Student Assistance General Provisions

SUMMARY: The Secretary proposes to amend the Student Assistance General

Provisions regulations by revising the requirement for compliance

audits and adding a new subpart establishing financial responsibility

standards. The proposed regulations would improve the Secretary's

oversight of institutions participating in programs authorized by title

IV of the Higher Education Act of 1965, as amended.

DATES: Comments must be received on or before November 4, 1996.

ADDRESSES: All comments concerning these proposed regulations should be

addressed to: Mr. David Lorenzo, U.S. Department of Education, P.O. Box

23272, Washington, D.C. 20026, or to the following internet address:

[email protected]

A copy of any comments that concern information collection

requirements should also be sent to the Office of Management and Budget

at the address listed in the Paperwork Reduction Act section of this

preamble.

A copy of the report prepared by the firm of KPMG Peat Marwick, LLP

(KPMG) referred to in this Notice of Proposed Rulemaking (NPRM) is

available for inspection during regular business hours at the following

address: U.S. Department of Education, 7th and D Streets S.W., Room

3045, ROB-3, Washington, D.C.

FOR FURTHER INFORMATION CONTACT: Mr. Francis Meyer or Mr. Keith

Kistler, U.S. Department of Education, Financial Analysis Branch,

Institutional Participation and Oversight Service, 600 Independence

Avenue, S.W., Room 3522 ROB-3, Washington, D.C. 20202, telephone (202)

708-4906, for questions regarding financial analysis and other

technical questions related to accounting and audits. For other

information contact Mr. John Kolotos or Mr. David Lorenzo, U.S.

Department of Education, 600 Independence Avenue, S.W., Room 3045 ROB-

3, Washington, D.C. 20202, telephone (202) 708-7888. Individuals who

use a telecommunications device for the deaf (TDD) may call the Federal

Information Relay Service (FIRS) at 1-800-877-8339 between 8 a.m. and 8

p.m., Eastern standard time, Monday through Friday.

SUPPLEMENTARY INFORMATION: The Student Assistance General Provisions

regulations (34 CFR part 668) apply to all institutions that

participate in the student financial assistance programs authorized by

title IV of the Higher Education Act of 1965, as amended (title IV, HEA

programs).

The Secretary proposes to revise subpart B as follows: the proposed

regulations would eliminate the financial report currently required in

Sec. 668.15; revise Sec. 668.23, and include the audit exceptions and

repayments requirements now contained in Sec. 668.24 in the new

Sec. 668.23. The Secretary also proposes to add a new Subpart L to part

668 by replacing and significantly changing the current ratio standards

contained in Sec. 668.15 to include an expanded financial ratio

analysis, and standards based on that analysis, as primary tests of

financial responsibility; clarify guidance on the entity required to

demonstrate financial responsibility; set standards for submitting

documentation and demonstrating financial responsibility for foreign

institutions; set standards for submitting documents and demonstrating

financial responsibility for institutions undergoing a change of

ownership; clarify the type of late-refund finding that triggers the

refund letter of credit provisions; and make changes to one alternative

means of demonstrating financial responsibility.

Tests of financial responsibility based on audited financial

statements are necessary to ensure that institutions participating in

the title IV, HEA programs possess sufficient financial resources to

provide the educational services for which students contract, provide

the human and capital resources necessary to administer the title IV,

HEA programs, and provide the financial and technical resources

necessary to act as a fiduciary for title IV, HEA program funds.

The Secretary intends to issue final rules that will make technical

amendments to the appropriate sections of part 668 on or before

December 1, 1996, to eliminate conflicting references between those

regulations and the proposed Sec. 668.23 and the proposed subpart L of

the General Provisions regulations, and to otherwise harmonize the

requirements of the proposed Sec. 668.23 and the proposed subpart L

with other Federal audit and financial responsibility requirements. In

this regard, the Secretary has identified throughout the discussion of

proposed changes the major sections of part 668 that would be amended

and consolidated.

Background

Statutory and Regulatory History

The authority to establish reasonable standards of financial

responsibility for purposes of determining an institution's eligibility

to participate in title IV, HEA programs was first granted the

Commissioner of Education by the Education Amendments of 1976--Pub. L.

94-482. The statute was subsequently amended in 1983, 1987, and 1992,

mostly with regard to the nature and provision of financial audits.

As a result of the 1992 amendments, the statute currently requires

the Secretary to:

Develop standards to ensure that an institution is able to

provide educational services and the necessary administrative resources

to comply with program requirements, and that the institution meets its

financial obligations (particularly in the area of refunds);

Determine an institution's financial responsibility on the

basis of an examination of operating losses, net worth, operating fund

deficits, and asset to liability ratios that takes into account the

differences in generally accepted accounting principles that are

applicable to for-profit and non-profit institutions;

Determine whether an institution is financially

responsible, despite its failure to meet standards based on the above

measures, if that institution can meet certain other criteria, such as

the posting of a letter of credit, demonstrating that it is not in

danger of recipitous closure, or demonstrating that its liabilities are

backed by the full faith and credit of a state or by an equivalent

governmental entity;

Require the annual submission of an audited and certified

financial statement as a means of gathering information about financial

responsibility and other requirements.

The statute also allows the Secretary, when necessary, and to the

extent necessary to protect the financial interests of the United

States, to require financial guarantees from institutions, and the

assumption of personal liabilities on the part of persons who exercise

substantial control over an institution.

Current regulations contain the following requirements:

That institutions must meet general standards of financial

responsibility, including the ability to provide contracted services,

to provide necessary administrative resources, to meet all financial

obligations with regard to debts, and to meet obligations with regard

to federal funds,

[[Page 49553]]

particularly refunds. The test for refund responsibility can be met in

several different ways.

That institutions must meet or exceed specific financial

tests as indicated on an annual audited financial statement. Some, but

not all, of these tests are differentiated among those that apply to

for-profit institutions, those that apply to non-profit institutions,

and those that apply to public institutions.

That institutions must meet tests of past performance of

an institution, or persons affiliated with the institution.

That institutions, if they fail to meet particular

criteria, must demonstrate financial responsibility according to an

alternative method, including posting a letter of credit, demonstrating

they are not in danger of precipitous closure, demonstrating they are

backed by the full faith and credit of a state or equivalent government

entity, or agreeing to be provisionally certified, in order to continue

to be eligible to participate in title IV, HEA programs.

Improving Financial Responsibility Standards

The Department is continually evaluating the measures it uses to

exercise its statutory oversight of the institutions participating in

title IV, HEA programs. In this regard, the Department is interested in

improving its oversight of such institutions, based on its experiences

with the application of current tests and standards to financial

statements. The HEA requires the annual submission of audited financial

statements from all institutions that participate in any of the federal

student financial assistance programs. Financial statements may be

presented in any of several formats depending on the reporting entity's

legal status and general purpose financial reporting requirements.

Public institutions typically prepare financial statements conforming

to the American Institute of Certified Public Accountants (AICPA) Audit

Guide for Colleges and Universities, or a governmental accounting model

described in Governmental Accounting Standard Board Statement 15.

Private nonprofit institutions will follow an accounting model

consistent with the Financial Accounting Standards Board (FASB)

Statements of Financial Accounting Standards (SFAS) 116 and 117.

Additionally, independent hospitals (i.e, medically-related

institutions) report under a hospital model, while proprietary

institutions, ranging in size and complexity from sole proprietorships

to publicly traded multi-national corporations, each employ a financial

reporting model consistent with the complexity of the reporting entity

and in conformity with commercial Generally Accepted Accounting

Principles (GAAP).

Currently the Secretary, at the direction of Congress, has

established specific regulatory tests with respect to certain assets to

liability ratios and net worth that measure an institution's financial

capabilities. When applied uniformly across the universe of

participating proprietary vocational schools, private non-profit

colleges and universities, public colleges and universities, and profit

and non-profit independent hospitals and health maintenance

organizations, these tests provide generally reliable information about

the financial health of the institutions examined. The Secretary,

however, believes that the kind of information that the Department can

extract from financial statements, and standards of financial

responsibility based on that information, can be further improved. Such

improvements would take into account both the total financial situation

of the institution, and the different financial and operational

characteristics that exist among commercial enterprises,

municipalities, states, private nonprofit organizations and hospitals,

each of which may be subject to fundamentally different accounting

standards and financial reporting requirements.

For example, the Secretary now employs a limited type of ratio

analysis as the principal means of assessing financial responsibility.

Generally, these ratios address fundamental concepts such as liquidity,

profitability and net worth. Current regulations require institutions

to meet certain requirements for each one of these components

separately. An institution that fails one test is deemed not

financially responsible. In practice, however, the uniform application

of independent sets of ratio measures across the universe of

participating institutions reduces the reliability of the information

gathered, because such an application does not always capture in a

comparable fashion all relevant information about the fiscal

responsibility of the respective institutions. Differences in

accounting classifications and standards among different types of

institutions exaggerate the perceived differences in financial strength

of those institutions when they are measured under independent

standards, even though those institutions may be identical with respect

to fiscal responsibility when their total financial situation is taken

into account. The current requirements therefore do not consider

whether a weakness in one particular financial component is offset by

financial strengths in the other components. For example, there may be

instances in which an institution may fail a single measure or test

(such as the acid test ratio) but could compensate for that failure by

exhibiting strengths in other areas. Accordingly, the Secretary

proposes to expand the scope of ratio analysis to take into account a

greater range of financial data.

The Secretary also recognizes that the unique characteristics that

distinguish the various business segments from one another are

significant. As such, while it is appropriate to evaluate institutions

within a given business segment by applying a general standard to that

business segment, and it is also appropriate to evaluate the same

elements of financial health across all business segments, it is

difficult to establish comparable financial responsibility levels when

applying a single standard across all business segments. The Secretary

is committed to developing financial responsibility guidelines that

take these differences into consideration. The Secretary is also

committed to establishing fair and reasonable standards that measure

the common, fundamental elements of financial health of all

postsecondary institutions, such that standards developed according to

sector-sensitive guidelines can be applied equitably across all

sectors.

The KPMG Report

As part of its overall effort to improve its measures of financial

responsibility, and as part of the Secretary's overall commitment to

improve the quality, efficiency, and effectiveness of its oversight

responsibility, the Department of Education commissioned in the Fall of

1995 the accounting firm of KPMG Peat Marwick, LLP to examine the

current regulatory measures, and recommend improvements to those

measures, especially in terms of taking into account the institution's

business sector and total financial condition. The goal of the study

was the development of processes, measures and standards the Secretary

could use to better assess risk to federal funds through the analysis

of financial statements and other documentation.

Over the past 20 years, KPMG has developed a methodology that uses

ratios to measure key elements common across all business sectors.

These ratios are constructed so that the individual numerators and

denominators are defined in such a way that they can be easily drawn

from the financial

[[Page 49554]]

statements of institutions from different business segments. Drawing

upon this methodology and on professional experience and literature in

the field, KPMG conducted this study for the Department during the Fall

of 1995 and Spring of 1996. As a result of the study, KPMG identified

the most significant fundamental elements of financial health in

postsecondary institutions--viability, profitability, liquidity,

ability to borrow, and capital resources.

After consultation with a task force of individuals from the higher

education community as well as other financial experts, and after

conducting a reasonableness test of the proposed ratios by applying

those ratios to a judgmental sample of institutional financial reports,

KPMG recommended the following:

The Secretary adopt three ratios as the primary tests of financial

responsibility. These ratios are the Viability Ratio, Primary Reserve

Ratio, and the Net Income Ratio. The Viability Ratio is the ability of

the institution to liquidate debt from its expendable resources. If the

ratio is greater than 1 to 1, existing debt could be repaid from

expendable resources available today. The Primary Reserve Ratio

measures the ability to support current operations from expendable

resources. This ratio provides a snapshot of financial strength and

flexibility by comparing expendable resources to total expenditures or

expenses, or operating size. This snapshot indicates how long the

institution could operate using its expendable reserves without relying

on additional net assets generated by operations. The Net Income Ratio

measures the ability of an institution to live within its means in a

given operating cycle. A positive Net Income Ratio indicates a surplus

or profit for the year. Generally speaking, the larger the surplus or

profit, the stronger the institution's financial position as a result

of the year's operations. A negative ratio indicates a deficit or loss

for the year.

The ratios scores be assigned strength factor values that take into

account the differences between sectors, and that reflect the range of

financial health. (The KPMG report refers to strength factor values as

``threshold values''). A strength factor value of (5) would indicate

that, on the basis of that ratio alone, the institution is in exemplary

financial health. A strength factor value of (1), on the other hand,

indicates that the institution, based on that ratio alone, appears to

be in immediate financial difficulty. The strength factor values for

each ratio, broken down by sector, are contained in Appendix F of the

proposed regulations (which will be codified with those regulations),

and a more detailed explanation for these strength factor values is

contained in the separate appendix to this Notice of Proposed

Rulemaking that will not be codified in final regulations.

The strength factor scores for each institution be summed in

accordance with a weighting mechanism that again takes into account the

differences among business sectors to create a composite score. For

example, public and private non-profit institutions would both have

their Primary Reserve ratios weighted most heavily, while for

proprietary institutions, the Net Income ratio would be weighted most

heavily. This difference reflects the fact that privates and non-

profits can and usually do retain expendable resources, while

proprietaries can, but usually do not, retain expendable resources. The

weighting values for each sector are contained in Appendix F of the

proposed regulations, and a fuller explanation of those weightings is

contained in the appendix to this Notice of Proposed Rulemaking.

The composite scores be divided into categories that reflect the

overall financial position of the institution, which can be used by

Departmental analysts to determine the level of risk represented by the

institution. For purposes of this proposed rule, however, the only

relevant score is that which marks the boundary between those

institutions which, by regulation, are financially responsible by this

test, and those that are not. As discussed below, the Department is

proposing that the appropriate composite score be set at 1.75; i.e.,

those institutions that receive a composite score of 1.75 or higher

would be considered financially responsible by this test (though they

still must meet other tests, such as prior performance, in order to be

deemed financially responsible), and those that receive a score of less

than 1.75 would not be deemed financially responsible by this test.

This standard is based on KPMG's conclusion that an institution that

attains a composite score of less than 1.75 represents an immediate

financial problem.

A more extensive discussion of KPMG's report is contained in the

appendix to this Notice of Proposed Rulemaking. The entire report is

also available for inspection during regular business hours at the

address provided at the beginning of this preamble. The Secretary also

invites comments on the KPMG report.

Definitions of the Proposed Ratios

Viability Ratio

------------------------------------------------------------------------

Public Public

institutions institutions Private non-

following the following a profit Proprietaries For-profit

1973 AICPA government hospitals and hospitals

audit guide 1 model institutions

------------------------------------------------------------------------

Expendable

Fund

Balances 2..

.....

Plant Debt... Gov't and

Proprietary

Fund Equity

General Long-

Term Debt Expendable

Net Assets 3

Long-Term

Debt 4 Adjusted

Equity 5

Total Long-

Term Debt Expendable

Fund

Balances

Long-Term

Debt

------------------------------------------------------------------------

1 Public institutions have the option of preparing their statements

according to the 1973 AICPA Guide for Colleges and Universities, or

the governmental model.

2 Expendable Fund Balances are computed as follows: General, specific

purpose, and quasi-endowment fund balances--plant equity. True

endowments are specifically excluded from the numerator.

3 Expendable Net Assets are calculated as follows:

Unrestricted Net Assets.

Plus Temporarily Restricted Net Assets.

Minus Property, plant and equipment.

Minus Plant debt (including all notes, bonds, and leases payable to

finance those fixed assets).

Equals Expendable Net Assets.

4 Long-term debt is defined as all amounts borrowed for long-term

purposes from third parties and includes: (1) Notes payable, (2) Bonds

payable, and (3) Leases payable.

5 Adjusted equity is computed as follows:

Total Owner(s) or Shareholders Equity.

[[Page 49555]]

Minus Intangible assets.

Minus Unsecured related party receivables.

Minus Property, plant and equipment (net of accumulated depreciation).

Plus Total long-term debt.

Equals Adjusted Equity.

If total long-term debt exceeds the value of net property, plant and

equipment, then the asset is not subtracted from equity nor is the

liability added back.

Primary Reserve Ratio

------------------------------------------------------------------------

Publics using Publics using Private non-

the 1973 a profit For-profit

AICPA audit governmental hospitals and Proprietaries hospitals

guide model institutions

------------------------------------------------------------------------

Expendable

Fund

Balances....

.....

Total

Expenditures

and

Mandatory

Transfers... Governmental

and

Proprietary

Fund Equity

Total

Government

Expenditures

and other

Financing

Uses

(Excluding

Transfers)

and Total

Proprietary

Expenses Expendable

Net Assets

Total

Expenses Adjusted

Equity

Total

Expenses Expendable

Fund

Balances

Total

Expenses

------------------------------------------------------------------------

Net Income Ratio

------------------------------------------------------------------------

Publics using Private non-

Publics using a profit For-profit

1973 AICPA governmental hospitals and Proprietaries hospitals

audit guide model institutions

------------------------------------------------------------------------

Net Total

Revenues

Total

Revenues.... Proprietary

Income Before

Operating

Transfers, +

Gov'tal

Revenues and

Other

Financing

Sources (exc.

transfers)--G

ov't

Expenditures

and Other

Financing

Uses

(excluding

transfers)

Total

Governmental

and

Proprietary

Revenues and

other

Financing

Sources

(excluding

transfers) Change in

Unrestricted

Net Assets

Total

Unrestricted

Income Income Before

Taxes

Total

Revenues Revenue &

Gains in

Excess of

Expenses &

Losses (Net

Total

Revenues)

Total

Revenues

------------------------------------------------------------------------

The Secretary's Use of the KPMG Report

The Secretary proposes adopting the methodology recommended in the

KPMG report to replace the ratio methodology now contained in

Sec. 668.15. For the most part, the Secretary proposes this methodology

without change in order to seek comment from the community on the

merits of this approach. However, in its final report KPMG concluded

that a composite score below 1.75 indicates an immediate financial

problem, but acknowledged that the identification of a bright line

standard for passing or failing the financial responsibility standards

was a policy decision that should be made by the Secretary. The

Secretary is therefore proposing to adopt the composite score standard

of 1.75 as the bright line standard for the ratio test, and to equate a

failure to demonstrate financial responsibility with the threshold that

KPMG identified as posing a significant risk of immediate financial

problems. The Secretary believes that including this methodology in the

proposed regulations in this fashion will best utilize the KPMG study,

and that any adjustments to the KPMG recommendations and the

Secretary's designation of 1.75 as the cutoff score would best be made

with the benefit of public comments.

In addition, the Secretary proposes in this NPRM a number of other

changes to the financial responsibility regulations, and to the audit

requirements contained in section 668.23. A summary of all these

changes follows.

Summary of Proposed Changes

In proposing to move the financial responsibility regulations from

Sec. 668.15 to the new Subpart L of Part 668, the Secretary proposes

that certain segments of the existing regulations be kept intact, and

that significant changes be made in others. A part of these proposed

changes is also a revision of Sec. 668.23. A summary of the new

locations of existing regulations, proposed changes to regulations, and

issues on which the Secretary particularly invites comments follows

below.

Sec. 668.23 Compliance Audits and Audited Financial Statements

In this section, the Secretary proposes to revise the provisions of

the current Sec. 668.23 and the audited financial statement

requirements formerly located in Sec. 668.15(e). The Secretary retains

the requirement that an institution submit financial statements audited

by an independent certified public accountant, and the provision for

the submission of working and other papers on demand from the

Secretary. However, the Secretary believes that it is possible to

provide relief to institutions without compromising the ability of the

Department to perform its oversight responsibilities. One way that this

may be accomplished is to require institutions to submit a single

audit, prepared on a fiscal year basis and audited under Generally

Accepted Government Auditing Standards (GAGAS) and including the

compliance information. A single compliance audit, prepared on a fiscal

year basis rather than on an award year basis, would provide the basic

information required by the Secretary for purposes of making a

determination of financial responsibility. The Student Financial

Assistance Audit Guide (SFA Audit Guide) now requires that all

institutions submit audited financial statements as part of their

compliance audits. For some institutions, particularly those in

[[Page 49556]]

the proprietary sector, this has resulted in a requirement that

institutions submit these two audited financial statements to the

Secretary annually, but at two different times. These audits differ in

at least two ways. One way in which they differ is that the financial

statement required under the current Sec. 668.15 is to be performed in

accordance with Generally Accepted Auditing Standards (GAAS) and the

financial statement that is required as part of the compliance audit is

to be performed under GAGAS. Under the GAGAS standard, the auditor must

go beyond GAAS standards to perform additional tests and express an

opinion on the internal control structure and on compliance with all

laws and title IV, HEA program regulations. The other difference is

that the financial statement required under the current Sec. 668.15 is

to be conducted on a fiscal year basis, and the compliance audit is

performed on an award year basis.

Thus the Secretary proposes to eliminate the submission of a

separate financial statement four months after the end of the entity's

fiscal year, as now required in Sec. 668.15. Instead the Secretary

proposes that the Department require institutions or third-party

servicers to submit the A-128 or A-133 report in the timeframe provided

by that guidance, or six months after the end of the institution's or

servicer's fiscal year for entities that follow the SFA Audit Guide, as

required in the proposed Sec. 668.23. This compliance report would now

include both the compliance audit and the audited financial statement,

would be prepared on a fiscal year basis, and be prepared in accordance

with GAGAS. It would be on the basis of the audited financial statement

contained in the compliance report, as well as other documentation,

that the Secretary would make determinations of financial

responsibility by applying this proposed ratio test and other forms of

analysis. As a result of this change, the compliance audit of an

institution whose fiscal year does not coincide with an award year

would cover parts of two award years. The Secretary recognizes that

such a change may pose difficulties associated with providing a

compliance audit spanning two different award years, but believes that

the overall burden reduction for institutions from combining the two

audits more than compensates for these difficulties.

The Secretary also proposes a modification of the treatment of the

entity covered by the financial statement by clarifying the

requirements that trigger the submission of consolidated statements.

The Secretary proposes that an institution, as part of its audited

financial statement, provide information regarding the institution's

financial relationship with related entities, and that on request the

institution must submit consolidated audited financial statements of

the institution and related entities.

This proposed section contains audit submission requirements for

foreign institutions, discussed below under the heading Sec. 668.176

Foreign Institutions. The Secretary also proposes adding a paragraph

regarding questionable accounting treatments. Under this proposal, if

the Secretary questions an accounting treatment, the Secretary may

submit the audit statements that contain those treatments to various

bodies, including the AICPA, for review or resolution.

This proposed section contains requirements for a proprietary

institution to disclose in a note to its financial statement the

proportion of revenues it receives from title IV, HEA programs. This

disclosure represents no added burden to the institution, since the

auditor will have already prepared the information contained in the

note to fulfill the requirements of Sec. 600.5(d) and (e) within 90

days of the end of the institution's fiscal year.

This proposed section also includes the requirements regarding

audit exceptions and repayments now contained in Sec. 668.24. Section

668.24 is now being separately amended by the Secretary to include

requirements regarding record retention.

Subpart L--Financial Responsibility

Sec. 668.171 Scope and Purpose

In this section the Secretary proposes to revise the scope and

purpose statement currently in Sec. 668.15(a) to more accurately

reflect the purpose and intent of the law, to clarify the

responsibilities of third-party servicers under this subpart, and to

include a special transition rule discussed below.

Sec. 668.172 Financial Standards

This section incorporates the requirements currently in

Sec. 668.15(b)(1)-(5), and Sec. 668.15(d) regarding financial

obligations, refund standards and the alternatives to meeting the

statutory refund reserve requirement, as well as the requirement that

the institution must submit its compliance report by the date and in

the manner prescribed in Sec. 668.23 in order to be considered

financially responsible.

The Secretary proposes in this section that a composite score of

1.75, calculated in accordance with Sec. 668.173, be the minimum score

an institution can achieve and still be determined financially

responsible using the new ratio analysis.

The Secretary is proposing this composite score as a measure of

financial responsibility because this score takes into consideration

many important variables, with particular emphasis on expendable

capital and profitability. A score of less than 1.75 suggests that the

overall financial circumstance of the institution is such that one or

more of the measured elements is at or below the minimum strength

factor value and neither remaining measure is higher than the median

strength factor value. Generally, this implies that the institution is

having difficulty maintaining a marginal position with respect to

financial health and, by at least one measure, it is failing to perform

at even a minimal acceptable level. Conversely, marginal institutions

that achieve a strength factor value indicating superior performance in

any one of the measured elements are likely to achieve a composite

score of 1.75 or more despite overall marginal performance. This is

based on the assumption that superior performance in any one of the

measured elements will, over time, lead to improvements in the other

measured elements.

The use of a composite score encompasses the total financial

circumstances of the institution examined. Each of the three principal

measures attempts to identify a fundamental strength or weakness

related to the institution's overall fiscal health. In particular, each

factor isolates a critical aspect of fiscal responsibility and measures

that element against an established benchmark. It is important to note,

however, that no single measure is used. Rather, the measures are

blended into a composite score that recognizes the basic differences

that exist among the several types of institutions. By taking these

differences into consideration, the Secretary is better able to make a

determination as to overall institutional fiscal health. The

differences among the institutions examined are recognized explicitly

through the weighting methodology.

The use of a composite measure represents a departure from the

Secretary's current approach to measuring fiscal responsibility.

Currently, the Secretary applies similar measures, but individual

compliance thresholds for each element are measured exclusively from

one another, and not in combination. Under the current regulations, the

Secretary implicitly recognizes the relationship among variables and

established compliance thresholds for each element separately. The

proposed regulations are similar in that poor performance in any one

element may lead to a finding of

[[Page 49557]]

non-compliance unless other measures are at least at the median

performance level. What differs in relation to the current regulations

is the recognition that superior performance in one or more fundamental

elements of financial health adds a dimension to any analysis of fiscal

responsibility that warrants consideration. Thus, with one exception

discussed below, strength in one area may be considered to the extent

that it offsets weakness in another. The Secretary believes that this

better takes into consideration the total financial circumstances of an

institution.

There is one proposed exception to the use of the composite score

rather than individual ratios as the test of financial responsibility.

Because KPMG recommended that a public or private non-profit

institution that has a negative Primary Reserve Ratio be deemed an

immediate financial problem despite its composite score, the Secretary

proposes that in such circumstances the institution not be considered

financially responsible under the ratio test. This adjustment is in

recognition that a public or private non-profit institution that has a

negative Primary Reserve Ratio is in such grave financial difficulty

that even exemplary performance in other areas cannot cover for this

deficiency.

The Secretary intends to publish on or by December 1, 1996 final

regulations resulting from these proposed rules. Because the final

regulations would become effective on July 1, 1997, the Secretary is

proposing a special transition rule with regard to the implementation

of the 1.75 composite score standard. The Secretary would allow an

institution under proposed Sec. 668.171(c) a one-year exemption from

the new composite score standard if that institution passes the

applicable ratio standard test now in place in Sec. 668.15(b)(7)-(9).

Thus an institution, for its fiscal year that began on or before June

30, 1997, that fails the 1.75 composite score standard but passes the

appropriate ratio standard test contained in the current Sec. 668.15,

would still be considered financially responsible for one year. The

Secretary believes it is appropriate to allow an institution to prove

financial responsibility under the current standards based on the

financial condition of the institution during the fiscal year that

begins before these proposed rules become effective. Moreover, this

one-time transition rule would give the institution at least 12 months

to adjust its operations to meet the new standards.

In this section the Secretary also proposes a modification in the

refund reserve requirement performance alternative. Section 498(c)(6)

of the HEA requires that institutions maintain a cash reserve to pay

required refunds. Current Sec. 668.15(b)(5), and these proposed

regulations, require institutions, unless they meet the provisions of

specific exceptions, to provide the Secretary with a letter of credit

equal to not less than 25% of the title IV, HEA program refunds for

their previous fiscal year. One exception to this requirement is the

provision for performance standards, in which the institution

demonstrates that it has made required refunds, as attested to by the

previous two years' compliance audits, and it has not had a finding of

failure to make timely refunds. The Secretary wishes to address the

issue of a finding of failure to make timely refunds. Without a

standard under which such a finding is made, even one late refund may

be interpreted as a failure to make timely refunds, and could trigger

this requirement. While the Secretary expects all institutions to make

all refunds in accordance with the regulations in Sec. 668.22, and will

enforce those regulations for every refund, the Secretary did not

intend for isolated instances of late refunds to trigger the

requirement for the provision of the letter of credit. Therefore, the

Secretary is proposing that an institution would be eligible for the

performance standard exception to the requirement to providing a 25%

letter of credit, if (1) the independent CPA who audited the

institution's financial statements and compliance audits, or the

Secretary, a State or a guarantee agency that conducted a review of the

institution, did not find that the institution made 5 percent or more

of its refunds late, based on a sample of records audited and reviewed,

and (2) the auditor did not note a material weakness or a reportable

condition in the institution's report on internal controls that is

related to refunds. The Secretary believes that these standards are

reasonable and particularly requests comments on this proposal.

Sec. 668.173 Financial Ratios

This proposed section incorporates the methodology recommended by

the KPMG study and contains the definitions of ratios by sector, and

the procedure by which composite ratio scores are calculated. Specific

strength factors for normalizing ratio scores and weighting the

normalized ratios by sector are contained in the proposed Appendix F to

Part 668. The Secretary proposes that these ratios and the resulting

composite score replace the definition of ratios currently contained in

Sec. 668.15(b).

This proposed section also contains a definition of ``independent

hospital'' for these purposes, and the accounting rules for calculating

ratios previously in Sec. 668.15(b) regarding the treatment of

intangibles, extraordinary gains and losses, the income or losses from

discontinued operations, cumulative effects of changes in accounting

principles, prior period adjustments, and temporarily restricted

assets.

The Secretary is particularly interested in comments regarding the

definition and utility of these ratios. Are the terms used in defining

them clear? Do the ratios themselves provide meaningful and useful

information regarding the financial health of an institution? Are the

ratios correctly constituted with relation to the different audit

requirements of the various sectors of participating institutions? Are

the weightings and strength factor levels appropriate for each sector?

Will the composite scores give accurate pictures of financial health

for all types of institutions? Will the composite scores give relevant

and useful information regarding the financial health of institutions?

Is the 1.75 composite score an appropriate bright line for determining

the financial responsibility of an institution?

Also, the financial strength factors and weightings for hospitals

currently reflect the situation of for-profit hospitals. The Secretary

is interested in comments addressing the situation of non-profit

hospitals, and whether the strength factors and weightings for those

institutions should be different from those for for-profit hospitals.

Sec. 668.174 Alternate Standards and Requirements

The Secretary is proposing to modify and relocate the provisions

permitting institutions to demonstrate financial responsibility under

an alternative to the proposed composite score. All of the exceptions

formerly located in Sec. 668.15(d) are relocated to this section.

In this section the Secretary proposes to modify the method by

which an institution demonstrates that it has sufficient assets to

ensure against precipitous closure. The existing regulatory provisions

implement the statutory exception in section 498(c)(3)(C) of the HEA

that permits an institution otherwise failing prescribed ratios to

demonstrate financial responsibility by showing that it has sufficient

resources to ensure against its precipitous closure. Current

regulations mirror certain statutory requirements that the institution

demonstrate that it is

[[Page 49558]]

meeting its financial obligations, and then require the institution to

make specific demonstrations that it has not engaged in certain

identified practices that could have caused the institution's

deteriorated financial strength. The proposed regulations differ from

this detailed analysis by establishing a lower threshold (represented

by a composite score of 1.25) in order to qualify for this one-year

exception, and then simply requiring the owners (or other persons who

exercise substantial control over the institution) to assume personal

liability for the institution's title IV obligations, rather than

requiring a detailed analysis of the business dealings between the

institution and its owners. The Secretary believes that this system

will improve the administrative efficiency of implementing this

exception and decrease the burden on the institutions using the

exception by avoiding the detailed analysis of the business

transactions between an institution and its owners. Furthermore, by

establishing a separate minimum performance standard for institutions

that seek to use this exception, the Secretary intends to ensure that

more significant protections will be required for institutions whose

financial condition has deteriorated during the preceding year to the

point where the institution cannot meet those minimum thresholds. In

such circumstances, these institutions must either use one of the other

alternative means of demonstrating financial responsibility or be

provisionally certified under the provisions for institutions that are

not financially responsible.

With regard to financial standards and alternative standards for

new institutions, the Secretary proposes that two alternatives

enumerated in the statute--the provision of a letter of credit for at

least 50% of the proposed title IV program funds that the Secretary

determines the institution will receive during its initial year of

participation, or proof that the institution is backed by the full

faith and credit of a State or equivalent governmental entity--be

utilized for new institutions. The requirement of meeting prior year

standards precludes new institutions from availing themselves of the

revised precipitous closure alternative. The Secretary believes this is

warranted due to the greater uncertainty presented by institutions that

have not established a track record of properly administering the title

IV, HEA programs.

Sec. 668.175 Special Rules for an Institution That Undergoes a Change

in Ownership

In this section the Secretary proposes to specify the requirements

by which an institution that undergoes a change of ownership is deemed

financially responsible, as well as establishing the audit submission

requirements for applications for approval of changes of ownership.

The Secretary is proposing that entities applying for changes of

ownership initially demonstrate financial responsibility in one of two

ways. Either the new owners of the institution must submit personal

financial guarantees, in an amount and form acceptable to the

Secretary, or submit a letter of credit payable to the Secretary in an

amount of not less than one half the amount of title IV, HEA program

funds the Secretary determines the institution will receive during the

year following the new ownership's opening day. A requirement for both

these methods is that the institution submit a consolidated date of

acquisition balance sheet for the institution as part of the

institution's application for a change of ownership. The Secretary is

also proposing that the personal guarantees or letter of credit remain

in place until the institution submits audited financial statements

that show that the institution meets the 1.75 composite score standard

that is part of the general standards for demonstrating financial

responsibility required of all participating institutions.

Historically, the Secretary has encountered difficulties in making

comparable assessments of the financial resources for institutions

seeking approval under new ownership. Sometimes the institution was

sold because of an eroded or deteriorating financial condition. Without

an opportunity to evaluate an audited financial statement that includes

the operation of the newly acquired institution, the Secretary has had

to make case-by-case examinations of the financial resources of the

institution under its new ownership. Sometimes, this additional

analysis has significantly delayed the approval of the applicant or

such approval has been premised upon unaudited financial information

that differed significantly from the audited financial statement that

was later provided by the institution. The proposed regulations would

streamline the approval process and provide greater protection to the

taxpayers, while permitting the institution to participate and later

demonstrate financial responsibility under the new proposed ratio

analysis.

In addition, the Secretary is concerned that some entities seek

multiple approvals for changes of ownership during one fiscal year, and

this rapid growth increases the difficulty of assessing the financial

resources that would be available to those institutions. The Secretary

intends that such applicants will have to provide audited financial

statements that incorporate all institutions for which they have

already obtained approval to operate as part of the application for a

new change of ownership. These proposed regulations therefore require

the entity seeking the change of ownership to demonstrate that it has

submitted audited financial statements to the Secretary that include

all other institutions participating in title IV, HEA programs in which

the entity has an ownership interest or over which it exercises

substantial control, or to submit a current audited financial statement

reflecting such operations and ownership interests. This means that for

every change of ownership, the entity seeking the change in ownership

would provide personal guarantees or a letter of credit until audited

financial statements are submitted to the Secretary showing all the

institutions that the entity owns or controls, including the

institution or institutions that are the subject of the change of

ownership application.

The Secretary is also considering requiring owners to post personal

financial guarantees when institutions add additional locations, and

these would remain in place until annual audits are submitted showing

that the institution demonstrates financial responsibility under its

expanded operations. The Secretary specifically invites comments on

this proposal.

668.176 Foreign Institutions

In this section the Secretary proposes to clarify financial

responsibility standards for foreign institutions. Under the proposed

regulation, foreign institutions whose annual title IV participation is

less than $500,000 per year will be permitted to submit their financial

statement audits in accordance with the generally accepted accounting

principles of each institution's home country. These audits will then

be examined to determine financial responsibility. Foreign institutions

whose annual title IV participation exceeds $500,000 per year will be

required to have their financial statement audits translated as well as

presented for analysis under U.S. GAAP and GAGAS, and would have to

meet all

[[Page 49559]]

regulatory requirements applicable to domestic institutions.

The Secretary is proposing this standard for foreign institutions

to take into consideration several important distinguishing factors.

First, foreign institutions are only eligible to participate in the

student loan programs, and the relative size of such title IV funding

at most institutions is relatively small when compared with their total

financial operations. Second, foreign institutions with such relatively

low volumes of title IV participation have not historically experienced

compliance problems that appear to have resulted from impaired

financial capability. Under the proposed regulations, these foreign

institutions will provide annual financial statement audits and annual

compliance audits that can be evaluated to determine whether an

institution's operations are posing a risk to the taxpayers. The

Secretary believes that the additional burden of translating the

financial statement audits and presenting them under U.S. GAAP and

GAGAS should only be imposed where significant amounts of title IV

funds are expended at the foreign institution on an annual basis.

Sec. 668.177 Past Performance

This proposed section contains the requirements for past

performance for an institution or persons affiliated with an

institution that were formerly contained in Sec. 668.15(c).

Sec. 668.178 Additional Requirements and Administrative Actions

This proposed section contains an outline of the administrative

actions the Secretary takes when an institution fails any one of the

various standards of financial responsibility, and specifies that

failure to meet general standards of financial responsibility may

subject institutions to the Limitation, Suspension, Termination, and

Emergency Action provisions of Subpart G of Part 668. This proposed

section also contains the portions of Sec. 668.13(d) dealing with

requirements and standards pertaining to provisional certification of

institutions that are not financially responsible. The Secretary

invites comments on whether the Department should include other types

of requirements for institutions that are provisionally certified

because they are not financially responsible, for example the

development of teach-out plans.

With regard to this section, the following clarifies the

consequences of not meeting the proposed 1.75 composite score standard

(these consequences are also those that currently affect institutions

that fail to meet one of the current ratio standards):

A certified institution whose financial statement is undergoing its

annual review, or an institution that is undergoing recertification,

would have the opportunity to meet one of the following alternate

standards. If it had demonstrated financial responsibility in the

previous year, it could prove that it is not in danger of precipitous

closure by attaining a composite score of at least 1.25, and showing

that it is current in its debt obligations, and if its owners or board

of trustees submit personal financial guarantees and agree to be

jointly and severally liable for any liabilities arising from the

institution's participation in title IV, HEA programs. It could also

submit to the Secretary an irrevocable letter of credit for at least

50% of the total title IV, HEA program funds the institution received

during its latest fiscal year. A public institution would also have the

opportunity to demonstrate that it is backed by the full faith and

credit of a State or an equivalent government entity. An institution

that meets any of these alternatives would be considered financially

responsible. If an institution referred to above cannot or does not

meet one of these alternatives, it may be offered provisional

certification by the Secretary. In this case the institution would be

required to submit to the Secretary an irrevocable letter of credit for

at least 10% of the total title IV, HEA program funds the institution

received during its latest fiscal year, demonstrate that it met all its

financial obligations and was current on its debt payments for its two

most recent fiscal years, and demonstrate that it is capable of

participating under a funding arrangement other than the Department's

advance funding method. An institution that participates under

provisional certification in these circumstances is not considered to

be financially responsible. If the institution is not offered

provisional certification, or turns down provisional certification, the

institution would then be subject to termination proceedings.

An institution seeking to participate for the first time in the

title IV, HEA programs would have the opportunity to meet one of the

following alternate standards. It could submit to the Secretary an

irrevocable letter of credit for at least one-half of the amount of

title IV, HEA program funds that the Secretary determines the

institution will receive during its initial year of participation. A

public institution would have the opportunity to demonstrate that it is

backed by the full faith and credit of a State or an equivalent

government entity. If the institution could not meet one of these

alternative standards, it may be offered provisional certification, the

terms of which are described above. If the institution is not offered

provisional certification, or turns down provisional certification, it

would not be eligible to participate in any title IV, HEA program.

Appendix F

This proposed appendix contains the strength factors and sector

weightings for the new ratio analysis, an example of how composite

scores are calculated, and a section for technical terms, all adopted

from the KPMG report.

In enumerating the strength factors for institutions, the Secretary

proposes following KPMG's adjustments by specifying that public and

private non-profit institutions that have a negative Primary Reserve

Ratio be deemed to fail the composite score test. The Secretary also

proposes following KPMG's recommendation that for a proprietary

institution that earns a (2) or (1) strength factor for its Primary

Reserve Ratio, the strength factor for the Viability Ratio be no

greater than the result of the Primary Reserve Ratio. The purpose of

this adjustment is to prevent insignificant amounts of debt from

significantly affecting the categorization of an institution.

Executive Order 12866

1. Assessment of Costs and Benefits

These proposed regulations have been reviewed in accordance with

Executive Order 12866. Under the terms of the order the Secretary has

assessed the potential costs and benefits of this regulatory action.

The potential costs associated with the proposed regulations are

those resulting from statutory requirements and those determined by the

Secretary to be necessary for administering this program effectively

and efficiently. To the extent there are burdens specifically

associated with information collection requirements, they are

identified and explained elsewhere in this preamble under the heading

Paperwork Reduction Act of 1995.

Thus, in assessing the potential costs and benefits--both

quantitative and qualitative--of these proposed regulations, the

Secretary has determined that the benefits of the proposed regulations

justify the costs.

The Secretary has also determined that this regulatory action does

not interfere unduly with State and local governments in the exercise

of their governmental functions.

To assist the Department in complying with the specific

[[Page 49560]]

requirements of Executive Order 12866, the Secretary invites comment on

how to minimize potential costs or to increase potential benefits

resulting from these proposed regulations consistent with the purposes

of sections 487(c) and 498(c) of the HEA.

Summary of Potential Costs and Benefits

The Department has assessed the costs and benefits of the proposed

regulations. This information is provided under the Initial Flexibility

Analysis (below), and Summary of the KPMG Report Commissioned by the

Department (appended to this NPRM).

2. Clarity of Regulations

Executive Order 12866 requires each agency to write regulations

that are easy to understand.

The Secretary invites comments on how to make these regulations

easier to understand, including answers to questions such as the

following: (1) Are the requirements in the regulations clearly stated?

(2) Do the regulations contain technical terms or other wording that

interferes with their clarity? (3) Does the format of the regulations

(grouping and order of sections, use of headings, paragraphing, etc.)

aid or reduce their clarity? Would the regulations be easier to

understand if they were divided into more (but shorter) sections? (A

``section'' is preceded by the symbol ``Sec. '' and a numbered heading:

For example, Sec. 668.174 Alternate standards and requirements). (4) Is

the description of the proposed regulations in the ``Supplementary

Information'' section of the preamble helpful in understanding the

proposed regulations? How could this description be more helpful in

making the proposed regulations easier to understand? (5) What else

could the Department do to make the regulations easier to understand?

A copy of any comments that concern how the Department could make

these proposed regulations easier to understand should be sent to Mr.

Stanley Cohen, Regulations Quality Officer, U.S. Department of

Education, 600 Independence Avenue, S.W., Room 5121, FOB-10,

Washington, D.C. 20202-2241.

3. Initial Flexibility Analysis

The Secretary has determined that a substantial number of small

entities may experience significant economic impacts from this proposed

regulation. In accordance with the Regulatory Flexibility Act (RFA), an

Initial Flexibility Analysis (IRFA) of the adverse economic impact on

small entities has been performed. A summary of the IRFA appears below.

Description of the Objectives of, and Legal Basis for, the Rule

The Secretary is directed by section 498(b) of the HEA to

establish, on an annual basis, that institutions participating in title

IV, HEA programs are financially responsible. As part of the

Department's regulatory reinvention process, the Department has

analyzed the current standards whereby institutions can demonstrate

financial responsibility and found that improvements can be made. The

proposed improvements are discussed at length in the preamble to this

proposed rule.

Definition and Identification of Small Entities

The Secretary has adopted the U.S. Small Business Administration

(SBA) Size Standards for this analysis. RFA directs that small entities

are the sole focus of the Regulatory Flexibility Analysis. There are

three types of small entities that are analyzed here. They are: for-

profit entities with total annual revenue below $5,000,000; non-profit

entities with total annual revenue below $5,000,000; and entities

controlled by governmental entities with populations below 50,000. An

estimate of the proportion of entities in each of these categories was

calculated using the best available data, the National Center for

Education Statistics IPEDS survey for the academic year 1993-1994.

These estimates were applied to Department administrative files where

no data element for total revenue is available. The estimates are that

1,690 small for-profit entities, 660 small non-profit entities and 140

small governmental entities will be covered by the proposed rule. Where

exact data were not available to estimate the proportion of small

entities, data elements were chosen that would have overestimated,

rather than underestimated, the proportion. The Secretary particularly

invites comments on the definition of small entity and the estimate of

the number of small entities that would be covered by the proposed

rule.

The component of the proposed rule that could potentially cause a

small entity to be economically affected is the proposed modification

of the tests for financial responsibility that are applied to the

submitted financial statements. The proposed consolidation of the

financial statement audit with the compliance audit that must be

submitted to the Secretary would have a positive economic impact on all

small (and large) entities. The proposed changes to one of the

alternative methods of demonstrating financial responsibility would

have a positive economic impact on those institutions that choose this

alternative (otherwise it would not be chosen) and the Secretary

believes that most institutions that would have been able to use the

existing alternative method set out in the current regulations would be

able to use the modified version. The costs of this alternative and the

other existing alternatives are discussed below in the context of those

institutions that experience adverse economic impacts.

Compliance Costs of the Proposed Rule for Small Governmental Entities

Small (and large) governmental entities that participate in the SFA

programs have a statutory (section 498(c)(3)(B) of the HEA) alternative

to the existing and proposed tests for demonstrating financial

responsibility. This alternative allows for entities that are backed by

the full faith and credit of a State to be considered financially

responsible, and to be relieved of any costs of demonstrating financial

responsibility. It is the Secretary's practice to identify financial

statements from public institutions that appear to fail the numeric

financial responsibility standards, and then to determine on a case by

case basis whether that institution is backed by the full faith and

credit of the state in which it is located. This alternative method of

demonstrating financial responsibility is not changed under the

proposed regulations, so the proposed rule will not have an increased

significant economic impact on small governmental entities.

Compliance Costs of the Proposed Rule for Small For-profit and Small

Non-profit Entities

Some small (and large) for-profit and non-profit entities will

experience adverse economic impacts from this proposed rule, to the

extent that they may fail the proposed standards (including the

alternative measures for demonstrating financial responsibility) but

would have been able to pass the current standards. Using the KPMG

analysis described elsewhere, it was estimated that between 456 and 625

small for-profit entities and between 18 and 80 small non-profit

entities would pass the existing test but fail the new proposed tests,

and the Secretary seeks to minimize these adverse economic impacts by

including in the regulations a provision that will treat an institution

that passes the old standards as being financially responsible for any

fiscal year that begins prior to the effective

[[Page 49561]]

date of the final regulation. To the extent that some of these small

entities will be unable to adjust their operations to come into

compliance with the new standards beyond that transition period, the

negative economic impact on these entities are those costs associated

with employing the alternative methods for demonstrating financial

responsibility. Costs for adjusting the operation of the institution to

come into compliance may, in some cases, be significant, although more

difficult to estimate.

The Secretary seeks comments on alternative ways of minimizing

burden on small entities. One possible alternative for which the

Secretary seeks comment is to delay the effective date of these rules

for small entities.

To the extent that an institution that passed the current standards

of financial responsibility could no longer do so without posting a

surety, a rough estimate of the calculable costs of each of these

alternative methods for a typical small entity was calculated. The

typical small entity was proposed as one with $2,000,000 in total

revenue, 84% of which comes from the SFA programs. It was not

practicable to estimate the cost of obtaining external financing if the

required capital was not readily available. This would depend on the

risk profile of the particular entity and reliable estimates of this

feature were not practicable. This rough estimate is that it could cost

a typical small institution as much as $56,500 to secure a 50% letter

of credit, although the actual costs to most institutions would be less

if available credit lines or other assets could be pledged against the

letter of credit. Similarly, if the institution were allowed to post a

smaller surety in conjunction with provisional certification, the 10%

letter of credit could cost as much as $20,500, or less depending on

the other available resources that were used to secure the letter of

credit. The Secretary notes that the relative cost of providing these

letters of credit will correspond to the relative risk assessments made

by the banks that provide the letters of credit to the institutions.

The amount it would cost a typical small entity to avail itself of

the revised alternative standard for financial responsibility where the

institution demonstrates that it has sufficient resources to ensure

against its precipitous closure could not be reasonably estimated, but

it is assumed that the costs would be smaller than those listed above

for institutions that choose this method. These estimates are for the

typical institution and the costs experienced by the actual

institutions will undoubtedly be different. These estimates are

provided to satisfy the RFA requirements that costs of compliance be

described and should be used as illustrative examples only. The

Secretary particularly invites comments on these estimates of each of

these alternatives for small entities.

Discussion of Adverse Economic Impacts

This analysis has determined that between an estimated 456 and 625

small for-profit entities and between an estimated 18 and 80 small non-

profit entities may not initially pass the proposed standards to

demonstrate financial responsibility even though these institutions

might have passed the current standards. This estimate was derived from

information used in the KPMG study that had selectively included a

number of schools that had a demonstrated lack of financial

responsibility, so the projections in this analysis may overstate the

expected number of institutions that are in this category. In order to

ameliorate the effects of implementing a new standard for financial

responsibility, the proposed regulations include a proposed alternative

means to demonstrate financial responsibility under the current

standards for fiscal years that began prior to the effective date of

the proposed regulation. Institutions not able to come into compliance

with the proposed standards following this transition period will

experience adverse economic impacts from this proposed regulation, and

the relative economic costs these institutions may face if they are

required to post a letter of credit are discussed above. Since the

proposed regulations provide a better measure of an institution's

financial responsibility, the Secretary believes it is necessary to

impose these additional costs on institutions that are unable to adjust

their operations to meet these ratios, because failure to meet these

ratios indicates a heightened risk to students and taxpayers.

The adverse economic impacts experienced by some small (and large)

entities is balanced by the positive economic impacts experienced by

some small (and large) entities. These positive impacts arise from the

ability of the proposed tests to better judge financial responsibility.

Between an estimated 138 and 369 small entities that failed the

existing tests will pass the new tests because the proposed regulation

determines financial responsibility by blending more financial

information together into a composite score. These entities that have

resources that were not adequately measured under the regulation will

be spared the expense of pursuing alternative demonstrations of

financial responsibility.

The negative economic impacts from this proposed regulation will

only be felt by those additional entities that are judged to be not

financially responsible by the proposed tests but may have been

determined to be financially responsible under the current regulations.

The Secretary believes that the proposed tests, developed by KPMG

through extensive consultations with small (and large) entities, are

better determinants of financial responsibility than the existing

tests. The use of the proposed tests will enable the Secretary to

better meet the responsibilities of section 498(c) of the HEA and to

better safeguard the Federal fiscal interests and the interests of

students.

Identification of Relevant Federal Rules Which May Duplicate, Overlap,

or Conflict With the Proposed Rule

This rule reduces the number of audits which must be submitted to

the Secretary by consolidating the financial statement audit with the

compliance audit, removing some redundancy in these reporting

requirements because financial information about the institution was

being gathered separately through both of these submissions. The

Secretary has not found any other Federal rules which duplicate,

overlap, or conflict with the proposed rule. The Secretary particularly

invites comments on other Federal rules which might meet these

criteria.

Significant Alternatives That Would Satisfy the Same Legal and Policy

Objectives While Minimizing the Economic Impact on Small Entities

The proposed changes to the financial responsibility regulations

would satisfy the same legal and policy objectives that are addressed

by the current regulations in a manner that the Secretary believes more

accurately measures the financial strength of institutions

participating in the title IV, HEA programs. This adoption of ratio

analysis in conjunction with the revised alternative means for

demonstrating financial responsibility will minimize the adverse

economic impact on small (and large) entities that choose this

alternative. Other alternatives, such as those that would establish

differing compliance or reporting requirements or timetables based upon

the size of the institution rather than the type of institution, or the

use of performance standards rather than establishing baseline

measures, or an exemption from coverage of the rule or any part thereof

for small entities,

[[Page 49562]]

would not adequately discharge the Secretary's obligation under section

498(c) of the HEA to determine the financial responsibility of

participating institutions and guard the Federal fiscal interest. The

Secretary has determined that there are no other significant

alternatives that would satisfy the same legal and policy objectives

while minimizing the economic impact on small entities. This

determination is based, in part, on the extensive consultation that the

Department and KPMG performed with small (and large) entities in

developing these proposed revisions. The Secretary particularly invites

comments on this determination.

Conclusion

The Secretary concludes that a number of small entities that are

able to demonstrate financial responsibility under the current

regulations may experience significant adverse economic impacts if they

are unable to adjust their operations over time to meet the financial

responsibility standards in the proposed rule. However, as discussed in

the section referring to the cost-benefit assessment of the proposed

rule pursuant to Executive Order 12866, the Secretary has concluded

that the costs are outweighed by the benefits of putting in place a

better system for measuring financial responsibility. In this case, the

benefits are better protection of the Federal fiscal interest due to an

improved numerical measure, and a transition to a system that will

recognize some small entities as being financially responsible even

though they would not pass the tests required under the current

regulations.

The Secretary invites comments on any aspect of this analysis,

particularly comments on the definition of small entity, the estimated

number of institutions that are expected to experience adverse economic

impacts, the estimated costs of alternative demonstration of financial

responsibility, and any significant alternatives that would satisfy the

same legal and policy objectives while minimizing the economic impact

on small entities.

Paperwork Reduction Act of 1995

Sections 668.23 and 668.175 contain information collection

requirements. As required by the Paperwork Reduction Act of 1995, the

Department of Education has submitted a copy of these sections to the

Office of Management and Budget (OMB) for its review.

Collection of Information: Financial Responsibility

These regulations affect the following types of entities eligible

to participate in the title IV, HEA programs: Educational institutions

that are public or nonprofit institutions, and businesses and other

for-profit institutions. The information to be collected are audited

financial statements, and, for institutions undergoing changes of

ownership, consolidating date of acquisition balance sheets.

Institutions of higher education that participate in title IV, HEA

programs will need this information required by these regulations to

meet the eligibility requirements for participation set forth in

sections 487 and 498 of the HEA. Institutions must submit annually

audited financial statements to the Secretary in accordance the time

limits established in either the relevant OMB circular or the SFA Audit

Guide. This annual submission, already required of institutions and

already reflected in the burden hour inventory, will also serve for the

separate submission of an annual audited financial statement currently

required under Sec. 668.15. For-profit institutions undergoing a change

of ownership must also submit consolidating date of acquisition balance

sheets with their application for approval of change of ownership. The

Secretary needs and uses these audits and balance sheets (in the case

of institutions undergoing a change of ownership) to analyze the

financial situation of institutions and to determine whether particular

institutions have sufficient financial strength to provide the

educational services which they have contracted to provide, and to act

as fiduciaries for federal student aid.

Information is to be collected, audited, and reported to the

Secretary once each year for institutions and third-party servicers

covered by Sec. 668.23 and formerly covered by Sec. 668.15. Annual

public reporting and recordkeeping burden is estimated to average 1

hour for each response for 8,000 respondents for Sec. 668.23. These

hours include the time needed for searching existing data sources, and

gathering, maintaining, and disclosing the data. Educational

institutions that are public or nonprofit institutions or businesses or

other for-profit institutions may participate in the title IV, HEA

programs. Institutions of higher education that participate in title

IV, HEA programs will need and use the information required by these

regulations to meet the eligibility requirements for participation in

programs contained in sections 487 and 498 of the HEA.

Because these proposed regulations would eliminate the separate

financial statement submission in Sec. 668.15 there is a reduction in

recordkeeping burden of 1 hour per institution, or a total reduction of

10,000 burden hours for the elimination of Sec. 668.15.

Information is to be collected and reported to the Secretary with

applications for changes of ownership for institutions covered by

Sec. 668.175. Annual public reporting and recordkeeping burden is

estimated to average 0.25 hours for each response for an average of 200

responses annually for Sec. 668.175. These hours include the time

needed for searching existing data sources, and gathering, maintaining,

and disclosing the data. Educational institutions that are businesses

or other for-profit institutions will need and use the information

required by these regulations to meet the eligibility requirements for

participation in programs contained in section 498 of the HEA.

Organizations and individuals desiring to submit comments on the

information collection requirements should direct them to the Office of

Information and Regulatory Affairs, OMB, Room 10235, New Executive

Office Building, Washington, DC 20503; Attention: Desk Officer for U.S.

Department of Education.

The Department considers comments by the public on these proposed

collections of information in--

Evaluating whether the proposed collections of

information are necessary for the proper performance of the functions

of the Department, including whether the information will have

practical use;

Evaluating the accuracy of the Department's estimate of

the burden of the collection of information are necessary for the

proper performance of the functions of the Department, including

whether the information will have practical use;

Enhancing the quality, usefulness, and clarity of the

information to be collected; and

Minimizing the burden of the collection of information on

those who are to respond, including the use of appropriate automated,

electronic, mechanical, or other technological collection techniques,

or other forms of information technology; e.g., permitting electronic

submission of responses.

OMB is required to make a decision concerning the collection of

information contained in these proposed regulations between 30 and 60

days after publication of this document in the

[[Page 49563]]

Federal Register. Therefore, a comment to OMB is best assured of having

its full effect if OMB receives it within 30 days of publication. This

does not affect the deadline for the public to comment to the

Department on the proposed regulations.

Invitation to Comment

Interested persons are invited to submit comments and

recommendations regarding these proposed regulations.

All comments submitted in response to these proposed regulations

will be available for public inspection, during and after the comment

period, in Room 3045, Regional Office Building 3, 7th and D Streets

S.W., Washington, D.C. between the hours of 8:30 a.m. and 4 p.m.,

Monday through Friday of each week except Federal Holidays. A copy of

the KPMG report will also be available for inspection at this location.

List of Subjects in 34 CFR Part 668

Administrative practice and procedures, Colleges and universities,

Reporting and Recordkeeping requirements, Student aid.

Dated: September 11, 1996.

Richard W. Riley,

Secretary of Education.

(Catalog of Federal Domestic Assistance Number: 84.007 Federal

Supplemental Educational Opportunity Grant Program; 84.032 Federal

Family Educational Loan Program; 84.032 Federal PLUS Program; 84.032

Federal Supplemental Loans for Students Program; 84.033 Federal

Work-Study Program; 84.038 Federal Perkins Loan Program; 84.063

Federal Pell Grant Program; 84.069 Federal State Student Incentive

Grant Program, and 84.268 Direct Loan Program)

The Secretary proposes to amend part 668 of title 34 of the Code of

Federal Regulations as follows:

PART 668--STUDENT ASSISTANCE GENERAL PROVISIONS

1. The authority citation for part 668 continues to read as

follows:

Authority: 20 U.S.C. 1085, 1088, 1091, 1092, 1094, 1099c and

1141, unless otherwise noted.

Sec. 668.13 [Amended]

2. Under Sec. 668.13, paragraph (d) is being removed and paragraphs

(e) and (f) are redesignated as paragraphs (d) and (e).

Sec. 668.15 [Removed and reserved]

3. Section 668.15 is removed and reserved.

4. Section 668.23 is revised to read as follows:

Sec. 668.23 Compliance audits and audited financial statements.

(a) General--(1) Institutions. An institution that participates in

any title IV, HEA program must at least annually have an independent

auditor conduct a compliance audit of its administration of that

program. As part of that compliance audit the institution must also

have an independent auditor conduct an audit of the institution's

general purpose financial statement.

(2) Third-party servicers. Except as provided under this part or 34

CFR part 682, with regard to complying with the provisions under this

section a third-party servicer must follow the procedures contained in

the SFA Audit Guide for third-party servicers. A third-party servicer

is defined under Sec. 668.2 and 34 CFR 682.200. (The SFA Audit Guide is

available from the Department of Education's Office of Inspector

General.)

(3) Submission deadline. Except as provided by the Single Audit

Act, Chapter 75 of title 31, United States Code, an institution must

submit annually to the Secretary its compliance audit (including its

audited financial statement) no later than six months after the last

day of the institution's fiscal year.

(4) Audit submission requirements. In general, the Secretary

considers the compliance audit submission requirements (including those

of the audited financial statement) of this section to be satisfied by

an audit conducted in accordance with the Office of Management and

Budget Circular A-133, ``Audits of Institutions of Higher Education and

Other Nonprofit Organizations''; Office of Management and Budget

Circular A-128, ``Audits of State and Local Governments'', or the SFA

Audit Guide, whichever is applicable to the entity. (Both circulars are

available by calling OMB's Publication Office at (202) 395-7332, or

they can be obtained in electronic form on the OMB Home Page at (http:/

/www.whitehouse.gov).)

(b) Compliance audits for institutions. (1) An institution's

compliance audit must cover, on a fiscal year basis, all title IV, HEA

program transactions, and must cover all of those transactions that

have occurred since the period covered by the institution's last

compliance audit.

(2) The compliance portion of the audit required under this section

must be conducted in accordance with--

(i) The general standards and the standards for compliance audits

contained in the U.S. General Accounting Office's (GAO's) Government

Auditing Standards. (This publication is available from the

Superintendent of Documents, U.S. Government Printing Office,

Washington, DC 20402); and

(ii) Procedures for audits contained in audit guides developed by,

and available from, the Department of Education's Office of Inspector

General. (These audit guides do not impose any requirements beyond

those imposed under applicable statutes and regulations and GAO's

Government Auditing Standards.)

(3) The Secretary may require an institution to provide a copy of

its compliance audit report to guaranty agencies or eligible lenders

under the FFEL programs, State agencies, the Secretary of Veterans

Affairs, or nationally recognized accrediting agencies.

(4) An institution that has a compliance audit conducted under this

section must--

(i) Give the Secretary and the Inspector General access to records

or other documents necessary to review the audit; and

(ii) Require an individual or firm conducting a compliance audit to

give the Secretary and the Inspector General access to records, audit

work papers, or other documents necessary to review the audit.

(5) An institution must give the Secretary and the Inspector

General access to records or other documents necessary to review a

third-party servicer's audit.

(c) Compliance audits for third-party servicers. (1) A third-party

servicer that administers title IV, HEA programs for institutions does

not have to have a compliance audit performed if--

(i) The servicer contracts with only one institution; and

(ii) The audit of that institution's administration of the title

IV, HEA programs involves every aspect of the servicer's administration

of that program for that institution.

(2) A third-party servicer that contracts with more than one

participating institution may submit a single compliance audit report

that covers the servicer's administration of the title IV, HEA programs

for each institution with which the servicer contracts.

(3) A third-party servicer must submit annually to the Secretary

its compliance audit no later than six months after the last day of the

servicer's fiscal year.

(4) A third-party servicer must give the Secretary and the

Inspector General access to records or other documents necessary to

review an institution's compliance audit.

[[Page 49564]]

(5) The Secretary may require a third-party servicer to provide a

copy of its audit report to guaranty agencies or eligible lenders under

the FFEL programs, State agencies, the Secretary of Veterans Affairs,

or nationally recognized accrediting agencies.

(6) A third-party servicer that has a compliance audit conducted

under this section must--

(i) Give the Secretary and the Inspector General access to records

or other documents necessary to review the audit; and

(ii) Require an individual or firm conducting an audit described in

this section to give the Secretary and the Inspector General access to

records, audit work papers, or other documents necessary to review the

audit.

(d) Audited financial statements--(1) General. To enable the

Secretary to make a determination of financial responsibility, as part

of its compliance audit an institution must submit to the Secretary a

set of financial statements for it latest complete fiscal year. These

financial statements must be prepared on an accrual basis in accordance

with generally accepted accounting principles, and audited by an

independent certified public accountant in accordance with generally

accepted government auditing standards and other guidance contained in

the Office of Management and Budget Circular A-133, ``Audits of

Institutions of Higher Education and Other Nonprofit Organizations'';

Office of Management and Budget Circular A-128, ``Audits of State and

Local Governments'', or the SFA Audit Guide, whichever is applicable.

As part of these statements, the institution shall include a detailed

description of related entities consistent with the definitions in SFAS

57, describing in detail the extent and nature of the related entity's

interest, and the structure of the relationship between the institution

and the related entity. The Secretary may also require the institution

to submit or otherwise make available the accountant's work papers, and

to submit additional substantive information.

(2) Resolution of questionable accounting treatments. In the event

that the Secretary objects to accounting treatments contained in an

institution's audited financial statements, the Secretary notifies the

institution of the Secretary's concerns, and may refer those financial

statements, along with other relevant documents, to the AICPA Committee

on Accounting Standards, and other professional bodies and accounting

experts for review or resolution.

(3) Submission of additional financial statements. (i) To determine

whether an institution is financially responsible, the Secretary may

also require the institution to submit the audited financial statements

of related entities, consolidated financial statements, or full

consolidating financial statements based upon the institution's

economic relationship to those entities.

(ii) If the Secretary requires the submission of a related entity's

financial statement, the Secretary may also require that the statement

be supplemented with consolidating schedules showing the consolidation

of each of the parent corporation's subsidiaries and divisions (each

separate institution participating in the title IV, HEA programs shown

separately) intercompany eliminating entries, and derived consolidated

totals.

(4) Audited financial statements for foreign institutions. As part

of an annual compliance audit, a foreign institution must submit--

(i) Audited financial statements conducted in accordance with the

generally accepted accounting principles of the institution's home

country, if the institution received less than $500,000 in title IV,

HEA program funds during its most recently completed fiscal year; or

(ii) Audited financial statements translated to meet the

requirements of paragraph (d) of this section, if the institution

received $500,000 or more in title IV, HEA program funds during its

most recently completed fiscal year.

(5) Disclosure of title IV HEA program revenue. A proprietary

institution must disclose in a footnote to its financial statement the

percentage of the title IV, HEA program revenue the institution

received during that fiscal year, as calculated in accordance with

Sec. 600.5(d);

(6) Audited financial statements for third party servicers. A

third-party servicer that enters into a contract with a lender or

guaranty agency to administer any aspect of the lender's or guaranty

agency's programs, as provided under 34 CFR part 682, must submit

annually an audited financial statement. This financial statement must

be prepared on an accrual basis in accordance with generally accepted

accounting principles, and audited by an independent certified public

accountant in accordance with generally accepted government auditing

standards and other guidance contained in the third party servicer

audit guide issued by the Department of Education's Office of Inspector

General.

(e) Notification of questioned expenditures or compliance. (1) As a

result of a Federal audit or an audit performed at the direction of an

institution or third-party servicer, if an expenditure made by the

institution or servicer is questioned, or the institution's or

servicer's compliance with an applicable requirement (including the

lack of proper documentation) is questioned, the Secretary notifies the

institution or servicer of the questioned expenditure or compliance.

(2) If the institution or servicer believes that the questioned

expenditure or compliance was proper, the institution or servicer shall

notify the Secretary in writing of the institution's or servicer's

position and the reasons for that position.

(3) The institution's or servicer's response must be based on

performing an attestation engagement in accordance with the Standards

for Attestation Engagements of the American Institute of Certified

Public Accountants and must be received by the Secretary within 45 days

of the date of the Secretary's notification to the institution or

servicer.

(f) Determination of liabilities. (1) Based on the audit finding

and the institution's or third-party servicer's response, the Secretary

determines the amount of liability, if any, owed by the institution or

servicer and instructs the institution or servicer as to the manner of

repayment.

(2) If the Secretary determines that a third-party servicer owes a

liability for its administration of an institution's title IV, HEA

programs, the servicer must notify each institution under whose

contract the servicer owes a liability of that determination. The

servicer must also notify every institution that contracts with the

servicer for the same service that the Secretary determined that a

liability was owed.

(g) Repayments. (1) An institution or third-party servicer that

must repay funds under the procedures in this section shall repay those

funds at the direction of the Secretary within 45 days of the date of

the Secretary's notification, unless--

(i) The institution or servicer files an appeal under the

procedures established in subpart H of this part; or

(ii) The Secretary permits a longer repayment period.

(2) Notwithstanding paragraphs (f) and (g)(1) of this section--

(i) If an institution or third-party servicer has posted surety or

has provided a third-party guarantee and the Secretary questions

expenditures or compliance with applicable requirements and identifies

liabilities, then the Secretary may determine that

[[Page 49565]]

deferring recourse to the surety or guarantee is not appropriate

because--

(A) The need to provide relief to students or borrowers affected by

the act or omission giving rise to the liability outweighs the

importance of deferring collection action until completion of available

appeal proceedings; or

(B) The terms of the surety or guarantee do not provide complete

assurance that recourse to that protection will be fully available

through the completion of available appeal proceedings; or

(ii) The Secretary may use administrative offset pursuant to 34 CFR

part 30 to collect the funds owed under the procedures of this section.

(3) If, under the proceedings in subpart H, liabilities asserted in

the Secretary's notification, under paragraph (e)(1) of this section,

to the institution or third-party servicer are upheld, the institution

or third-party servicer must repay those funds at the direction of the

Secretary within 30 days of the final decision under subpart H of this

part unless--

(i) The Secretary permits a longer repayment period; or

(ii) The Secretary determines that earlier collection action is

appropriate pursuant to paragraph (g)(2) of this section.

(h) An institution is held responsible for any liability owed by

the institution's third-party servicer for a violation incurred in

servicing any aspect of that institution's participation in the title

IV, HEA programs and remains responsible for that amount until that

amount is repaid in full.

(Authority: 20 U.S.C. 1088, 1094, 1099c, 1141 and section 4 of Pub.

L. 95-452, 92 Stat. 1101-1109)

5. A new Subpart L is added to read as follows:

Subpart L--Financial Responsibility

Sec.

668.171 Scope and purpose.

668.172 Financial standards.

668.173 Financial ratios.

668.174 Alternate standards and requirements.

668.175 Special rules for an institution that undergoes a change in

ownership.

668.176 Foreign institutions.

668.177 Past performance.

668.178 Additional requirements and administrative actions.

Subpart L--Financial Responsibility

Sec. 668.171 Scope and purpose.

(a) General. To begin and to continue to participate in any title

IV, HEA program, an institution must demonstrate to the Secretary that

it is financially responsible under the standards established in this

subpart. These standards are intended to ensure that a participating

institution has the financial resources to--

(1) Deliver its education and training programs to students without

interruption; and

(2) Meet its financial and administrative responsibilities to

students and to the Secretary.

(b) Third-party servicers. (1) The general standards in this

subpart apply to a third-party servicer that enters into a contract

with a lender or guaranty agency to administer any aspect of the

lender's or guaranty agency's programs, as provided under 34 CFR part

682; and

(2) The provisions regarding past performance contained in

Sec. 668.177 apply to all third-party servicers.

(c) Special transition-year rule. (1) If an institution fails to

satisfy the general standards under this subpart solely because it did

not achieve a composite score of at least 1.75, as determined under

Sec. 668.173, the institution may demonstrate that it is financially

responsible under the standards formerly codified under Sec. 668.15

(b)(7) through (b)(9).

(2) An institution may demonstrate that it is financially

responsible under the former standards only once, and only for the

institution's fiscal year that began on or before June 30, 1997.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.172 Financial standards.

(a) General standards. In general, the Secretary considers an

institution to be financially responsible if the Secretary determines

that--

(1)(i) The institution's Viability, Primary Reserve, and Net Income

ratios yield a composite score of at least 1.75, as calculated under

Sec. 668.173; and

(ii) For a public or private non-profit institution, that

institution has a positive Primary Reserve ratio;

(2) The institution is meeting all of its financial obligations,

including but not limited to--

(i) Refunds that it is required to make; and

(ii) Repayments to the Secretary for liabilities and debts incurred

in programs administered by the Secretary;

(3) The institution is current in its debt payments. The

institution is not current in its debt payments if--

(i) The institution is in violation of any existing loan agreement

at its fiscal year end, as disclosed in a note to its audited financial

statement; or

(ii) The institution fails to make a payment in accordance with

existing debt obligations for more than 120 days, and at least one

creditor has filed suit to recover funds under those obligations; and

(4) In the institution's audited financial statements, the opinion

expressed by the auditor was not an adverse opinion or disclaimed

opinion, or the auditor did not express doubt about the continued

existence of the institution as a going concern.

(b) Refund standards. (1) Letter of credit. In addition to

satisfying the general standards, an institution must submit an

irrevocable letter of credit, acceptable and payable to the Secretary,

equal to 25 percent of the total amount of title IV, HEA program

refunds paid by the institution during its most recently completed

fiscal year, unless the institution qualifies for an exemption under

this section.

(2) Exemptions. An institution is not required to submit the letter

of credit described in paragraph (b)(1) of this section, if--

(i) The institution's liabilities are backed by the full faith and

credit of the State, or by an equivalent government entity;

(ii) The institution is located in a State that has a tuition

recovery fund approved by the Secretary and the institution contributes

to that fund; or

(iii) The institution demonstrates that it made its title IV, HEA

program refunds within the time permitted under Sec. 668.22 during its

two most recently completed fiscal years. The Secretary considers an

institution to qualify for this exemption if the independent CPA who

audited the institution's financial statements and compliance audits

for either of those fiscal years, or the Secretary or a State or

guaranty agency that conducted a review of the institution during those

fiscal years--

(A) Did not find that the institution made 5 percent or more of its

refunds late, based on the sample of records audited or reviewed; and

(B) Did not note a material weakness or a reportable condition in

the institution's report on internal controls that is related to

refunds.

(3) Failure to make timely refunds. (i) If the Secretary or a State

or guaranty agency determines in a review conducted of the institution

that the institution no longer qualifies for an exemption under this

section, the institution must--

(A) Submit the irrevocable letter of credit to the Secretary no

later than 30 days after the Secretary, or State or guaranty agency

notifies the institution of that determination; and

(B) Notify the Secretary of the guaranty agency or State that

conducted that review.

[[Page 49566]]

(ii) If an auditor determines in the institution's annual

compliance audit that the institution no longer qualifies for an

exemption under this section, the institution must submit the

irrevocable letter of credit to the Secretary no later than 30 days

after the date the institution's compliance audit must be submitted to

the Secretary.

(4) State tuition recovery funds. In determining whether to approve

a State's tuition recovery fund, the Secretary considers the extent to

which that fund--

(i) Provides refunds to both in-State and out-of-State students;

(ii) Allocates all refunds in accordance with the order required

under Sec. 668.22; and

(iii) Provides a reliable mechanism for the State to replenish the

fund should any claims arise that deplete the fund's assets.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.173 Financial ratios.

(a) Composite score. As detailed in Appendix F, the Secretary

determines an institution's composite score by--

(1) Calculating the Viability, Primary Reserve, and Net Income

ratios, as described in paragraph (b) of this section;

(2) Assigning a strength factor to each ratio that corresponds to

the value of each of those ratios;

(3) Multiplying the assigned strength factor by the appropriate

weighting percentage for each ratio; and

(4) Summing the resulting products of all three ratios.

(b) Ratios. (1) Public institutions. (i) As detailed in Appendix,

F, the ratios for public institutions using the 1973 AICPA Audit Guide

for Colleges and Universities are calculated as follows:

Viability ratio=Expendable Fund BalancesPlant Debt

Primary Reserve ratio=Expendable Fund BalancesTotal

Expenditures and Mandatory Transfers

Net Income ratio=Net Total RevenuesTotal Revenues

(ii) As detailed in Appendix F, the ratios for public institutions

using a governmental accounting model are calculated as follows:

Viability Ratio=Governmental and Proprietary Fund EquityGeneral

Long-Term Debt

Primary Reserve Ratio=Governmental and Proprietary Fund

EquityTotal Governmental Expenditures and Other Financing Uses

(excluding transfers) and Total Proprietary Expenses

Net Income Ratio=Proprietary Income Before Operating

Transfers,+Governmental Revenues and Other Financing Sources (excluding

transfers)-Governmental Expenditures and Other Financing Uses

(excluding transfers)Total Governmental and Proprietary

Revenues and Other Financing Sources (excluding transfers)

(2) Private non-profit institutions. As detailed in Appendix F, the

ratios for private non-profit institutions are calculated as follows:

Viability ratio=Expendable Net AssetsLong-term Debt

Primary Reserve ratio=Expendable Net AssetsTotal Expenses

Net Income ratio=Change in Unrestricted Net AssetsUnrestricted

Income

(3) Proprietary institutions. As detailed in Appendix F, the ratios

for proprietary institutions are calculated as follows:

Viability ratio=Adjusted EquityTotal Long-term Debt

Primary Reserve ratio=Adjusted EquityTotal Expenses

Net Income ratio=Income Before TaxesTotal Revenues

(4) Independent hospitals. (i) As detailed in Appendix F, the

ratios for non-profit independent hospitals are calculated as follows:

Viability ratio=Expendable Net AssetsLong-term Debt

Primary Reserve ratio=Expendable Net AssetsTotal Expenses

Net Income ratio=Change in Unrestricted Net AssetsUnrestricted

Income

(ii) As detailed in Appendix F, the ratios for for-profit

independent hospitals are calculated as follows:

Viability ratio=Expendable Fund BalancesLong-term Debt

Primary Reserve ratio=Expendable Fund BalancesTotal Expenses

Net Income ratio=Revenue & Gains in Excess of Expenses and Losses (Net

Total Revenue)Total Revenues

(c) Ratio values, strength factors and weighting percentages.

Appendix F contains--

(1) The ratio values and corresponding strength factors and weighting

percentages for each type of institution under paragraph (b) of this

section;

(2) Additional information regarding the calculation of certain ratios;

and

(3) The conditions under which an adjustment may be made to the

strength factors or weighting percentages in determining an

institution's composite score.

(d) Special definition. For purposes of this subpart, an

independent hospital is an institution that--

(1) Is not controlled by, or included in the financial statement

of, another institution; and

(2) Prepares its financial statements under the accounting

standards established in the AICPA's audit guide for Audits of Health

Care Organizations.

(e) Special rules for calculating ratios and determining financial

responsibility. For purposes of calculating the ratios defined in this

section, and for purposes of determining whether an institution

qualifies as financially responsible under an alternative method

contained in this subpart, the Secretary--

(1) Excludes all unsecured or uncollateralized related-party

receivables;

(2) Excludes all intangible assets defined as intangible in

accordance with generally accepted accounting principles; and

(3) May exclude--

(i) Extraordinary gains or losses;

(ii) Income or losses from discontinued operations;

(iii) Prior period adjustment; and

(iv) The cumulative effect of changes in accounting principles.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.174 Alternate standards and requirements.

(a) Alternatives for participating institutions. A currently

participating institution that fails to achieve a composite score of at

least 1.75 may demonstrate to the Secretary that it is nevertheless

financially responsible if--

(1) The institution's liabilities are backed by the full faith and

credit of a State, or by an equivalent government entity;

(2) The institution submits an irrevocable letter of credit, that

is acceptable and payable to the Secretary, for an amount equal to not

less than one-half of the title IV, HEA program funds received by the

institution during its most recently completed fiscal year; or

(3)(i) The owners, board of trustees, or other persons or entities

who under Sec. 668.177(c) exercise substantial control over the

institution--

(A) Submit to the Secretary personal financial guarantees

acceptable to the Secretary; and

(B) Agree to be jointly and severally liable for any liabilities

that may arise from the institution's participation in the title IV,

HEA programs.

[[Page 49567]]

(ii) The Secretary considers an institution to qualify under this

alternative only if--

(A) The institution achieves a composite score of at least 1.25,

based on its current fiscal year audited financial statements;

(B) The institution satisfied all of the general standards under

Sec. 668.172(a) in its previous fiscal year, based on that year's

audited financial statements;

(C) The persons or entities providing financial guarantees submit

to the Secretary their personal financial statements; and

(D) The institution convinces the Secretary that it will not close

precipitously by demonstrating to the Secretary that it has sufficient

resources to meet all of its financial obligations, including its

obligations to students and to the Secretary, based on the

institution's current fiscal year audited financial statements and the

personal financial statements of the persons or entities providing

personal financial guarantees.

(b) Alternatives for new institutions. If an institution seeking to

participate for the first time in the title IV, HEA programs fails to

satisfy any of the general standards, the institution may demonstrate

that it is financially responsible if--

(1) The institution's liabilities are backed by the full faith and

credit of a State, or by an equivalent government entity; or

(2) The institution submits an irrevocable letter of credit

acceptable and payable to the Secretary, for at least one-half of the

amount of title IV, HEA program funds that the Secretary determines the

institution will receive during its initial year of participation.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.175 Special rules for an institution that undergoes a change

in ownership.

(a) General standards for financial responsibility. The Secretary

considers an institution that undergoes a change in ownership that

results in a change of control, as described under 34 CFR 600.31, to be

financially responsible only if the persons or entities that acquired

an ownership interest in the institution, or that exercise substantial

control over the institution, submit a consolidating date of

acquisition balance sheet for the institution with their application

for approval, and--

(1)(i) Submit to the Secretary personal financial guarantees from

the owners, supported by personal financial statements, in an amount

and form acceptable to the Secretary; or

(ii) Submit an irrevocable letter of credit acceptable and payable

to the Secretary, for at least one-half of the amount of title IV, HEA

program funds that the Secretary determines the institution will

receive during the year following its date of acquisition.

(2) Personal financial guarantees or letters of credit submitted

under this section will remain in place until the institution submits

audited financial statements, prepared in the manner prescribed by

Sec. 668.23, showing that the institution attains a composite score of

at least 1.75.

(b) Audit requirements for changes of ownership applications. An

entity that seeks approval of a change in ownership--

(1) Must demonstrate that it has submitted to the Secretary an

audited financial statement fulfilling the requirements of Sec. 668.23

that includes all entities in which it holds an ownership interest, or

over which it exercises substantial control; or

(2) Must submit a current audited financial statement acceptable to

the Secretary that includes all entities in which it holds an ownership

interest or over which it exercises substantial control, if the latest

financial statement it submitted to the Secretary in fulfillment of the

requirements of Sec. 668.23 does not include, as of the date of the

acquisition of the institution for which it seeks an approval of change

of ownership, all entities in which it holds an ownership interest or

over which it exercises substantial control .

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.176 Foreign institutions.

The Secretary makes a determination of financial responsibility for

a foreign institution on the basis of financial statements submitted

under the following requirements--

(a) If the institution received less than $500,000 U.S. in title

IV, HEA program funds during its most recently completed fiscal year,

the institution must submit its audited financial statement for that

year. For purposes of this paragraph, the audited financial statements

may be prepared under the auditing standards and accounting principals

used in the institution's home country; or

(b) If the institution received $500,000 U.S. or more in title IV,

HEA program funds during its most recently completed fiscal year, the

institution must submit its audited financial statement in accordance

with the requirements of Sec. 668.23, and satisfy the general standards

or qualify under an alternate standard under this subpart.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.177 Past performance.

(a) Past performance of an institution or persons affiliated with

an institution. The Secretary does not consider an institution to be

financially responsible if--

(1) A person who exercises substantial control over the institution

or any member or members of the person's family alone or together--

(i)(A) Exercises or exercised substantial control over another

institution or a third-party servicer that owes a liability for a

violation of a title IV, HEA program requirement; or

(B) Owes a liability for a violation of a title IV, HEA program

requirement; and

(ii) That person, family member, institution, or servicer does not

demonstrate that the liability is being repaid in accordance with an

agreement with the Secretary; or

(2) The institution has been limited, suspended, terminated, or

entered into a settlement agreement to resolve a limitation,

suspension, or termination action initiated by the Secretary or a

guaranty agency (as defined in 34 CFR part 682) within the preceding

five years; or

(3) The institution had--

(i) An audit finding, during its two most recent compliance audits

of its conduct of the title IV, HEA programs, that resulted in the

institution's being required to repay an amount greater than five

percent of the funds that the institution received under the title IV,

HEA programs for any fiscal year covered by the audit;

(ii) A program review finding, during its two most recent program

reviews of its conduct of the title IV, HEA programs, that resulted in

the institution's being required to repay an amount greater than five

percent of the funds that the institution received under the title IV,

HEA programs for any year covered by the program review;

(iii) Been cited during the preceding five years for failure to

submit acceptable audit reports required under this part, or individual

title IV, HEA program regulations, in a timely fashion; or

(iv) Failed to resolve satisfactorily any compliance problems

identified in program review or audit reports based upon a final

decision of the Secretary issued pursuant to subpart G or subpart H of

this part.

[[Page 49568]]

(b) Correcting past performance. The Secretary may determine an

institution to be financially responsible even if the institution is

not otherwise financially responsible under paragraph (a) of this

section if--

(1) The institution notifies the Secretary, in accordance with 34

CFR 600.30, that the person referenced in paragraph (a)(1)(i) of this

section exercises substantial control over the institution; and

(2)(i) The person repaid to the Secretary a portion of the

applicable liability, and the portion repaid equals or exceeds the

greater of--

(A) The total percentage of the ownership interest held in the

institution or third-party servicer that owes the liability by that

person or any member or members of that person's family, either alone

or in combination with one another;

(B) The total percentage of the ownership interest held in the

institution or servicer that owes the liability that the person or any

member or members of the person's family, either alone or in

combination with one another, represents or represented under a voting

trust, power of attorney, proxy, or similar agreement; or

(C) Twenty-five percent of the applicable liability, if the person

or any member of the person's family is or was a member of the board of

directors, chief executive officer, or other executive officer of the

institution or servicer that owes the liability, or of an entity

holding at least a 25 percent ownership interest in the institution

that owes the liability, and provided that the person or any member of

the person's family did not hold more than a twenty-five percent

ownership interest in the institution or servicer that owes the

liability.

(ii) The applicable liability described in paragraph (a)(1) of this

section is currently being repaid in accordance with a written

agreement with the Secretary; or

(iii) The institution demonstrates why--

(A) The person who exercises substantial control over the

institution should nevertheless be considered to lack that control; or

(B) The person who exercises substantial control over the

institution and each member of that person's family nevertheless does

not or did not exercise substantial control over the institution or

servicer that owes the liability.

(c) Ownership Interest. (1) An ownership interest is a share of the

legal or beneficial ownership or control of, or a right to share in the

proceeds of the operation of, an institution, institution's parent

corporation, a third party servicer, or a third party servicer's parent

corporation. The term ``ownership interest'' includes, but is not

limited to--

(i) An interest as tenant in common, joint tenant, or tenant by the

entireties;

(ii) A partnership; and

(iii) An interest in a trust.

(2) The term ``ownership interest'' does not include any share of

the ownership or control of, or any right to share in the proceeds of

the operation of a profit-sharing plan, provided that all employees are

covered by the plan.

(3) The Secretary generally considers a person to exercise

substantial control over an institution or third party servicer, if the

person--

(i) Directly or indirectly holds at least 20 percent ownership

interest in the institution or servicer;

(ii) Holds together with other members of his or her family, at

least a 20 percentownership interest in the institution or servicer;

(iii) Represents either alone or together with other persons, under

a voting trust, power of attorney, proxy, or similar agreement one or

more persons who hold, either individually or in combination with the

other persons represented or the person representing them, at least a

20 percent ownership in the institution or servicer; or

(iv) Is a member of the board of directors, the chief executive

officer, or other executive officer of--

(A) The institution or servicer; or

(B) An entity that holds at least a 20 percent ownership interest

in the institution or servicer; and

(4) The Secretary considers a member of a person's family to be a

parent, sibling, spouse, child, spouse's parent or sibling, or

sibling's or child's spouse.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

Sec. 668.178 Additional requirements and administrative actions.

(a) Limitations, Suspensions, and Terminations. The Secretary may

initiate an action under subpart G of this part to limit, suspend, or

terminate an institution's participation in the title IV, HEA programs

if--

(1) The institution does not submit its audited financial

statements by the date permitted and in the manner required under

Sec. 668.23; or

(2) The institution does not demonstrate that it is financially

responsible under this subpart by satisfying the general standards or

qualifying under an alternative standard, unless the Secretary permits

the institution to participate under a provisional certification, as

provided under Sec. 668.13(c).

(b) Participation of institutions that are not deemed financially

responsible. (1) The Secretary may permit an institution that is not

financially responsible under paragraph (a)(2) of this section to

participate under a provisional certification if--

(i) The institution submits to the Secretary an irrevocable letter

of credit, that is acceptable and payable to the Secretary, for an

amount equal not less than 10 percent of the title IV, HEA program

funds received by the institution during its most recently completed

fiscal year; and

(ii) If the institution demonstrates that it met all of its

financial obligations and was current on its debt payments, as required

under Sec. 668.172(a)(2), for its two most recent fiscal years.

(2) The Secretary provides title IV, HEA program funds to an

institution provisionally certified under this paragraph by

reimbursement, as described under subpart K of this part, or under a

funding arrangement other than the advance funding method.

(c) Financial responsibility standards under provisional

certification. The Secretary may permit an institution described under

paragraph (d) of this section to participate or to continue to

participate under a provisional certification, only if the owners,

board of trustees, or other persons or entities who under

Sec. 668.177(c) exercise substantial control over the institution--

(1) Submit to the Secretary their personal financial statements and

personal financial guarantees for an amount acceptable to the

Secretary;

(2) Agree to be jointly and severally liable for any liabilities

that may arise from the institution's participation in the title IV,

HEA programs; and

(3) Convince the Secretary that the institution will not close

precipitously by demonstrating to the Secretary that it has sufficient

resources to meet all of its financial obligations, including its

obligations to students and to the Secretary, based on the

institution's current fiscal year audited financial statements and the

personal financial statements of the persons or entities providing

personal financial guarantees.

(d) Provisional certification for failure to meet financial

responsibility standards. The institution referred to under paragraph

(c) of this section is an institution that--

(1) Is not financially responsible because of an adverse action

taken by the Secretary, a material finding in prior audit or review, or

because the institution failed to resolve satisfactorily

[[Page 49569]]

any compliance problems, as described under Sec. 668.177(a) (2) and

(3); or

(2) Is not currently financially responsible because it failed to

satisfy all the general standards or qualify under an alternate

standard under this subpart, and for this reason was certified

provisionally at any time during the preceding 5 years.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-

452, 92 Stat. 1101-1109)

5. A new Appendix F is added to part 668 to read as follows:

Appendix F--Financial Responsibility

This appendix contains the strength factors and weightings used to

calculate composite ratio scores, the procedure for and an example of

calculating a composite score, and technical definitions.

A. Strength Factors:

(1) Public Institutions

----------------------------------------------------------------------------------------------------------------

Strength factor 1 2 3 4 5

----------------------------------------------------------------------------------------------------------------

Viability Ratio.............................

4.0

Primary Reserve Ratio.......................

.70

Net Income Ratio............................

.05

----------------------------------------------------------------------------------------------------------------

Additional Strength Factor Adjustment: If a public institution has

a negative (less than zero) Primary Reserve Ratio result, the

institution will be deemed as not financially responsible under the

general standards contained in Sec. 668.172(a).

(2) Private Non-Profit Institutions That Have Adopted FASB Statements 116 and 117

----------------------------------------------------------------------------------------------------------------

Strength factor 1 2 3 4 5

----------------------------------------------------------------------------------------------------------------

Viability Ratio.............................

4.75

Primary Reserve Ratio.......................

1.5

Net Income Ratio............................

.08

----------------------------------------------------------------------------------------------------------------

Additional Strength Factor Adjustment: If a private non-profit

institution has a negative (less than zero) Primary Reserve Ratio

result, the institution will be deemed as not financially responsible

under the general standards contained in Sec. 668.172(a).

(3) Private Non-Profit Institutions That Have Not Adopted FASB Statements 116 and 117

----------------------------------------------------------------------------------------------------------------

Strength factor 1 2 3 4 5

----------------------------------------------------------------------------------------------------------------

Viability Ratio.............................

4.0

Primary Reserve Ratio.......................

1.00

Net Income Ratio............................

.05

----------------------------------------------------------------------------------------------------------------

Additional Strength Factor Adjustment: If a private non-profit

institution has a negative (less than zero) Primary Reserve Ratio

result, the institution will be deemed as not financially responsible

under the general standards contained in Sec. 668.172(a)

(4) Proprietary Institutions

----------------------------------------------------------------------------------------------------------------

Strength factor 1 2 3 4 5

----------------------------------------------------------------------------------------------------------------

Viability Ratio.............................

4.0

Primary Reserve Ratio.......................

.70

Net Income Ratio............................

.12

----------------------------------------------------------------------------------------------------------------

Additional Strength Factor Adjustment: If a proprietary institution

earns a strength factor of two (2) or one (1) for its Primary Reserve

Ratio, the strength factor for the Viability Ratio will be no greater

than the strength factor for its Primary Reserve Ratio. The purpose of

this adjustment is to prevent insignificant amounts of debt from

significantly affecting the categorization of an institution.

(5) Independent Hospitals

----------------------------------------------------------------------------------------------------------------

Strength factor 1 2 3 4 5

----------------------------------------------------------------------------------------------------------------

Viability Ratio.......................

4.0

Primary...............................

1.00

Net Income............................

.05

----------------------------------------------------------------------------------------------------------------

[[Page 49570]]

B. Weighting Factors:

----------------------------------------------------------------------------------------------------------------

Private non- Public non-

Institutions profits profits Proprietaries Hospitals

(percent) (percent) (percent) (percent)

----------------------------------------------------------------------------------------------------------------

Viability Ratio........................................... 35 35 30 40

Primary Reserve Ratio..................................... 55 55 20 20

Net Income Ratio.......................................... 10 10 50 40

Totals.............................................. 100 100 100 100

----------------------------------------------------------------------------------------------------------------

Additional Adjustments

Private and Public Non-Profits--If the institution has no debt,

only the Primary Reserve and Net Income ratios are used, weighted 90%

and 10% respectively.

Proprietaries--If the institution has no debt, only the Primary

Reserve and Net Income ratios are used, weighted 50% each.

Hospitals: If the institution has no debt, only the Primary Reserve

and Net Income ratios are used, weighted 60% and 40% respectively.

C. Computing the Composite Score.

Procedure

1. Calculate the Viability, Primary Reserve, and Net Income ratios.

2. Assign the appropriate strength factor to each ratio.

3. Multiply the assigned strength factors by the appropriate

weighting percentage for each ratio.

4. Sum the resulting products of all three ratios to derive the

composite score.

Example:

1. A public institution has the following ratio results:

Viability Ratio: Expendable Fund Balances Plant Debt = 0.60

Primary Reserve Ratio: Expendable Fund Balances Total

Expenditures & Mandatory Transfers = 0.40

Net Income Ratio: Net Total RevenuesTotal Revenues = -0.008

2. These results are assigned a strength factor in accordance with

the appropriate chart in part A of this appendix. Thus, for the public

institution in this example:

A Viability Ratio of 0.60 corresponds to a strength factor of 2.

A Primary Reserve Ratio of 0.40 corresponds to a strength factor of

3.

A Net Income Ratio of -0.008 corresponds to a strength factor of 1.

3. The strength factors are then weighted in accordance with the

chart in part B of this appendix. For the public institution in this

example:

The Viability Ratio strength factor of 2 is weighted at 35%:

2 x .35=0.70

The Primary Reserve Ratio strength factor of 3 is weighted at 55%:

3 x .55=1.65

The Net Income Ratio strength factor is weighted at 10%: 1 x .10=0.10

4. The weighted results are then summed:

Weighted Viability Ratio....................................... .70

Weighted Primary Reserve Ratio................................. 1.65

Weighted Net Income Ratio...................................... +.10

--------

Composite Score.......................................... 2.45

D. Technical Definitions.

For Private Non-Profit Institutions

Expendable Net Assets are calculated as follows:

Unrestricted Net Assets.

Plus Temporarily Restricted Net Assets.

Minus Property, plant and equipment.

Minus Plant debt (including all notes,

bonds, and leases payable to

finance those fixed assets).

------------------------------------------------------------------------

Equals Expendable Net Assets.

For Proprietary Institutions

Adjusted Equity is computed as follows:

Total Owner(s) or Shareholders

Equity.

Minus Intangible Assets.

Minus Unsecured Related Party Receivables.

Minus Property, Plant and Equipment (Net

of Accumulated Depreciation).

Plus Total Long-Term Debt.

------------------------------------------------------------------------

Equals Adjusted Equity.

If Total Long-Term Debt exceeds the value of Net Property, Plant

and Equipment, then the asset is not subtracted from equity nor is the

liability added back to equity

Total Long-Term Debt is comprised of all debt obtained for long-

term purposes. The short-term portion of any long-term debt is

included.

For Independent Hospitals

Expendable Net Assets are the general, specific purpose and quasi-

endowment fund balances, less plant equity. True endowments are

specifically excluded from the numerator.

Long-term Debt is notes payable, bonds payable, leases payable, and

other long-term debt. Total Expenses are retrieved from the Statement

of Revenue and Expenses of General Funds and is comprised of all

expenses.

Appendix to the NPRM

Note: This appendix wll not appear in the Code of Federal

Regulations.

Summary of the KPMG Report Commissioned by the Department

As part of its overall effort to improve its measures of

financial responsibility, and as part of the Department's overall

commitment to improve the quality, efficiency, and effectiveness of

its oversight responsibility, the Department, in the Fall of 1995,

commissioned the accounting firm of KPMG Peat Marwick, LLP to

examine the current regulatory measures, and recommend improvements

to those measures. KPMG was to assist the Department in developing

an improved methodology, using financial ratios, that could be used

as a screening device to identify financially troubled institutions

and as a mechanism for efficiently exercising its financial

oversight responsibility. For such a methodology to be effective, it

would have to measure an institution's total financial condition,

accommodate different organizational structures and missions of

participating institutions, and reflect the different accounting and

reporting requirements to which participating institutions are

subject. The overall goal of the study was the development of

processes, measures and standards the Department could use to better

assess risk to federal funds through the analysis of financial

statements and other documentation.

This study included the following elements:

Analyses of existing financial reports using current

standards, and using an alternative, expanded ratio analysis;

The development of a new methodology that includes the

use of an expanded set of specific ratios;

The submission of that methodology to a task force and

other outside reviewers for comment regarding the applicability of

the ratios as measures, the definitions of the ratios, the treatment

of particular accounting statements, the weighting of ratios in the

construction of a composite score, and a ranking of composite scores

that yields a category denoting institutions that would be

considered, in the professional judgment of accountants, to be

financial risks. More than a dozen reviewers participated, and

included representatives from accounting firms, professional

accounting associations, financial experts from the business

community, officers of professional

[[Page 49571]]

education associations, and institutional financial officers and

auditors.

The subsequent refinement and retesting of the

recommended methodology and standards, and the resubmission of that

methodology and set of standards to the reviewers.

Problems of Reporting and Accounting Standards for Different Business

Segments

One of the problems to be dealt with in the study was that of

different reporting standards for different business segments. The

financial responsibility regulations cover four segments in its

regulation of participating institutions: public institutions,

private non-profit institutions, proprietary institutions, and

independent hospitals. The following summarizes differences in

reporting standards.

Public institutions generally prepare financial statements in

accordance with Statement No. 15 of the Governmental Accounting

Standards Board.

Private non-profit institutions historically have prepared their

financial statements consistent with the 1973 AICPA Audit Guide for

Colleges and Universities. Those financial statements were similar,

in most respects, to those prepared by public institutions. However,

in 1993 the Financial Accounting Standards Board (FASB) issued two

statements, Statement of Financial Accounting Standards (SFAS) No.

116, Accounting for Contributions Received and Contributions Made,

and SFAS No. 117, Financial Statements of Non-for-Profit

Organizations, that significantly redefined financial accounting and

reporting for private non-profit institutions. As a result, these

institutions are currently in a state of transition in complying

with these new standards. Most private non-profit institutions are

required to adopt these new standards during their 1996 fiscal year.

Proprietary institutions prepare their financial statements in

accordance with accounting standards promulgated by FASB and the

AICPA.

Independent hospitals prepare their financial statements by

following guidelines set forth by the AICPA Audit Guide, Providers

of Health Care Services. Similar to private non-profit institutions,

many hospitals will also be subject to FASB Statements 116 and 117,

but the financial statements of these institutions will not be as

dramatically affected.

Also problematic are differences in GAAP among different

business segments. Institutions of higher education have followed

different accounting models for many years. For-profit institutions

prepare their financial statements with GAAP applicable to

commercial entities promulgated by FASB. Non-profit entities and

public entities have generally used fund accounting models

promulgated by industry groups and the AICPA. There have been

obvious differences over the years, such as non-profits and publics

not recording depreciation, nor being required to present a cash

flow statement like their for-profit counterparts. To date, the

financial statements of both public and private non-profit

institutions have remained similar in most respects. However, recent

actions by the FASB and GASB (primarily the issuance of FASB

Statements 116 and 117) have substantially increased the differences

in accounting and financial reporting between public and private

non-profit institutions.

Some of the resulting differences in these various reporting and

accounting standards are as follows. Under FASB Statements 116 and

117, three basic financial statements--a statement of financial

position, a statement of activities, and a cash flow statement--are

required for private non-profit institutions. These statements are

prepared on an accrual basis and measure economic resources and

changes therein. Prepared as they are on a highly aggregated basis,

these statements include certain required minimum information.

Generally, matters of format are left to the discretion of the

institution. Public institutions, on the other hand, will for the

foreseeable future prepare the statements called for by the 1973

AICPA Guide--a statement of financial position, a statement of

changes in fund balances, and a statement of current funds revenue,

expenditures, and other changes. (A limited number of institutions

may also report financial results using the government reporting

model--an option allowed under GASB Statement 15). These statements

under the 1973 AICPA Guide are prepared on a highly desegregated

basis and follow the traditional managed funds structure. As such,

they include changes in fund balances arising from expenditures and

disposals of fixed assets rather than any capital usage charge such

as historical cost depreciation. The format of each statement must

generally conform to the example financial statements in the AICPA

Guide, which are considered by GASB Statement 15 to be prescriptive

rather than illustrative.

Thus, with each statement issued under FASB and GASB standards,

there are differences between the accounting and reporting

requirements for institutions that affect the information the

Department uses to assess financial responsibility. The most

significant differences have arisen in the following areas: (1)

Consolidation/reporting entity; (2) Recording of contributions; (3)

Accounting for pension and postretirement benefits, and (4)

Recording of depreciation. KPMG took these different reporting

standards into account when recommending a methodology.

Problems of Exclusive Tests

Another problem KPMG was to examine was that of exclusive tests.

The current regulations measure and establish minimum acceptable

standards for liquidity, net worth, and profitability. Each is

measured separately and the results are considered independently.

For example, the liquidity standard for a for-profit institution is

an acid test with a minimum acceptable result of 1:1. If the acid

test (or any of the other ratio tests) is not met, the institution

may not be considered financially responsible. In such situations,

the institution would be required to demonstrate financial

responsibility by another method even if it had exhibited strengths

in other tests.

This problem is further complicated by the accounting and

reporting differences across the business sectors, as described

above. The current ratio tests and basic thresholds for non-profit

and for-profit institutions are common, leading to gaps in necessary

information where certain information necessary to evaluate an item

is not required under that entity's general reporting format. One

example is the use of the same acid test requirement of 1:1 for non-

profit and for profit institutions. GAAP does not require non-profit

institutions to prepare financial statements that classify assets

and liabilities as current and noncurrent. Therefore, calculation of

the acid test cannot be accurately performed without additional

information. Moreover, differing cash management and investment

strategies (investing excess cash in other than short-term

instruments) may result in an institution failing the acid test

requirement, when sufficient expendable resources are available in

unrestricted investments to support operations for more than one

year without any additional revenue.

Proposed Solution

KPMG proposed a ratio methodology that, similar to the current

regulations, takes into account liquidity, profitability, and

viability, but attempts to improve on the current regulations in

three ways. First, it would consider all ratio results together,

instead of as independent tests. The calculation of a composite

score that blends the results of the individual tests would allow

the Department to form a conclusion about the institution's total

financial condition, instead of three separate conclusions

concerning liquidity, profitability, and net worth. Second, the

proposed methodology would establish a range of results for each

ratio in contrast to the one minimum standard embodied in the

current regulations. This range would assist the Department in

allocating resources toward financially risky institutions. Finally,

the proposed methodology takes into consideration the accounting and

reporting differences of the different business segments by

establishing different ratio definitions and strength factors for

the same element of financial health (e.g., viability) for each

business segment.

Methodology

KPMG introduced its first edition of Ratio Analysis in Higher

Education in the 1970's to use as a tool to better understand and

interpret an institution's financial situation. Today many

industries, rating agencies and investors, and accrediting bodies

use key ratios from GAAP financial statements to compare similar

institutions' basic financial performance. In particular, KPMG and

others developed this analysis to help them answer three fundamental

questions with regard to the financial condition of institutions of

postsecondary education:

Is the reporting institution clearly financially

healthy or not as of the reporting date?

Is the reporting institution financially better off or

not at the end than it was at the beginning of the year reported on?

Did the reporting institution live within its means

during the year being reported on?

While these questions were originally posed as a way of better

informing such

[[Page 49572]]

responsible parties as institutional administrators and trustees of

the financial condition of the institution, they also serve the same

purpose for the Department in its statutory responsibility to assess

the financial health of a participating institution. Like

administrators and trustees, the Department has a vital interest in

assessing whether or not an institution can survive financially into

the near future.

Ratio analysis provides answers to these questions by comparing

sets of relevant numbers from the institution's financial report.

Conceptually, this comparison describes the status, sources, and

uses of an institution's financial resources in relation to its

liabilities in such a way as to quantify the institution's relative

ability to repay current and future debt and other obligations.

Ratio analysis assumes that this comparison is necessary based on

the fact that when considered in isolation, or as compared with

absolute dollar standards, the dollar amounts representing assets

and liabilities included in financial statements are not always

meaningful measures of financial health. For example, the burden of

debt and liabilities for an institution of any one size and

operation and having access to a particular amount of resources will

be different from another institution of a different size and

operation and with access to a different amount of resources. Thus

to provide an accurate measure of financial health, dollar amounts

taken from an institution's financial statement should be analyzed

in context of the institution's size, operations, and resources.

In turn, using ratios in tandem with one another depicts the

institution in its financial totality. When the results of the

application of a series of ratios are assigned to strength factors,

weighted in accordance to sector, and then summed, the composite

score that results provides an overall measure of financial

responsibility. It is this overall measure, in the form of a

composite score, that allows an investigator using professional

judgement to determine the risk associated with the financial

structure of the institution, and to develop a relative scale to

compare institutions, and thus judge the magnitude of the risk, by

comparing the institution's current position with similarly placed,

comparable institutions. This approach avoids the possibility that

failure to pass one test in isolation will automatically result in

the conclusion that an institution is not financially responsible.

KPMG initially proposed the application of nine ratios to a

random sample of the Department's financial reports as the empirical

vehicle upon which to test the usefulness of ratio analysis as a

gatekeeping tool, and to check the results of the application for

reasonableness. Comments from reviewers at this point led KPMG to

modify this research agenda. While all respondents believed that the

overall approach was generally acceptable, some commenters

recommended that KPMG revise its sampling approach to include a

selection of financial reports from institutions that have failed

financially, or are known to be in perilous financial health, in

order to check that the measures not only accurately mark financial

health, but also financial distress. It was believed that using as a

test a random sample of only those institutions that are still

continuing to participate in title IV, HEA programs without the

check provided by the assured presence of distressed or closed

schools in the sample, would lead to indicators that could not

provide sufficient information for analysts to identify the point at

which the risk of closure is so great that the Department would

determine that the institution was not financially responsible. KPMG

responded by constructing a judgmental sample that included

institutions selected by reference to sector and financial history.

A summary of this sample is as follows. KPMG selected a purely

random sample of public institutions. For private non-profit

institutions, KPMG selected a group of institutions that included

large research institutions, large and small liberal arts schools,

institutions with going concern statements on their most recently

audited financial statements, and some other randomly selected

institutions. KPMG also randomly selected a group of private non-

profit institutions that have adopted FASB statements 116 and 117.

For proprietary institutions, KPMG selected institutions that passed

and institutions that failed the standards set forth by the

Accrediting Commission of Career Schools and Colleges of Technology.

KPMG also selected proprietary institutions that were on the

Department's list of institutions subject to surety requirements.

KPMG then randomly selected some additional proprietary

institutions. For the hospital sector, KPMG randomly selected a

group of institutions.

Accordingly, KPMG applied nine ratios--Viability, Primary

Reserve, Net Income, Liquidity, Leverage, Debt Burden, Debt

Coverage, Secondary Reserve, and Plant Equity--to the financial

reports of the institutions in this sample.

Results: Ratios

The first result was a confirmation of some of the reviewers'

initial comments. Some respondents had expressed the belief that,

for practical purposes, a total of nine ratios was excessive for an

initial analysis. The process of applying the ratios to the

financial reports confirmed that use of all nine ratios provided

additional detail as to the source of financial problems, but added

little value for purposes of differentiating clearly financially

healthy institutions from the group of institutions whose financial

health is uncertain. In light of the reviewers' comments and these

results, KPMG reexamined the range and scope of ratios needed as an

initial test of financial health, and determined that three--

Viability, Primary Reserve, and Net Income would be sufficient to

identify institutions that are of immediate financial concern.

KPMG conceptualizes these ratios as follows:

Viability Ratio: the ability of the institution to

liquidate debt from its expendable resources. If the ratio is

greater than 1 to 1, existing debt could be repaid from expendable

resources available today.

In the short term, substantial amounts of expendable capital, as

measured by the Viability Ratio (and Primary Reserve Ratio, as

discussed below) can counter the effects of poor profitability,

liquidity, or an inability to borrow. Likewise, insufficient

expendable capital is a clear warning sign of poor financial health.

While a ratio of 1:1 or greater indicates that an institution is

clearly healthy, no absolute strength factor is likely to indicate

whether an institution is no longer financially viable. Most debt

relating to plant assets is long term and does not have to be paid

off at once. Yet it is clear that the lower the institution's

viability ratio is below 1:1, the more likely that an institution

must live with no margin for error and meet severe cash flow needs

by obtaining short-term loans. Ultimately, such a financial

condition will impair the ability of an institution to fulfill its

mission and meet its service obligations to students. An institution

that is continually experiencing a perilous financial situation will

usually find itself driven primarily by financial rather than

programmatic decisions.

Primary Reserve Ratio: measures the ability to support

current operations from expendable resources.

This ratio provides a snapshot of financial strength and

flexibility by comparing expendable resources to total expenditures

or expenses, or operating size. This snapshot indicates how long the

institution could operate using its expendable reserves without

relying on additional net assets generated by operations. A ratio of

1:1 or greater would indicate that an institution could operate for

one year without any additional revenue being generated. A ratio of

.5 to 1 (reserves necessary to operate for 6 months) would probably

give an institution the flexibility needed to transform itself by

means of a capital expansion, or a change in mission. A negative or

decreasing trend over time indicates a weakening financial

condition.

Net Income Ratio: measures the ability of an

institution to live within its means in a given operating cycle.

A positive Net Income Ratio indicates a surplus or profit for

the year. Generally speaking, the larger the surplus or profit, the

stronger the institution's financial position as a result of the

year's operations. A negative ratio indicates a deficit or loss for

the year. Small deficits may not be significant if the institution

has large expendable capital. However, continued or large deficits

or losses are usually a warning sign that major program or

operational adjustments should be made. Because of its direct effect

on viability, this ratio is one of the primary indicators of the

underlying causes of a change in an institution's financial

condition.

Strength Factors

In assigning the strength factors (called ``threshold factors''

in the KPMG report) for each applicable ratio, KPMG posed the

question: What is the minimum result for each ratio that would

indicate acceptable financial health? The answer to that question

established the lower end of the neutral or mid range for which a

strength factor of three (3) would be assigned. For example, KPMG's

experience with for private colleges and universities indicates that

a Primary Reserve Ratio of less than .30 indicates a less than

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healthy financial position. This conclusion is consistent with

standard bond rating practices. Hence in order to receive a strength

factor of (3) in its Primary Reserve Ratio, the result for a private

college or university must be at least .30.

To establish the upper strength factor of five (5), the risk

associated with the Department's overall objective of separating

financially responsible institutions from those that appear

financially unhealthy had to be considered. Assigning the highest

strength factor to a ratio correlates to a very good financial

condition. The process of assessing that institution for financial

responsibility may be shortened. If the financial condition of such

an institution were to be subsequently affected, the Department and

students could suffer unanticipated financial losses. Accordingly,

the range for such a rating should be high enough to minimize that

risk. The nature of each ratio and what it represents also had to be

considered. A Primary Reserve Ratio result of 1.00 or more indicates

that the institution can continue to operate at its present level

for at least one year without any additional revenue. If analysis

were limited to the Primary Reserve Ratio, one would have to

conclude that such an institution is in a strong financial position.

The minimum strength factors were established to clearly reflect

financial problems. For example, a negative Net Income Ratio result

for an institution demonstrates that during its fiscal year, the

institution spent more than it received. Such activity will

eventually create a financial problem. Accordingly, a negative Net

Income ratio would be assigned a strength factor of one (1).

The recommended strength factors described in the proposed

Appendix F have been customized for each sector. A discussion of the

strength fac

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