Methodology for Regulatory Test of Financial Responsibility Using Financial Ratios - December 1997
The U.S. Department of Education (ED or the Department) is charged by statute to ensure that institutions participating in the Title IV Student Financial Assistance programs are financially responsible. Under the Act, ED has the on-going responsibility for ensuring that each of approximately 6,300 postsecondary institutions participating in Title IV programs meet established standards. ED engaged KPMG Peat Marwick LLP (KPMG) to assist in developing a methodology that could be used as a regulatory test of financial responsibility. According to the statute, "...a school is considered financially responsible if it has sufficient resources to:
Elements of financial responsibility standards have existed in statute and regulation since the 1970's. However, as a result of the 1992 amendments to the Act, Title IV participants were required to file an annual financial statement with ED for the first time. The annual financial statement submission must be prepared in accordance with Generally Accepted Accounting Principles (GAAP) and audited by an independent accounting firm. This annual filing provides ED with a basis for determining that each participating institution has the financial resources necessary to provide the educational services for which the students contract and meet all of its financial obligations.
ED's task is complicated by the fact that four different types of institutions participate in Title IV programs. They have different organizational structures and accounting requirements. Recently, the Financial Accounting Standards Board (FASB) changed the reporting requirements for private non-profit institutions. The two new standards, FASB Statement 116, Accounting for Contributions Received and Contributions Made, and FASB Statement 117, Financial Statements of Not-for-Profit Organizations, significantly redefined the financial accounting and reporting for institutions in this business segment. As a result, these institutions were in a state of transition in complying with these new standards during their 1996 fiscal year (required adoption year for most colleges and universities).
At the same time, ED determined that improvements could be made to the current financial responsibility tests so that they could more adequately take into account an institution?s total financial circumstances. One example of an area for potential improvement in the current regulation is the use of the same acid test requirement of 1:1 for private non-profit and for-profit organizations. GAAP does not require private non-profit organizations to prepare financial statements which classify assets and liabilities as current and noncurrent. Moreover, differing cash management and investment strategies (investing excess cash in other than short-term instruments) may result in an institution failing the acid test requirement when sufficient resources are in fact available to support its operations and meet the requirements of the statute.
The U.S. Department of Education (ED) engaged KPMG Peat Marwick LLP (KPMG) to assist in developing a methodology that could be used as a regulatory test of financial responsibility for schools participating in Title IV programs. The test compliments other requirements and would not replace current standards such as the requirement to not have a going-concern opinion on the audited financial statements or to maintain compliance with other administrative requirements in the regulations. The scope of this engagement included establishing a methodology that would employ financial ratios and build upon the screening mechanism that KPMG developed previously. The basis (as required by the Higher Education Act section 498) on which a school is considered financially responsible is whether it has sufficient resources to :
The regulatory test developed will be based on information contained in the school's audited financial statements and will focus on the minimum level of financial health necessary for a school to satisfy these conditions for a period of twelve to eighteen months following its fiscal year end. The twelve to eighteen month time frame correlates to the period of time that generally passes before ED receives another financial statement from any particular school. The next financial statement gives ED another observation point, that is, information about improved financial condition or financial problems.
To achieve ED's objectives, the engagement was divided into three phases. During the first phase, KPMG would gather and analyze financial statements and compute ratios for at least 100 non-profit colleges and universities and 100 proprietary institutions. In the second phase, KPMG would make recommendations for a new methodology or modifications to the methodology that ED proposed in its September 20, 1996 Notice of Proposed Rule Making (NPRM). ED requested that KPMG consider responses received from the higher education community during the comment period when developing its recommendations. The purpose of the third and final phase was for KPMG to provide technical assistance to ED officials as they sought and considered comments from the higher education community received during the extended NPRM comment period and as they prepared the final regulation.
In satisfying its oversight responsibilities over Title IV, HEA Student Financial Assistance programs, ED is committed to promulgating regulation that safeguard the Federal and student interests, among other things. In protecting against the loss of Federal funds, ED is also committed to minimizing the administrative burden placed on postsecondary educational institutions that participate in Title IV programs. With regard to the financial responsibility standards, and more specifically the ratio test described in this report, ED attempts to minimize two basic risks:
Some level of risk of the loss of Federal funds is always present, even with the best managed institutions. In the event that these two risks are in contrast, the Department stated that the second risk was of greater concern to them. The Department prefers to allow some financially weak institutions to participate in federal programs and incur the costs associated with occasional precipitous closures rather than inappropriately prohibit other institutions with sufficient financial resources to operate for another twelve to eighteen months from participating. KPMG's final recommendations provide the Department with a methodology to rank institutions by financial health so that it can establish a standard which balances these potentially opposing risks.
Although KPMG has worked closely with ED to recommend individual ratios, strength factors, weightings, and overall methodologies to be employed in this report, the ultimate responsibility for setting a standard of financial responsibility in conjunction with the above objectives would necessarily rest with ED. Such a standard must ultimately be based on the level of risk that ED, as a matter of policy, is willing to tolerate.
KPMG's recommendations in this report are based, in part, on empirical data gathered during the first phase of this project. The empirical data was gathered from all financial statements available at the Department through December 31, 1996 covering 507 proprietary institutions and 395 private non-profit institutions. These samples represent approximately 20% of the total universe of proprietary institutions participating in Title IV programs, and approximately 18% of the total universe of the private non-profit sector. These samples represent all financial statements available through December 31, 1996 for the private non-profit colleges adopting the new accounting standards and a non-random sample of 1995 financial statements for the proprietary sector.
In this report, KPMG recommends a methodology that provides a measure of an institution's overall financial health. The methodology is intended to be used solely as a regulatory test of financial responsibility. The focus of the recommended test is to rank institutions by a range of financial health so that ED can set that point (or range of points) above which an institution is deemed to be financially responsible and its objectives are being met. The methodology is limited to financial factors and is not intended to replace ED's reliance on other factors such as default rates, program review results, or compliance audit attestations. Measurement of those factors is beyond the scope of this engagement.
KPMG believes the financial ratios, strength factors, and weighting percentages, taken as a whole, provide reasonable tools for ED to exercise its duty to assess institutional financial responsibility. However, in setting a regulatory standard, KPMG understands that ED may decide to modify particular components of the methodology to better suit the level of risk it deems appropriate.
Comparison to KPMG's Prior Recommendations
On August 1, 1996 KPMG delivered a report to ED recommending a methodology using financial ratios that ED could use to efficiently exercise its financial oversight responsibility. That methodology was seen as a way for ED to quickly identify financially weak institutions that merit more extensive review as well as those in exemplary financial condition for whom regulatory relief might be warranted. The methodology employed three ratios, customized to accommodate accounting and reporting differences between business segments, along with thresholds and a weighting mechanism to place all institutions into four categories of financial health. The four categories were:
The intent of that methodology is shown graphically below:
The methodology placed institutions into the four categories of financial health. Because the model was to potentially be used for regulatory relief between recertification cycles, certain of the strength factors were set to consider a longer time frame of financial health (two to four years). In this regard, the primary consideration addressed was the risk that a financially weak institution would be categorized as something other than a potential or immediate problem and precipitously close within the next two to four years. ED used KPMG's recommended methodology as a basis for proposing modifications to its financial responsibility regulation and issued a Notice of Proposed Rule Making (NPRM) in September of 1996.
In contrast, the methodology recommended in this report is intended to give insight into establishing a minimum acceptable standard above which institutions are considered to be financially responsible in accordance with the HEA. Accordingly, the four categories in KPMG's original methodology have been replaced by two categories; satisfies the ratio test and does not satisfy ratio test.
The methodology recommended in this report is shown graphically below:
Another factor KPMG had to consider in developing the methodology was administrative workability. For the methodology to be acceptable to the higher education community and workable for ED, it had to consider the effect of the methodology on the population of schools participating in Title IV programs. Each year ED makes a determination concerning financial responsibility for approximately 6,300 institutions. A ratio methodology that most of these schools are unable to satisfy would require additional individual institutional follow up and would not provide a workable solution to the Department.
Therefore, the focus in developing this methodology was to provide a mechanism which can be used to properly determine financial responsibility of the participating institutions and at the same time reasonably be administered by the Department. The critical factor for ED is a clear understanding of the risk it assumes from each participant in the Title IV program and a consistent and equitable method of monitoring that risk.
The methodology that KPMG recommends in this report relies on data taken from financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP). This information is subject to audit by independent accountants and is required to be presented in accordance with a commonly accepted set of standards. Therefore, this approach provides ED with a methodology that measures institutions' total financial condition and that is easily repeatable at a manageable level of effort. Use of other information not subject to such a set of standards was not considered practical or useful for this purpose. Other factors such as default rates or program review compliance history are items which are monitored by other functional units at the Department and used. This useful information is not considered as part of this financial ratio analysis test.