On February 5, 1997, the Department of Education convened a meeting with about 20 members of the postsecondary education community to discuss proposed rules for financial responsibility. Included in the meeting were representatives from institutions and the higher education associations. The following is a brief summary of the issues that were discussed at the meeting.

Opening Remarks by David A. Longanecker, Assistant Secretary for Postsecondary Education, and Jamienne Studley, Deputy General Counsel for Regulations and Legislation

Jamie Studley, the meeting's facilitator, outlined the agenda for the meeting and indicated that the Department wanted to engage in a meeting with the community specifically on the proposed rules for financial responsibility and the ratio analysis methodology that is the heart of the proposed rules. For this reason, and due to time constraints, it was suggested that comments on the following be saved for separate discussion: (1) items in the NPRM that became final in November 1996; (2) items in the NPRM that were tangential to the ratio methodology, including change of ownership provisions; and (3) financial responsibility rules for third party servicers.

The Department then discussed its goals and intention for working with KPMG Peat Marwick LLP to develop financial responsibility regulations. The rules are intended to (1) develop a sufficient picture of the financial health of institutions, using measures that evaluate financial strengths and weaknesses; (2) reflect the accounting variations among different segments of the higher education community; (3) balance the risk of loss of federal funds with the cost of placing unnecessary burden on financially healthy institutions; and (4) develop an administratively manageable regulation. Before handing-off the discussion to representatives from KPMG, 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.

Presentation by KPMG

KPMG Partners Herbert Folpe and Ron Salluzzo began with a summary of their August 1996 Final Report. They presented an overview of the ratio methodology they designed for the Department and a brief history of the use of ratio analysis in higher education. KPMG first published a guide to ratio analysis based on the financial statements of institutions of higher education 20 years ago. The guide is now in its third edition and includes 27 ratios.

According to KPMG, there are five fundamental elements of financial health demonstrated in any audited financial statement. These elements are viability, liquidity, ability to borrow, ability to live within its means and by having sufficient capital resources. These elements of financial health can be measured using financial ratios. Ratios are used to create a manageable methodology that provides a comprehensive picture of how management has run the institution and what resources it has available to continue operating and meeting its mission. The three primary ratios selected to evaluate the financial health of an institution are the viability, primary reserve, and net income ratios.

KPMG emphasized that expendable resources, the numerator in both the viability and primary reserve ratios, are controlled within the institution and are a hedge against long-term debt, which is controlled by forces outside the institution. Expendable resources are calculated as resources available to meet those debt obligations and excludes all unavailable assets such as long-term fixed assets (property, plant, and equipment), endowments, and intangibles. Resources retained within the institution also demonstrate a commitment to programs. In KPMG's experience, a decline in program does not happen independently of a decline in finances.

Discussion of Issues and Suggestions

The remainder, and vast majority, of the meeting, was spent discussing issues and questions raised both in comments to the NPRM and by the meeting participants. The following briefly summarizes this discussion.

TREATMENT OF DEBT. The Department, KPMG, and meeting participants discussed the treatment of debt in the viability ratio. It was suggested that, in some cases, schools might intentionally incur debt in order to build assets, e.g., borrow money to build a new dormitory. Some participants suggested that if debt is incurred to invest in the institution, it should be considered an asset, not a liability. Another participant indicated that the focus should be on the acquisition of debt. The point was made that if a school lacks the ability to borrow, the only way to build assets is to invest funds acquired through profit.

KPMG stated that the viability ratio does not measure the amount of debt, but the available resources an institution has to manage the debt. If a school cannot handle its debt, creditors will force it out of business, resulting in the loss of educational services and the potential loss of federal funds. A school will score well if its debt is well leveraged, indicating that it is growing at a manageable rate.

WEIGHTING OF RATIOS. A participant expressed concern about putting so much weight on the three ratios and the consequences if an institution failed all three ratios. The Department and KPMG indicated that there needs to be a mechanism for evaluating a school's financial responsibility reliably and predictably. Suggestions for establishing financial strength beyond the ratio test included a second tier of analysis to evaluate other assets, such as an institution's ability to borrow, its enrollment trends, or its facilities.

ZERO-DEBT SCHOOLS. A comment was made that schools without any debt cannot be evaluated using the viability ratio and must rely only on the net income and the primary reserve ratios. Meeting participants discussed what it means when an institution has no debt? Why does the school have no debt? Many people indicated that the answer is not always straightforward. In other words, has the school made a management decision to be debt-free or is the school debt-free because of its inability to incur debt or unwillingness to invest in fixed assets?

It was suggested that the methodology could take this factor into consideration either through a secondary analysis that examined an institution's ability to borrow or by assigning an average score for the viability ratio (so that the viability ratio would still be used) for those schools with no debt. The discussion moved to the potential calculation of a school's ability to borrow and the complexities inherent in assessing a school's reasonable debt load from data included on the general purpose financial statements.

PREDICTIVE VALUE OF RATIO ANALYSIS: A comment was made that the ratios cannot predict the imminent failure of a school and that more reliance should be placed on audited financial statements by giving the responsibility to the auditor to judge an institution's financial health. KPMG indicated that auditors do not have the responsibility to determine whether an institution will continue to function. An auditor might opine that a school is in trouble, but whether the school goes out of business is separate from the statutory standard related to its ability to deliver to students the programs it contracts to provide. Similarly, a lack of a going concern statement by the school's auditor is not a guarantee that the school will continue or be able to maintain an adequate level of student services.

Later in the meeting, it was suggested that certain elements reported on financial statements, both included and excluded in the construction of the proposed ratios, may not increase the predictive value of the ratios. Specifically, participants questioned the inclusion of debt in the viability ratio and the exclusion of fixed assets in both the viability and primary reserve ratios. The ensuing discussion suggested that it is extremely difficult, if not impossible, to predict whether an institution will continue to operate for any length of time. As a result, it was suggested that it is necessary to measure whether adequate resources are available to meet obligations at any given time and how these available resources have changed from the previous year.

SECOND TIER ANALYSIS. A comment was made in support of a second tier of analysis after the three ratios have been evaluated, i.e., it was stated that the three proposed ratios should not be the "be-all/end-all." In response, there were concerns raised about the availability of data that would be necessary to evaluate trends for all 7,000 postsecondary institutions. It was suggested that the ratio analysis be used to identify "risky" schools that could benefit from another stage of analysis. A second tier could be used to evaluate additional financial measures that might amplify the picture of the school at that moment, e.g. zero-debt.

TRENDS VS. SNAPSHOT. A comment was made that a trend rather than a snapshot approach would generate a more accurate picture of a school's financial health. KPMG stated that the trend approach has some merit, but that ratio analysis is designed to evaluate a school's current financial health. In addition, the ratio methodology, which measures an institution's financial capability at a particular point in time inherently reflects prior performance. Implementation of trend analysis would need to be considered.

PUBLIC INSTITUTIONS. A suggestion was made that public institutions be eliminated from the financial responsibility regulatory process. KPMG stated that while public schools might be less of a risk due to government backing, their financial statements are important for reasons other than financial responsibility determination. The Department indicated that it is looking at retaining the current regulatory treatment of public institutions that have financial backing from their state.

INSTITUTIONAL GRANTS. A question was raised about how institutional grants are incorporated into ratio analysis. For example, an institution may not have an incentive to pursue an Upward Bound grant since it could decrease the school's primary reserve ratio because of increased expenditures. It was suggested that when a grant has no effect on institutional costs, there should be a neutral effect. KPMG explained how the grant money is considered a restricted revenue upon receipt or accrual of the grant as well as a temporarily restricted asset until the funds are used at which time it is released to unrestricted assets and becomes an unrestricted expenditure. Both KPMG and the Department agreed that this was an issue they would continue to consider.

INCOME LINE ITEMS. A comment was made about the inclusion of specific income line items, such as taxes and dividends, as well as any possible tax implications with respect to the proposed rules. KPMG agreed to pursue the specific questions and to consider carefully their treatment in the calculation.

DISINCENTIVE TO INVEST. Several participants commented that the calculation of expendable resources, which excludes plant assets, would discourage investment in fixed assets. KPMG responded that all program decisions need to be considered in terms of fiscal viability as well, and that if an institution could not afford an investment, it would be reflected in the ratios. The Department and KPMG agreed that plant investment is an important area for further review.

DONOR INCOME. Some participants represented institutions that are sustained by donors that had consistently demonstrated a commitment to the school, yet the commitment does not appear directly on the financial statements. It was suggested that some institutions, in effect, are protected from failing or financial crisis by support from third parties of various kinds. The ensuing discussion indicated that it is difficult to consider voluntary funding in the ratio analysis. No method was suggested for measuring this commitment nor did the representatives think these donors would make a formal pledge, which could be recorded as an asset under FASB 116. The group sought approaches to recognize long-term frugal, but stable, operations based on information from audited financial statements.

UNOFFICIAL FUNDING. A participant stated that the viability ratio is not appropriate at a public institution with debt, because although the debt is backed by the county or another independent entity, full-faith and credit is not available. The group suggested that trend analysis could be used to indicate the sustained financial health of a school that receives significant non-guaranteed funding from a state or other source.

CASH FLOW. A comment was made that cash flow analysis should be included in the analysis. KPMG and the Department agreed that this is an issue to consider. Comments were made that cash flow is quite susceptible to manipulation and the items incorporated in the proposed ratios are a measure of the resources available to an institution to manage its operation.

EVALUATION AT INTERVALS/EVALUATION AT RECERTIFICATION. A comment was made that an institution's financial responsibility should not be evaluated annually, and that the Department could implement a means of identifying problems in the time period between evaluations. Currently, the statute requires schools to submit their financial statements every year. There is no additional administrative burden placed on schools if the Department calculates the ratios annually. Another suggestion was made that the Department should evaluate financial responsibility when a school is recertified. At that point, the Department could either fully certify the school, deny certification, or put the school on a "watch list" in which it would undergo closer scrutiny. The Department noted that it can use ratio methodology for determining schools that require closer administrative oversight through internal procedures at the current time.

QUANTITATIVE THRESHOLD. A participant asked whether the 1.75 score in the proposed rule indicates, inherently, that an institution is financially responsible (and that a score below the threshold indicates that school is not financially responsible). KPMG and the Department commented that the entire methodology is based on comprehensive financial analysis by KPMG and that the 1.75 threshold, as explained in the August 1996 Final Report, relates to combinations of ratio scores such that an institution would have to score consistently low on all three ratios in order to earn a composite score less than the threshold. KPMG stated that adjustments to the threshold reflecting different levels of financial strength and risk would naturally be considered with respect to any potential modifications it proposes to the methodology.

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