Summary of Comments
On February 27, 1997, the Department of Education (ED) convened a meeting with a group of eight proprietary school representatives, including owners and accountants, to discuss the proposed financial responsibility regulations. The major issues discussed at this meeting are summarized below.
Opening remarks by Jamienne Studley, Deputy General Counsel for Regulations and Legislation
Jamie Studley opened the meeting by outlining ED's objectives in proposing, and for finalizing, new rules and standards of financial responsibility. First, the standards must measure the strengths and weaknesses of schools in a more subtle and complete manner than the current standards. Second, the standards must reflect the differences in business sectors. Next, the rules must balance appropriately the risk of loss of Federal funds with the costs of placing unnecessary burden on financially healthy schools. Lastly, the final rules must be manageable and practicable.
Before handing-off the discussion to representatives from KPMG Peat Marwick LLP, Jamie Studley stated that ED was not seeking to obtain consensus from the group on any issue. Rather, ED was interested only in obtaining comment from the individual group representatives. In addition, she noted that the comment period for proposed rules was still open and that a summary of the group's comments would be made publicly available. In closing, Jamie Studley and Steve Finley (program attorney for ED) emphasized that the statute requires ED to determine that a school is financially responsible on the basis of whether the school is able to (1) provide its educational programs and services, (2) provide the administrative resources necessary to comply with title IV, HEA program regulations and statutory requirements, and (3) meet all of its financial obligations. In this context, the standards of financial responsibility must be broader than what may otherwise be required to simply identify schools that may close precipitously.
Presentation by KPMG
Herbert Folpe, partner at KPMG, gave a brief overview of the proposed ratio methodology. He noted that the methodology was developed to enable ED to effectively manage its caseload and to more appropriately regulate program participants by taking into account the differences between private, public, proprietary, and hospital affiliated schools. Mr. Folpe characterized proprietary schools as business that (1) are generally thinly capitalized, (2) range from small, simple organizations to large, very complex corporate structures, (3) use diverse accounting treatments, and (4) frequently show contingent liabilities. Although these characteristic differences must be taken into account, all economic entities have basic similarities: they require investment and must earn more than they spend. The chief difference between the sectors is that owners of proprietary schools regularly remove capital. Therefore, KPMG customized the methodology for each sector by defining the ratios slightly differently, establishing different weighting mechanisms and threshold values, and by removing intangibles and unsecured related party receivables. Mr. Folpe concluded by stating that fixed, capital assets were removed because they are sunk investments and not expendable.
Discussion of issues and suggestions
Several group members suggested that the viability ratio penalized schools with no debt and inquired why this viability ratio was linked to the primary reserve ratio. KPMG responded by stating that the link was established to prevent a school with no debt from achieving an artificially high score on the viability ratio simply by acquiring a nominal amount of long term debt. Also, KPMG acknowledged that the utility of the viability ratio decreases as the amount of long term debt becomes very low.
Several group representatives suggested that a cash flow ratio focusing on operating activities should be used instead of the viability ratio to highlight a school's ability to generate positive cash flows. The representatives argued that such a ratio would not penalize growing schools for reinvesting in fixed assets, or hurt established schools with high depreciation. KPMG noted that regulatory credibility might be diminished if a cash flow ratio was used because cash is more easily manipulated than ratios using an accrual basis.
Net Income ratio
Some group representatives were concerned that the net income ratio did not take into account certain tax issues such as the treatment of C versus S corporations, and the accumulated earning tax. KPMG responded that it researching these issues.
The group also felt that net income, at 50 percent of the composite score, was weighted too heavily. They suggested that net income account for only 30 to 40 percent of the composite score, remarking that the incentive to be highly profitable is counterproductive. Some representatives noted that schools which are very profitable often fail because they earn profits improperly or value short term gains over prudent long term fiscal planning.
Several representatives suggested that the net income thresholds were too high. One representative believed that for a threshold factor of 3, the corresponding net income ratio should be set at 4 or 5 percent. He stated that 5 percent would be considered an excellent net income ratio by most proprietary schools.
The group generally believed that schools should receive some credit for reinvesting in the business and that ED should link financial measures to the schools' business objectives, noting that many proprietary schools need to maintain state-of-the-art assets such as computer systems. One representative observed that, contrary to the non-marketability of private non-profit school campuses, proprietary facilities tend to be located at valuable commercial sites. He argued that the value of these facilities is similar to the value of a private school's expendable reserves. He continued by noting that a proprietary school can borrow against its plant assets in slow times not only to guard against precipitous closure, but to maintain normal business operations. Further, he stated that lenders consider this type of leverage a source of financial strength and the ED should give credit to schools for plant assets to encourage investment. ED and KPMG were concerned that property not related to a school's core business might be lumped into a corporation's fixed assets, including the owner's car or dwelling. The group cautioned ED about managing by anecdote and thus penalizing the entire population for the practices of a few schools. Further, one representative felt that even assets unrelated to providing educational instruction still benefit the educational institutions themselves, even if indirectly.
In response to these comments, KPMG introduced the concept of an equity ratio which might be measured by net tangible assets divided by total assets. This ratio would take into account long-term investment, such as property, plant and equipment, while still measuring how leverage is managed. The majority of the group believed that the equity ratio, as a measure of the extent to which a school is reinvesting in itself, should be one of the more important measures of financial responsibility. Several representatives suggested that it replace the viability ratio. One representative suggested that the ratio include total equity, not just retained earnings. Another suggested that if related party debt is subordinated, it should be added to equity.
The group discussed whether small schools could be considered separately from large schools, and whether they could receive less burdensome compliance requirements such as reduced reporting requirements or ratios that were easier to pass. According to the group, a small school could be defined as one having revenues of less than $1 to $3 million. The group argued that this segment of the population posed a relatively small risk of financial loss to ED since many of these schools have fewer than fifty students. In addition, the group suggested that these schools are generally run by individuals more interested in providing education than in keeping track of complicated federal regulations (i.e., such a school could fail the standards simply by not being aware of an action that it could take to comply with the standards). ED noted that ratios control for size and that the statute requires all schools to submit audited financial statements annually. ED is looking at school size, risk and burden as part of the Regulatory Flexibility Analysis process.
The group discussed using trend data to account for the cyclical nature of school finances. In particular, averaging earnings over a three-year period would smooth out occasional "hiccups" or losses that may be related to reinvestments in property or to programmatic and academic decisions made by a school that are intended to improve its long term health and viability. The group suggested that a three-year average would encourage reinvestment and that this analysis would identify a sustained drain of capital from the business.
Entity and changes in ownership
ED and KPMG noted that trend data may not useful, or appropriate, for schools that have undergone a change in ownership or where the proper "entity" has not been historically identified. ED raised the latter issue to solicit comment on how and to what entity ED should apply financial standards. For example, an owner has 5 schools, signs a program participation agreement for each school, and ED assigns an OPE-ID number to each school. Are the standards applied to each school separately or to the entire corporate structure? Most representatives felt that the standards should be applied to the level of the organization that is legally liable to ED.
Several representatives suggested that ED amend the proposed financial requirements regarding changes of ownership. First, to better implement the use of personal financial guarantees for a school that undergoes a change of ownership, ED should only require these guarantees from the principal owners or investors. The group noted that the proposed jointly and severally liable requirements effectively eliminate this option for schools that have minority investors--relative to their potential losses, these investors are unlikely to place their personal assets at risk. Second, the group suggested that ED develop a "pre-approval" process similar to that used by some States. Under this process, ED would determine whether to approve a change of ownership before the change actually occurred.
One representative objected to the removal of intangible assets from the ratios, arguing that goodwill is important to newly acquired schools. He, and other representatives, argued that since goodwill is the extra consideration paid above the market price of a school's assets (to account for the school's reputation), ED should not discount the effect of the school's reputation in generating future revenue. For instance, a school could still have a bad year after purchasing another school because of transition costs, but the new owner could rely on the goodwill to produce profits in following years. ED and KPMG noted that the problem with intangibles is that their true value is only realized over time and to the extent that goodwill enhances future revenue, that revenue is accounted for by the net income ratio. KPMG suggested "hair-cutting" goodwill (a practice used in some industries)--give a newly acquired school full or nearly full credit for its goodwill in the initial year, but then reduce that credit rapidly over the next several years, as the business would be expected to replace the goodwill will accumulated earnings. How such a process could be implemented would require careful consideration.