block grants”) under which grantees provide a variety of services or payments to individuals and local agencies. Expenses are recorded as the grantees draw funds. These grants are funded on an allocation basis determined by budgets and agreements approved by the sponsoring OPDIV as opposed to a reimbursable basis. Therefore, they are not subject to grant expense accrual.

Grants Subject to Grant Expense Accrual: For grants subject to grant expense accrual, commonly referred to as “non-block grants,” grantees draw funds (recorded as Advances to Grantees) based on their estimated cash needs. As grantees report their actual disbursements (quarterly), the amounts are recorded as expenses, and their advance balances are reduced. At year-end, the OPDIVs report both actual payments made through the fourth quarter and an unreported grant expenditures estimate for the fourth quarter based on historical spending patterns of the grantees. The year-end accrual estimate equals the estimate of fourth quarter disbursements plus an average of two weeks annual expenditures for expenses incurred prior to the cash being drawn down.

Exceptions to the definition of “block” or “non-block” grants for reporting purposes are the Temporary Assistance for Needy Families program and the Child Care Development Fund program. These two programs are referred to as “block” grants but, since the programs report expenses to the HHS, they are treated as “non-block” grants for the estimate of the grant accrual.

Inventory and Related Property, Net

Inventory and Related Property primarily consist of Inventory Held for Sale, Operating Materials and Supplies, and Stockpile Materials.

Inventory Held for Sale consists of small equipment and supplies held by the Service and Supply Fund for sale to HHS components and other Federal entities. Inventories held for sale are valued at historical cost using the weighted average valuation method for PSC inventories and using the moving average valuation method for the NIH inventories.

Operating Materials and Supplies consist of pharmaceuticals, biological products, and other medical supplies used in providing medical services and conducting medical research. Operating materials and supplies are recorded as assets when purchased and are expensed when they are consumed. Operating materials and supplies are valued at historical cost.

Stockpile Materials are materials held in reserve to respond to local and national emergencies. In addition, the CDC maintain a stockpile of vaccines to meet unanticipated needs in the case of a national emergency. As required by the Project BioShield Act of 2004, the Department of Homeland Security transferred Strategic National Stockpile materials to the HHS in FY 2004. The Strategic National Stockpile materials are not available for sale and are valued at historical cost using the FIFO cost flow assumption and the CDC’s vaccine stockpile is valued at historical cost.

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General Property, Plant and Equipment, Net

General Property, Plant and Equipment (PP&E) consist of buildings, structures, and facilities used for general operations; land acquired for general operating purposes; equipment; assets under capital lease; leasehold improvements; construction-in-progress; and internal use software. The basis for recording purchased PP&E is full cost, net of accumulated depreciation including all costs incurred to bring the PP&E to a form and location suitable for its intended use. The cost of PP&E acquired under a capital lease is the amount recognized as a liability for the capital lease at its inception. The cost of PP&E acquired through donation is the estimated fair market value when acquired. The cost of PP&E transferred from other Federal entities is the net book value of the transferring entity. All PP&E with an initial acquisition cost of $25,000 or more and an estimated useful life of two years or more are capitalized, except for internal use software discussed below.

The PP&E is depreciated using the straight-line method over the estimated useful life of the asset. Land and land rights, including permanent improvements, are not depreciated. Normal maintenance and repair costs are expensed as incurred.

The SFFAS No. 10, Accounting for Internal Use Software, requires that the capitalization of internally developed, contractor-developed and commercial off-the-shelf (COTS) software begin in the software development phase. In FY 2004, the HHS incurred development costs for UFMS, a COTS software package, and began capitalizing the cost. The estimated useful life for internal use software was determined to be five to ten years for amortization purposes. The HHS began amortization when the internal use software was placed in use. Capitalized costs include all direct and indirect costs. In FY 2005, the CMS began amortizing HIGLAS over ten years using the straight-line method in accordance with the HHS policy for UFMS. In addition, the CMS has other capitalized internal use software that is currently being amortized over a useful life of five years.

The capitalization threshold for internal use software costs for appropriated fund accounts is $1 million and the capitalization threshold for revolving funds is $500 thousand. Costs below the threshold levels are expensed. The software is depreciated for a period of time consistent with the estimated useful life used for planning and acquisition purposes.

Stewardship Property, Plant & Equipment

Stewardship PP&E consist of heritage assets and stewardship land whose physical properties resemble those of general PP&E that are traditionally capitalized in financial statements. Based on SFFAS No. 29, Heritage Assets and Stewardship Land, and due to the difficulty in valuing these assets, the HHS does not report a related amount on the balance sheet. This standard requires that the balance sheet reference a note that discloses information but not an amount for Stewardship PP&E.

Liabilities

Liabilities are recognized for amounts of probable and measurable future outflows or other sacrifices of resources as a result of past transactions or events. Since the HHS is a component of the U.S. Government, a sovereign entity, its liabilities cannot be liquidated without legislation that provides resources to do so. Payments of all liabilities other than contracts can be abrogated by the sovereign entity. In accordance with public law and existing Federal accounting standards, no liability is recognized for future payments to be made on behalf of current workers contributing to the Medicare Health Insurance Trust Fund, since liabilities are only those items that are present obligations of the Government. The Department’s liabilities are classified as covered by budgetary resources or not covered by budgetary resources.

Liabilities Covered by Budgetary Resources: Available budgetary resources include: (1) new budget authority, (2) spending authority from offsetting collections, (3) recoveries of expired budget authority, (4) unobligated balances of budgetary resources at the beginning of the year, and (5) permanent indefinite appropriation or borrowing authority.

Liabilities Not Covered by Budgetary Resources: Sometimes funding has not yet been made available through Congressional appropriations or current earnings. The major liabilities in this category include employee annual leave earned but not taken, amounts billed by the Department of Labor (DOL) for Federal Employees’ Compensation Act (FECA) disability payments, and portions of the Entitlement Benefits Due and Payable liability (discussed below) for which no obligations have been incurred. Also included in this category is the actuarial FECA liability determined by DOL but not yet billed. For HHS revolving funds, all liabilities are funded as they occur.

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Accounts Payable

Accounts Payable primarily consist of amounts due for goods and services received, progress in contract performance, interest due on accounts payable, and other miscellaneous payables.

Accrued Payroll and Benefits

Accrued Payroll and Benefits consist of salaries, wages, leave and benefits earned by employees, but not disbursed as of September 30. Liability for annual and other vested compensatory leave is accrued when earned and reduced when taken. At the end of each fiscal year, the balance in the accrued annual leave liability account is adjusted to reflect current pay rates. Annual leave earned but not taken is considered an unfunded liability since this leave will be funded from future appropriations when it is actually taken by employees. Sick leave and other types of leave are not accrued and are expensed when taken. Intragovernmental Accrued Payroll and Benefits consists of the HHS FECA liability.

Entitlement Benefits Due and Payable

Entitlement Benefits Due and Payable primarily represent the liability for Medicare and Medicaid for medical services incurred but not reported (IBNR) as of the balance sheet date.

Medicare

The Medicare liability is developed by the Office of the Actuary of the Centers for Medicare & Medicaid Services and includes (a) an estimate of claims incurred that may or may not have been submitted to the Medicare contractors but were not yet approved for payment, (b) actual claims that have been approved for payment by the Medicare contractors for which checks have not yet been issued, (c) checks that have been issued by the Medicare contractors in payment of claims that have not yet been cashed by payees, (d) periodic interim payments for services rendered in the current fiscal year but paid in the subsequent fiscal year, and (e) an estimate of retroactive settlements of cost reports submitted to the Medicare contractors by health care providers.

Medicaid

The Medicaid estimate represents the net Federal share of expenses incurred by the States but not yet reported to CMS. The September2007 estimate was developed based on historical relationships between prior Medicaid net payables and current Medicaid activity.

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Federal Employee and Veterans’ Benefits

Most HHS employees participate in either the Civil Service Retirement System (CSRS) – a defined benefit plan, or the Federal Employees Retirement System (FERS) – a defined benefit and contribution plan. For employees covered under CSRS, the Department contributes a fixed percentage of pay. Most employees hired after December 31, 1983, are automatically covered by FERS. For employees covered under FERS, the Department contributes the employer’s matching share for Social Security and Medicare Insurance. A primary feature of FERS is that it offers a Thrift Savings Plan into which the Department automatically contributes one percent of employee pay and matches employee contributions up to an additional four percent of pay.

The U.S. Office of Personnel Management is the administering agency for both of these benefit plans and, thus, reports CSRS or FERS assets, accumulated plan benefits, or unfunded liabilities applicable to Federal employees. Therefore, the HHS does not recognize any liability on its balance sheet for pensions, other retirement benefits, and other post-employment benefits with the exception of Commissioned Corps (see below). The HHS does, however, recognize an expense in the Consolidated Statements of Net Cost and an imputed financing source for the annualized unfunded portion of pension and post-retirement benefits in the Consolidated Statements of Changes in Net Position.

The HHS administers the Public Health Service (PHS) Commissioned Corps Retirement System, a defined noncontributory benefit plan, for its active duty officers and retiree annuitants or survivors. The plan does not have accumulated assets, and funding is provided entirely on a pay-as-you-go basis by Congressional appropriations. The HHS records the actuarial liability based on the present value of accumulated pension plan benefits and the post-retirement health benefits.

The liability for Federal employee and veterans’ benefits also includes a liability for actual and estimated future payments for workers’ compensation pursuant to the Federal Employees Compensation Act (FECA). The FECA provides income and medical cost protection to

(1) Federal employees who were injured on the job or who have sustained a work-related occupational disease and (2) beneficiaries of employees whose deaths are attributable to job-related injury or occupational disease. The FECA program is administered by the Department of Labor (DOL), which pays valid claims and subsequently bills the employing Federal agency. The FECA liability consists of two components: the (1) actual claims paid by DOL but not yet disbursed, and (2) estimated liability for future benefit payments as a result of past events, such as death, disability, and medical costs.

Revenue and Financing Sources

The Department receives the majority of funding needed to support its programs through Congressional appropriation and through reimbursement for the provision of goods or services to other Federal agencies. The United States Constitution prescribes that no money may be expended by a Federal agency unless and until funds have been made available by Congressional appropriation. Appropriations are recognized as financing sources when related expenses are incurred or assets are purchased. Revenues from reimbursable agreements are recognized when the goods or services are provided by the Department. Other financing sources, such as donations and transfers of assets without reimbursements, are also recognized on the Consolidated Statements of Changes in Net Position.

Appropriations . The Department receives annual, multi-year, and no year appropriations that may be used within statutory limits. For example, funds for general operations are normally made available for one fiscal year; funds for long-term projects such as major construction will be available for the expected life of the project; and funds used to establish revolving fund operations are generally available indefinitely (i.e., no year funds).

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Exchange and Non-Exchange Revenue. The HHS classifies revenues as either exchange or non-exchange. Exchange revenues are recognized when earned, i.e., when goods have been delivered or services have been rendered. These revenues reduce the cost of operations borne by the taxpayer.

Non-exchange revenues result from donations to the government and from the government’s sovereign right to demand payment, including taxes. Non-exchange revenues are recognized when a specifically identifiable, legally enforceable claim to resources arises, but only to the extent that collection is probable and the amount is reasonably estimable. Non-exchange revenues are not considered to reduce the cost of the Department’s operations and are reported in the Statements of Changes in Net Position.

For periods after December 31, 1993, employees and employers are each required to contribute 1.45 percent of employee wages and self-employed persons are required to contribute 2.90 percent of net income, with no limitation, to the General Fund of the Treasury. The Social Security Act requires the transfer of these contributions from the General Fund of the Treasury to the HI trust fund based on the amount of wages certified by the Social Security Administration (SSA) from SSA records of wages established and maintained by the SSA in accordance with wage information reports. The SSA uses the wage totals reported annually by employers and self-employed individuals to the Internal Revenue Service as the basis for conducting quarterly certification of regular wages.

With minor exceptions, all receipts of revenues by Federal agencies are processed through the Treasury’s central accounting system. Regardless of whether they derive from exchange or non-exchange transactions, all receipts not earmarked by Congressional appropriation for immediate departmental use are deposited in the general or special funds of the Treasury. Amounts not retained for use by the HHS are reported as transfers to other government agencies on the HHS Statements of Changes in Net Position.

Imputed Financing Sources. In certain instances, operating costs of the HHS are paid out of funds appropriated to other Federal agencies. For example, by law, certain costs of retirement programs are paid by the Office of Personnel Management, and certain legal judgments against the HHS are paid from the Judgment Fund maintained by the Treasury. When costs that are identifiable to the HHS and directly attributable to the Department’s operations are paid by other agencies, the Department recognizes these amounts as imputed costs on the Statements of Net Cost and as an imputed financing source on the Consolidated Statements of Changes in Net Position.

Other Financing Sources. Medicare’s HI program, or Medicare Part A, is financed through the HI trust fund, whose revenues come primarily from the Medicare portion of payroll and self-employment taxes collected under the Federal Insurance Contribution Act (FICA) and under the Self-Employment Contribution Act (SECA). Contribution rates are discussed under Exchange and Non-Exchange Revenue. Medicare’s Supplemental Medical Insurance (SMI) program, or Medicare Part B, is financed primarily by general fund appropriations (Payments to the Health Care Trust Funds) provided by Congress and by monthly premiums paid by beneficiaries.

Contingencies

A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to the Department. The uncertainty should ultimately be resolved when one or more future events occur or fail to occur. The likelihood that the future event or events will confirm the loss or the incurrence of a liability can range from probable to remote. SFFAS No. 5, Accounting for Liabilities of the Federal Government, as amended by SFFAS No. 12, Recognition of Contingent Liabilities from Litigation, contain the criteria for recognition and disclosure of contingent liabilities. With the exception of pending, threatened, or potential litigation, a contingent liability is recognized when a past transaction or event has occurred; a future outflow or other sacrifice of resources is more likely than not to occur; and the related future outflow or sacrifice of resources is measurable. For pending, threatened, or potential litigation, a liability is recognized when a past transaction or event has occurred, a future outflow or other sacrifice of resources is likely to occur, and the related future outflow or sacrifice of resources is measurable.

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Parent/Child Reporting

The HHS is a party to allocation transfers with other federal agencies as both a transferring (parent) entity and/or a receiving (child) entity. Allocation transfers are legal delegations by one department of its authority to obligate budget authority and outlay funds to another department. A separate fund account (allocation account) is created in the U.S. Treasury as a subset of the parent fund account for tracking and reporting purposes. All allocation transfers of balances are credited to this account, and subsequent obligations and outlays incurred by the child entity are charged to this allocation account as they execute the delegated activity on behalf of the parent entity. Generally, all financial activity related to these allocation transfers (e.g., budget authority, obligations, outlays) is reported in the financial statements of the parent entity, from which the underlying legislative authority, appropriations and budget apportionments are derived.

Exceptions to this general rule affecting the HHS include Treasury-Managed Trust Funds: Federal Supplementary Medical Insurance Trust Fund, the Federal Hospital Insurance Trust Fund, the Vaccine Injury Compensation Program Trust Fund and the Healthcare Fraud and Abuse Control Account, for which the HHS is the child in the allocation transfer but, per OMB guidance, will report all activity relative to these allocation transfers in the HHS financial statements.

In addition to these funds, the HHS allocates funds, as the parent, to the Department of the Interior, Bureau of Indian Affairs. The HHS receives allocation transfers, as the child, from the Environmental Protection Agency and the Departments of Homeland Security, Justice and State.

Intragovernmental Relationships and Transactions

In the course of its operations, the HHS has relationships and financial transactions with numerous Federal agencies. The more prominent of these are the SSA and the Department of the Treasury. The SSA determines eligibility for Medicare programs and also allocates a portion of Social Security benefit payments to the Medicare Part B Trust Fund for Social Security beneficiaries who elect to enroll in the Medicare Part B program. The Treasury receives the cumulative excess of Medicare receipts and other financing over outlays and issues interest-bearing securities in exchange for the use of those monies. Similarly, Medicare Part D is also primarily financed by the General Fund of the Treasury.

Earmarked Funds

SFFAS No. 27, Identifying and Reporting Earmarked Funds, defines earmarked funds and requires that they be shown separately from all other funds on the Statement of Changes in Net Position, as well as in the Net Position section of the Balance Sheet. Earmarked funds are defined as those financed by specifically identified revenues, often supplemented by other financing sources, which remain available over time; are required by statute to be used for designated activities, benefits or purposes; and must be accounted for separately from the Government’s general revenues. “Fund” in this statement’s definition of earmarked funds refers to a “fiscal and accounting entity with a self-balancing set of accounts recording cash and other financial resources, together with all related liabilities and residual equities or balances, and changes therein, which are segregated for the purpose of carrying on specific activities or attaining certain objectives in accordance with special regulations, restrictions, or limitations.”

Whether the appropriation is provided by authorizing legislation or annual appropriations acts, the cumulative results of operations arising from earmarked funds are reserved or restricted to the designated activity, benefit or purpose. The standard also requires that condensed information on assets, liabilities and costs for earmarked funds be disclosed. An earmarked fund may be classified in the unified budget as a trust, special or public enterprise fund. Examples of the HHS earmarked funds include the HI trust fund that is used to process claims associated with Part A benefits and the SMI trust fund that is used to process claims associated with Part B and Part D benefits.

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Medicare Hospital Insurance (HI) Trust Fund – Part A

Section 1817 of the Social Security Act established the Medicare Hospital Insurance Trust Fund. Medicare contractors are paid by the HHS to process Medicare claims for hospital inpatient services, hospice, and certain skilled nursing and home health services. Benefit payments made by the Medicare contractors for these services, as well as administrative costs, are charged to the HI trust fund. The HHS payments to Medicare Advantage plans (previously known as Managed Care plans) are also charged to this fund. The financial statements include the HI trust fund activities administered by the Department of Treasury. This trust fund has permanent indefinite authority. Employment tax revenue is the primary source of financing for Medicare’s HI program. Medicare’s portion of payroll and self-employment taxes is collected under FICA and SECA. Employee and employers are both required to contribute 1.45 percent of earnings, with no limitation, to the HI trust fund. Self-employed individuals contribute the full 2.9 percent of their net income. The Social Security Act requires the transfer of these contributions from the General Fund of Treasury to the HI trust fund based on the amount of wages certified by the Commissioner of Social Security from SSA records of wages established and maintained by SSA in accordance with wage information reports. The SSA uses the wage totals reported annually by employers via the quarterly Internal Revenue Service Form 941 as the basis for conducting quarterly certification of regular wages.