Student Assistance General Provisions
Federal RegisterNov 25, 1997
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SUMMARY: The Secretary amends the Student Assistance General Provisions
regulations (34 CFR part 668) to revise Subparts B and K and add a new
Subpart L. These final regulations improve the Secretary's oversight of
institutions participating in programs authorized by title IV of the
Higher Education Act of 1965, as amended (title IV, HEA programs), by
revising the standards of financial responsibility to provide a more
accurate and comprehensive measure of an institution's financial
condition. The regulations reflect the Secretary's commitment to
ensuring institutional accountability and protecting the Federal
interest while imposing the least possible burden on participating
institutions.
DATES: Effective dates: These regulations take effect on July 1, 1998.
Applicability and Compliance Dates: The Secretary will apply the
standards of financial responsibility established in these regulations
to institutions that submit audited financial statements to the
Department on or after July 1, 1998. However, affected parties do not
have to comply with the information collection requirements in
Secs. 668.171(c), 668.172(c)(5), 668.174(b)(2)(i), 668.175(d)(2)(ii),
668.175(f)(2)(iii), and 668.175(g)(2)(i) until the Department publishes
in the Federal Register the control number assigned by the Office of
Management and Budget (OMB) to these information collection
requirements.
FOR FURTHER INFORMATION CONTACT: For general information contact Mr.
John Kolotos or Mr. Lloyd Horwich, U.S. Department of Education, 600
Independence Avenue, S.W., Room 3045, ROB-3, Washington, D.C. 20202,
telephone (202) 708-8242. For information regarding accounting and
compliance issues, an institution should contact the Department's
Institutional Participation and Oversight Service (IPOS) Case
Management Team for the state in which it is located:
IPOS Case Management Team Contacts
Boston Team, (617) 223-9338 (covering Connecticut, Maine,
Massachusetts, New Hampshire, Rhode Island and Vermont)
New York City Team, (212) 264-4022 (covering New Jersey, New York,
Puerto Rico and the Virgin Islands)
Philadelphia Team, (215) 596-0247 (covering Delaware, District of
Columbia, Maryland, Pennsylvania, Virginia and West Virginia)
Atlanta Team, (404) 562-6315 (covering Alabama, Florida, Georgia,
Mississippi, North Carolina and South Carolina)
Chicago Team, (312) 886-8767 (covering Illinois, Indiana, Michigan,
Minnesota, Ohio and Wisconsin)
Dallas Team, (214) 880-3044 (covering Arkansas, Louisiana, New Mexico,
Oklahoma and Texas)
Kansas City Team (816) 880-4053 (covering Iowa, Kansas, Kentucky,
Missouri, Nebraska and Tennessee)
Denver Team, (303) 844-3677 (covering Colorado, Montana, North Dakota,
South Dakota, Utah and Wyoming)
San Francisco Team, (415) 437-8276 (covering Arizona, California,
Hawaii, Nevada, American Samoa, Guam, Federated States of Micronesia,
Palau, Marshall Islands and Northern Marianas)
Seattle Team, (206) 287-1770 (covering Alaska, Idaho, Oregon and
Washington).
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.
Individuals with disabilities may obtain a copy of this document in
an alternate format (e.g. Braille, large print, audiotape, or computer
diskette) by contacting Mr. John Kolotos or Mr. Lloyd Horwich.
SUPPLEMENTARY INFORMATION:
The following is an ordered list of the key topics covered in this
preamble:
Overview of the Standards and Provisions of Financial
Responsibility.
Community Involvement in the Regulatory Process.
The Secretary's Responsibility for Assessing the Financial
Condition of Participating Institutions.
Need for Revising the Rules.
The Final Rule.
Provisions for Public Institutions.
The Ratio Methodology for Private Non-Profit and
Proprietary Institutions.
Overview of the Methodology.
Issues Raised in the Notice of Proposed Rulemaking and
other Department Publications.
Substantive Changes to the NPRM.
Analysis of Comments and Changes.
On September 20, 1996, the Secretary published in the Federal
Register a Notice of Proposed Rulemaking (NPRM) addressing a variety of
topics, including a ratio methodology that would be used in part to
determine whether an institution is financially responsible (61 FR
49552-49574). The NPRM also included financial responsibility standards
for third-party servicers that enter into a contract with a lender or
guaranty agency, and provisions for submitting financial statement and
compliance audits, adding additional locations, and changes of
ownership that result in a change of control (61 FR 49552-49574). On
November 29, 1996, the Secretary published final regulations governing
submissions of financial statement and compliance audits and other
aspects of financial responsibility, but delayed establishing final
standards regarding the ratio methodology and other proposed provisions
(including changes of ownership and additional locations), pending
further comment, study, and review (61 FR 60565-60577).
The Secretary provided an extensive opportunity for public
involvement and comment on these final regulations. On December 18,
1996, the Secretary reopened the comment period until February 18, 1997
for the delayed standards and provisions (61 FR 66854). On February 18,
1997, the Secretary extended that comment period until March 24, 1997
(62 FR 7333-7334). On March 20, 1997, the Secretary again extended the
comment period until April 14, 1997 (62 FR 13520).
These regulations establish under a new Subpart L the provisions
and standards of financial responsibility that an institution must
satisfy to begin or continue to participate in the title IV, HEA
programs. Furthermore, these regulations amend certain sections of
Subparts B and K to harmonize the requirements under those sections
with the provisions and standards under Subpart L. As discussed more
fully under Parts 4 and 15 of the Analysis of Comments and Changes,
these regulations do not establish new standards of financial
responsibility for lender or guaranty agency third-party servicers, or
new provisions regarding additional locations and changes of ownership.
Overview of the Standards and Provisions of Financial
Responsibility
As provided under section 498 of the HEA, the Secretary determines
whether an institution is financially responsible based on the extent
to which an institution satisfies three statutory components, which are
illustrated below.
[[Page 62831]]
Statutory Components of Financial Responsibility
------------------------------------------------------------------------
Financial obligations Administration of Financial condition
(provisions for debt the title IV, HEA (ratio standards)
payments, refunds, and programs (past ---------------------
repayments) performance and
----------------------------- program compliance
provisions)
---------------------- HEA sections
HEA sections 498(c)(1)(C) HEA sections 498(c)(1)(A)
498(c)(1)(B) and
498(d)
------------------------------------------------------------------------
The extent to which an The extent to which The extent to which
institution: an institution or an institution has
(1) Satisfies its the persons or the resources
obligations to students entities that necessary to:
and to the Secretary, exercise (1) Provide and to
including making refunds substantial control continue to
to students in a timely over the provide the
manner and repaying institution education and
program liabilities to administer properly services
the Secretary; and the title IV, HEA described in its
(2) Is current in its debt programs. official
payments. publications; and
(2) Continue to
satisfy its
financial
obligations.
------------------------------------------------------------------------
The current standards and provisions under 34 CFR 668.15 relating
to an institution's financial obligations and administration of title
IV, HEA programs are detailed in the above chart and carried forward in
these regulations, under Secs. 668.171 and 668.174, respectively. These
regulations focus on establishing a ratio methodology that provides a
comprehensive measure of the financial condition of proprietary and
private non-profit institutions.
The current regulations employ three independent tests for
assessing the financial condition of an institution, and require an
institution to satisfy the minimum standard established for each of
those separate tests to be considered financially responsible.
In contrast, these regulations employ a ratio methodology under
which an institution need only satisfy a single standard--the composite
score standard. Unlike the current tests that treat different measures
of an institution's financial condition without reference to each
other, the ratio methodology takes into account an institution's total
financial resources and provides a combined score of the measures of
those resources along a common scale (from negative 1.0 to positive
3.0). This new approach is more informative and allows a relative
strength in one measure to mitigate a relative weakness in another
measure.
Under these regulations, the Secretary considers a proprietary or
private non-profit institution to be financially responsible based on
its composite score. If an institution achieves a composite score of at
least 1.5, it is financially responsible without further oversight. An
institution with a composite score in the zone from 1.0 to 1.4 is
financially responsible, subject to additional monitoring, and may
continue to participate as a financially responsible institution for up
to three years.
An institution that does not satisfy either the composite score or
zone standards, or that fails to meet its financial obligations or
satisfy other standards of financial responsibility, may be allowed to
participate in the title IV, HEA programs by qualifying under the
provisions of an alternative standard. The alternative standards are
described under Sec. 668.175 of these regulations and illustrated in
the following table.
Alternative Standards
------------------------------------------------------------------------
Alternative Used when: Provisions
------------------------------------------------------------------------
Letter of credit \1\ for a An institution that The institution may
new institution. seeks to begin to
participate in the participate by
title IV, HEA submitting a letter
programs for the of credit for at
first time does not least 50 percent of
satisfy the the title IV, HEA
composite score program funds that
standard but the Secretary
satisfies all other determines the
applicable institution will
standards and receive during its
provisions. initial year of
participation, as
provided under Sec.
668.175(b).
Letter of credit for a A participating The institution may
participating institution. institution does continue to
not satisfy one or participate as a
more of the financially
standards of responsible
financial institution by
responsibility submitting a letter
(including the of credit for at
composite score least 50 percent of
standard) or the the title IV, HEA
institution's program funds the
auditor expresses institution
an adverse, received during its
qualified, or last completed
disclaimed opinion, fiscal year, as
or the auditor provided under Sec.
expresses doubt 668.175(c).
about the continued
existence of the
institution as a
going concern.
Provisional certification... A participating The institution may
institution:. participate under a
(1) Does not provisional
satisfy the certification by
composite score submitting a letter
standard or any of credit for at
provision least 10 percent of
regarding its the title IV, HEA
financial program funds the
obligations; or institution
(2) Has or had a received during its
program last completed
compliance fiscal year and
problem as meeting other
provided under provisions
Sec. 668.174 but described under
satisfied or Sec. 668.175(f).
resolved that
problem.
Provisional certification The persons or The institution may
for an institution where entities that continue to
persons or entities owe exercise participate under a
liabilities. substantial control provisional
over the certification if it
institution owe a satisfies the
liability for a provisions
violation of a described under
title IV, HEA Sec. 668.175(g).
program requirement.
------------------------------------------------------------------------
\1\ A letter of credit is a financial instrument, typically issued by a
commercial bank, whereby the bank guarantees payment to the Secretary
for an amount up to the amount of the letter of credit.
[[Page 62832]]
A public institution demonstrates that it is financially
responsible under these regulations by providing a letter from an
official of the State or other government entity confirming the
institution's status as a public institution.
Although the Secretary proposed to treat independent hospital
institutions slightly differently under the ratio methodology, the
Secretary now believes that any differences between these institutions
and institutions in the other sectors relate primarily to control.
Under these regulations, therefore, an independent hospital institution
must satisfy the provisions of the ratio methodology established for a
proprietary institution if it is a for-profit entity, or the provisions
established for a private non-profit institution if it is a non-profit
entity. If an independent hospital institution is a public entity, it
must satisfy the requirements established for public institutions.
Community Involvement in the Regulatory Process
The Secretary sought to maximize the postsecondary education
community's participation in this regulatory initiative. In developing
the initial study on which the NPRM was based, the Department's
contractor, KPMG Peat Marwick LLP (KPMG), consulted with a task force
representing various sectors of the community. To ensure that the
community was given sufficient time to analyze and comment on the
proposed rules, the Secretary reopened the original comment period and
then extended that comment period twice, so that the total comment
period was 207 days. In response, the Secretary received approximately
850 comments during the original and extended comment periods.
Between December 18, 1996 and the publication of these final
regulations, the Department took the following actions to supplement
the original empirical work on which the NPRM was based, and to solicit
questions, suggestions, and other comments regarding the proposed ratio
methodology:
The Department again engaged KPMG to assist the Department
in reexamining the proposed ratio methodology, considering public
comments and suggestions to change and improve the methodology, and
conducting additional empirical studies of financial statements and
other sources of information. Much of this additional work was based on
suggestions made by the community.
The Department held meetings with more than 20
representatives of higher education associations and institutions on
February 5, 1997 and March 11, 1997, with nine representatives of
proprietary institutions on February 27, 1997, and with four
representatives of higher education associations and public
institutions on April 4, 1997. The Department also conducted a number
of other meetings with parties representing individual institutions or
groups of institutions.
For purposes of public consideration and comment, the
Department published on the Office of Postsecondary Education's World-
Wide Web site, minutes of the meetings with representatives of
postsecondary education associations, information regarding possible
changes to the proposed ratio methodology, and the results of some of
the empirical studies. The Department also made available, for viewing
on-line, the KPMG report on which the Department based the proposed
ratio methodology.
Many commenters expressed their appreciation to the Secretary for
the open, collaborative, and cooperative nature of this rulemaking
process and for the extensive opportunities for public and community
involvement. The Secretary in turn appreciates the commenters'
thoughtful and constructive contributions to this process.
The Secretary's Responsibility for Assessing the Financial Condition of
Participating Institutions
The statute and the legislative record show that Congress expects
the Secretary to determine whether institutions participating in the
title IV, HEA programs are financially sound and administratively
capable of providing the education they advertise (Higher Education
Amendments of 1992, Report of the Committee on Education and Labor,
House of Representatives, One Hundred Second Congress, Second Session,
p. 74). Congress authorized the Secretary (at that time, the
Commissioner) to establish financial responsibility standards with the
passage of the Education Amendments of 1976 (Pub. L. 94-482), and
reinforced that authority in subsequent amendments to the HEA. In those
amendments, but particularly in the legislative history leading to the
1992 Amendments, Congress made clear that the Secretary should
scrutinize closely the financial condition of institutions with regard
to their capacity to fulfill their educational and administrative
responsibilities, and thus expected the Department to ``play a more
active role'' in the gatekeeping process (i.e., determining whether
institutions should begin to participate in the title IV, HEA programs
and overseeing participating institutions to determine whether those
institutions should continue to participate).
In keeping with the statute and congressional intent, the Secretary
establishes in these regulations the standards and provisions that a
postsecondary institution must satisfy to demonstrate that it is
financially sound enough for students to confidently invest their time
and money in programs offered by the institution, and for the Federal
government, on behalf of taxpayers, to provide that institution with
access to substantial amounts of public funds. The Department is
committed to carrying out the Secretary's gatekeeping and oversight
responsibilities in a manner that ensures accountability and program
integrity but that provides as much flexibility to, and places as
little burden on, institutions as possible.
Need for Revising the Rules
The current regulations have enabled the Department to identify and
take action against many financially weak problem institutions that
drew the attention of Congress. The Secretary nevertheless believes
that problems still exist that call for continued close scrutiny, and
undertook an extensive process to develop more effective regulations
for the following reasons.
First, the Secretary believes that the standards need to be revised
to provide a more comprehensive measure of an institution's financial
condition. As previously noted, the current standards provide discrete
measures of certain aspects of an institution's financial condition.
Those aspects are measured by three independent tests--an acid test
ratio, a test for operating losses, and a test of tangible net worth.
However, because each test provides a measure of financial health
without regard to the other tests or to other resources available to an
institution, the assessment made under each of these tests does not
always reflect the overall financial condition of an institution.
Second, because the current standards do not consider the extent to
which an institution satisfies or fails to satisfy the tests, the
Department cannot readily make distinctions among (1) institutions that
are clearly not financially healthy, (2) institutions that are
financially sound enough to participate in the title IV, HEA programs,
and (3) institutions whose financial health is questionable.
Consequently, a more considered approach is needed to evaluate the
relative level of financial health of institutions to more closely tie
the Department's gatekeeping and oversight efforts to the corresponding
risk to the
[[Page 62833]]
Federal interest posed by institutions at various levels.
Third, the Secretary believes that the current standards must be
improved to properly address the different accounting, financial, and
operating characteristics that exist between proprietary and private
non-profit institutions.
Finally, based on KPMG's original study and the additional analysis
performed during the extended comment period, the Secretary is prepared
to carry out a commitment made to representatives of the postsecondary
education community in the context of the promulgation of the 1994
financial responsibility regulations, that instead of establishing
independent tests, the Department would assess the institutions'
financial responsibility based on blended test scores.
The Final Rule
Provisions for Public Institutions
The Secretary initially proposed to apply the ratio methodology to
public institutions, but, based on public comment, the Secretary has
decided not to use the methodology to determine the financial
responsibility of those institutions for two primary reasons. First,
these institutions are subject to more public oversight and scrutiny
than private non-profit and proprietary institutions. The Secretary
believes that it is the responsibility of the State or responsible
government entity to make available the resources necessary for those
institutions to provide the education and services expected by students
who enroll at those institutions and the residents of the State or
locality whose funds support the institutions. Second, the legal and
financial relationships between public institutions and their
respective State or local governments vary widely, impacting in
different ways the assets and liabilities reported on those
institutions' financial statements. Thus, the ratio methodology would
not treat all public institutions equitably.
In view of these and other reasons noted by the commenters (see
Analysis of Comments and Changes, Part 4), the Secretary does not
establish in these regulations a composite score standard for public
institutions. Rather, the Secretary will rely on the statutory
alternative that, in lieu of satisfying the general standards of
financial responsibility (including the composite score standard), a
public institution is financially responsible if its debts and
liabilities are backed by the full faith and credit of the State or
other government entity. The Secretary will consider that a public
institution has that backing if the institution provides a letter from
the cognizant State or government entity confirming the institution's
status as a public institution. The Secretary takes this approach in
implementing the full faith and credit provision under section
498(c)(3)(B) of the HEA to eliminate technical and other problems
experienced by public institutions in demonstrating their compliance
with this provision under the current regulations.
The Ratio Methodology for Private Non-Profit and Proprietary
Institutions
In developing the final regulations, the Secretary sought to
address all of the needs for revising the current rules by formulating
a ratio methodology, and provisions relating to the methodology, that
would be fair, easily understood by institutions, and efficiently
administered by the Department.
Based on the additional analysis performed by the Department and
KPMG during the extended comment period, and the many helpful comments
and suggestions made by the community, the Department establishes by
these final regulations a ratio methodology for proprietary and private
non-profit institutions that:
(1) Provides a comprehensive measure of financial health (the
composite score) by using ratios that take into account all of the
resources of an institution and employing an approach under which the
financial strength demonstrated in one ratio mitigates a financial
weakness in another ratio;
(2) Provides the Department the means to assess the relative health
of all institutions along a common scale; and
(3) Takes into account the key differences between these sectors of
postsecondary institutions.
In so doing, the ratio methodology enables the Department to use
more effectively the case management system implemented by IPOS. Under
this system, case teams responsible for particular institutions have
access to all of the data available to the Department regarding those
institutions, including financial, compliance, and programmatic
information. The case teams use this information to identify
institutions whose level of financial health, or whose conduct in
administering the title IV, HEA programs, or both, indicates that those
institutions (1) need technical assistance, (2) must be monitored more
closely, or (3) pose a risk to the Federal interest that requires the
Department to initiate an adverse action.
Furthermore, in the interest of treating all institutions fairly
and equitably, the Department will calculate the ratios under the
methodology by using only the information contained in an institution's
audited financial statements that are prepared in accordance with
generally accepted accounting principles (GAAP) and by removing the
effects of questionable accounting treatments.
The Secretary is committed to ensuring a smooth transition and to
helping institutions understand the ratio methodology and other
provisions established in these regulations by offering technical
assistance, both initially and as case teams identify institutions in
need of further assistance.
Overview of the Methodology
The methodology is an arithmetic means of combining different but
complementary measures (ratios) of fundamental elements of financial
health that yields a single measure (the composite score) representing
an institution's overall financial health. Under the methodology, the
composite score is calculated by:
(1) Determining the value of each ratio;
(2) Calculating a strength factor score for each of the ratios;
(3) Calculating a weighted score by multiplying the strength factor
score by its corresponding weighting percentage; and
(4) Adding together the weighted scores to arrive at the composite
score.
In the first step of the methodology, the values of the Primary
Reserve, Equity, and Net Income ratios are calculated from information
contained in an institution's audited financial statement. These ratios
together measure the five fundamental elements of financial health:
financial viability, liquidity, ability to borrow, capital resources,
and profitability. The strength factor scores are calculated using
linear algorithms (equations) and those scores reflect along a common
scale the degree to which an institution in a particular sector
demonstrates strength or weakness in the fundamental elements. The
weighting percentages for each of the ratios make it possible to
compare institutions across sectors by accounting for the relative
importance that the fundamental elements have for institutions in each
sector. In the final step of the methodology, the weighted scores are
added together. The resulting value, the composite score, represents an
overall measure of an institution's financial health.
[[Page 62834]]
Each step of calculating the composite score under the ratio
methodology is illustrated in Appendices F and G of these regulations
and discussed more fully in the following sections.
Step 1: Financial Ratios
The methodology employs three ratios that measure the same elements
of financial health but are customized to reflect the accounting
differences between the sectors. The values of the ratios are
determined from information contained in an institution's audited
financial statement and are generically defined as follows:
For proprietary institutions:
[GRAPHIC] [TIFF OMITTED] TR25NO97.020
For private non-profit institutions:
[GRAPHIC] [TIFF OMITTED] TR25NO97.021
A detailed description of the components of the numerators and
denominators of the ratios is provided under Appendix F of these
regulations for proprietary institutions and under Appendix G for
private non-profit institutions.
In view of the public comment and the empirical work performed by
KPMG, the Secretary selected these ratios because together they take
into account the total financial resources of an institution and
provide broad measures of the following fundamental elements of
financial health:
1. Financial viability: The ability of an institution to continue
to achieve its operating objectives and fulfill its mission over the
long-term;
2. Profitability: Whether an institution receives more or less than
it spends during its fiscal year;
3. Liquidity: The ability of an institution to satisfy its short-
term obligations with existing assets;
4. Ability to borrow: The ability of an institution to assume
additional debt; and
5. Capital resources: An institution's financial and physical
capital base that supports its operations.
In identifying these fundamental elements, the Secretary relied on
KPMG's extensive experience in analyzing the financial condition of
postsecondary institutions and the work of the community task force
assembled to assist the Department and KPMG in developing the ratio
methodology.
The Primary Reserve ratio provides a measure of an institution's
expendable or liquid resource base in relation to its overall operating
size. It is, in effect, a measure of the institution's margin against
adversity. The Primary Reserve ratio measures whether an institution
has financial resources sufficient to support its mission--that is,
whether the institution has (1) sufficient financial reserves to meet
current and future operating commitments, and (2) sufficient
flexibility in those reserves to meet changes in its programs,
educational activities, and spending patterns. Thus, the Primary
Reserve ratio provides a measure of two of the fundamental elements of
financial health--financial viability and liquidity.
The Equity ratio provides a measure of the amount of total
resources that are financed by owners' investments, contributions or
accumulated earnings, depending on the type of institution, or stated
another way, the amount of an institution's assets that are subject to
claims of third parties. Thus, the ratio captures an institution's
overall capitalization structure, and by inference its ability to
borrow. With respect to the fundamental elements of financial health,
the Equity ratio measures capital resources, ability to borrow, and
financial viability.
The Net Income ratio provides a direct measure of an institution's
profitability or ability to operate within its means and is one of the
primary indicators of the underlying causes of a change in an
institution's financial condition.
A more thorough description of the ratios is provided under part 4
of the Analysis of Comments and Changes.
Step 2: Strength Factor Scores
The strength factor score reflects the degree to which an
institution demonstrates strength or weakness in the fundamental
elements as measured by the ratios. That strength or weakness is
assigned a point value of not less than negative 1.0 nor more than
positive 3.0, where a negative 1.0 indicates a relative weakness in the
fundamental elements and a positive 3.0 indicates relative strength in
those elements. The point values are assigned by a linear algorithm
(equation) developed for each ratio.
For example, the linear algorithm for calculating the strength
factor score for the Equity ratio of a proprietary institution is ``6 X
Equity ratio result.'' A proprietary institution with an Equity ratio
equal to -0.167 would have a strength factor score of negative 1.0 (6 X
-0.167=-1.002).
The linear algorithms developed for each ratio are contained in
Appendix F for proprietary institutions and Appendix G for private non-
profit institutions. The algorithms are explained in greater detail
under Part 6
[[Page 62835]]
of the Analysis of Comments and Changes.
In developing the algorithms, the Department, having consulted with
KPMG, determined the value of each ratio at three critical points along
the scoring scale:
(1) The point at which an institution begins to demonstrate a
minimal level of strength;
(2) The point at which an institution demonstrates no strength; and
(3) The point at which an institution demonstrates relative
strength.
The algorithms were then constructed to yield, at these relative
levels of financial health, strength factor scores of 1.0, zero, and
3.0, respectively. For example, as calculated under the algorithms, a
strength factor score of 1.0 indicates that an institution has a
minimal level of expendable reserves (Primary Reserve ratio), is just
beginning to demonstrate equity (its assets are greater than its
liabilities, but not by much) (Equity ratio), and broke even (Net
Income ratio). A strength factor score of zero indicates that an
institution has no expendable reserves or equity, and incurred a small
loss. On the upper end of the scale, a strength factor score of 3.0
indicates that an institution has a healthy level of expendable
reserves and equity (its assets are substantially greater than its
liabilities) and generated operating surpluses that added to its
overall wealth.
The Secretary considered carefully the comments made by the
community regarding the proposed scoring scale and the impact of the
proposed methodology on an institution's ability to satisfy its mission
objectives. In view of these comments and the empirical work performed
by KPMG during the extended comment period, the Secretary revised the
scoring scale to make greater distinctions among institutions on the
lower end of the scale and to consider more fairly the actual financial
health of institutions as measured by the methodology. Since the
strength factor scores reflect the degree to which an institution
demonstrates strength or weakness in the fundamental elements as
measured by the ratios, these scores enable the Department to assess
the extent to which an institution has the financial resources to:
(1) Replace existing technology with newer technology;
(2) Replace physical capital that wears out over time;
(3) Recruit, retain, and re-train faculty and staff (human
capital); and
(4) Develop new programs.
A more thorough discussion of the revisions to the scoring process
and strength factor scores is provided under Part 6 of the Analysis of
Comments and Changes.
Step 3: Weighting Percentages
The weighting percentages for each of the ratios make it possible
to compare institutions across sectors by accounting for the relative
importance that the fundamental elements have for institutions in each
sector. For example, expendable resources (as measured by the Primary
Reserve ratio) are more important to private non-profit institutions
than to proprietary institutions--proprietary institutions generally
have greater access to capital markets, and owners, unlike trustees,
may invest cash as needed to support operations, or may increase
expendable resources by leaving earnings in the institution. On the
other hand, non-profit institutions are generally dependent on
contributions from donors as their primary source of additional
capital.
In this step of the methodology, the strength factor score is
multiplied by a weighting percentage. For example, the weighting
percentage for the Primary Reserve strength factor score of a
proprietary institution is 30 percent. To determine the weighted score
for a proprietary institution with a Primary Reserve strength factor
score of 1.2, the institution would multiply 1.2 by 30 percent, for a
weighted score of 0.36 (1.2 x 30 percent = 0.36).
The regulations revise the proposed weighting percentages to
account for the effect of replacing the proposed Viability ratio with
the Equity ratio and to reflect more accurately the importance of each
ratio. These revisions, and the rationale for establishing the
weighting percentages, are discussed more fully under Part 7 of the
Analysis of Comments and Changes.
Step 4: Composite Score
In the final step of the methodology the weighted scores are added
together to arrive at the composite score. Because the weighted scores
reflect the strengths and weaknesses represented by the ratios and take
into account the importance of those strengths and weaknesses, a
strength in the weighted score of one ratio may compensate for a
weakness in the weighted score of another ratio. Thus, the composite
score reflects the overall financial health of an institution and
provides a cardinal ranking of all institutions along a common scale
from negative 1.0 to positive 3.0.
A sample calculation of a composite score is illustrated in the
following chart.
Calculating a Proprietary Institution's Composite Score
Step 1 Step 2 Step 3 Step 4 \1\
Calculate the ratio results Calculate strength factor score by Calculate weighted score
use of the appropriate algorithm (multiply strength factor score
by weighting percentage)
----------------------------------------------------------------------------------------------------------------
Primary reserve ratio = .06.. .06 x 20 = 1.20 1.20 x 30% = 0.36000
Equity ratio = .27........... .27 x 6 = 1.620 1.620 x 40% = 0.64800
Net income ratio = .029...... (.029 x 33.3) + 1 = 1.9657 1.9657 x 30% = 0.58971
----------------------------------------------------------------------------------------------------------------
\1\ Step 4: Add the weighted scores (=1.59771) and round the total of the weighted scores to one digit after the
decimal point to arrive at the composite score = 1.6.
While institutions may achieve the same composite score in
different ways (by having different ratio results), institutions with
the same scores are similarly situated with respect to the resources
that they can bring to bear to satisfy their obligations to students
and to the Secretary.
The Regulatory Standard of Financial Responsibility
As noted previously, an institution must satisfy the standards and
provisions under each component of financial responsibility. With
respect to its financial condition, an institution must achieve a
composite score of at least 1.5 (the composite score standard).
In determining the minimum composite score that an institution
[[Page 62836]]
would need to achieve to demonstrate that it is financially
responsible, the Department, having consulted with KPMG, formulated the
algorithms to establish the point along the scoring scale below which
an institution is clearly not financially healthy, i.e., a composite
score of 1.0. From that point, the Secretary determined the level of
financial health that indicates that an institution has the resources
necessary not only to continue operations, but to fund to some extent
its mission objectives.
An institution with a composite score of 1.0 should be able to
continue operations but does not have the financial resources to meet
its operating needs without difficulty, or the financial reserves
necessary to deal with adverse economic events without having to rely
on additional sources of capital. Moreover, because it has very limited
resources, the institution will have difficulty funding its technology,
capital replacement, and program needs. Below this level, an
institution will have even more difficulties, if not serious
difficulties, in meeting its operating needs without additional revenue
or support, and in funding any of its technology, capital replacement,
human capital, or program needs.
A composite score of 1.5 generally characterizes an institution
that has some margin against adversity, is funding its historical
capital replacement costs, and has the resources to provide funding for
some investment in human and physical capital. However, the institution
has no excess funds to support new program initiatives or major
infrastructure upgrades.
The composite score reflects the relative financial health of
institutions along the scoring scale from negative 1.0 to positive 3.0.
Stated another way, any given composite score along this scale reflects
the degree of uncertainty that an institution will be able to continue
operations and meet its obligations to students and to the Secretary;
the uncertainty that an institution will be able to continue operations
and meet its obligations increases as its composite score decreases.
Thus, if the Secretary's sole aim for these regulations had been to
accept the lowest level of uncertainty, only institutions achieving the
highest composite score would be considered financially responsible.
The Secretary notes that a significant number of institutions in the
samples examined by the Department and KPMG attained composite scores
of 3.0 (44 percent of the institutions in the private non-profit
sample, and 13 percent of the institutions in the proprietary sample).
However, the Secretary believes that a composite score of 1.5 reflects
a level of financial health that is in keeping with the statutory
requirements and the Secretary's goals in determining that institutions
are financially responsible. This level balances the need to minimize
uncertainty with the need to minimize regulatory burdens on
institutions that are likely to remain in business, provide educational
services at a satisfactory level, and administer properly the title IV,
HEA programs.
Institutions With Composite Scores in the Zone
As noted previously, provided that an institution satisfies the
standards relating to its debt payments and its administration of the
title IV, HEA programs, an institution demonstrates that it is
financially responsible by achieving a composite score of at least 1.5,
or by achieving a composite score in the zone from 1.0 to 1.4 and
meeting certain provisions.
The ratio methodology is designed to identify the point along the
scoring scale where an institution is financially sound enough (a
composite score of at least 1.5) to continue to participate in the
title IV, HEA programs without any additional monitoring arising from a
review of its financial condition, and the point below which (a
composite score of less than 1.0) there is considerable uncertainty
regarding an institution's ability to continue operations and meet its
obligations to students and to the Secretary. For institutions scoring
below 1.0, additional monitoring and surety are required immediately to
protect the Federal interest.
The Secretary considers institutions with composite scores in the
zone between these two points (i.e., a composite score of 1.0 to 1.4)
to be financially weak but viable, and therefore allows these
institutions up to three consecutive years to improve their financial
condition without requiring surety. The provisions for institutions
scoring in the zone are contained in Sec. 668.175(d) of these
regulations under the zone alternative.
Under those provisions, an institution qualifies initially as a
financially responsible institution by achieving a composite score
between 1.0 and 1.4, and continues to qualify by achieving a composite
score of at least a 1.0 in each of its two subsequent fiscal years. If
an institution does not achieve at least a 1.0 in each of its
subsequent two fiscal years or does not sufficiently improve its
financial condition so that it satisfies the 1.5 composite score
standard by the end of the three-year period, the institution may
continue to participate in the title IV, HEA programs by qualifying
under another alternative.
Institutions scoring in the zone should generally be able to
continue operations in the short-term, absent any adverse economic
events. However, even though the resources of institutions scoring in
the zone are notably greater than the resources of institutions scoring
below 1.0, those resources provide only a limited margin against
adversity. Moreover, because zone institutions have notably less
resources than institutions scoring above the zone, their ability to
fund necessary mission objectives is similarly limited. In view of the
limited resources of zone institutions, and the uncertainty regarding
the ability of those institutions to continue operations and satisfy
their obligations to students and to the Secretary in times of fiscal
distress, the Secretary believes it is necessary to monitor more
closely the operations of zone institutions, including their
administration of title IV, HEA program funds.
Accordingly, the regulations require an institution in the zone to
provide timely information regarding certain accrediting agency actions
that may adversely effect the institution's ability to satisfy its
obligations to students and to the Secretary, and certain financial
events that may cause or lead to a deterioration of the institution's
financial condition. In addition, the Secretary may require the
institution to submit its compliance and financial statement audits
soon after the end of its fiscal year.
With regard to the administration of title IV, HEA program funds,
the Secretary provides those funds to a zone institution, or to an
institution with a composite score of less than 1.0, under the
reimbursement payment method or under a new payment method, cash
monitoring. The Secretary establishes as part of these regulations the
cash monitoring payment method in view of the public comment that the
reimbursement payment method is burdensome or that it may be
inappropriate for some institutions. Under either the reimbursement or
cash monitoring payment method, to help ensure that title IV, HEA
program funds are used for their intended purposes, an institution must
first make disbursements to eligible students and parents before it
requests or receives funds for those disbursements from the Secretary.
However, unlike reimbursement, where an institution must provide
specific and detailed documentation for each student to whom it made a
disbursement, before
[[Page 62837]]
the Department provides title IV, HEA programs funds to the
institution, the Department provides funds to an institution under the
cash monitoring payment in one of two less burdensome ways. The
Department either requires an institution to make disbursements to
eligible students or parents before drawing down title IV, HEA program
funds for the amount of those disbursements, or requires the
institution to submit some documentation identifying the eligible
students and parents to whom a disbursement was made before the
Secretary provides funds to the institution for those disbursements.
Although the Secretary anticipates that the documentation requirements
under cash monitoring will be minimal for most institutions, the Case
Teams have the flexibility under these regulations to tailor the
documentation requirements on a case-by-case basis. In addition, the
Secretary expects that institutions with composite scores of less than
1.0 will continue to receive funds under the reimbursement payment
method if those institutions are provisionally certified (in rare
instances, however, the Secretary may provide funds under the cash
monitoring payment method to an institution based in part on its
compliance history and the amount of the letter of credit submitted to
the Department).
The Secretary notes that the future implementation of the just-in-
time payment method--which the Secretary intends to implement as soon
as possible--may reduce or eliminate the use of the cash monitoring
payment method. Any changes to the cash monitoring payment method
arising from the implementation of the just-in-time payment method will
be addressed in a future proposed regulation, and the Secretary will
invite public comment on those changes. (For more information on Cash
Monitoring, see the discussion under part 9 of the Analysis of Comments
and Changes).
In developing these provisions, the Secretary intended to achieve
three objectives. First, the Secretary wished to provide a reasonable
amount of time for institutions to improve their financial condition
without increasing the risks to the Federal interest. Second, the
Secretary did not wish to interfere unnecessarily in the operations of
institutions seeking to improve their financial condition. Third, the
Secretary wished to provide as much flexibility as possible to the
Department's case teams in determining the appropriate level of
monitoring and oversight required of institutions in the zone.
Alternative Ways of Demonstrating Financial Responsibility
Section 498(c)(3) of the HEA provides alternatives under which the
Secretary must consider an institution to be financially responsible if
it fails to satisfy one or more of the components of financial
responsibility. These alternatives are described under Sec. 668.175 of
the regulations. This section also contains alternatives under which
the Secretary will permit an institution that does not demonstrate that
it is financially responsible under the statutory provisions to
continue to participate in the title IV, HEA programs.
An institution that does not achieve a composite score of 1.5, or
qualify under the zone alternative, may demonstrate that it is
financially responsible by submitting to the Secretary a letter of
credit for at least 50 percent of the title IV, HEA program funds the
institution received in its last fiscal year. If the institution's
composite score is less than 1.0, it may continue to participate as a
financially responsible institution by submitting the 50 percent letter
of credit, or the institution may submit a smaller letter of credit (at
least 10 percent of the amount of its prior year title IV, HEA program
funds) and participate under a provisional certification.
As noted previously, the ratio methodology is designed to consider
all of an institution's resources. In particular, the Primary Reserve
and Equity ratios together reflect all of the resources accumulated
over time by an institution that are available to the institution to
support its current and future operations. For this and other reasons
discussed under Part 7 of the Analysis of Comments and Changes, these
two ratios account for 70 percent of the composite score for
proprietary institutions and 80 percent for non-profit institutions.
Institutions that do not satisfy the composite score standard that
would otherwise participate under the zone alternative or be required
to provide a letter of credit may find that it is less costly to take
the steps necessary to improve their financial condition. Based on an
analysis of the data compiled by KPMG, the Secretary notes that a
number of institutions scoring below the zone (i.e., have composite
scores of less than 1.0) may qualify under the zone alternative by
making relatively small capital infusions or increasing modestly their
unrestricted net assets. For some of these institutions, the amount of
the cash infusion or increase in net assets that would be necessary to
achieve a composite score of 1.0 is less than five percent of total
revenue because that infusion or increase is reflected positively in
both the Primary Reserve and Equity ratios. Alternatively, institutions
may choose to retain more earnings. In either case, the cost to many
institutions of improving their financial condition is less, sometimes
far less, than the cost of securing a letter of credit.
Institutions that qualify under the zone alternative may find that
by taking similar actions they can improve sufficiently their financial
condition to achieve a composite score of 1.5. A zone institution that
achieves a composite score of 1.5 at the end of any year in the zone or
by the end of the three-year period, avoids the costs that it would
otherwise incur in securing a letter of credit under the available
alternatives.
More importantly, the resources that would otherwise be used, by a
zone institution or an institution scoring below the zone, to secure
the letter of credit would now be available to the institution to
support its mission objectives. The Secretary anticipates that
financially weak institutions will move into and out of the zone as
those institutions demonstrate a commitment to improve their financial
health. Furthermore, the Secretary expects that institutions will seek
to improve their financial health in the manner that most benefits
students.
Collective Guarantees
Several commenters suggested that the Secretary revise the final
regulations to include an alternative under which a group of
institutions could (under some type of insurance-pooling arrangement)
collectively provide a letter of credit, or other financial instrument,
that would serve to cover the potential liabilities of any institution
in the group. The merits of this alternative are that all of the
institutions in the group could continue to participate in the title
IV, HEA programs as financially responsible institutions at a lower
cost than if any one of those institutions posted a letter of credit on
its own. In the meetings held during the extended comment period, some
participants noted that the potential interest in such an alternative
would depend on the nature of the final regulations.
Although the Secretary did not revise the regulations to include
this suggested alternative (primarily because the commenters and
meeting participants did not provide any details regarding insurance-
pooling arrangements or alternative financial instruments, and because
the Secretary is uncertain about the continued community interest in
[[Page 62838]]
this alternative), the Secretary will consider collective guarantee or
insurance-pooling requests on a case-by-case basis.
Issues Raised in the Notice of Proposed Rulemaking and Other Department
Publications
The September 20, 1996 NPRM included a discussion of the major
issues surrounding the proposed regulations (as well as a summary of
the August 1996 report by KPMG) that will not be repeated here. The
following list summarizes those issues and identifies the pages of the
preamble to the NPRM (61 FR 49552-49563) on which the discussion of
those issues can be found:
The scope and purpose statement of the new subpart L (p.
49556).
A proposal to modify the precipitous closure alternative
to demonstrating financial responsibility, and a clarification of the
types of alternatives to demonstrating financial responsibility
available to new institutions (pp. 49557-49558).
Financial responsibility standards and other requirements
for institutions undergoing a change of ownership (p. 49558).
Past performance standards (p. 49559).
An outline of additional requirements and administrative
actions, including requirements for institutions that are provisionally
certified, and an outline of administrative actions taken when an
institution fails to demonstrate financial responsibility (p. 49559).
The contents of the proposed Appendix F (p. 49559).
The following list summarizes the areas of discussion that were
posted on the Department's World-Wide Web site. This site is located at
(http://www.ed.gov/offices/OPE/PPI/finanrep.html). This web site will
remain active at least until the regulations are fully effective.
The possibility of using in the ratio analysis an Equity
ratio either as an additional ratio, or as a substitute for the
Viability ratio; and a discussion of the components of, and possible
strength factor scores for, that ratio.
Possible adjustments to the threshold factors to take into
account new data of the effects of Financial Accounting Standards Board
(FASB) Statements 116 and 117 on private non-profit institutions, and
to take into account additional data on proprietary institutions.
Possible modifications to the weighting percentages of the
ratios, including the weighting for the proposed Equity ratio.
Possible modifications to the calculation of composite
scores from the ratio analysis to eliminate ``cliff effects,''
including the possible use of a linear algorithm or the addition of
more strength factor categories to linearize the composite scores.
Possible modifications to the scoring scale, including
truncating the upper end of the scale to eliminate unnecessary
differentiation of institutions that attain high composite scores.
Community suggestions regarding the treatment of goodwill
in the calculation of the ratios.
Community suggestions for a secondary tier of analysis,
and suggested changes to the alternative means of demonstrating
financial responsibility for those institutions that fail the ratio
test.
Discussions of the utility of using a cash flow analysis.
Discussions of the treatment of institutional grants and
other fully-funded operations in the calculation of the ratios.
Discussions of donor income with regard to determining the
financial responsibility of non-profit institutions, and in particular
of institutions that have continued for many years on tight budgets
with a minimal financial cushion.
The treatment of debt in the proposed ratio methodology,
including concerns that the proposed ratio methodology could penalize
institutions for taking on necessary amounts of debt to expand or to
invest in infrastructure, and suggestions for the evaluation of
institutions that remain debt-free.
Community suggestions for altering the proposed standards
for changes of ownership.
Discussions of the utility and practicality of using a
trend analysis rather than a snapshot approach, and community
suggestions that financial responsibility need not be determined
annually, at least for stronger institutions.
Community suggestions for revising the ``full faith and
credit'' alternative for public institutions.
Substantive Changes to the NPRM
The following discussion reflects substantive changes made to the
NPRM in the final regulations.
The proposed ratio standards for public institutions have
been eliminated in favor of a revised approach in implementing the
statutory alternative that an institution is financially responsible if
it is backed by the full faith and credit of a State or equivalent
government entity.
The proposed Viability ratio has been replaced by the
Equity ratio.
The proposed scoring scale has been modified to range from
negative 1.0 to positive 3.0, rather than from 1.0 to 5.0. The low end
of the range, below 1.0, indicates the poorest financial condition. At
the high end, a score of 3.0 indicates financial health.
The proposed strength factor tables have been replaced by
linear algorithms.
The proposed ratio results necessary to earn points along
the scoring scale have been lowered to reflect a time frame of 12-to-18
months rather than 3-to-4 years.
As a result of revising the scoring scale and the strength
factor scores, and the change in focus from 3-to-4 years to 12-to-18
months, the minimum composite score for establishing financial
responsibility has been changed from the proposed standard of 1.75 (on
a scale of 1.0 to 5.0) to 1.5 (on a scale of negative 1.0 to positive
3.0).
The proposed precipitous closure alternative has been
modified and implemented in these regulations as the zone alternative.
Under the zone alternative, an institution whose composite score is
less than 1.5 but equal to at least 1.0 may participate in title IV,
HEA programs as a financially responsible institution for up to three
consecutive years.
As part of the modifications to the proposed precipitous
closure alternative, the provision requiring owners or persons
exercising substantial control over an institution to provide personal
financial guarantees is eliminated. Instead, an institution whose
composite score is less than 1.5 is required to provide information
regarding certain oversight and financial events, and the Department
provides title IV, HEA program funds to that institution under the
reimbursement payment method or under a new, less burdensome payment
method, Cash Monitoring (discussed above and under part 9 of the
Analysis of Comments and Changes).
The proposal to apply the ratio methodology to third-party
servicers entering into a contact with lenders and guaranty agencies
has been withdrawn. The financial standards currently under Sec. 668.15
continue to apply to those entities.
The proposed revisions to the procedures relating to
changes of ownership have been withheld pending further review and
comment.
Executive Order 12866
These final regulations have been reviewed as significant in
accordance with Executive Order 12866. Under the
[[Page 62839]]
terms of the order, the Secretary has assessed the potential costs and
benefits of this regulatory action.
The potential costs associated with the final regulations are those
resulting from statutory requirements and those determined by the
Secretary to be necessary for administering the title IV, HEA programs
effectively and efficiently.
In assessing the potential costs and benefits--both quantitative
and qualitative--of these regulations, the Secretary has determined
that the benefits of the regulations justify the costs.
The Secretary has also determined that this regulatory action does
not unduly interfere with State, local, and tribal governments in the
exercise of their governmental functions.
Summary of Potential Costs and Benefits
The potential costs and benefits of these final regulations are
discussed elsewhere in this preamble under the heading Final Regulatory
Flexibility Analysis (FRFA), and in the information previously stated
under Supplementary Information and in the following Analysis of
Comments and Changes.
Analysis of Comments and Changes
In response to the Secretary's invitation to comment on the NPRM,
approximately 850 parties submitted comments. An analysis of the
comments and of the changes in the regulations since the publication of
the NPRM follows.
The Department received comments on these regulations from
September 20, 1996 through April 14, 1997. Although the Department
received and considered comments on all of the topics included in the
NPRM, the comments discussed here are primarily those which address the
changes to the NPRM made by these final regulations.
Major issues are discussed under the section of the regulations to
which they pertain. Comments concerning the new Subpart L are grouped
by topic or issue. Technical and other minor changes--and suggested
changes the Secretary is not legally authorized to make under
applicable statutory authority--are not addressed. An analysis of the
comments received regarding the Initial Regulatory Flexibility Analysis
(IRFA) can be found elsewhere in this preamble under the heading Final
Regulatory Flexibility Analysis (FRFA).
Section 668.23--Compliance Audits and Audited Financial Statements
Comments: Several commenters noted that the requirements under
Sec. 668.23(f)(3) (previously codified under Sec. 668.24), are not
always possible to meet. Under this section, an institution's or
servicer's response to the Secretary regarding notification of
questioned expenditures must be based on an attestation engagement
performed by the institution's or servicer's auditor. The commenters
maintained that an attestation engagement is proper only when the
subject of the attestation is capable of being evaluated based on
reasonable, objective criteria, and that some responses to
notifications of questioned expenditures may be based on grounds that
could not be so evaluated, i.e., the contention that an auditor
misinterpreted or misapplied a regulatory requirement when the auditor
questioned the institution's or servicer's compliance or expenditure.
Discussion: The Secretary agrees that there are cases in which the
institution's response to an audit does not have to be based on an
attestation engagement. This provision was intended to inform
institutions that new information or documentation that was not
available during the original audit should be accompanied by the
auditor's attestation report, when that report is submitted to the
Secretary. Without the auditor's report, the resolution of the audit
may be delayed or the data may not be considered reliable. However, the
Secretary agrees that the necessity for the attestation engagement is
determined by the nature of the response being made, and may not be
required in all cases.
The Secretary also has determined that the procedures described in
Sec. 668.23(f)(1)-(3) are redundant with requirements under OMB
Circulars A-128 and A-133 and the Office of Inspector General Audit
Guide, and that redundancy may cause confusion for some institutions.
The OMB Circulars and the Audit Guide each contain requirements that a
Corrective Action Plan, which includes the institution's responses to
the audit findings and questioned costs, be submitted with the audit.
If the institution disagrees with the findings or believes corrective
action is not needed, it provides the rationale for that belief in the
Corrective Action Plan.
Normally, an institution submits information in its Corrective
Action Plan, in response to a specific request from the Secretary, or
as part of an appeal under 34 CFR 668 subpart H. The Secretary
establishes whether an attestation report is required as part of the
Secretary's request for information; the Hearing Official evaluates the
reliability of information submitted with an appeal. To avoid
duplication and unnecessary audit work and because few institutions
submit additional data as described in paragraph (f), the Secretary
removes this paragraph.
Changes: The Secretary removes paragraph (f) under Sec. 668.23.
Subpart L--Financial Responsibility
Part 1. General Comments Regarding the Proposed Ratio Methodology
Comments: Many participants involved in the discussions conducted
by the Secretary during the extended comment period expressed the view
that the manner in which those discussions were conducted demonstrated
the Department's commitment to public and community involvement in the
rulemaking process and should serve as a model for future rulemaking.
Several commenters maintained that the Secretary cannot change the
current standards of financial responsibility without first convening
regional meetings to obtain public involvement in the development of
proposed regulations as provided under the negotiated rulemaking
process described in section 492 of the HEA. One commenter opined that
absent a negotiated rulemaking process the Secretary could not
promulgate regulations that would have legal force and effect.
Several commenters argued that the proposed ratio methodology is
contrary to statutory provisions under section 498 of the HEA because
the proposed ratios do not include the type of ratios specified by the
HEA.
Other commenters maintained that any attempt by the Secretary to
promulgate financial responsibility standards was duplicative, and that
for reasons of efficiency and regulatory relief the Secretary should
rely upon standards used by financial institutions and accrediting
agencies.
Discussion: The Secretary appreciates the participants' remarks and
thanks those persons for their valuable input regarding the direction
and development of these rules. The Secretary disagrees that negotiated
rulemaking is required under the HEA to implement these regulations. In
accordance with section 492 of the HEA, the Secretary conducted
regional meetings to obtain public involvement in the preparation of
draft regulations for parts B, G and H of the HEA as amended by the
Higher Education Amendments of 1992. As required under section 492,
those draft regulations were then used in a negotiated rulemaking
process that was subject to specific time limits connected with the
enactment of the 1992
[[Page 62840]]
Amendments. The negotiated rulemaking requirement was therefore
anchored at one end by the statutorily required regional meetings that
followed the enactment of the 1992 Amendments, and at the other end by
fixed time limits for the final regulations created by that process.
Subsequent regulatory changes to these sections cannot be tied to those
requirements for negotiated rulemaking because the regional meetings
and statutory timeframes for those regulations have already passed. The
HEA does not restrict the Secretary's authority to make additional
regulatory changes in this area, and changes to the regulations may
therefore be made without using negotiated rulemaking.
Even though negotiated rulemaking was not required for these
regulations, the Secretary believes that the opportunities afforded to
the higher education community during the extended comment period to
provide input regarding the proposed regulations are consistent with
the spirit of cooperation that underlies the negotiated rulemaking
process. In the numerous meetings held during the extended comment
period with representatives from institutions, higher education
associations, and other interested parties, the meeting participants
identified many areas in the proposed regulations that the Secretary
has since modified and improved to more accurately measure the relative
financial health of institutions.
The Secretary disagrees that section 498(c)(2) of the HEA requires
the Secretary to utilize particular ratios in determining financial
responsibility. That section of the HEA merely provides examples of
ratios that the Secretary may use in determining whether an institution
is financially responsible, e.g., the statutory reference to an ``asset
to liabilities'' ratio is a generic rather than a specific reference or
requirement. Moreover, the Secretary believes that the ratio
methodology established by these regulations not only incorporates the
same aspects of financial health as the ratios illustrated in the HEA,
but does so in a more comprehensive manner.
With respect to the comments that the Secretary should rely on
financial determinations made by accrediting agencies or financial
institutions, the Secretary notes that section 498(c) of the HEA
requires the Secretary to make those determinations for institutions
participating in the title IV, HEA programs. In addition, because the
financial standards used by other parties reflect the mission of those
parties or are used by those parties to initiate or continue a business
relationship, there is no assurance that determinations made under
those standards by those parties will have a direct bearing on whether
an institution is financially responsible for the purposes required
under HEA, i.e., that the institution is able to (1) provide the
services described in its official publications, (2) administer
properly the title IV, HEA programs in which it participates, and (3)
meet all of its financial obligations to students and to the Secretary.
Moreover, and absent any provision in the statute that permits the
Secretary to delegate financial responsibility determinations to other
parties, if the Secretary adopted the commenters' suggestion, similarly
situated institutions would be treated differently depending on the
party making the determination.
Changes: None.
Part 2. Comments Regarding the Timing and Implementation of New
Financial Standards
Comments: Several commenters recommended that the Secretary
postpone any changes to the financial responsibility standards until
after reauthorization of the HEA. The commenters argued that if new
standards are implemented now, these standards might be changed during
the reauthorization process or the statute may be amended to include
other requirements, thus potentially subjecting institutions to several
different requirements within a few years. Another commenter suggested
that the proposed standards form the starting point for discussions
between the Secretary and the higher education community on
reauthorization issues involving financial responsibility.
Many commenters believed that the reporting requirements under FASB
116, Accounting for Contributions Received and Contributions Made, and
FASB 117, Financial Statements of Not-for-Profit Organizations, are too
recent to be thoroughly understood. In particular, the commenters
maintained that since the impact of these FASB requirements on the
proposed ratio methodology is not known, the Secretary should delay
publishing final rules. Along the same lines, commenters representing
proprietary institutions maintained that the Secretary should not
promulgate the ratio methodology because it is untested and its impact
on the community is not known.
Discussion: The Secretary believes that changes to the current
financial responsibility standards are necessary for the reasons cited
in the preamble to this regulation (see the discussion under the
heading Need for Revising the Rules in the SUPPLEMENTARY INFORMATION
section of these regulations).
With regard to new accounting standards under FASB Statements 116
and 117, since most private non-profit colleges and universities
adopted the new FASB standards for their fiscal years that ended June
30, 1996, only a limited number of financial statements prepared under
those standards were available for examination at the time the NPRM was
published. Based on that limited number of financial statements, the
proposed strength factors for the Primary Reserve ratio were set
approximately 66 percent higher than strength factors for institutions
under a fund accounting model (AICPA Audit Guide financial reporting
model). This increase in the strength factors was intended to reflect
the fact that under FASB 116/117 realized and unrealized gains on
investments held as endowments are included in unrestricted or
temporarily restricted net assets, whereas under fund accounting these
gains were generally treated as nonexpendable assets. Therefore, it was
anticipated that the expendable net assets of all institutions would
increase significantly.
During the extended comment period KPMG conducted an analysis of
financial statements from 395 non-profit institutions that adopted FASB
116/117 and found that the impact of the new accounting standards is
not uniform across the private non-profit sector. The anticipated
impact that expendable net assets would increase significantly occurred
only among institutions holding large endowments; the impact was
negligible for institutions with little or no endowment. Based on the
more thorough KPMG analysis, the Secretary revises the strength factors
for the Primary Reserve ratio for private non-profit institutions in a
manner that discounts the effects of the new FASB standards for all
non-profit institutions.
Changes: See the discussion of the strength factor score for the
Primary Reserve ratio, Analysis of Comments and Changes, Part 6.
Comments: A commenter representing proprietary institutions
questioned the manner in which the KPMG study was conducted. The
commenter believed that small business interests were not considered
since no representatives of small proprietary institutions were among
those institutional representatives that assisted with the KPMG study.
Moreover, the commenter implied that the Secretary did not consider the
comments submitted by a group of CPAs on behalf of proprietary
institutions regarding the KPMG report, and therefore may have violated
the
[[Page 62841]]
requirement in the Regulatory Flexibility Act (RFA) that the Secretary
confer with representatives of small businesses.
Discussion: The Secretary notes that the suggestions of the group
of CPAs referenced by the commenters were considered in developing
these final regulations. More significantly, however, during the
extended comment period the Secretary sought and obtained the views and
comments of individuals and organizations with diverse experience in
higher education finance. Specifically, the Secretary met with
organizations representing proprietary institutions and directly with
persons from proprietary institutions, including representatives from
small institutions. In addition the Secretary provided on the
Department's web site a summary of the views expressed by the
participants at those meetings and additional information regarding the
ratio methodology.
Changes: None.
Part 3. Comments Regarding Annual Determinations of Financial
Responsibility
Comments: Many commenters from private non-profit institutions
maintained that institutions should not be subjected to annual
determinations of financial responsibility. The commenters believed
that annual determinations are unnecessarily burdensome, and represent
an inefficient use of the Secretary's resources, particularly in cases
in which an institution has been recently recertified. The commenters
opined that when a determination is made during the recertification
process that an institution is financially responsible, the Secretary
has sufficiently discharged his oversight responsibilities in this
area.
Discussion: The Secretary believes that it is not prudent to ignore
the financial condition of many institutions for the three- to four-
year period between recertification cycles for several reasons. First,
the financial condition of an institution may deteriorate, increasing
unnecessarily the risks to students and taxpayers that the institution
will close or will otherwise be unable to meet its obligations. Second,
many institutions prepare an annual audited financial statement for
other purposes, so the only burden that may result from an annual
determination stems from the institution's failure to satisfy the
standards of financial responsibility. Lastly, if the Secretary were to
adopt the commenters' suggestion by establishing longer term financial
standards for all institutions, those standards would necessarily need
to be much higher than the standards in these regulations, resulting in
more institutions failing the standards and creating additional burdens
for those institutions and the Secretary. Nevertheless, the Secretary
may in the future explore the possibility of determining the financial
responsibility of certain institutions less often or only during the
recertification process.
Changes: None.
Part 4. Comments Regarding the Adequacy and Appropriateness of the
Proposed Ratio Methodology
General comments: Many commenters from a variety of sectors
supported the direction taken by the proposed regulations, including
customizing the ratios for each sector. The commenters agreed with the
Secretary that the proposed methodology provides a better assessment of
an institution's financial condition than the regulatory tests
currently in place. However, the commenters believed that some changes
should be made to the proposed regulations.
Several commenters asserted that the proposed ratio methodology is
inadequate because it does not consider other factors, such as
enrollment trends, used by credit rating agencies like Moody's or
Standard and Poor's. The commenters suggested that along with using the
proposed methodology, the Secretary should consider an institution's
Moody's or Standard and Poor's credit rating, and the institution's
history of handling Federal funds, before the Secretary determines
whether the institution is financially responsible.
Similarly, one commenter from a non-profit institution argued that
credit rating agencies place a significant emphasis on the strength of
an organization's revenue stream, but the proposed ratios virtually
ignore this variable. The commenter stated that in assessing the
revenue strength of educational institutions, the rating agencies
typically review such data as average SAT scores and student acceptance
rates. It was the commenter's view that a revenue strength score should
be part of the evaluation process and should carry no lesser weight
than that associated with expenses.
Other commenters from non-profit institutions maintained the ratio
methodology is not valid because it is not based on traditional
measures of financial strength, and did not take into account the
institution's total financial circumstances as required by the HEA.
Another commenter from the non-profit sector argued that the proposed
rules, because of their emphasis on profitability, appeared to be
designed for proprietary institutions. The commenter urged the
Secretary to amend the rules to reflect the difference in each sector.
Several other commenters from private non-profit institutions asserted
that the proposed ratio methodology is deficient because it does not
take into account specific missions of institutions.
Several commenters believed that the proposed methodology is too
restrictive, arguing that it is too heavily biased in safeguarding the
Secretary from events that are very rare.
Several other commenters representing proprietary institutions
maintained that the new methodology was incomplete because it contained
no way to measure the effectiveness of an institution's management.
Other commenters believed that many small institutions with good
educational and compliance records that pass the current standards
would fail the standards proposed in the NPRM. The commenters opined
that this outcome points to a flaw in the manner in which the
methodology treats small institutions. An accountant for a proprietary
institution argued that because the proposed methodology does not
provide an adjustment for size, it is unfair to compare an institution
with $10 million in tuition revenue to an institution with $500,000 in
tuition revenue by applying the same standards and criteria to both
institutions.
Several commenters maintained that the proposed methodology is
complex and difficult to understand. The commenters argued that the
proposed rules will require institutions to rely more heavily on CPAs,
thus increasing their costs.
Discussion: The Secretary thanks the commenters supporting the
approach taken under these rules to establish better, more
comprehensive financial standards and appreciates the cooperation and
effort of commenters and other participants in the rulemaking process
for sharing their views and concerns with the Secretary during the
initial and extended comment periods.
With regard to the concerns raised by the commenters about the
adequacy of the ratio methodology, the Secretary wishes to make the
following points. First, the ratio methodology is designed to make
appropriate, albeit broad, distinctions between the sectors of higher
education institutions. The Secretary acknowledges that the methodology
does not directly consider intra-sector differences nor does it take
into account all of the variables or elements suggested by the
commenters regarding the mission or organizational
[[Page 62842]]
structure of institutions. To do so would create an enormously complex
model that as a practical matter would be impossible to implement.
Rather, the methodology focuses on key ratios and differences between
the sectors that the Secretary believes are the most critical in
evaluating fairly the relative financial health of all institutions
along a common scale.
Second, the adequacy of the ratio methodology should be judged in
the context of both its design objectives and the associated regulatory
provisions that complement those objectives. In developing these
regulations the Secretary sought to minimize two potential errors--that
a financially healthy institution would fail the ratio standard and be
inappropriately subject to additional requirements and burdens, and
that a financially weak institution would satisfy the ratio standard
and later fail to carry out its obligations at the expense of students
and taxpayers. The ratio methodology, in combination with the
alternative standards established by these regulations (see Analysis of
Comments and Changes, Part 9), reflects the Secretary's decision to err
on the side of allowing some financially weak institutions to
participate in the title IV, HEA programs but in a manner that protects
the Federal interest.
Third, the Secretary disagrees that the ratio methodology is flawed
because it does not provide an adjustment for the size of an
institution. To the contrary, an adjustment for size is unnecessary
because a ratio converts amounts into a metric that is relative to an
institution's own size, making possible a comparison of that
institution to other institutions regardless of the size of those
institutions. This comparative analysis is the basic design element of
the ratio methodology that enables the Secretary to evaluate the
relative financial health of all institutions along a common scale.
Similarly, the Secretary disagrees that the methodology favors
large or publicly traded institutions. Presumably, the commenters are
referring to a situation where a large institution is not dependent
upon a single revenue stream or has access to wider donor bases or more
capital markets than a small institution. While this flexibility may
advantage a large institution, the Secretary believes that flexibility
is inherent to the institution and beyond the scope of the methodology.
The fact that a large institution may be able to improve its financial
condition by managing its resources effectively also holds true for a
small institution, particularly since the ratios account for an
institution's performance relative to its size.
With regard to the comment from the non-profit sector that the
proposed ratio methodology appeared to be designed for proprietary
institutions because it emphasized profitability, the Secretary notes
that the measure of profitability (the Net Income ratio) accounted for
50 percent of the composite score for proprietary institutions, but for
only 10 percent of the composite score for non-profit institutions. As
discussed more fully under Part 7 of the Analysis of Comments and
Changes (Comments regarding the weighting of the proposed ratios), the
Secretary has revised the proposed percentages for the Net Income ratio
to more accurately reflect the differences between the sectors of
postsecondary institutions.
The Secretary disagrees that the methodology will require
institutions to rely more heavily on CPAs. As illustrated in the
appendices to these regulations, an institution can readily calculate
its composite score from its audited financial statements, provided
that those statements are prepared in accordance with GAAP.
Furthermore, by limiting the number of ratios, the Secretary believes
that it should not be difficult for any institution to determine the
impact that its business and programmatic decisions have or will have
on its financial condition as measured by the methodology.
Changes: None.
Comments regarding alternative ratios: Several commenters argued
that the proposed ratio methodology is limited and arbitrary,
suggesting alternative ratios that should be used instead, including:
the acid test ratio; a debt to equity ratio; a title IV, HEA loan
program default ratio; a debt to revenue ratio; a longevity ratio; a
debt service coverage ratio; and a measure of working capital.
Several commenters believed that the Primary Reserve ratio
disadvantages institutions that converted short-term liabilities into
long-term debt to meet the acid test ratio requirement.
A commenter from an accrediting agency asserted that the composite
score based on the proposed ratio methodology is inadequate in
assessing an institution's financial health, and that other measures
such as operating income, debt levels, availability of working capital,
and significant items contained in notes to the financial statements
should be used instead.
Discussion: The Secretary considered a number of ratios that could
be used in addition to or in place of the proposed ratios, including
the ratios suggested by the commenters, but decided to replace only the
proposed Viability ratio, with an Equity ratio. As discussed below,
while the ratios suggested by the commenters are valid measures, taken
individually or as a whole they measure the financial health of an
institution more narrowly than do the ratios established by these
regulations. In selecting the ratios, the Secretary considered the
extent to which those ratios provided broad measures of the following
fundamental elements of financial health:
1. Financial viability: The ability of an institution to continue
to achieve its operating objectives and fulfill its mission over the
long-term;
2. Profitability: Whether an institution receives more or less than
it spends during its fiscal year;
3. Liquidity: The ability of an institution to satisfy its short-
term obligations with existing assets;
4. Ability to borrow: The ability of an institution to assume
additional debt; and
5. Capital resources: An institution's financial and physical
capital base that supports its operations.
The Secretary believes that the ratios used in the methodology,
Primary Reserve, Equity, and Net Income, not only measure these
fundamental elements well, but that they do so in a manner that takes
into account the total resources of an institution. With respect to the
ratios suggested by the commenters, the Secretary wishes to make the
following points.
The Secretary agrees that the acid test ratio (cash and cash
equivalents divided by current liabilities) is a useful measure of
highly liquid assets available to meet current obligations, and it is
used in the current regulations as a test of financial responsibility.
However, the acid test is not included in the ratio methodology for
several reasons. First, it has been the Department's experience that
certain institutions manipulate the ratio elements to satisfy the 1:1
acid test standard, such as by reclassifying current liabilities as
long-term liabilities. Second, the information needed to calculate the
ratio is difficult to extract from the financial statements prepared
for non-profit institutions because that information is not a required
disclosure (assets and liabilities are not necessarily classified on
those financial statements as current and noncurrent). Moreover,
expendable capital (as measured by the Primary Reserve ratio) is a
broader and more important element of financial health than highly
liquid capital, because it mitigates the effects of differing cash
management and investment strategies used by institutions. For example,
an
[[Page 62843]]
institution that invests excess cash in other than short-term
instruments may fail the acid test requirement, whereas that excess
cash, regardless of how it is invested, is considered an expendable
resource under the Primary Reserve ratio. For these same reasons,
Working Capital ratios (working capital is the difference between
current assets and current liabilities) are not included in the
methodology.
With respect to Cash Flow ratios, the Secretary considered several
measures of cash provided from operations to cover debt payments.
However, cash flow (taken directly from the Cash Flow Statement) can be
easily manipulated. For example, delaying payment to creditors by
simply extending the normal payment terms to 120 days would give the
appearance that cash has been provided by operations. Therefore, the
Secretary decided to retain the Net Income ratio which, as an accrual-
based measure, recognizes expenses when they are incurred, not when
they are paid.
The Secretary considered an Operating Income ratio that would
measure income from operations as a percentage of net revenue, but the
results of that ratio would only partially address the question of
whether an institution operated within its means during its fiscal
year. By comparison, the Net Income ratio measures net income as a
percentage of net revenues after operations and other non-operating
items and thus provides a more complete measure of whether an
institution spent more than it brought in during the fiscal year.
The Secretary also considered adjusting the Net Income ratio for
non-cash items, but decided instead to make an allowance for the
largest non-cash item--depreciation expense--in the strength factors
for this ratio (see Analysis of Comments and Changes, part 6).
With regard to the Debt to Equity ratio and the other suggested
Debt ratios, the Secretary notes that, like the proposed Viability
ratio, these ratios cannot be applied universally. Based on the audited
financial statements reviewed by KPMG during the extended comment
period, approximately 35 percent of proprietary institutions and 13
percent of private non-profit institutions have no debt. In addition,
Debt to Revenue and Debt Service Coverage ratios, while providing
insight as to how the institution is managing its debt, are less
important than a measure of leverage itself. For these and other
reasons, the Secretary includes in the ratio methodology an Equity
ratio (tangible equity divided by tangible total assets) as the primary
measure of leverage.
The Secretary is not convinced that the utility of a Longevity
measure or ratio is on par with the utility of the ratios used in the
methodology. Unlike the ratios used in the methodology that measure the
actual financial condition of an institution, it is not clear how a
Longevity measure could be used as part of the methodology. A Longevity
measure merely implies that an institution that has been operating for
many years will continue to operate, but provides no insight regarding
the institution's current financial condition or its ability to satisfy
its obligations. Moreover, a Longevity measure cannot be used as an
independent test because it has no predictive value at the
institutional level. Based on data obtained from Dun & Bradstreet
regarding the probabilities of credit stress and bankruptcy, the
Secretary found that institutions that have been in existence for more
than 30 years have on average more likelihood of enduring credit stress
and less likelihood of going bankrupt than institutions that are less
than 30 years old. However, there were a significant number of
institutions in the data group that have been in existence for more
than 30 years that were rated by Dun & Bradstreet as representing high
risks of late payments or financial failure. In addition, the Secretary
reviewed the files of closed institutions and found that a significant
percentage of those institutions (12 percent) were in existence for
more than 25 years.
With regard to the notes to financial statements and independent
accountants' reports, the Secretary wishes to clarify that these notes
and reports are reviewed by the Secretary to determine if an
institution complies with other standards or elements of financial
responsibility. For example, if an auditor expresses a ``going-
concern'' opinion, the institution is not financially responsible even
if it satisfies all other standards. However, the information contained
in the notes and reports does not always constitute a sufficient basis
on which the Secretary makes or can make a determination of financial
responsibility.
Changes: The proposed ratio methodology is revised, in part, by
replacing the Viability ratio with the Equity ratio.
Comments regarding the use of ratios: One commenter from the
proprietary sector argued that the proposed ratio methodology should
not be used to determine that an institution is not financially
responsible. The commenter stated that the AICPA CPA/MAS Technical
Consulting Practice Aid No. 3 warns of the shortcomings of ratio
analysis, including improper comparisons that do not take into account
size, geographical location and business practices, and other variables
such as depreciation and number of years considered by that analysis.
Based on these shortcomings, the commenter concluded that a financially
strong institution may fail to achieve the required composite score
requirement or be forced to make unsound business decisions solely to
meet the requirement. Although the commenter believed that the proposed
ratio methodology could be used to determine that an institution is
financially responsible, the commenter recommended that the Secretary
allow an institution that fails to achieve the composite score to
demonstrate its financial strength without imposing the letter of
credit requirement.
Discussion: The Secretary disagrees. The practice aid is
specifically designed to provide a consulting or accounting
practitioner illustrative examples of the use of financial ratio
analysis techniques in performing a comparative analysis of a client
organization with other appropriate organizations.
The ``shortcomings'' referred to by the commenter relate to factors
that should be considered by the practitioner in understanding the
differences that may occur between comparable companies and explaining
those differences to the client. To the extent practicable, the ratio
methodology developed for these regulations mitigates these differences
by evaluating the financial health of an institution relative to other
institutions, and by measuring an institution's financial health
against a minimum standard established by the Secretary. In addition,
the individual ratio definitions are constructed to account for
reporting and accounting differences between the sectors of higher
education institutions. While other factors, such as operating
structure, could affect an institution's performance, the consequences
of those factors reflect management decisions that fall outside the
scope of the Secretary's review.
Changes: None.
Comments regarding public institutions: One commenter argued that
there is no need for Federal financial standards for public
institutions for several reasons.
First, the commenter maintained that there is no danger of a
``precipitous closure'' of a public institution because, in his State,
the closure of a State college or university requires the approval of
the State General Assembly. Moreover, the commenter believed that
[[Page 62844]]
in authorizing a closure, the General Assembly would be careful to
protect the interests of students and all creditors. In any event, the
commenter opined that the Secretary could recover any monies due from a
closed State institution by offset against future aid to other State
institutions. For local public institutions (community colleges), the
commenter stated that, in his State, a closure would have to be
approved in a general election. However, the closure of a local
institution cannot adversely affect student refunds or other
liabilities of the institution because State law requires the
continuance of property tax assessments until all debts of the
institution are paid in full.
Second, the commenter noted that public institutions are subject to
far more official oversight than private or proprietary institutions.
In his State, the activities of State institutions are monitored by,
among others, the State Controller, the State Auditor, and the State
Commission on Higher Education.
Third, the commenter pointed out that public institutions are
subject to more public scrutiny than are private and proprietary
institutions, i.e., public institutions conduct their affairs in
public, publish budgets, hold governing board meetings that are open to
the public, and make their financial statements available for public
inspection. The commenter believed strongly that this scrutiny enhances
the financial responsibility of public institutions.
Fourth, the commenter noted that the 1973 AICPA Audit Guide is
obsolete for colleges and universities under FASB jurisdiction and will
soon be obsolete for other public institutions. The commenter stated
that the Government Accounting Standards Board (GASB) intends to
publish an exposure draft on its Colleges and Universities Reporting
Model at the end of March 1997 and a final Statement of Financial
Reporting Standards in the second quarter of 1988. According to the
commenter, since the proposed reporting model makes major changes to
public institutions' financial statements, it is unlikely that any
ratio definitions based on the 1973 AICPA Audit Guide will be useful
when the new model takes effect (probably the fiscal year starting in
2000). The commenter suggested therefore that the Secretary delay
promulgating financial ratio standards for public institutions until
the new GASB standards are in effect.
Next, the commenter argued that the proposed methodology's reliance
on profits and expendable fund balances is inappropriate for public
institutions, and may be contrary to State public policy. The commenter
believed that unlike private non-profit and proprietary institutions
that need to have sufficient reserves (or be able generate the profits
necessary to accumulate sufficient reserves) to continue operations
during economic fluctuations, public institutions have much less need
for reserves because their major funding sources are less susceptible
to those fluctuations.
In addition, the commenter stated that in his State, public policy
prohibits State institutions from accumulating large expendable funds
balances. The State General Assembly appropriates funds for the purpose
of meeting the immediate education needs of State residents and not for
creating institutional reserves. The commenter continued that
consistent with this policy, the State does not fund colleges and
universities for the long-term compensated absence liabilities that
those institutions are required to accrue under GASB Statement No. 16
(the State funds these liabilities when they become due). Consequently,
the commenter believed that the existence of these liabilities
virtually guarantees that smaller State institutions will fail the
proposed ratio standards. Moreover, the commenter argued that the
proposed ratio standards do not sufficiently recognize the differences
between public sector financial reporting requirements (GASB) and
private sector requirements (FASB).
Several other commenters maintained that some State institutions
would not achieve the required composite score if they are required to
include in the calculation of the proposed ratios, items that are
beyond the control of those institutions. Therefore, the commenters
suggested that it would be fairer to allow State institutions to
exclude from the ratio analysis items such as plant debt and certain
employee benefits that are the obligation of the State or funded by the
State.
For several reasons, commenters representing public institutions
believed that the Secretary should amend proposed Sec. 668.174(a)(1).
Under this section, an institution that fails to achieve the required
composite score may demonstrate to the Secretary that it is
nevertheless financially responsible if the institution's liabilities
are backed by the full faith and credit of the State or by an
equivalent government entity. First, the commenters recommended that
the Secretary qualify the term ``liabilities'' by adding the phrase
``that may arise from the institution's participation in the title IV,
HEA programs.'' In support of this recommendation, the commenters noted
that in both of the other alternatives under this section, liabilities
are either based on or limited to the amount of title IV, HEA program
funds received by an institution. Moreover, the commenters argued that
if the Secretary interprets ``liabilities'' to mean all balance sheet
liabilities of an institution, the State would have to accept these
liabilities as General Obligations of the State. According to the
commenters, since most States have constitutional prohibitions against
general obligation debt, States would be prohibited from providing the
required backing for any institution that has revenue bonds or similar
debt outstanding.
Next, the commenters recommended that the Secretary amend the term
``equivalent government entity'' by adding the phrase ``including local
governments or separate districts with taxing authority'' to clarify
that the guarantee required under Sec. 668.174(a)(1) may be provided by
any entity that has the taxing power to validate its guarantee.
Discussion: The Secretary agrees with many of the points made by
the commenters and therefore does not establish in these regulations a
composite score standard for public institutions. Instead of satisfying
the composite score standard, an institution must notify the Secretary
that it is designated as a public institution by the State, local or
municipal government entity, tribal authority, or other government
entity that has the legal authority to make that designation, and
provide a letter from an official of that State or government entity
confirming that it is a public institution.
Changes: The composite score standard and Primary Reserve
requirements proposed under Sec. 668.172(a)(1)(i) and (ii) for public
institutions are eliminated. The replacement provisions described above
are relocated under Sec. 668.171(c).
Comments regarding third-party servicers: Several commenters
believed strongly that the proposed regulations are unsuitable for
third-party servicers, noting that the KPMG study did not include an
analysis of third-party servicers. The commenters argued that the
servicer business sector is fundamentally different from any type of
institutional educational sector, pointing out that the contractual
obligations and legal structures of servicers are different than those
of institutions.
In addition, the commenters contended that while the proposed
requirements regarding alternative financial standards and the actions
the
[[Page 62845]]
Secretary may take against entities that fail to satisfy the standards
may be appropriate for institutions, these alternate standards and
actions are not applicable or appropriate for third-party servicers.
For these reasons, the commenters requested the Secretary to put aside
the proposed rules and work with third-party servicers to formulate
new, more applicable rules.
Several other commenters representing third-party servicers argued
that since the proposed methodology favors entities with high equity
and low debt, it is inappropriate for third-party servicers that have
low equity and high debt but generate high income streams. Moreover,
the commenters noted that while the Secretary consulted with third-
party servicers in establishing the current regulations (as part of the
Negotiated Rulemaking process), third-party servicers were not
consulted before these proposed rules were published. Therefore, the
commenters recommended that the Secretary continue to evaluate third-
party servicers under the current regulations.
Several commenters representing third-party servicers maintained
that the alternative of submitting a letter of credit of up to 50
percent of title IV, HEA program funds does not apply to third-party
servicers. The commenters suggested instead that third-party servicers
that are collection agencies for FFELP funds post a fidelity bond in
the amount equal to the amount held each month by the agency in its
trust account on behalf of the guarantors prior to remittance to the
guarantor. These commenters argued that such a standard represents the
current industry practice to protect guaranty agencies with which a
collection agency contracts, from loss caused by the agency's actions.
Discussion: The Secretary agrees to develop in the future financial
standards solely for third-party servicers. In the meantime, those
servicers must comply with the requirements under 34 CFR Parts 668 and
682.
Changes: The third-party servicer requirements under proposed
Sec. 668.171(b) are removed.
Part 5. General Comments Regarding the Proposed Ratios
Comments regarding the Primary Reserve ratio: Many commenters
opposed the requirement that public and private non-profit institutions
must have a positive Primary Reserve ratio to meet the general
standards of financial responsibility. The commenters maintained that
this requirement represents a separate, single standard, contradicting
both the intent of proposed ratio methodology and the statutory
requirement that the Secretary consider an institution's total
financial condition.
Several commenters from non-profit institutions believed that the
Primary Reserve ratio favors colleges and universities that accumulate
resources to safeguard Federal funds rather than expend those resources
to provide student services. The commenters argued that this preference
is not only contrary to the operation and mission of most colleges and
universities, it will result in inflationary pressures that create
tuition increases.
Several commenters argued that institutions will be forced to
reduce teaching and other staff to attain adequate scores for the
Primary Reserve ratio. The commenters reasoned that reducing ``total
expenses'' to improve the ratio score necessarily reduces salaries and
wages for teachers and staff because salaries and wages comprise the
largest component of ``total expenses'' at most institutions.
A commenter from a non-profit institution argued that expended
title IV, HEA program funds should be subtracted from ``total
expenses'' because these funds are not included in ``total unrestricted
income.'' Likewise, the commenter believed that revenues expended from
restricted endowments should not be included in ``total expenses'' if
those funds are not counted in ``total unrestricted income.''
Other commenters opined that the Primary Reserve ratio treats non-
profit institutions unfairly because the numerator excludes most
restricted assets, but the denominator does not exclude the expenses
attributable to those assets.
Some commenters suggested that the Secretary refine the term
``expenses'' in several ways. First, it should be adjusted so that it
reflects cash consumption rather than non-cash accounting charges--such
non-cash charges as depreciation and amortization expense should be
eliminated, while principal repayments on debt should be added. Second,
expenses associated with sponsored programs should be eliminated. These
commenters, and other commenters, maintained that sponsored program
expenses, such as those associated with the U.S. Government-sponsored
scientific research programs, are a function of those research programs
and can generally be eliminated upon termination of those programs
(during the course of the program, expenses are funded by revenues
received from the sponsoring agency). The commenters concluded that the
Secretary should not penalize an institution whose researchers are
capable of generating significant grants.
Discussion: The Primary Reserve ratio provides a measure of an
institution's expendable or liquid resource base in relation to its
overall operating size. It is, in effect, a measure of the
institution's margin against adversity. Specifically, the Primary
Reserve ratio measures whether an institution has financial resources
sufficient to support its mission--that is, whether the institution has
(1) sufficient financial reserves to meet current and future operating
commitments, and (2) sufficient flexibility in those reserves to meet
changes in its programs, educational activities, and spending patterns.
Therefore, the Secretary continues to believe that an institution with
a negative Primary Reserve ratio has serious financial difficulties.
If an institution's Primary Reserve ratio is negative, expendable
net assets are in a deficit position. In those cases the institution
will need to generate surpluses to replenish the deficit, or may be
forced to draw on other resources or sell off assets to make ends meet,
thus increasing the uncertainty that the institution will be able to
meet its obligations. However, because an Equity ratio is now included
in the methodology, the Secretary eliminates the proposed provision
that a non-profit institution is not financially responsible if it has
a negative Primary Reserve ratio. The Equity ratio measures the amount
of total resources that are financed by owners' investments,
contributions, or accumulated earnings (or conversely, the amount of
total resources that are subject to claims of third parties) and thus
captures an institution's overall capitalization structure and, by
inference, its overall leverage. Because the Equity ratio supplements
the measure of the amount of expendable reserves provided by the
Primary Reserve ratio with a measure of other capital resources
available to support the institution, it provides a measure of
resources that could mitigate the effects of a negative Primary Reserve
ratio.
With regard to the comments about total expenses, those expenses,
including salaries paid to faculty and staff, are part of the
commitment of an institution to provide services to students. The
relative size of each component in an institution's annual operating
budget is a management decision. In addition, the Secretary notes that
based on the AICPA Audit Guide for Not-for-Profit Organizations issued
on June 1, 1996, most title IV,
[[Page 62846]]
HEA program funds will not be included in total expenses of colleges
and universities. For example, payments made to those institutions
under the Direct Loan, Federal Family Education Loan, Federal Pell
Grant, and Federal Supplementary Educational Opportunity Grant programs
are not included in total expenses reported on the statement of
activities. In addition, the Audit Guide will require scholarship
expenses to be netted against tuition income in the revenue portion of
the statement.
The Secretary disagrees that the definition of the term
``expenses'' as used in the Primary Reserve ratio should exclude non-
cash charges such as depreciation and amortization and, except in
certain circumstances, sponsored program expenses. The Primary Reserve
ratio measures an institution's expendable or liquid resource base in
relation to its overall operating size. Operating size is the total of
all expenses incurred by the institution in the course of its business
and is a key financial element because it provides the best view of the
size of its programmatic activities and commitments. Because
depreciation expense represents a charge to operations that reflects
the future replenishment of the existing plant (and replaces the actual
cash outlays for equipment and repairs formerly in the revenue and
expenditures statement of private non-profit institutions under the
fund accounting model), it represents a commitment of capital resources
to the institution and reflects its overall operating size.
The Secretary disagrees that an institution can eliminate expenses
relating to U.S. Government-sponsored scientific research programs
immediately upon the termination of those programs. To the contrary,
because many universities require highly specialized facilities and
equipment to conduct research under those programs, they will likely
incur significant upfit and other costs in re-deploying their research
facilities in the event of a loss in program funding. Therefore, the
Secretary considers scientific research expenditures to be an
appropriate component of the operating size of an institution since the
institution is committed to making those expenditures until adjustments
can be made.
However, the Secretary agrees that in certain instances sponsored
program expenses should be excluded from the ratio calculations. The
Secretary believes that an institution that receives HEA grant program
funds, especially those associated with programs that strengthen
institutions or expand access to higher education, should not fail the
composite score standard solely because of the expenditure of those
funds. Therefore, the amount of HEA funds that an institution reports
as expenses in its Statement of Activities for a fiscal year are
excluded from the ratio calculations but only if these reported
expenses alone are responsible for the institution's failure to achieve
a composite score of 1.5 for that fiscal year.
Changes: The Secretary eliminates the requirement proposed under
Sec. 668.172(a)(1)(ii) that a public or private non-profit institution
must have a positive Primary Reserve ratio.
Proposed Sec. 668.173(e), describing the items that are excluded
from the ratio calculations, is relocated under Sec. 668.172(c) and
revised, in part, to provide that the Secretary may exclude from the
ratio calculations reported expenses of HEA program funds under the
conditions described previously.
Comments regarding the Viability ratio: A commenter from a non-
profit institution maintained that the implicit assumption of the
Viability ratio is that an institution should minimize or eliminate
debt in order to preserve the accumulation of assets. The commenter
opined that such a philosophy would lead to institutions avoiding the
creation of revenue-creating assets, such as residence halls.
Accordingly, the commenter believed that the correct measurement should
be the amount of risky loans that an institution undertakes, and
recommended therefore that the amount of loans secured by collateral be
eliminated from the denominator of the Viability ratio.
Similarly, many commenters opined that the proposed definition of
adjusted equity will discourage institutions from financing property,
plant and equipment from current revenues. The commenters believed that
institutions will elect instead to assume long-term debt even if the
assumption of long-term debt is contrary to good business practice.
For several reasons, many commenters opposed the proposed
adjustment for proprietary institutions that would limit the threshold
factor for the Viability Ratio to the threshold factor for the Primary
Reserve ratio in cases where the institution's Primary Reserve ratio
threshold factor is a one or a two. First, these commenters maintained
that such an adjustment defeats the purpose of measuring financial
responsibility on the basis of three ratios. Second, the commenters
argued that if the reason for this adjustment is to circumvent possible
abuse and manipulation of the Viability ratio, then there may be
something wrong with using the ratio as part of the methodology. Third,
the commenters argued that it is arbitrary and unfair to assume, based
on the premise that the institution has manipulated its financial
report, that an institution's Viability ratio will always be higher
than its Primary Reserve ratio. Rather, the commenters maintained that
an institution could achieve a high Viability ratio through careful
financial management. The commenters recommended therefore that the
Secretary use this adjustment only if the reason for using it is
consistent with the concepts underlying the proposed ratio methodology.
Similarly, commenters maintained that this adjustment is unfair to non-
profit institutions that have no debt, because the weighting for the
Primary Reserve ratio increases from 55 percent to 90 percent.
One commenter suggested that if an institution has no debt, the
Secretary should allow an institution to show the amount of long-term
debt that it would be able to obtain, such as, by demonstrating to the
Secretary that the institution has a line of credit, or by providing to
the Secretary a letter from a bank indicating the bank's willingness to
make a long-term loan to the institution.
Many other commenters from the proprietary sector believed the
Secretary should reward an institution that has no debt for its sound
management practices, rather than penalize that institution by
increasing the weighting for its Primary Reserve ratio from 20 percent
to 50 percent. These commenters, and other commenters, suggested
instead that for an institution that has no debt the Secretary should
assign a threshold factor of 5.0 on its Viability ratio, or weight the
Viability ratio at 30 percent, or both. Another commenter maintained
that the amount of equity needed to achieve a strength factor score of
3.0 on the Viability Ratio is excessive and penalizes an institution
for using leverage prudently. This commenter proposed that the amount
of equity that results in achieving a strength factor score of 3.0
should instead yield a strength factor score of 5.0.
Another commenter suggested that an institution's Viability ratio
strength factor be limited to two times the Primary Reserve strength
factor in cases where the institution has a Primary Reserve strength
factor score of 1.0 or 2.0. According to the commenter, this weighting
scheme would allow an institution with no debt, but with a reasonable
Primary Reserve ratio score,
[[Page 62847]]
to pass the ratio standards if it has a bad year (i.e., achieves only a
strength factor score of 1.0 on the Net Income ratio). The commenter
further stated that under this approach, a similarly situated
institution with a Primary Reserve ratio strength factor score of 1.0
would not pass the ratio standards.
Several commenters from proprietary institutions asserted that
eliminating the Viability ratio for institutions that have no debt is
particularly unjust because the current acid test ratio compels
institutions to remain debt-free. One of the commenters argued that the
proposed adjustment to the Viability ratio acts to raise the Primary
Reserve weighting for proprietary institutions to a level required of
non-profits despite the real differences between these sectors. The
commenter asserted that this methodology would only encourage
institutions to take out debt in order to use the Viability ratio,
rather than discourage that practice. The commenter suggested that if
the Secretary chooses to keep this methodology, the Net Income and
Primary Reserve ratios should be weighted at 80 percent and 20 percent,
respectively.
Discussion: The Secretary proposed the Viability ratio because it
measures one of the most basic elements of clear financial health: the
availability of expendable resources (resources which can be accessed
in short order) to cover debt should the institution need to settle its
obligations. As such, it is useful in measuring the financial condition
of most institutions. However, the Secretary has decided to remove the
Viability ratio from the ratio methodology established in these
regulations for the following reasons.
First, in linking the results of the Viability and Primary Reserve
ratios the Secretary sought to discourage an institution from
manipulating its Viability ratio by taking on a small amount of debt
solely to inflate its composite score. However, linking the two ratios
may result in a composite score that understates the financial health
of an institution that legitimately carries a small amount of debt.
Second, based on analyses conducted by KPMG during the extended
comment period of 507 audited financial statements from proprietary
institutions and 395 audited financial statements from private non-
profit institutions, the Secretary found that 35 percent of those
proprietary institutions and 13 percent of those non-profit
institutions had no long-term debt. Accordingly, the Viability ratio
could not be applied to a significant number of institutions in each
sector--the composite score for those institutions would therefore be
determined solely on the results of the Primary Reserve and Net Income
ratios. The Secretary agrees that this was a shortcoming in the
proposed methodology, and includes in the ratio methodology established
by these regulations only ratios that can be applied to all
institutions.
In view of the public comments, the Secretary agrees that certain
aspects of the proposed methodology associated with the Viability ratio
may cause, unintentionally, tensions between an institution's desire to
make appropriate business decisions and the institution's compliance
with the proposed regulations. Among these business decisions are those
related to whether an institution should finance the cost of plant
assets with external sources, or whether it should fund the cost of
those investments internally with revenues from operations (or from
some combination of those sources). From the analysis performed during
the extended comment period, the Secretary found that some institutions
chose to utilize internal resources to fund their plant assets as
opposed to borrowing from external sources. For some of those
institutions, that choice was a prudent business decision that is not
reflected directly in either the Viability or Primary Reserve ratios.
The impact of those business decisions is now reflected in the Equity
ratio.
Changes: The proposed Viability ratio is replaced by the Equity
ratio.
Comments regarding the numerator of the Primary Reserve and
Viability ratios--Expendable Net Assets or Adjusted Equity: Commenters
from non-profit institutions asserted that the numerator of the
Viability and Primary Reserve ratios mistakenly neglects permanently
restricted endowment net assets. The commenters maintained that revenue
generated from these assets not only helps fund operations, but also
helps to provide scholarships to students that generate more revenue
for the institution. Some commenters believed that the Primary Reserve
and Viability ratios should also include some percentage of the
physical plant which is free and clear of debt, arguing that excluding
physical plant from the numerators of these ratios will only encourage
institutions to keep assets in cash rather than invest in physical
assets that benefit students. Alternately, these commenters, and other
commenters, asserted that if physical plant is not included in the
numerator of the Primary Reserve ratio, then depreciation costs on
physical plant should not be included in ``total expenses'' of the
denominator of this ratio.
Another commenter representing private non-profit institutions
objected to the blanket exclusion of related party receivables from the
ratio calculations. The commenter asserted that this exclusion would
impact negatively many institutions that depend on church pledges, and
suggested instead that the Secretary consider such factors as prior
payment history and the financial strength of the related party before
making a decision to exclude these receivables.
A few commenters suggested that expendable net assets exclude an
institution's liability for post-retirement benefits, maintaining that
this liability represents a very long-term moral obligation that will
not render any institution incapable of teaching its students or
discharging its obligations under the title IV, HEA programs.
Many commenters from the proprietary sector, including students,
objected to the definition of ``adjusted equity'' as used in the
numerator of the Primary Reserve and Viability ratios. The commenters
asserted that excluding fixed assets (property, plant, and equipment)
and intangible assets from the definition will cause institutions to
forego investing in new educational equipment and educational
facilities, resulting in an erosion in the quality of education
students receive. Moreover, these commenters argued that the proposed
treatment of equity is counterproductive because it creates a
disincentive for owners to invest the resources necessary to provide
quality education.
Based on the information provided by the Secretary during the
extended comment period, one commenter calculated the Primary Reserve
ratio for the 30 Dow Jones companies. According to the commenter, 18 of
those companies would receive a strength factor score of zero, and only
9 would receive a strength factor score of 2.0 or 3.0. In order for 50
percent of these companies to achieve a strength factor score of 2.0 or
3.0, the commenter indicated that the suggested ratio score of .20
would need to be reduced to .07. From this analysis, the commenter
concluded that the suggested strength factors for the Primary Reserve
ratio do not appear to be reasonable and recommended that the Secretary
modify the proposed definition of adjusted equity to include fixed
assets.
One commenter opposed the proposed definition of adjusted equity,
arguing that the definition is not explained or justified, and that it
is contrary to evaluations conducted by
[[Page 62848]]
other agencies, such as the Securities and Exchange Commission (SEC).
The commenter suggested that if the Secretary is attempting to
ascertain through this definition which assets the institution holds
that have value and may easily be converted to cash, then all items
that result in cash flow should be included. An example of this would
be that all of an institution's deferred income (reflected as a
liability on the balance sheet) will not be paid in cash. In
particular, the commenter maintained that many of the costs associated
with an institution's recruiting activities will already have been
incurred and when the deferred income is recognized on the
institution's income statement as shareholder equity, the cash outlay
will be less than the revenue, i.e., if the cash outlay is 55 percent
of the revenue, the remaining 45 percent of the deferred income should
be added to equity to arrive at the institution's adjusted equity.
Another commenter from a proprietary institution objected to the
proposed definition of ``adjusted equity'' because it does not measure
the debt capacity of an institution. This commenter suggested that the
definition be changed to ``net tangible assets plus unused lines of
credit.''
Several commenters maintained that the proposed definition of
``adjusted equity'' does not capture the institution's ability to
adjust to periods of declining revenue, which the commenters believed
is the aim of the Primary Reserve and Viability ratios.
Discussion: The Secretary disagrees with the commenters who
suggested that the definition of expendable net assets mistakenly
excludes permanently restricted net assets. The Primary Reserve ratio
is a measure of the resources available to an institution on relatively
short notice, and therefore the ratio measures only expendable net
assets. Permanently restricted net assets are neither liquid or
expendable, except in the event of some legal action, and therefore do
not form any part of the resource measured by this ratio. The Secretary
wishes to emphasize that the non-liquid resources represented by
permanently restricted assets are measured by the Equity ratio.
With regard to the comment concerning the applicability of the
Primary Reserve ratio to the 30 Dow Jones companies, the Secretary
notes that the ratio methodology is designed to measure the elements of
financial health that are appropriate for postsecondary institutions,
not for manufacturing and industrial entities, which comprise most of
the Dow Jones companies.
The Secretary disagrees that fixed assets should be included in
adjusted equity or that plant assets should be included in the
definition of expendable net assets. Because the Primary Reserve ratio
provides a measure of an institution's expendable resource base in
relation to its overall operating size, the logic for excluding net
investment in plant is twofold. First, plant assets represent sunk
costs to be used in future years by an institution to fulfill its
mission--plant assets will not normally be sold to produce cash since
they will presumably be needed to support on-going programs. Moreover,
in some instances there is a lack of a ready market to turn the assets
into cash, even if they are not needed programmatically.
Second, excluding net plant assets is necessary in identifying the
expendable or relatively liquid net assets (that would be used as a
component of any measure of liquid equity) available to the institution
on relatively short notice. Including plant assets would distort the
measure of liquid equity, and therefore would distort an important
short-term measure of the institution's financial health. (The
regulatory practice of excluding fixed assets is not unique to these
rules. Various other regulated industries, such as depository
institutions and broker dealers, are also subject to practices that
exclude or limit the extent that fixed assets may comprise regulatory
capital.) The Secretary notes that all tangible assets are considered
by the Equity ratio.
The definition of expendable net assets excludes from those assets
an institution's post-retirement benefits obligation.
The Primary Reserve ratio is not meant to capture debt or ability
to borrow, but to measure the institution's expendable reserves. A
measure of debt and ability to borrow is incorporated in the Equity
ratio.
The Secretary disagrees that the proposed definition of ``adjusted
equity'' does not capture an institution's ability to adjust to periods
of declining revenue because the balance sheet ratios, Primary Reserve
and Equity, represent the resources accumulated over time by the
institution that are available to the institution to make necessary
adjustments.
Changes: None.
Comments regarding the Equity ratio: Several commenters from
proprietary institutions who opposed excluding fixed assets from
adjusted equity (in calculating the Primary Reserve ratio) believed
that this exclusion not only discourages institutions from investing in
educational equipment, but rewards institutions that invest the least,
i.e., those institutions that lease instead of purchase equipment.
Most commenters supported the suggestion made by the Secretary
during the extended comment period to use an Equity ratio instead of
the proposed Viability ratio. Some of these commenters believed that
the use of an Equity ratio not only resolves many of the problems
associated with the Viability ratio; it is also a good measure of how
well an institution is capitalized and an indirect measure of an
institution's ability to borrow. Moreover, these commenters opined that
an Equity ratio encourages the kind of behavior that the Secretary
should want to encourage--reinvestment in the institution.
Similarly, several commenters believed that the Equity ratio
provides a necessary measure of capital investment, and argued that it
is a better ratio than the liquidity ratio under current regulations.
One of these commenters stated that liquidity ratios measure assets
that can be removed fraudulently, whereas capital investment ratios
measure assets that can be used to determine the owner's commitment to
the institution.
Other commenters supporting the use of an Equity ratio recommended
that the ratio include endowment assets in the numerator. However, some
of these commenters suggested the Secretary should not raise the
strength factors for the Equity ratio to compensate for the inclusion
of endowment assets because this would disadvantage institutions with
little or no endowments. Another commenter believed that excluding
endowment assets from the Equity ratio would treat all institutions
more fairly.
Discussion: The Secretary reiterates that fixed assets are not
expendable assets and are thus not included in calculating the Primary
Reserve ratio. However, fixed assets are included (as part of the total
resources of the institution) in the Equity ratio. In providing a
measure of capital resources, the Equity ratio supplements the
expendable resources measured by the Primary Reserve ratio.
By comparing equity to total assets, the Equity ratio indicates the
share of assets shown on the institution's balance sheet that the
institution actually owns, reflecting the commitment to the institution
of the owners or persons that control the institution, and provides
insight into the capital structure of the institution, i.e., it
indicates whether an institution has acquired a disproportionate amount
of its assets utilizing debt. Excessive amounts of debt will adversely
affect the
[[Page 62849]]
ratio and little or no debt will have the opposite effect.
The Secretary notes that Permanently Restricted Net Assets (which
include the permanently restricted piece of endowment funds) are
included in the numerator of the Equity ratio. However, in including
those assets the Secretary did not adjust the strength factors for the
Equity ratio. The strength factor values for the Equity ratio are not
normalized to the relative equity of institutions in either sector;
therefore inclusion of permanently restricted endowment in the
calculation of the Equity ratio will help the ratio results of
institutions with large endowments, but will not hurt the ratio results
of institutions with little or no endowment.
Changes: The ratios described under proposed Sec. 668.173 are
relocated under Sec. 668.172 and revised to include the Equity ratio.
The Equity ratio is specifically defined for proprietary institutions
under Appendix F and for private non-profit institutions under Appendix
G.
Comments regarding the Net Income ratio: A few commenters believed
that the proposed Net Income ratio is not fair to proprietary
institutions, arguing that since the ratio is constructed and weighted
in a manner that does not allow institutions that have operating losses
to meet the composite score standard, those institutions would be
forced to submit a letter of credit. One of these commenters asserted
that operating losses sometimes occur due to changing economic
circumstances (e.g., the acquisition and redevelopment of a
financially-troubled institution), but that this condition is usually
not a permanent feature of the institution's financial condition.
Accordingly, the commenter suggested that one way of remedying this
inequity would be for the Secretary to determine that an institution is
financially responsible if the institution satisfies the composite
score requirement for two years in a three-year cycle, or three years
in a four-year cycle.
Similarly, other commenters believed that the Net Income ratio
should be eliminated because it represents only the results from
operations for one fiscal year but does not take into consideration
prior year reserves that may be available to offset negative net income
in any year.
Several commenters representing proprietary institutions asserted
that institutions operating in states such as Oregon, Texas, Florida,
Alaska, and Nevada that have taxes on gross receipts or property rather
than on income are disadvantaged by the Net Income ratio because taxes
on gross receipts or property are always reflected as a business tax in
operating expenses rather than an income tax.
Many commenters from proprietary institutions maintained that,
although it is important under the proposed methodology to attain a
strength factor score of at least 3.0 on the Primary Reserve ratio (so
that the Viability ratio can be counted independently), attaining that
strength factor requires that adjusted equity be at least 30 percent of
annual expenses. The commenters argued that this strength factor was
too high for several reasons. First, the commenters opined that
retaining 30 percent of equity as a reserve fund creates a disincentive
to invest in property and equipment. Second, the commenters stated that
retaining equity rather than distributing profits to shareholders
exposes a for-profit institution to an ``accumulated earnings tax'' of
39.6 percent on profits in excess of $250,000, unless the institution
provides a reasonable business reason for retaining the equity and a
plan for its use. Under this 30 percent requirement, the commenters
maintained that an institution with as little as $833,333 in annual
expenses would be exposed to the accumulated earnings tax. Third, the
commenters maintained that it is very unusual for a business that is
expected to provide a return on investment to retain equity exclusive
of fixed assets in an amount equal to 30 percent of a year's expenses.
Similarly, several commenters representing proprietary institutions
maintained that the ratios erroneously ignore differences between
Chapter S and C corporations, particularly in regard to accumulated
earnings tax. The commenters argued that since the treatment of owners'
salaries is discretionary under both types of corporations, the
proposed methodology creates an incentive for owners to manipulate
their salaries (or dividends and other equity distributions) to meet
the composite score. The commenters further stated that this
manipulation runs afoul of income and payroll tax laws, and that
regulations should not entice owners to behave in this manner. One of
these commenters suggested that the Secretary define ``income before
taxes'' as the profit before owners' salaries and distributions so that
all proprietary institutions are treated in the same manner with
respect to calculating the Net Income ratio.
Discussion: An institution must generate surpluses to build
reserves for future program initiatives and to increase its margin
against adversity. However, the Secretary accepts that there will be
circumstances where this is not possible. Therefore, the strength
factors for the Net Income ratio allow an institution to earn some
points toward its composite score if the institution incurs a small
loss.
Regarding the comment that the Net Income ratio does not consider
prior-year reserves, the Secretary reminds the commenters that those
reserves are considered by the Primary Reserve and Equity ratios.
With regard to the Accumulated Earnings Tax, the Secretary would
like to clarify that the only portion of stockholders' equity that is
subject to the tax is retained earnings. Other components of equity
such as common stock and other capital are not subject to this tax.
Moreover, the Secretary believes that any potential exposure to the
accumulated earnings tax on excess profits is a tax planning issue
regardless of the value of the strength factors for the Primary Reserve
ratio (of the 507 financial statements reviewed for proprietary
institutions, the Primary Reserve ratio was 0.30 or higher for 84 or 17
percent of these institutions; of those 84 institutions, only 39 had
equity (retained earnings) greater than $250,000). These and other
institutions should already be considering the potential impact of the
tax, including ways to use earnings accumulated beyond the IRS limits
for reasonable business needs. In any event, the Secretary notes that
the changes made to the proposed methodology for other reasons minimize
an institution's exposure to the accumulated earnings tax--the
Viability ratio has been eliminated, and a Primary Reserve ratio result
of 0.15 (as opposed to the proposed result of 0.30) is now required to
earn the maximum strength factor score for that ratio.
If earnings are accumulated beyond the IRS limits, IRS regulation
26 CFR 1.537-2(b) provides some broad criteria that can be used to
support the contention that earnings are being accumulated for the
reasonable needs of the business, including to: (1) Provide for bona
fide business expansion or plant replacement, (2) acquire a business
enterprise through purchasing stock or assets, (3) provide for the
retirement of bona fide indebtedness created in connection with the
trade or business, (4) provide necessary working capital for the
business, (5) provide for investments in or loans to customers or
suppliers if necessary to maintain the business of the corporation, and
(6) provide for the payment of reasonable anticipated product liability
losses, an actual or potential lawsuit, the loss of a major customer,
or self-insurance. A
[[Page 62850]]
business contingency can be considered a reasonable need if the
contingency is likely to occur (e.g. flood losses in a flood prone
area). The accumulation of earnings to provide against unrealistic
contingencies is not considered a reasonable need.
The Secretary notes that there are several other ways to determine
reasonable working capital needs, including the ``Bardahl'' formula.
Institutions should work with their tax advisor with respect to these
matters.
The Secretary disagrees that the methodology should discount Gross
Receipt Tax paid by institutions in certain States because these taxes,
just like other sales and property taxes that differ from State to
State, are a cost of doing business.
Changes: The strength factors and weighting percentages for the
Primary Reserve and Net Income ratios are revised (see Analysis of
Comments and Changes, Parts 6-7).
Comments regarding the market value of assets: A commenter from a
non-profit institution noted that the Viability ratio ignores the
market value of assets (assets are booked at cost for balance sheet
presentations), but that lenders look to market values when considering
collateral to secure long-term debt. Consequently, the commenter argued
that an institution's ability to borrow in order to liquidate or
restructure debt may be a better measure of financial viability than an
institution's ability to liquidate long-term debt from expendable
resources.
Similarly, several commenters from proprietary institutions
maintained that since the proposed ratio methodology does not consider
the market value of real estate, it depresses the financial score of an
institution that holds valuable properties, particularly if those
properties have been depreciated over a long period of time. One
commenter argued that this is evidenced by the fact that the
commenter's institution was rated ``good'' by Dun and Bradstreet as of
June 30, 1995, and passes the current financial responsibility
standards under Sec. 668.15, but would fail the proposed ratio
standards. The commenter suggested that this problem could be solved
either by allowing the institution to credit back the difference
between the net book value of the property and the secured debt
(mortgage), or allow the institution to provide and include as an asset
the amount of the property's appraised value as certified by an
appraiser. A few commenters suggested that the term ``expendable net
assets'' include at least the book value (if not the market value) of
property, plant, and equipment, arguing that it is unrealistic to
assume that these assets are valueless or incapable of being
liquidated.
Discussion: The Secretary has decided not to consider the market
value of property, plant, and equipment because accepting the market
value of those assets would introduce a significant amount of
subjectivity into the ratio calculations--the appraised value of those
assets may differ depending on the person making the appraisal and the
method by which that appraisal is made (such as future cash flows or
comparable sales). In addition, the ratio methodology would favor
unfairly an institution that chose to bear appraisal costs over an
institution that did not similarly do so.
Changes: None.
Comments regarding second-tier and trend analysis: Several
commenters suggested that the Secretary perform a ``second-tier
analysis'' or use trend data to determine whether an institution that
fails to achieve the required composite score is nevertheless
financially responsible.
Other commenters believed that trend analysis is more revealing
than the proposed one-year snapshot of an institution's financial
health and suggested that the Secretary require that CPAs include that
analysis as part of the institution's audited statements. One of these
commenters stated that since trend data is available to an
institution's current CPA, the CPA could add a footnote to the
financial statement that contained the required ratio results for the
institution's three most current fiscal years, as well as an average
for that three-year period.
Another commenter argued that the proposed ratio methodology is
useless because it employs hybrid ratios that cannot be benchmarked.
This commenter proposed instead that the standards consist of a
liquidity ratio, a trend analysis of cash flows from operations, and a
different, better defined income ratio.
One commenter believed that the proposed methodology should be
discarded in favor of more easily constructed measures, including a
three-year averaged adjusted current ratio of 1:1 that would compare
tangible current assets with adjusted current liabilities and a five-
to ten-year trend analysis of cash flows from operations.
Discussion: In addition to the ratios suggested by the commenters
previously discussed under this Part, the Secretary considered other
ratios (Age of Plant, Cash Income, Secondary Reserve, and Debt to Total
Assets) that could be used as secondary measures.
The Secretary did not adopt these ratios because, like the ratios
suggested by the commenters, they measure financial health more
narrowly than the Primary Reserve, Equity, and Net Income ratios.
Moreover, the Secretary believes that these ratios do not provide
significant additional insight with respect to evaluating the financial
health of an institution that would warrant their inclusion in the
methodology.
Although the Secretary believes that trend analysis could be a
useful approach or consideration in determining whether an institution
is financially responsible, historical data regarding the ratios and
the ratio methodology must first be obtained and analyzed before
promulgating regulations.
Changes: None.
Comments regarding extraordinary gains and losses: Several
commenters representing the proprietary sector opposed the proposal
under which the Secretary may exercise discretion in determining
whether an institution is financially responsible. Under this proposal,
the Secretary may decide to exclude extraordinary gains and losses,
income or losses from discontinued operations, prior period
adjustments, and the cumulative effects of changes in accounting
principles. The commenters argued that the uncertainty inherent in this
proposal would make it difficult for an institution to calculate the
ratios (preventing the institution from determining its regulatory
status), and to develop a plan to compensate for a treatment that may
exclude these items. Moreover, the commenters believed that if some
institutions are favored by this discretionary treatment, public
confidence in the fairness of the proposed methodology would be eroded.
For these reasons, the commenters suggested that the proposal be
amended by eliminating the Secretary's discretion in favor of excluding
these items for all institutions.
Discussion: The commenters are correct that extraordinary gains and
losses, income or losses from discontinued operations, prior period
adjustments, and the cumulative effects of changes in accounting
principles, should be excluded from the calculation of the Net Income
ratio because these items are generally non-recurring and do not
reflect the institution's continuing operations. The Secretary notes
that these items are generally excluded from the ratio calculations.
The commenters are also correct in arguing that the ratio
methodology should treat all institutions fairly with respect to these
items, and that is the basis for the Secretary's discretion. It
[[Page 62851]]
has been the Secretary's experience that certain institutions do not
present these items in accordance with GAAP or employ questionable
accounting treatments that beneficially distort their financial
condition. Consequently, the Secretary retains the discretion to
include or exclude these items, or include or exclude the effects of
questionable accounting treatments.
Changes: The items that the Secretary may exclude from the ratio
calculations proposed under Sec. 668.173(e) are relocated under
Sec. 668.172(c) and revised to provide that the Secretary generally
excludes extraordinary gains or losses, income or losses from
discontinued operations, prior period adjustments, the cumulative
effect of changes in accounting principles, and the effect of changes
in accounting estimates. This section is also revised to provide that
the Secretary may include or exclude the effects of questionable
accounting treatments.
Comments regarding unsecured related party receivables and
intangible assets: Several commenters maintained that because GAAP
requires that an asset possess value before it can be included in a
financial statement, the Secretary improperly excludes all unsecured
related party receivables on the assumption that those receivables have
no value. The commenters believed that in order to obtain a complete
and accurate picture of an institution's cash flow, and thus financial
condition, the Secretary must change the definition of ``adjusted
equity'' to include intangible assets, unsecured related party
receivables, and fixed assets that the institution's independent
auditor determines have value and liquidity. The commenters suggested
that adjusted equity include at least the following: (1) Fixed assets
and intangible assets that the institution's CPA determines to have
value and liquidity, and (2) unsecured related party receivables, if
the related party co-signs the institution's Program Participation
Agreement and satisfies the same financial ratios required of the
institution.
Other commenters suggested that equity be defined in accordance
with the FASB pronouncement, ``Accounting for the Impairment of Long-
Lived Assets'', maintaining that all authoritative accounting
pronouncements must be taken into account in preparing financial
statements under GAAP.
Several commenters argued that excluding intangible assets
disregards accounting conventions used when acquisitions occur.
A commenter asserted that the definition of intangible assets
contained in Accounting Principles Board (APB) Opinion No. 17 is too
vague to be useful, and that the final rules should include a
clarification of the term, specifically as it relates to deferred tax
benefits, deferred direct response advertising costs, deferred
enrollment expenses, and prepaid expenses.
A few commenters responding to the alternative set forth by the
Secretary during the extended comment period for dealing with
intangible assets--that intangibles could either be excluded from the
calculation of the Equity ratio or that the strength factors for the
Equity ratio could be increased to compensate for including
intangibles--generally preferred to exclude intangibles because this
alternative would disadvantage fewer institutions. One of these
commenters suggested, however, that the Secretary include intangible
assets but not increase the strength factors in cases where those
assets are less than 10 percent of shareholders' equity. Another
commenter suggested that the Secretary include in the calculation of
the ratios a portion of intangible assets but require that an
institution amortize those assets over a limited period, for example
eight years.
Other commenters from proprietary institutions believed that the
Secretary should exclude intangible assets because of the difficulties
in valuing those assets.
Discussion: The Secretary uses the term ``intangible assets'' with
the same meaning as the definition contained in APB Opinion No. 17,
Intangible Assets, and disagrees that this definition is unsuitable for
regulatory purposes. That definition, which may not be all inclusive,
includes specifically identifiable intangibles, i.e., patents,
franchises, and trademarks. The definition also includes the most
common intangible asset, goodwill. ``Goodwill'' is the common name used
to describe the excess of the cost of an acquired enterprise over the
sum of identifiable net assets. The Secretary notes that items such as
deferred tax assets and liabilities, deferred enrollment expenses,
deferred direct response advertising costs and prepaid expenses do not
meet the definition of an intangible asset in accordance with the
definition in APB Opinion No. 17.
The Secretary does not agree that intangible assets should be
included in the calculation of the ratios, because those assets
generally represent amounts that are not readily available to meet
obligations. In addition, the Secretary believes that including those
assets would inject a very subjective element into the ratio
calculations, leading to an evaluation of financial health that would
be arbitrary, or that could oversta
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