Financial Irresponsibility

As discussed in the last post of this blog series, the Department of Education began renegotiating elements of the rules that set standards for the financial condition of institutions of higher education earlier this month. The Department took the unusual step of establishing a special subcommittee of experts prior to the first convening of the first negotiation session as a working group that will evaluate recent updates in generally accepted accounting principles (GAAP). The subcommittee—set to operate behind closed doors—will be tasked with developing recommendations for the larger committee’s consideration at its third and final meeting.

Although the issue papers shared by the Department suggest its intent to limit the financial responsibility discussion to a narrow set of changes based on new accounting standards by the Financial Accounting Standards Board (FASB), we should be leery of any effort by negotiators to steer the discussion towards more fundamental changes to the financial responsibility framework that could render the Department’s composite score ineffectual.

Accounting for Accounting Changes

While the accounting terms in FASB’s update may appear too abstruse for the uninitiated, the implications of the accounting updates to the composite score framework are fairly straightforward—even if the business officers’ representative at the present rulemaking has little faith in the public’s interest in or competence to understand the issues, as she indicated during the first session.

First, the update streamlines asset formulas for nonprofit institutions, simplifying from three categories (unrestricted net assets, permanently restricted net assets, and temporarily restricted net assets) to two (net assets with donor restrictions and net assets without donor restrictions). Donations made to nonprofits frequently come with strings attached (i.e., schools can’t always spend the money as they want to). In accounting parlance, such funds are considered “restricted.” Under the old accounting standards, institutions had to differentiate between their restricted assets, identifying assets as either “temporarily restricted” or “permanently restricted.” A temporary restriction might be a stipulation that a donation can only be spent after five years, while a permanent restriction would be a requirement that a donation be used for a specific cause in perpetuity.  These distinctions no longer matter after the update; there’s now only one restricted category. Disagreements with the Department over the classification of restricted and unrestricted assets have been common over the life of the rule; this change should reduce the frequency of those disputes.

Second, the update changes the way a nonprofit institution must account for restricted funds (money with donor-imposed restrictions) that are used towards assets like new buildings. To state it plainly, this provision governs the point at which a donor-imposed restriction expires and the institution can consider an asset to be unrestricted—and get credit for it in its composite score ratios. Depending on an institution’s particular circumstances, this change could either help or hurt a school’s composite score in a given year.

Third, the update expands the disclosures required of nonprofit institutions in their financial statements. This should have minimal impact on the calculation of the score itself, but more extensive disclosures should benefit the Department’s oversight activities by providing increased transparency into institutions’ finances. This should also reduce the amount of additional information the Department has to request from institutions when conducting reviews of institutions’ finances. The Department should consider ways to leverage this new information to improve its oversight.

Finally, in a separate update, FASB made changes to the way that leases are reported on all types of institutions’ balance sheets. All leases must now be reported on financial statements, whereas only some types of leases were reported in the past. That meant complicated leasing arrangements could go unseen on financial statements, enabling an institution to hide substantial debts and liabilities that might threaten its long-term viability. This change from FASB should improve the assessment of an institution’s finances by ensuring that all liabilities associated with leasing activity are properly accounted for.

The question now is whether the subcommittee will stay within the boundaries set by the Department’s issue papers. Since the inception of the financial responsibility rule in 1997, FASB has issued other accounting updates that have had an impact on the way institutions approach their financial statements, like to the way institutions account for their pension obligations or to the method institutions, particularly those with large endowments, use to account for complex investment activities like hedging and derivatives. However, the Department’s issue papers don’t raise these concerns--and it’s clear the Department prefers, appropriately, to keep these conversations limited to a couple of narrow issues.

Also unaddressed in the issue papers are any fundamental changes to the composite score, such as adjustments of the weighting of the ratios or changes to the formulas underlying the composite score metric. Or changes to the treatment of long-term debt, which is already treated favorably in the primary reserve ratio (the Department’s ratios consider long-term debt as a component of an institution’s net assets up to a limit in order to incentivize long-term investments in institutions). Historically, the Department has capped the amount of long-term debt that can be considered as an asset to long-term debt held to support an institution’s “long-term purposes,” such as buildings. Institutions could seek to remove this cap or expand the definition of “long-term purposes” to improve their primary reserve ratio.

The Department needs to be careful to ensure it does not stray from the FASB guidelines or the narrow set of issues it introduced at the first negotiating session to the detriment of students and taxpayers. But assuming the aforementioned issues stay untouched, updating the Department’s existing regulations shouldn’t threaten the composite score methodology, even if the updates could shift some institutions’ scores due to marginal changes in the reporting of financial information. If anything, this rulemaking could give the Department an opportunity to create clarity around contentious accounting disagreements in public and on the record, avoiding protracted disputes with failing institutions on the back end.

If Rulemaking Runs Amok

If the negotiating committee does attempt to pursue more substantial updates to the financial responsibility rules—which it should not—they will probably resemble positions advocated by a report published by NAICU, the lobbying association for private nonprofit colleges, in 2012. NAICU’s report surfaced after the recession had taken a major hit on the finances of independent institutions and failing scores in the nonprofit sector skyrocketed. Given the context, it’s no surprise that it pushes for changes that would make it easier for institutions to pass the composite score test.

Among the report’s more innocuous recommendations, they argued the Department should standardize its use of financial definitions across colleges and regional offices and establish an advisory panel of accounting experts to provide technical guidance to the Department. Official clarifications on the new FASB terminology during the present rulemaking--those items the Department listed on its agenda--could help address this concern. It would also be worthwhile for the Department to maintain an advisory panel of accounting experts to act as arbiters on contentious issues, as the report suggests, although it’s unclear whether the Department has the authority to do so through regulation, especially given restrictions imposed by the Federal Advisory Committee Act (FACA).

Next, NAICU asked for more flexibility to demonstrate financial responsibility, including an appeals process in the event an institution wants to object to its score. The Department has been burned in the past when schools have disputed the Department’s calculation of their composite score to delay the consequences of a failing composite score. The most notable example of this is Corinthian Colleges, whose executives engaged in a months-long back and forth with the Department over their failing score until their subsequent year’s score, which was passing, was issued (although it was later determined that score had been manipulated). Adding an additional layer of challenges on top of existing challenges at the Department would create additional delays before surety can be requested from failing schools, leading to taxpayer losses in the event of closure.

On top of that, NAICU called for more favorable treatment of endowment funds—such as donor funds earmarked for particular expenses—in calculating the primary reserve ratio, the metric used to assess the funds available to a college to meet its current expenses. The planned simplifications to the asset categories in accordance with the FASB changes could help address this proposal, since some of the disagreement between schools and the Department centers around fuzzy distinctions between permanently and temporarily restricted assets when determining whether an institution should be given the benefit of certain assets in the primary reserve ratio. NAICU also pushed to reduce the impact that a decline in the value of an endowment has on an institution’s composite score, which the Department currently treats as a loss within an institution’s total expenses, reducing an institution’s primary reserve ratio. To counter the effect of this loss, NAICU proposed including all asset types--funds the school can spend and funds it cannot--in the primary reserve ratio, meaning a school would get credit for money it doesn’t have access to. Observers should watch closely to ensure that changes aren’t made that fly in the face of FASB guidance.

Finally, NAICU argued the Department should examine each institution’s “total financial circumstances” before assessing penalties against a school – already the stated goal of the financial responsibility composite score. In effect, they asked for a subjective escape valve that would enable the Department to absolve an institution of consequences if things seem “okay.” But it’s unwise to introduce subjectivity into a process that requires consistent objectivity. If the Department were required to make case-by-case determinations on financial responsibility each year, the process would probably grind to a halt as staff become more and more consumed with individual schools’ objections.

Ironically, it’s not even clear that NAICU’s proposed changes would help many institutions. NAICU’s own report analyzed a random sample of 20 failing institutions to assess the impact of one of its principal complaints—that the Department uses varying definitions for some technical terms in applying the financial responsibility rule to calculate composite scores. But the report found that even when “correct definitions” were applied in calculating the composite scores, all 20 institutions still failed the test. The report cites other (unnamed) institutions that suffered from failing scores and apparently would have benefitted from a recalculation of the score under “accurate” definitions. But the report simply asserts the anonymous schools with failing composite scores were not at risk for closure--despite scant evidence about their overall financial well-being--and therefore deserved a clean bill of health.

Stakeholders should pay special attention to proposals emanating from the borrower defense committee member representing university business officers, whose employer, Rensselaer Polytechnic Institute, has been embroiled in a years-long debate with the Department over its failing composite score. The Washington Post reports that Rensselaer is “mired in debt, with nearly $1 billion in liabilities from issuing bonds to cover construction and years of operating at a deficit.” Moody’s Investor Service has also expressed concerns about the institution’s “very high financial leverage, weak expendable financial resources depressed by a relatively large pension liability and thin unrestricted liquidity, including use of operating lines of credit.” The borrower defense committee member from Rensselaer was vocal in her opposition to adding additional members to the financial responsibility subcommittee or to allowing any public coverage or representation for the subcommittee. She also expressed an interest in expanding the list of issues addressed in the subcommittee during the first session of the full committee, pursuing changes that would likely benefit her own university. 

Although for-profit lobbyists have remained fairly quiet on composite score methodology, if the financial responsibility rule is reopened, we might hear calls for beneficial treatment of “goodwill,” an accounting concept most pertinent when one company acquires another (in this case another institution). In the same vein, proprietary institutions could push for the consideration of other intangible assets--such as the  value of a school’s brand, which can evaporate in a day--in the composite score, puffing up the net assets of the institution. Commenters representing proprietary institutions pushed for similar changes in the 1997 rulemaking.  Additionally, while composite scores are currently calculated for many corporations as a whole, we may hear calls for the Department to issue unique composite scores for the individual campuses of a multi-campus or multi-institution proprietary corporation. Doing so might help flagship subsidiaries appear to be financially sound, even if the subsidiary could be negatively impacted by the poor fortunes of another branch of the school or of its holding company.

Thinking Long Term

While the Department shouldn’t touch the substance of the composite score in this rulemaking, improving the efficacy of the model over the long term is critical. The Department must improve its financial oversight and processes—but only following a rigorous analysis that identifies specific weaknesses of the model to predict failure. (Stay tuned for our third and final post in the series for more detail.) However, a full analysis of the composite score’s efficacy and the impact of making changes to it will take more time than is allotted for the current rulemaking. A fulsome analysis will also require accounting experts the Department has not yet contracted with (the KPMG report commissioned by the Department in the nineties took two years and millions of dollars to produce). Accordingly, the Department shouldn’t make any substantive changes to the financial composite score until it has the time and funds to dedicate to the process, and any changes it does make should be carefully considered with a strong sense of their actual impact. Deviating from basic updates in this rulemaking could result in a financial responsibility composite score that’s even less effective tomorrow than it is today.