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federal register

September 20, 1996

Part III

Department of
34 CFR Part 668
Student Assistance General Provisions;
Proposed Rule

49552 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules


Student Assistance General Provisions
Statutory and Regulatory History
34 CFR Part 668 regulations (34 CFR part 668) apply to
all institutions that participate in the The authority to establish reasonable
student financial assistance programs standards of financial responsibility for
RIN 1840–AC36
authorized by title IV of the Higher purposes of determining an institution’s
Student Assistance General Provisions Education Act of 1965, as amended (title eligibility to participate in title IV, HEA
IV, HEA programs). programs was first granted the
AGENCY: Department of Education. The Secretary proposes to revise Commissioner of Education by the
ACTION: Notice of Proposed Rulemaking. subpart B as follows: the proposed Education Amendments of 1976—Pub.
regulations would eliminate the L. 94–482. The statute was subsequently
SUMMARY: The Secretary proposes to amended in 1983, 1987, and 1992,
financial report currently required in
amend the Student Assistance General mostly with regard to the nature and
§ 668.15; revise § 668.23, and include
Provisions regulations by revising the provision of financial audits.
the audit exceptions and repayments
requirement for compliance audits and As a result of the 1992 amendments,
requirements now contained in § 668.24
adding a new subpart establishing the statute currently requires the
in the new § 668.23. The Secretary also
financial responsibility standards. The Secretary to:
proposes to add a new Subpart L to part
proposed regulations would improve
668 by replacing and significantly • Develop standards to ensure that an
the Secretary’s oversight of institutions institution is able to provide
changing the current ratio standards
participating in programs authorized by educational services and the necessary
contained in § 668.15 to include an
title IV of the Higher Education Act of administrative resources to comply with
expanded financial ratio analysis, and
1965, as amended. program requirements, and that the
standards based on that analysis, as
DATES: Comments must be received on primary tests of financial responsibility; institution meets its financial
or before November 4, 1996. clarify guidance on the entity required obligations (particularly in the area of
ADDRESSES: All comments concerning to demonstrate financial responsibility; refunds);
these proposed regulations should be • Determine an institution’s financial
set standards for submitting
addressed to: Mr. David Lorenzo, U.S. responsibility on the basis of an
documentation and demonstrating
Department of Education, P.O. Box examination of operating losses, net
financial responsibility for foreign
23272, Washington, D.C. 20026, or to worth, operating fund deficits, and asset
institutions; set standards for submitting
to liability ratios that takes into account
the following internet address: documents and demonstrating financial
fin the differences in generally accepted
responsibility for institutions
A copy of any comments that concern accounting principles that are
undergoing a change of ownership;
information collection requirements applicable to for-profit and non-profit
clarify the type of late-refund finding
should also be sent to the Office of institutions;
that triggers the refund letter of credit • Determine whether an institution is
Management and Budget at the address provisions; and make changes to one financially responsible, despite its
listed in the Paperwork Reduction Act alternative means of demonstrating failure to meet standards based on the
section of this preamble. financial responsibility. above measures, if that institution can
A copy of the report prepared by the Tests of financial responsibility based meet certain other criteria, such as the
firm of KPMG Peat Marwick, LLP on audited financial statements are posting of a letter of credit,
(KPMG) referred to in this Notice of necessary to ensure that institutions demonstrating that it is not in danger of
Proposed Rulemaking (NPRM) is participating in the title IV, HEA recipitous closure, or demonstrating that
available for inspection during regular programs possess sufficient financial its liabilities are backed by the full faith
business hours at the following address: resources to provide the educational and credit of a state or by an equivalent
U.S. Department of Education, 7th and services for which students contract, governmental entity;
D Streets S.W., Room 3045, ROB–3, provide the human and capital • Require the annual submission of
Washington, D.C. resources necessary to administer the an audited and certified financial
FOR FURTHER INFORMATION CONTACT: Mr. title IV, HEA programs, and provide the statement as a means of gathering
Francis Meyer or Mr. Keith Kistler, U.S. financial and technical resources information about financial
Department of Education, Financial necessary to act as a fiduciary for title responsibility and other requirements.
Analysis Branch, Institutional IV, HEA program funds. The statute also allows the Secretary,
Participation and Oversight Service, 600 The Secretary intends to issue final when necessary, and to the extent
Independence Avenue, S.W., Room rules that will make technical necessary to protect the financial
3522 ROB–3, Washington, D.C. 20202, amendments to the appropriate sections interests of the United States, to require
telephone (202) 708–4906, for questions of part 668 on or before December 1, financial guarantees from institutions,
regarding financial analysis and other 1996, to eliminate conflicting references and the assumption of personal
technical questions related to between those regulations and the liabilities on the part of persons who
accounting and audits. For other proposed § 668.23 and the proposed exercise substantial control over an
information contact Mr. John Kolotos or subpart L of the General Provisions institution.
Mr. David Lorenzo, U.S. Department of regulations, and to otherwise harmonize Current regulations contain the
Education, 600 Independence Avenue, the requirements of the proposed following requirements:
S.W., Room 3045 ROB–3, Washington, § 668.23 and the proposed subpart L • That institutions must meet general
D.C. 20202, telephone (202) 708–7888. with other Federal audit and financial standards of financial responsibility,
Individuals who use a responsibility requirements. In this including the ability to provide
telecommunications device for the deaf regard, the Secretary has identified contracted services, to provide
(TDD) may call the Federal Information throughout the discussion of proposed necessary administrative resources, to
Relay Service (FIRS) at 1–800–877–8339 changes the major sections of part 668 meet all financial obligations with
between 8 a.m. and 8 p.m., Eastern that would be amended and regard to debts, and to meet obligations
standard time, Monday through Friday. consolidated. with regard to federal funds,
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49553

particularly refunds. The test for refund employ a financial reporting model therefore do not consider whether a
responsibility can be met in several consistent with the complexity of the weakness in one particular financial
different ways. reporting entity and in conformity with component is offset by financial
• That institutions must meet or commercial Generally Accepted strengths in the other components. For
exceed specific financial tests as Accounting Principles (GAAP). example, there may be instances in
indicated on an annual audited Currently the Secretary, at the which an institution may fail a single
financial statement. Some, but not all, of direction of Congress, has established measure or test (such as the acid test
these tests are differentiated among specific regulatory tests with respect to ratio) but could compensate for that
those that apply to for-profit certain assets to liability ratios and net failure by exhibiting strengths in other
institutions, those that apply to non- worth that measure an institution’s areas. Accordingly, the Secretary
profit institutions, and those that apply financial capabilities. When applied proposes to expand the scope of ratio
to public institutions. uniformly across the universe of analysis to take into account a greater
• That institutions must meet tests of participating proprietary vocational range of financial data.
past performance of an institution, or schools, private non-profit colleges and The Secretary also recognizes that the
persons affiliated with the institution. universities, public colleges and unique characteristics that distinguish
• That institutions, if they fail to meet universities, and profit and non-profit the various business segments from one
particular criteria, must demonstrate independent hospitals and health another are significant. As such, while
financial responsibility according to an maintenance organizations, these tests it is appropriate to evaluate institutions
alternative method, including posting a provide generally reliable information within a given business segment by
letter of credit, demonstrating they are about the financial health of the applying a general standard to that
not in danger of precipitous closure, institutions examined. The Secretary, business segment, and it is also
demonstrating they are backed by the however, believes that the kind of appropriate to evaluate the same
full faith and credit of a state or information that the Department can elements of financial health across all
equivalent government entity, or extract from financial statements, and business segments, it is difficult to
agreeing to be provisionally certified, in standards of financial responsibility establish comparable financial
order to continue to be eligible to based on that information, can be responsibility levels when applying a
participate in title IV, HEA programs. further improved. Such improvements single standard across all business
Improving Financial Responsibility would take into account both the total segments. The Secretary is committed to
Standards financial situation of the institution, and developing financial responsibility
the different financial and operational guidelines that take these differences
The Department is continually characteristics that exist among into consideration. The Secretary is also
evaluating the measures it uses to commercial enterprises, municipalities, committed to establishing fair and
exercise its statutory oversight of the states, private nonprofit organizations reasonable standards that measure the
institutions participating in title IV, and hospitals, each of which may be common, fundamental elements of
HEA programs. In this regard, the subject to fundamentally different financial health of all postsecondary
Department is interested in improving accounting standards and financial institutions, such that standards
its oversight of such institutions, based reporting requirements. developed according to sector-sensitive
on its experiences with the application For example, the Secretary now guidelines can be applied equitably
of current tests and standards to employs a limited type of ratio analysis across all sectors.
financial statements. The HEA requires as the principal means of assessing
the annual submission of audited financial responsibility. Generally, these The KPMG Report
financial statements from all institutions ratios address fundamental concepts As part of its overall effort to improve
that participate in any of the federal such as liquidity, profitability and net its measures of financial responsibility,
student financial assistance programs. worth. Current regulations require and as part of the Secretary’s overall
Financial statements may be presented institutions to meet certain commitment to improve the quality,
in any of several formats depending on requirements for each one of these efficiency, and effectiveness of its
the reporting entity’s legal status and components separately. An institution oversight responsibility, the Department
general purpose financial reporting that fails one test is deemed not of Education commissioned in the Fall
requirements. Public institutions financially responsible. In practice, of 1995 the accounting firm of KPMG
typically prepare financial statements however, the uniform application of Peat Marwick, LLP to examine the
conforming to the American Institute of independent sets of ratio measures current regulatory measures, and
Certified Public Accountants (AICPA) across the universe of participating recommend improvements to those
Audit Guide for Colleges and institutions reduces the reliability of the measures, especially in terms of taking
Universities, or a governmental information gathered, because such an into account the institution’s business
accounting model described in application does not always capture in sector and total financial condition. The
Governmental Accounting Standard a comparable fashion all relevant goal of the study was the development
Board Statement 15. Private nonprofit information about the fiscal of processes, measures and standards
institutions will follow an accounting responsibility of the respective the Secretary could use to better assess
model consistent with the Financial institutions. Differences in accounting risk to federal funds through the
Accounting Standards Board (FASB) classifications and standards among analysis of financial statements and
Statements of Financial Accounting different types of institutions exaggerate other documentation.
Standards (SFAS) 116 and 117. the perceived differences in financial Over the past 20 years, KPMG has
Additionally, independent hospitals strength of those institutions when they developed a methodology that uses
(i.e, medically-related institutions) are measured under independent ratios to measure key elements common
report under a hospital model, while standards, even though those across all business sectors. These ratios
proprietary institutions, ranging in size institutions may be identical with are constructed so that the individual
and complexity from sole respect to fiscal responsibility when numerators and denominators are
proprietorships to publicly traded their total financial situation is taken defined in such a way that they can be
multi-national corporations, each into account. The current requirements easily drawn from the financial
49554 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

statements of institutions from different operating cycle. A positive Net Income proprietaries can, but usually do not,
business segments. Drawing upon this Ratio indicates a surplus or profit for the retain expendable resources. The
methodology and on professional year. Generally speaking, the larger the weighting values for each sector are
experience and literature in the field, surplus or profit, the stronger the contained in Appendix F of the
KPMG conducted this study for the institution’s financial position as a proposed regulations, and a fuller
Department during the Fall of 1995 and result of the year’s operations. A explanation of those weightings is
Spring of 1996. As a result of the study, negative ratio indicates a deficit or loss contained in the appendix to this Notice
KPMG identified the most significant for the year. of Proposed Rulemaking.
fundamental elements of financial The ratios scores be assigned strength The composite scores be divided into
health in postsecondary institutions— factor values that take into account the categories that reflect the overall
viability, profitability, liquidity, ability differences between sectors, and that financial position of the institution,
to borrow, and capital resources. reflect the range of financial health. which can be used by Departmental
After consultation with a task force of (The KPMG report refers to strength analysts to determine the level of risk
individuals from the higher education factor values as ‘‘threshold values’’). A represented by the institution. For
community as well as other financial strength factor value of (5) would purposes of this proposed rule,
experts, and after conducting a indicate that, on the basis of that ratio however, the only relevant score is that
reasonableness test of the proposed alone, the institution is in exemplary which marks the boundary between
ratios by applying those ratios to a financial health. A strength factor value those institutions which, by regulation,
judgmental sample of institutional of (1), on the other hand, indicates that are financially responsible by this test,
financial reports, KPMG recommended the institution, based on that ratio alone, and those that are not. As discussed
the following: appears to be in immediate financial below, the Department is proposing that
The Secretary adopt three ratios as the difficulty. The strength factor values for the appropriate composite score be set
primary tests of financial responsibility. each ratio, broken down by sector, are at 1.75; i.e., those institutions that
These ratios are the Viability Ratio, contained in Appendix F of the receive a composite score of 1.75 or
Primary Reserve Ratio, and the Net proposed regulations (which will be higher would be considered financially
Income Ratio. The Viability Ratio is the codified with those regulations), and a responsible by this test (though they
ability of the institution to liquidate more detailed explanation for these still must meet other tests, such as prior
debt from its expendable resources. If strength factor values is contained in the performance, in order to be deemed
the ratio is greater than 1 to 1, existing separate appendix to this Notice of financially responsible), and those that
debt could be repaid from expendable Proposed Rulemaking that will not be receive a score of less than 1.75 would
resources available today. The Primary codified in final regulations. not be deemed financially responsible
Reserve Ratio measures the ability to The strength factor scores for each by this test. This standard is based on
support current operations from institution be summed in accordance KPMG’s conclusion that an institution
expendable resources. This ratio with a weighting mechanism that again that attains a composite score of less
provides a snapshot of financial strength takes into account the differences than 1.75 represents an immediate
and flexibility by comparing expendable among business sectors to create a financial problem.
resources to total expenditures or composite score. For example, public A more extensive discussion of
expenses, or operating size. This and private non-profit institutions KPMG’s report is contained in the
snapshot indicates how long the would both have their Primary Reserve appendix to this Notice of Proposed
institution could operate using its ratios weighted most heavily, while for Rulemaking. The entire report is also
expendable reserves without relying on proprietary institutions, the Net Income available for inspection during regular
additional net assets generated by ratio would be weighted most heavily. business hours at the address provided
operations. The Net Income Ratio This difference reflects the fact that at the beginning of this preamble. The
measures the ability of an institution to privates and non-profits can and usually Secretary also invites comments on the
live within its means in a given do retain expendable resources, while KPMG report.


Viability Ratio

Public institutions following Public institutions following Private non-profit hospitals

the 1973 AICPA audit Proprietaries For-profit hospitals
a government model and institutions
guide 1

Expendable Fund Bal- Gov’t and Proprietary Fund Expendable Net Assets 3 Adjusted Equity 5 Expendable Fund
ances 2 Equity ÷ ÷ Balances
÷ ÷ Long-Term Debt 4 Total Long-Term Debt ÷
Plant Debt General Long-Term Debt Long-Term Debt
1 Public institutions have the option of preparing their statements according to the 1973 AICPA Guide for Colleges and Universities, or the gov-
ernmental model.
2 Expendable Fund Balances are computed as follows: General, specific purpose, and quasi-endowment fund balances—plant equity. True en-
dowments are specifically excluded from the numerator.
3 Expendable Net Assets are calculated as follows:
Unrestricted Net Assets.
Plus Temporarily Restricted Net Assets.
Minus Property, plant and equipment.
Minus Plant debt (including all notes, bonds, and leases payable to finance those fixed assets).
Equals Expendable Net Assets.
4 Long-term debt is defined as all amounts borrowed for long-term purposes from third parties and includes: (1) Notes payable, (2) Bonds pay-
able, and (3) Leases payable.
5 Adjusted equity is computed as follows:
Total Owner(s) or Shareholders Equity.
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49555

Minus Intangible assets.

Minus Unsecured related party receivables.
Minus Property, plant and equipment (net of accumulated depreciation).
Plus Total long-term debt.
Equals Adjusted Equity.
If total long-term debt exceeds the value of net property, plant and equipment, then the asset is not subtracted from equity nor is the liability
added back.
Primary Reserve Ratio

Publics using the 1973 Publics using a govern- Private non-profit hospitals Proprietaries For-profit hospitals
AICPA audit guide mental model and institutions

Expendable Fund Bal- Governmental and Expendable Net Assets Adjusted Equity Expendable Fund
ances Proprietary Fund Equity ÷ ÷ Balances
÷ ÷ Total Expenses Total Expenses ÷
Total Expenditures and Total Government Total Expenses
Mandatory Transfers Expenditures and other
Financing Uses (Excluding
Transfers) and Total
Proprietary Expenses

Net Income Ratio

Publics using 1973 AICPA Publics using a govern- Private non-profit hospitals Proprietaries For-profit hospitals
audit guide mental model and institutions

Net Total Revenues ÷ Proprietary Income Before Change in Unrestricted Income Before Taxes Revenue & Gains in
Total Revenues Operating Transfers, + Net Assets ÷ Excess of Expenses &
Gov’tal Revenues and ÷ Total Revenues Losses (Net Total
Other Financing Sources Total Unrestricted Income Revenues)
(exc. transfers)—Gov’t ÷
Expenditures and Other Total Revenues
Financing Uses (excluding
Total Governmental and
Proprietary Revenues and
other Financing Sources
(excluding transfers)

The Secretary’s Use of the KPMG Report designation of 1.75 as the cutoff score statement requirements formerly located
The Secretary proposes adopting the would best be made with the benefit of in § 668.15(e). The Secretary retains the
methodology recommended in the public comments. requirement that an institution submit
KPMG report to replace the ratio In addition, the Secretary proposes in financial statements audited by an
methodology now contained in § 668.15. this NPRM a number of other changes independent certified public
For the most part, the Secretary to the financial responsibility accountant, and the provision for the
proposes this methodology without regulations, and to the audit submission of working and other papers
change in order to seek comment from requirements contained in section on demand from the Secretary.
the community on the merits of this 668.23. A summary of all these changes However, the Secretary believes that it
approach. However, in its final report follows. is possible to provide relief to
KPMG concluded that a composite score institutions without compromising the
Summary of Proposed Changes ability of the Department to perform its
below 1.75 indicates an immediate
financial problem, but acknowledged In proposing to move the financial oversight responsibilities. One way that
that the identification of a bright line responsibility regulations from § 668.15 this may be accomplished is to require
standard for passing or failing the to the new Subpart L of Part 668, the institutions to submit a single audit,
financial responsibility standards was a Secretary proposes that certain segments prepared on a fiscal year basis and
policy decision that should be made by of the existing regulations be kept intact, audited under Generally Accepted
the Secretary. The Secretary is therefore and that significant changes be made in Government Auditing Standards
proposing to adopt the composite score others. A part of these proposed changes (GAGAS) and including the compliance
standard of 1.75 as the bright line is also a revision of § 668.23. A information. A single compliance audit,
standard for the ratio test, and to equate summary of the new locations of prepared on a fiscal year basis rather
a failure to demonstrate financial existing regulations, proposed changes than on an award year basis, would
responsibility with the threshold that to regulations, and issues on which the provide the basic information required
KPMG identified as posing a significant Secretary particularly invites comments by the Secretary for purposes of making
risk of immediate financial problems. follows below. a determination of financial
The Secretary believes that including responsibility. The Student Financial
§ 668.23 Compliance Audits and
this methodology in the proposed Audited Financial Statements
Assistance Audit Guide (SFA Audit
regulations in this fashion will best Guide) now requires that all institutions
utilize the KPMG study, and that any In this section, the Secretary proposes submit audited financial statements as
adjustments to the KPMG to revise the provisions of the current part of their compliance audits. For
recommendations and the Secretary’s § 668.23 and the audited financial some institutions, particularly those in
49556 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

the proprietary sector, this has resulted information regarding the institution’s The Secretary is proposing this
in a requirement that institutions submit financial relationship with related composite score as a measure of
these two audited financial statements entities, and that on request the financial responsibility because this
to the Secretary annually, but at two institution must submit consolidated score takes into consideration many
different times. These audits differ in at audited financial statements of the important variables, with particular
least two ways. One way in which they institution and related entities. emphasis on expendable capital and
differ is that the financial statement This proposed section contains audit profitability. A score of less than 1.75
required under the current § 668.15 is to submission requirements for foreign suggests that the overall financial
be performed in accordance with institutions, discussed below under the circumstance of the institution is such
Generally Accepted Auditing Standards heading § 668.176 Foreign Institutions. that one or more of the measured
(GAAS) and the financial statement that The Secretary also proposes adding a elements is at or below the minimum
is required as part of the compliance paragraph regarding questionable strength factor value and neither
audit is to be performed under GAGAS. accounting treatments. Under this remaining measure is higher than the
Under the GAGAS standard, the auditor proposal, if the Secretary questions an median strength factor value. Generally,
must go beyond GAAS standards to accounting treatment, the Secretary may this implies that the institution is
perform additional tests and express an submit the audit statements that contain having difficulty maintaining a marginal
opinion on the internal control structure those treatments to various bodies, position with respect to financial health
and on compliance with all laws and including the AICPA, for review or and, by at least one measure, it is failing
title IV, HEA program regulations. The resolution. to perform at even a minimal acceptable
other difference is that the financial This proposed section contains level. Conversely, marginal institutions
statement required under the current requirements for a proprietary that achieve a strength factor value
§ 668.15 is to be conducted on a fiscal institution to disclose in a note to its indicating superior performance in any
year basis, and the compliance audit is financial statement the proportion of one of the measured elements are likely
performed on an award year basis. revenues it receives from title IV, HEA to achieve a composite score of 1.75 or
Thus the Secretary proposes to programs. This disclosure represents no more despite overall marginal
eliminate the submission of a separate added burden to the institution, since performance. This is based on the
financial statement four months after the auditor will have already prepared assumption that superior performance
the end of the entity’s fiscal year, as the information contained in the note to in any one of the measured elements
now required in § 668.15. Instead the fulfill the requirements of § 600.5(d) and will, over time, lead to improvements in
Secretary proposes that the Department (e) within 90 days of the end of the the other measured elements.
require institutions or third-party institution’s fiscal year. The use of a composite score
servicers to submit the A–128 or A–133 This proposed section also includes encompasses the total financial
report in the timeframe provided by that the requirements regarding audit circumstances of the institution
guidance, or six months after the end of exceptions and repayments now examined. Each of the three principal
the institution’s or servicer’s fiscal year contained in § 668.24. Section 668.24 is measures attempts to identify a
for entities that follow the SFA Audit now being separately amended by the fundamental strength or weakness
Guide, as required in the proposed Secretary to include requirements related to the institution’s overall fiscal
§ 668.23. This compliance report would regarding record retention. health. In particular, each factor isolates
now include both the compliance audit Subpart L—Financial Responsibility a critical aspect of fiscal responsibility
and the audited financial statement, and measures that element against an
would be prepared on a fiscal year basis, § 668.171 Scope and Purpose established benchmark. It is important
and be prepared in accordance with In this section the Secretary proposes to note, however, that no single measure
GAGAS. It would be on the basis of the to revise the scope and purpose is used. Rather, the measures are
audited financial statement contained in statement currently in § 668.15(a) to blended into a composite score that
the compliance report, as well as other more accurately reflect the purpose and recognizes the basic differences that
documentation, that the Secretary intent of the law, to clarify the exist among the several types of
would make determinations of financial responsibilities of third-party servicers institutions. By taking these differences
responsibility by applying this proposed under this subpart, and to include a into consideration, the Secretary is
ratio test and other forms of analysis. As special transition rule discussed below. better able to make a determination as
a result of this change, the compliance to overall institutional fiscal health. The
audit of an institution whose fiscal year § 668.172 Financial Standards differences among the institutions
does not coincide with an award year This section incorporates the examined are recognized explicitly
would cover parts of two award years. requirements currently in through the weighting methodology.
The Secretary recognizes that such a § 668.15(b)(1)–(5), and § 668.15(d) The use of a composite measure
change may pose difficulties associated regarding financial obligations, refund represents a departure from the
with providing a compliance audit standards and the alternatives to Secretary’s current approach to
spanning two different award years, but meeting the statutory refund reserve measuring fiscal responsibility.
believes that the overall burden requirement, as well as the requirement Currently, the Secretary applies similar
reduction for institutions from that the institution must submit its measures, but individual compliance
combining the two audits more than compliance report by the date and in the thresholds for each element are
compensates for these difficulties. manner prescribed in § 668.23 in order measured exclusively from one another,
The Secretary also proposes a to be considered financially responsible. and not in combination. Under the
modification of the treatment of the The Secretary proposes in this section current regulations, the Secretary
entity covered by the financial that a composite score of 1.75, implicitly recognizes the relationship
statement by clarifying the requirements calculated in accordance with § 668.173, among variables and established
that trigger the submission of be the minimum score an institution can compliance thresholds for each element
consolidated statements. The Secretary achieve and still be determined separately. The proposed regulations are
proposes that an institution, as part of financially responsible using the new similar in that poor performance in any
its audited financial statement, provide ratio analysis. one element may lead to a finding of
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49557

non-compliance unless other measures reserve requirement performance definition of ratios currently contained
are at least at the median performance alternative. Section 498(c)(6) of the HEA in § 668.15(b).
level. What differs in relation to the requires that institutions maintain a This proposed section also contains a
current regulations is the recognition cash reserve to pay required refunds. definition of ‘‘independent hospital’’ for
that superior performance in one or Current § 668.15(b)(5), and these these purposes, and the accounting
more fundamental elements of financial proposed regulations, require rules for calculating ratios previously in
health adds a dimension to any analysis institutions, unless they meet the § 668.15(b) regarding the treatment of
of fiscal responsibility that warrants provisions of specific exceptions, to intangibles, extraordinary gains and
consideration. Thus, with one exception provide the Secretary with a letter of losses, the income or losses from
discussed below, strength in one area credit equal to not less than 25% of the discontinued operations, cumulative
may be considered to the extent that it title IV, HEA program refunds for their effects of changes in accounting
offsets weakness in another. The previous fiscal year. One exception to principles, prior period adjustments,
Secretary believes that this better takes this requirement is the provision for and temporarily restricted assets.
into consideration the total financial performance standards, in which the The Secretary is particularly
circumstances of an institution. institution demonstrates that it has interested in comments regarding the
There is one proposed exception to made required refunds, as attested to by definition and utility of these ratios. Are
the use of the composite score rather the previous two years’ compliance the terms used in defining them clear?
than individual ratios as the test of audits, and it has not had a finding of Do the ratios themselves provide
financial responsibility. Because KPMG failure to make timely refunds. The meaningful and useful information
recommended that a public or private Secretary wishes to address the issue of regarding the financial health of an
non-profit institution that has a negative a finding of failure to make timely institution? Are the ratios correctly
Primary Reserve Ratio be deemed an refunds. Without a standard under constituted with relation to the different
immediate financial problem despite its which such a finding is made, even one audit requirements of the various
composite score, the Secretary proposes late refund may be interpreted as a sectors of participating institutions? Are
that in such circumstances the failure to make timely refunds, and the weightings and strength factor levels
institution not be considered financially could trigger this requirement. While appropriate for each sector? Will the
responsible under the ratio test. This the Secretary expects all institutions to composite scores give accurate pictures
adjustment is in recognition that a make all refunds in accordance with the of financial health for all types of
public or private non-profit institution regulations in § 668.22, and will enforce institutions? Will the composite scores
that has a negative Primary Reserve those regulations for every refund, the give relevant and useful information
Ratio is in such grave financial Secretary did not intend for isolated regarding the financial health of
difficulty that even exemplary instances of late refunds to trigger the institutions? Is the 1.75 composite score
performance in other areas cannot cover requirement for the provision of the an appropriate bright line for
for this deficiency. letter of credit. Therefore, the Secretary determining the financial responsibility
The Secretary intends to publish on or of an institution?
is proposing that an institution would
by December 1, 1996 final regulations Also, the financial strength factors
be eligible for the performance standard
resulting from these proposed rules. and weightings for hospitals currently
exception to the requirement to
Because the final regulations would reflect the situation of for-profit
providing a 25% letter of credit, if (1)
become effective on July 1, 1997, the hospitals. The Secretary is interested in
the independent CPA who audited the
Secretary is proposing a special comments addressing the situation of
institution’s financial statements and
transition rule with regard to the non-profit hospitals, and whether the
compliance audits, or the Secretary, a
implementation of the 1.75 composite strength factors and weightings for those
score standard. The Secretary would State or a guarantee agency that
institutions should be different from
allow an institution under proposed conducted a review of the institution,
those for for-profit hospitals.
§ 668.171(c) a one-year exemption from did not find that the institution made 5
percent or more of its refunds late, § 668.174 Alternate Standards and
the new composite score standard if that
institution passes the applicable ratio based on a sample of records audited Requirements
standard test now in place in and reviewed, and (2) the auditor did The Secretary is proposing to modify
§ 668.15(b)(7)–(9). Thus an institution, not note a material weakness or a and relocate the provisions permitting
for its fiscal year that began on or before reportable condition in the institution’s institutions to demonstrate financial
June 30, 1997, that fails the 1.75 report on internal controls that is related responsibility under an alternative to
composite score standard but passes the to refunds. The Secretary believes that the proposed composite score. All of the
appropriate ratio standard test these standards are reasonable and exceptions formerly located in
contained in the current § 668.15, would particularly requests comments on this § 668.15(d) are relocated to this section.
still be considered financially proposal. In this section the Secretary proposes
responsible for one year. The Secretary § 668.173 Financial Ratios to modify the method by which an
believes it is appropriate to allow an institution demonstrates that it has
institution to prove financial This proposed section incorporates sufficient assets to ensure against
responsibility under the current the methodology recommended by the precipitous closure. The existing
standards based on the financial KPMG study and contains the regulatory provisions implement the
condition of the institution during the definitions of ratios by sector, and the statutory exception in section
fiscal year that begins before these procedure by which composite ratio 498(c)(3)(C) of the HEA that permits an
proposed rules become effective. scores are calculated. Specific strength institution otherwise failing prescribed
Moreover, this one-time transition rule factors for normalizing ratio scores and ratios to demonstrate financial
would give the institution at least 12 weighting the normalized ratios by responsibility by showing that it has
months to adjust its operations to meet sector are contained in the proposed sufficient resources to ensure against its
the new standards. Appendix F to Part 668. The Secretary precipitous closure. Current regulations
In this section the Secretary also proposes that these ratios and the mirror certain statutory requirements
proposes a modification in the refund resulting composite score replace the that the institution demonstrate that it is
49558 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

meeting its financial obligations, and § 668.175 Special Rules for an financial responsibility under the new
then require the institution to make Institution That Undergoes a Change in proposed ratio analysis.
specific demonstrations that it has not Ownership In addition, the Secretary is
engaged in certain identified practices concerned that some entities seek
In this section the Secretary proposes multiple approvals for changes of
that could have caused the institution’s
to specify the requirements by which an ownership during one fiscal year, and
deteriorated financial strength. The
institution that undergoes a change of this rapid growth increases the
proposed regulations differ from this ownership is deemed financially
detailed analysis by establishing a lower difficulty of assessing the financial
responsible, as well as establishing the resources that would be available to
threshold (represented by a composite audit submission requirements for those institutions. The Secretary intends
score of 1.25) in order to qualify for this applications for approval of changes of that such applicants will have to
one-year exception, and then simply ownership. provide audited financial statements
requiring the owners (or other persons that incorporate all institutions for
The Secretary is proposing that
who exercise substantial control over which they have already obtained
entities applying for changes of
the institution) to assume personal ownership initially demonstrate approval to operate as part of the
liability for the institution’s title IV financial responsibility in one of two application for a new change of
obligations, rather than requiring a ways. Either the new owners of the ownership. These proposed regulations
detailed analysis of the business institution must submit personal therefore require the entity seeking the
dealings between the institution and its financial guarantees, in an amount and change of ownership to demonstrate
owners. The Secretary believes that this form acceptable to the Secretary, or that it has submitted audited financial
system will improve the administrative submit a letter of credit payable to the statements to the Secretary that include
efficiency of implementing this Secretary in an amount of not less than all other institutions participating in
exception and decrease the burden on one half the amount of title IV, HEA title IV, HEA programs in which the
the institutions using the exception by program funds the Secretary determines entity has an ownership interest or over
avoiding the detailed analysis of the the institution will receive during the which it exercises substantial control, or
business transactions between an year following the new ownership’s to submit a current audited financial
institution and its owners. Furthermore, opening day. A requirement for both statement reflecting such operations and
by establishing a separate minimum these methods is that the institution ownership interests. This means that for
performance standard for institutions submit a consolidated date of every change of ownership, the entity
acquisition balance sheet for the seeking the change in ownership would
that seek to use this exception, the
institution as part of the institution’s provide personal guarantees or a letter
Secretary intends to ensure that more
application for a change of ownership. of credit until audited financial
significant protections will be required statements are submitted to the
for institutions whose financial The Secretary is also proposing that the
personal guarantees or letter of credit Secretary showing all the institutions
condition has deteriorated during the that the entity owns or controls,
preceding year to the point where the remain in place until the institution
submits audited financial statements including the institution or institutions
institution cannot meet those minimum that are the subject of the change of
that show that the institution meets the
thresholds. In such circumstances, these ownership application.
1.75 composite score standard that is
institutions must either use one of the The Secretary is also considering
part of the general standards for
other alternative means of requiring owners to post personal
demonstrating financial responsibility
demonstrating financial responsibility financial guarantees when institutions
required of all participating institutions.
or be provisionally certified under the add additional locations, and these
provisions for institutions that are not Historically, the Secretary has would remain in place until annual
financially responsible. encountered difficulties in making audits are submitted showing that the
comparable assessments of the financial institution demonstrates financial
With regard to financial standards and resources for institutions seeking responsibility under its expanded
alternative standards for new approval under new ownership. operations. The Secretary specifically
institutions, the Secretary proposes that Sometimes the institution was sold invites comments on this proposal.
two alternatives enumerated in the because of an eroded or deteriorating
statute—the provision of a letter of financial condition. Without an 668.176 Foreign Institutions
credit for at least 50% of the proposed opportunity to evaluate an audited In this section the Secretary proposes
title IV program funds that the Secretary financial statement that includes the to clarify financial responsibility
determines the institution will receive operation of the newly acquired standards for foreign institutions. Under
during its initial year of participation, or institution, the Secretary has had to the proposed regulation, foreign
proof that the institution is backed by make case-by-case examinations of the institutions whose annual title IV
the full faith and credit of a State or financial resources of the institution participation is less than $500,000 per
equivalent governmental entity—be under its new ownership. Sometimes, year will be permitted to submit their
utilized for new institutions. The this additional analysis has significantly financial statement audits in accordance
requirement of meeting prior year delayed the approval of the applicant or with the generally accepted accounting
standards precludes new institutions such approval has been premised upon principles of each institution’s home
from availing themselves of the revised unaudited financial information that country. These audits will then be
precipitous closure alternative. The differed significantly from the audited examined to determine financial
Secretary believes this is warranted due financial statement that was later responsibility. Foreign institutions
provided by the institution. The whose annual title IV participation
to the greater uncertainty presented by
proposed regulations would streamline exceeds $500,000 per year will be
institutions that have not established a
the approval process and provide required to have their financial
track record of properly administering greater protection to the taxpayers, statement audits translated as well as
the title IV, HEA programs. while permitting the institution to presented for analysis under U.S. GAAP
participate and later demonstrate and GAGAS, and would have to meet all
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49559

regulatory requirements applicable to currently affect institutions that fail to equivalent government entity. If the
domestic institutions. meet one of the current ratio standards): institution could not meet one of these
The Secretary is proposing this A certified institution whose financial alternative standards, it may be offered
standard for foreign institutions to take statement is undergoing its annual provisional certification, the terms of
into consideration several important review, or an institution that is which are described above. If the
distinguishing factors. First, foreign undergoing recertification, would have institution is not offered provisional
institutions are only eligible to the opportunity to meet one of the certification, or turns down provisional
participate in the student loan following alternate standards. If it had certification, it would not be eligible to
programs, and the relative size of such demonstrated financial responsibility in participate in any title IV, HEA program.
title IV funding at most institutions is the previous year, it could prove that it
relatively small when compared with is not in danger of precipitous closure Appendix F
their total financial operations. Second, by attaining a composite score of at least This proposed appendix contains the
foreign institutions with such relatively 1.25, and showing that it is current in strength factors and sector weightings
low volumes of title IV participation its debt obligations, and if its owners or for the new ratio analysis, an example
have not historically experienced board of trustees submit personal of how composite scores are calculated,
compliance problems that appear to financial guarantees and agree to be and a section for technical terms, all
have resulted from impaired financial jointly and severally liable for any adopted from the KPMG report.
capability. Under the proposed liabilities arising from the institution’s In enumerating the strength factors for
regulations, these foreign institutions participation in title IV, HEA programs. institutions, the Secretary proposes
will provide annual financial statement It could also submit to the Secretary an following KPMG’s adjustments by
audits and annual compliance audits irrevocable letter of credit for at least specifying that public and private non-
that can be evaluated to determine 50% of the total title IV, HEA program profit institutions that have a negative
whether an institution’s operations are funds the institution received during its Primary Reserve Ratio be deemed to fail
posing a risk to the taxpayers. The latest fiscal year. A public institution the composite score test. The Secretary
Secretary believes that the additional would also have the opportunity to also proposes following KPMG’s
burden of translating the financial demonstrate that it is backed by the full recommendation that for a proprietary
statement audits and presenting them faith and credit of a State or an institution that earns a (2) or (1) strength
under U.S. GAAP and GAGAS should equivalent government entity. An factor for its Primary Reserve Ratio, the
only be imposed where significant institution that meets any of these strength factor for the Viability Ratio be
amounts of title IV funds are expended alternatives would be considered no greater than the result of the Primary
at the foreign institution on an annual financially responsible. If an institution Reserve Ratio. The purpose of this
basis. referred to above cannot or does not adjustment is to prevent insignificant
meet one of these alternatives, it may be amounts of debt from significantly
§ 668.177 Past Performance offered provisional certification by the affecting the categorization of an
This proposed section contains the Secretary. In this case the institution institution.
requirements for past performance for would be required to submit to the Executive Order 12866
an institution or persons affiliated with Secretary an irrevocable letter of credit
an institution that were formerly for at least 10% of the total title IV, HEA 1. Assessment of Costs and Benefits
contained in § 668.15(c). program funds the institution received These proposed regulations have been
§ 668.178 Additional Requirements during its latest fiscal year, demonstrate reviewed in accordance with Executive
and Administrative Actions that it met all its financial obligations Order 12866. Under the terms of the
and was current on its debt payments order the Secretary has assessed the
This proposed section contains an for its two most recent fiscal years, and potential costs and benefits of this
outline of the administrative actions the demonstrate that it is capable of regulatory action.
Secretary takes when an institution fails participating under a funding The potential costs associated with
any one of the various standards of arrangement other than the the proposed regulations are those
financial responsibility, and specifies Department’s advance funding method. resulting from statutory requirements
that failure to meet general standards of An institution that participates under and those determined by the Secretary
financial responsibility may subject provisional certification in these to be necessary for administering this
institutions to the Limitation, circumstances is not considered to be program effectively and efficiently. To
Suspension, Termination, and financially responsible. If the institution the extent there are burdens specifically
Emergency Action provisions of Subpart is not offered provisional certification, associated with information collection
G of Part 668. This proposed section or turns down provisional certification, requirements, they are identified and
also contains the portions of § 668.13(d) the institution would then be subject to explained elsewhere in this preamble
dealing with requirements and termination proceedings. under the heading Paperwork Reduction
standards pertaining to provisional An institution seeking to participate Act of 1995.
certification of institutions that are not for the first time in the title IV, HEA Thus, in assessing the potential costs
financially responsible. The Secretary programs would have the opportunity to and benefits—both quantitative and
invites comments on whether the meet one of the following alternate qualitative—of these proposed
Department should include other types standards. It could submit to the regulations, the Secretary has
of requirements for institutions that are Secretary an irrevocable letter of credit determined that the benefits of the
provisionally certified because they are for at least one-half of the amount of proposed regulations justify the costs.
not financially responsible, for example title IV, HEA program funds that the The Secretary has also determined
the development of teach-out plans. Secretary determines the institution will that this regulatory action does not
With regard to this section, the receive during its initial year of interfere unduly with State and local
following clarifies the consequences of participation. A public institution governments in the exercise of their
not meeting the proposed 1.75 would have the opportunity to governmental functions.
composite score standard (these demonstrate that it is backed by the full To assist the Department in
consequences are also those that faith and credit of a State or an complying with the specific
49560 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

requirements of Executive Order 12866, entities has been performed. A summary changes to one of the alternative
the Secretary invites comment on how of the IRFA appears below. methods of demonstrating financial
to minimize potential costs or to responsibility would have a positive
Description of the Objectives of, and
increase potential benefits resulting economic impact on those institutions
Legal Basis for, the Rule
from these proposed regulations that choose this alternative (otherwise it
consistent with the purposes of sections The Secretary is directed by section would not be chosen) and the Secretary
487(c) and 498(c) of the HEA. 498(b) of the HEA to establish, on an believes that most institutions that
annual basis, that institutions would have been able to use the existing
Summary of Potential Costs and participating in title IV, HEA programs alternative method set out in the current
Benefits are financially responsible. As part of regulations would be able to use the
The Department has assessed the the Department’s regulatory reinvention modified version. The costs of this
costs and benefits of the proposed process, the Department has analyzed alternative and the other existing
regulations. This information is the current standards whereby alternatives are discussed below in the
provided under the Initial Flexibility institutions can demonstrate financial context of those institutions that
Analysis (below), and Summary of the responsibility and found that experience adverse economic impacts.
KPMG Report Commissioned by the improvements can be made. The
Department (appended to this NPRM). proposed improvements are discussed Compliance Costs of the Proposed Rule
at length in the preamble to this for Small Governmental Entities
2. Clarity of Regulations proposed rule. Small (and large) governmental
Executive Order 12866 requires each entities that participate in the SFA
agency to write regulations that are easy Definition and Identification of Small
programs have a statutory (section
to understand. Entities
498(c)(3)(B) of the HEA) alternative to
The Secretary invites comments on The Secretary has adopted the U.S. the existing and proposed tests for
how to make these regulations easier to Small Business Administration (SBA) demonstrating financial responsibility.
understand, including answers to Size Standards for this analysis. RFA This alternative allows for entities that
questions such as the following: (1) Are directs that small entities are the sole are backed by the full faith and credit
the requirements in the regulations focus of the Regulatory Flexibility of a State to be considered financially
clearly stated? (2) Do the regulations Analysis. There are three types of small responsible, and to be relieved of any
contain technical terms or other entities that are analyzed here. They are: costs of demonstrating financial
wording that interferes with their for-profit entities with total annual responsibility. It is the Secretary’s
clarity? (3) Does the format of the revenue below $5,000,000; non-profit practice to identify financial statements
regulations (grouping and order of entities with total annual revenue below from public institutions that appear to
sections, use of headings, paragraphing, $5,000,000; and entities controlled by fail the numeric financial responsibility
etc.) aid or reduce their clarity? Would governmental entities with populations standards, and then to determine on a
the regulations be easier to understand below 50,000. An estimate of the case by case basis whether that
if they were divided into more (but proportion of entities in each of these institution is backed by the full faith
shorter) sections? (A ‘‘section’’ is categories was calculated using the best and credit of the state in which it is
preceded by the symbol ‘‘§ ’’ and a available data, the National Center for located. This alternative method of
numbered heading: For example, Education Statistics IPEDS survey for demonstrating financial responsibility is
§ 668.174 Alternate standards and the academic year 1993–1994. These not changed under the proposed
requirements). (4) Is the description of estimates were applied to Department regulations, so the proposed rule will
the proposed regulations in the administrative files where no data not have an increased significant
‘‘Supplementary Information’’ section of element for total revenue is available. economic impact on small governmental
the preamble helpful in understanding The estimates are that 1,690 small for- entities.
the proposed regulations? How could profit entities, 660 small non-profit
entities and 140 small governmental Compliance Costs of the Proposed Rule
this description be more helpful in for Small For-profit and Small Non-
making the proposed regulations easier entities will be covered by the proposed
rule. Where exact data were not profit Entities
to understand? (5) What else could the
Department do to make the regulations available to estimate the proportion of Some small (and large) for-profit and
easier to understand? small entities, data elements were non-profit entities will experience
A copy of any comments that concern chosen that would have overestimated, adverse economic impacts from this
how the Department could make these rather than underestimated, the proposed rule, to the extent that they
proposed regulations easier to proportion. The Secretary particularly may fail the proposed standards
understand should be sent to Mr. invites comments on the definition of (including the alternative measures for
Stanley Cohen, Regulations Quality small entity and the estimate of the demonstrating financial responsibility)
Officer, U.S. Department of Education, number of small entities that would be but would have been able to pass the
600 Independence Avenue, S.W., Room covered by the proposed rule. current standards. Using the KPMG
5121, FOB–10, Washington, D.C. 20202– The component of the proposed rule analysis described elsewhere, it was
2241. that could potentially cause a small estimated that between 456 and 625
entity to be economically affected is the small for-profit entities and between 18
3. Initial Flexibility Analysis proposed modification of the tests for and 80 small non-profit entities would
The Secretary has determined that a financial responsibility that are applied pass the existing test but fail the new
substantial number of small entities may to the submitted financial statements. proposed tests, and the Secretary seeks
experience significant economic The proposed consolidation of the to minimize these adverse economic
impacts from this proposed regulation. financial statement audit with the impacts by including in the regulations
In accordance with the Regulatory compliance audit that must be a provision that will treat an institution
Flexibility Act (RFA), an Initial submitted to the Secretary would have that passes the old standards as being
Flexibility Analysis (IRFA) of the a positive economic impact on all small financially responsible for any fiscal
adverse economic impact on small (and large) entities. The proposed year that begins prior to the effective
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49561

date of the final regulation. To the estimates are provided to satisfy the regulation will be spared the expense of
extent that some of these small entities RFA requirements that costs of pursuing alternative demonstrations of
will be unable to adjust their operations compliance be described and should be financial responsibility.
to come into compliance with the new used as illustrative examples only. The The negative economic impacts from
standards beyond that transition period, Secretary particularly invites comments this proposed regulation will only be
the negative economic impact on these on these estimates of each of these felt by those additional entities that are
entities are those costs associated with alternatives for small entities. judged to be not financially responsible
employing the alternative methods for by the proposed tests but may have been
Discussion of Adverse Economic determined to be financially responsible
demonstrating financial responsibility.
Impacts under the current regulations. The
Costs for adjusting the operation of the
institution to come into compliance This analysis has determined that Secretary believes that the proposed
may, in some cases, be significant, between an estimated 456 and 625 small tests, developed by KPMG through
although more difficult to estimate. for-profit entities and between an extensive consultations with small (and
The Secretary seeks comments on estimated 18 and 80 small non-profit large) entities, are better determinants of
alternative ways of minimizing burden entities may not initially pass the financial responsibility than the existing
on small entities. One possible proposed standards to demonstrate tests. The use of the proposed tests will
alternative for which the Secretary seeks financial responsibility even though enable the Secretary to better meet the
comment is to delay the effective date these institutions might have passed the responsibilities of section 498(c) of the
of these rules for small entities. current standards. This estimate was HEA and to better safeguard the Federal
To the extent that an institution that derived from information used in the fiscal interests and the interests of
passed the current standards of financial KPMG study that had selectively students.
responsibility could no longer do so included a number of schools that had
without posting a surety, a rough a demonstrated lack of financial Identification of Relevant Federal Rules
estimate of the calculable costs of each responsibility, so the projections in this Which May Duplicate, Overlap, or
of these alternative methods for a analysis may overstate the expected Conflict With the Proposed Rule
typical small entity was calculated. The number of institutions that are in this This rule reduces the number of
typical small entity was proposed as one category. In order to ameliorate the audits which must be submitted to the
with $2,000,000 in total revenue, 84% effects of implementing a new standard Secretary by consolidating the financial
of which comes from the SFA programs. for financial responsibility, the statement audit with the compliance
It was not practicable to estimate the proposed regulations include a audit, removing some redundancy in
cost of obtaining external financing if proposed alternative means to these reporting requirements because
the required capital was not readily demonstrate financial responsibility financial information about the
available. This would depend on the under the current standards for fiscal institution was being gathered
risk profile of the particular entity and years that began prior to the effective separately through both of these
reliable estimates of this feature were date of the proposed regulation. submissions. The Secretary has not
not practicable. This rough estimate is Institutions not able to come into found any other Federal rules which
that it could cost a typical small compliance with the proposed duplicate, overlap, or conflict with the
institution as much as $56,500 to secure standards following this transition proposed rule. The Secretary
a 50% letter of credit, although the period will experience adverse particularly invites comments on other
actual costs to most institutions would economic impacts from this proposed Federal rules which might meet these
be less if available credit lines or other regulation, and the relative economic criteria.
assets could be pledged against the costs these institutions may face if they
Significant Alternatives That Would
letter of credit. Similarly, if the are required to post a letter of credit are
Satisfy the Same Legal and Policy
institution were allowed to post a discussed above. Since the proposed
Objectives While Minimizing the
smaller surety in conjunction with regulations provide a better measure of
Economic Impact on Small Entities
provisional certification, the 10% letter an institution’s financial responsibility,
of credit could cost as much as $20,500, the Secretary believes it is necessary to The proposed changes to the financial
or less depending on the other available impose these additional costs on responsibility regulations would satisfy
resources that were used to secure the institutions that are unable to adjust the same legal and policy objectives that
letter of credit. The Secretary notes that their operations to meet these ratios, are addressed by the current regulations
the relative cost of providing these because failure to meet these ratios in a manner that the Secretary believes
letters of credit will correspond to the indicates a heightened risk to students more accurately measures the financial
relative risk assessments made by the and taxpayers. strength of institutions participating in
banks that provide the letters of credit The adverse economic impacts the title IV, HEA programs. This
to the institutions. experienced by some small (and large) adoption of ratio analysis in conjunction
The amount it would cost a typical entities is balanced by the positive with the revised alternative means for
small entity to avail itself of the revised economic impacts experienced by some demonstrating financial responsibility
alternative standard for financial small (and large) entities. These positive will minimize the adverse economic
responsibility where the institution impacts arise from the ability of the impact on small (and large) entities that
demonstrates that it has sufficient proposed tests to better judge financial choose this alternative. Other
resources to ensure against its responsibility. Between an estimated alternatives, such as those that would
precipitous closure could not be 138 and 369 small entities that failed establish differing compliance or
reasonably estimated, but it is assumed the existing tests will pass the new tests reporting requirements or timetables
that the costs would be smaller than because the proposed regulation based upon the size of the institution
those listed above for institutions that determines financial responsibility by rather than the type of institution, or the
choose this method. These estimates are blending more financial information use of performance standards rather
for the typical institution and the costs together into a composite score. These than establishing baseline measures, or
experienced by the actual institutions entities that have resources that were an exemption from coverage of the rule
will undoubtedly be different. These not adequately measured under the or any part thereof for small entities,
49562 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

would not adequately discharge the Collection of Information: Financial programs contained in sections 487 and
Secretary’s obligation under section Responsibility 498 of the HEA.
498(c) of the HEA to determine the These regulations affect the following Because these proposed regulations
financial responsibility of participating types of entities eligible to participate in would eliminate the separate financial
institutions and guard the Federal fiscal the title IV, HEA programs: Educational statement submission in § 668.15 there
interest. The Secretary has determined institutions that are public or nonprofit is a reduction in recordkeeping burden
that there are no other significant institutions, and businesses and other of 1 hour per institution, or a total
alternatives that would satisfy the same for-profit institutions. The information reduction of 10,000 burden hours for the
to be collected are audited financial elimination of § 668.15.
legal and policy objectives while
Information is to be collected and
minimizing the economic impact on statements, and, for institutions
reported to the Secretary with
small entities. This determination is undergoing changes of ownership,
applications for changes of ownership
based, in part, on the extensive consolidating date of acquisition
for institutions covered by §668.175.
consultation that the Department and balance sheets. Institutions of higher
Annual public reporting and
KPMG performed with small (and large) education that participate in title IV,
recordkeeping burden is estimated to
entities in developing these proposed HEA programs will need this
average 0.25 hours for each response for
revisions. The Secretary particularly information required by these
an average of 200 responses annually for
invites comments on this determination. regulations to meet the eligibility
§ 668.175. These hours include the time
requirements for participation set forth
needed for searching existing data
Conclusion in sections 487 and 498 of the HEA.
sources, and gathering, maintaining, and
Institutions must submit annually
The Secretary concludes that a disclosing the data. Educational
audited financial statements to the
number of small entities that are able to institutions that are businesses or other
Secretary in accordance the time limits
demonstrate financial responsibility for-profit institutions will need and use
established in either the relevant OMB
under the current regulations may the information required by these
circular or the SFA Audit Guide. This
experience significant adverse economic regulations to meet the eligibility
annual submission, already required of
impacts if they are unable to adjust their requirements for participation in
institutions and already reflected in the
operations over time to meet the programs contained in section 498 of
burden hour inventory, will also serve
the HEA.
financial responsibility standards in the for the separate submission of an annual Organizations and individuals
proposed rule. However, as discussed in audited financial statement currently desiring to submit comments on the
the section referring to the cost-benefit required under § 668.15. For-profit information collection requirements
assessment of the proposed rule institutions undergoing a change of should direct them to the Office of
pursuant to Executive Order 12866, the ownership must also submit Information and Regulatory Affairs,
Secretary has concluded that the costs consolidating date of acquisition OMB, Room 10235, New Executive
are outweighed by the benefits of balance sheets with their application for Office Building, Washington, DC 20503;
putting in place a better system for approval of change of ownership. The Attention: Desk Officer for U.S.
measuring financial responsibility. In Secretary needs and uses these audits Department of Education.
this case, the benefits are better and balance sheets (in the case of The Department considers comments
protection of the Federal fiscal interest institutions undergoing a change of by the public on these proposed
due to an improved numerical measure, ownership) to analyze the financial collections of information in—
and a transition to a system that will situation of institutions and to • Evaluating whether the proposed
determine whether particular collections of information are necessary
recognize some small entities as being
institutions have sufficient financial for the proper performance of the
financially responsible even though
strength to provide the educational functions of the Department, including
they would not pass the tests required
services which they have contracted to whether the information will have
under the current regulations. provide, and to act as fiduciaries for practical use;
The Secretary invites comments on federal student aid. • Evaluating the accuracy of the
any aspect of this analysis, particularly Information is to be collected, Department’s estimate of the burden of
comments on the definition of small audited, and reported to the Secretary the collection of information are
entity, the estimated number of once each year for institutions and necessary for the proper performance of
institutions that are expected to third-party servicers covered by § 668.23 the functions of the Department,
experience adverse economic impacts, and formerly covered by § 668.15. including whether the information will
the estimated costs of alternative Annual public reporting and have practical use;
demonstration of financial recordkeeping burden is estimated to • Enhancing the quality, usefulness,
responsibility, and any significant average 1 hour for each response for and clarity of the information to be
alternatives that would satisfy the same 8,000 respondents for § 668.23. These collected; and
legal and policy objectives while hours include the time needed for • Minimizing the burden of the
minimizing the economic impact on searching existing data sources, and collection of information on those who
gathering, maintaining, and disclosing are to respond, including the use of
small entities.
the data. Educational institutions that appropriate automated, electronic,
Paperwork Reduction Act of 1995 are public or nonprofit institutions or mechanical, or other technological
businesses or other for-profit collection techniques, or other forms of
Sections 668.23 and 668.175 contain institutions may participate in the title information technology; e.g., permitting
information collection requirements. As IV, HEA programs. Institutions of higher electronic submission of responses.
required by the Paperwork Reduction education that participate in title IV, OMB is required to make a decision
Act of 1995, the Department of HEA programs will need and use the concerning the collection of information
Education has submitted a copy of these information required by these contained in these proposed regulations
sections to the Office of Management regulations to meet the eligibility between 30 and 60 days after
and Budget (OMB) for its review. requirements for participation in publication of this document in the
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49563

Federal Register. Therefore, a comment § 668.23 Compliance audits and audited publication is available from the
to OMB is best assured of having its full financial statements. Superintendent of Documents, U.S.
effect if OMB receives it within 30 days (a) General—(1) Institutions. An Government Printing Office,
of publication. This does not affect the institution that participates in any title Washington, DC 20402); and
deadline for the public to comment to IV, HEA program must at least annually (ii) Procedures for audits contained in
the Department on the proposed have an independent auditor conduct a audit guides developed by, and
regulations. compliance audit of its administration available from, the Department of
of that program. As part of that Education’s Office of Inspector General.
Invitation to Comment compliance audit the institution must (These audit guides do not impose any
Interested persons are invited to also have an independent auditor requirements beyond those imposed
submit comments and recommendations conduct an audit of the institution’s under applicable statutes and
regarding these proposed regulations. general purpose financial statement. regulations and GAO’s Government
(2) Third-party servicers. Except as Auditing Standards.)
All comments submitted in response provided under this part or 34 CFR part
to these proposed regulations will be (3) The Secretary may require an
682, with regard to complying with the institution to provide a copy of its
available for public inspection, during provisions under this section a third-
and after the comment period, in Room compliance audit report to guaranty
party servicer must follow the agencies or eligible lenders under the
3045, Regional Office Building 3, 7th procedures contained in the SFA Audit
and D Streets S.W., Washington, D.C. FFEL programs, State agencies, the
Guide for third-party servicers. A third- Secretary of Veterans Affairs, or
between the hours of 8:30 a.m. and 4 party servicer is defined under § 668.2
p.m., Monday through Friday of each nationally recognized accrediting
and 34 CFR 682.200. (The SFA Audit agencies.
week except Federal Holidays. A copy Guide is available from the Department
of the KPMG report will also be (4) An institution that has a
of Education’s Office of Inspector compliance audit conducted under this
available for inspection at this location. General.) section must—
List of Subjects in 34 CFR Part 668 (3) Submission deadline. Except as
(i) Give the Secretary and the
provided by the Single Audit Act,
Administrative practice and Inspector General access to records or
Chapter 75 of title 31, United States
procedures, Colleges and universities, Code, an institution must submit other documents necessary to review
Reporting and Recordkeeping annually to the Secretary its compliance the audit; and
requirements, Student aid. audit (including its audited financial (ii) Require an individual or firm
statement) no later than six months after conducting a compliance audit to give
Dated: September 11, 1996. the Secretary and the Inspector General
Richard W. Riley,
the last day of the institution’s fiscal
year. access to records, audit work papers, or
Secretary of Education. other documents necessary to review
(4) Audit submission requirements. In
(Catalog of Federal Domestic Assistance general, the Secretary considers the the audit.
Number: 84.007 Federal Supplemental compliance audit submission (5) An institution must give the
Educational Opportunity Grant Program; requirements (including those of the Secretary and the Inspector General
84.032 Federal Family Educational Loan audited financial statement) of this access to records or other documents
Program; 84.032 Federal PLUS Program; section to be satisfied by an audit necessary to review a third-party
84.032 Federal Supplemental Loans for servicer’s audit.
conducted in accordance with the Office
Students Program; 84.033 Federal Work- (c) Compliance audits for third-party
Study Program; 84.038 Federal Perkins Loan of Management and Budget Circular A–
133, ‘‘Audits of Institutions of Higher servicers. (1) A third-party servicer that
Program; 84.063 Federal Pell Grant Program;
Education and Other Nonprofit administers title IV, HEA programs for
84.069 Federal State Student Incentive Grant
Program, and 84.268 Direct Loan Program) Organizations’’; Office of Management institutions does not have to have a
and Budget Circular A–128, ‘‘Audits of compliance audit performed if—
The Secretary proposes to amend part State and Local Governments’’, or the (i) The servicer contracts with only
668 of title 34 of the Code of Federal SFA Audit Guide, whichever is one institution; and
Regulations as follows: applicable to the entity. (Both circulars (ii) The audit of that institution’s
are available by calling OMB’s administration of the title IV, HEA
PART 668—STUDENT ASSISTANCE programs involves every aspect of the
Publication Office at (202) 395–7332, or
GENERAL PROVISIONS servicer’s administration of that
they can be obtained in electronic form
on the OMB Home Page at (http:// program for that institution.
1. The authority citation for part 668 (2) A third-party servicer that
continues to read as follows:
(b) Compliance audits for institutions. contracts with more than one
Authority: 20 U.S.C. 1085, 1088, 1091, (1) An institution’s compliance audit participating institution may submit a
1092, 1094, 1099c and 1141, unless must cover, on a fiscal year basis, all single compliance audit report that
otherwise noted. covers the servicer’s administration of
title IV, HEA program transactions, and
§ 668.13 [Amended] must cover all of those transactions that the title IV, HEA programs for each
have occurred since the period covered institution with which the servicer
2. Under § 668.13, paragraph (d) is by the institution’s last compliance contracts.
being removed and paragraphs (e) and audit. (3) A third-party servicer must submit
(f) are redesignated as paragraphs (d) (2) The compliance portion of the annually to the Secretary its compliance
and (e). audit required under this section must audit no later than six months after the
§ 668.15 [Removed and reserved] be conducted in accordance with— last day of the servicer’s fiscal year.
(i) The general standards and the (4) A third-party servicer must give
3. Section 668.15 is removed and standards for compliance audits the Secretary and the Inspector General
reserved. contained in the U.S. General access to records or other documents
4. Section 668.23 is revised to read as Accounting Office’s (GAO’s) necessary to review an institution’s
follows: Government Auditing Standards. (This compliance audit.
49564 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

(5) The Secretary may require a third- (3) Submission of additional financial result of a Federal audit or an audit
party servicer to provide a copy of its statements. (i) To determine whether an performed at the direction of an
audit report to guaranty agencies or institution is financially responsible, the institution or third-party servicer, if an
eligible lenders under the FFEL Secretary may also require the expenditure made by the institution or
programs, State agencies, the Secretary institution to submit the audited servicer is questioned, or the
of Veterans Affairs, or nationally financial statements of related entities, institution’s or servicer’s compliance
recognized accrediting agencies. consolidated financial statements, or with an applicable requirement
(6) A third-party servicer that has a full consolidating financial statements (including the lack of proper
compliance audit conducted under this based upon the institution’s economic documentation) is questioned, the
section must— relationship to those entities. Secretary notifies the institution or
(i) Give the Secretary and the (ii) If the Secretary requires the servicer of the questioned expenditure
Inspector General access to records or submission of a related entity’s financial or compliance.
other documents necessary to review statement, the Secretary may also (2) If the institution or servicer
the audit; and require that the statement be believes that the questioned expenditure
(ii) Require an individual or firm supplemented with consolidating or compliance was proper, the
conducting an audit described in this schedules showing the consolidation of institution or servicer shall notify the
section to give the Secretary and the each of the parent corporation’s Secretary in writing of the institution’s
Inspector General access to records, subsidiaries and divisions (each or servicer’s position and the reasons for
audit work papers, or other documents separate institution participating in the that position.
necessary to review the audit. title IV, HEA programs shown (3) The institution’s or servicer’s
(d) Audited financial statements—(1) separately) intercompany eliminating response must be based on performing
General. To enable the Secretary to entries, and derived consolidated totals. an attestation engagement in accordance
(4) Audited financial statements for with the Standards for Attestation
make a determination of financial
foreign institutions. As part of an annual Engagements of the American Institute
responsibility, as part of its compliance
compliance audit, a foreign institution of Certified Public Accountants and
audit an institution must submit to the must submit—
Secretary a set of financial statements must be received by the Secretary
(i) Audited financial statements within 45 days of the date of the
for it latest complete fiscal year. These conducted in accordance with the
financial statements must be prepared Secretary’s notification to the institution
generally accepted accounting or servicer.
on an accrual basis in accordance with principles of the institution’s home (f) Determination of liabilities. (1)
generally accepted accounting country, if the institution received less Based on the audit finding and the
principles, and audited by an than $500,000 in title IV, HEA program institution’s or third-party servicer’s
independent certified public accountant funds during its most recently response, the Secretary determines the
in accordance with generally accepted completed fiscal year; or amount of liability, if any, owed by the
government auditing standards and (ii) Audited financial statements institution or servicer and instructs the
other guidance contained in the Office translated to meet the requirements of institution or servicer as to the manner
of Management and Budget Circular A– paragraph (d) of this section, if the of repayment.
133, ‘‘Audits of Institutions of Higher institution received $500,000 or more in (2) If the Secretary determines that a
Education and Other Nonprofit title IV, HEA program funds during its third-party servicer owes a liability for
Organizations’’; Office of Management most recently completed fiscal year. its administration of an institution’s title
and Budget Circular A–128, ‘‘Audits of (5) Disclosure of title IV HEA program IV, HEA programs, the servicer must
State and Local Governments’’, or the revenue. A proprietary institution must notify each institution under whose
SFA Audit Guide, whichever is disclose in a footnote to its financial contract the servicer owes a liability of
applicable. As part of these statements, statement the percentage of the title IV, that determination. The servicer must
the institution shall include a detailed HEA program revenue the institution also notify every institution that
description of related entities consistent received during that fiscal year, as contracts with the servicer for the same
with the definitions in SFAS 57, calculated in accordance with service that the Secretary determined
describing in detail the extent and § 600.5(d); that a liability was owed.
nature of the related entity’s interest, (6) Audited financial statements for (g) Repayments. (1) An institution or
and the structure of the relationship third party servicers. A third-party third-party servicer that must repay
between the institution and the related servicer that enters into a contract with funds under the procedures in this
entity. The Secretary may also require a lender or guaranty agency to section shall repay those funds at the
the institution to submit or otherwise administer any aspect of the lender’s or direction of the Secretary within 45
make available the accountant’s work guaranty agency’s programs, as provided days of the date of the Secretary’s
papers, and to submit additional under 34 CFR part 682, must submit notification, unless—
substantive information. annually an audited financial statement. (i) The institution or servicer files an
(2) Resolution of questionable This financial statement must be appeal under the procedures established
accounting treatments. In the event that prepared on an accrual basis in in subpart H of this part; or
the Secretary objects to accounting accordance with generally accepted (ii) The Secretary permits a longer
treatments contained in an institution’s accounting principles, and audited by repayment period.
audited financial statements, the an independent certified public (2) Notwithstanding paragraphs (f)
Secretary notifies the institution of the accountant in accordance with generally and (g)(1) of this section—
Secretary’s concerns, and may refer accepted government auditing standards (i) If an institution or third-party
those financial statements, along with and other guidance contained in the servicer has posted surety or has
other relevant documents, to the AICPA third party servicer audit guide issued provided a third-party guarantee and the
Committee on Accounting Standards, by the Department of Education’s Office Secretary questions expenditures or
and other professional bodies and of Inspector General. compliance with applicable
accounting experts for review or (e) Notification of questioned requirements and identifies liabilities,
resolution. expenditures or compliance. (1) As a then the Secretary may determine that
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49565

deferring recourse to the surety or standards established in this subpart. and at least one creditor has filed suit
guarantee is not appropriate because— These standards are intended to ensure to recover funds under those
(A) The need to provide relief to that a participating institution has the obligations; and
students or borrowers affected by the act financial resources to— (4) In the institution’s audited
or omission giving rise to the liability (1) Deliver its education and training financial statements, the opinion
outweighs the importance of deferring programs to students without expressed by the auditor was not an
collection action until completion of interruption; and adverse opinion or disclaimed opinion,
available appeal proceedings; or (2) Meet its financial and or the auditor did not express doubt
(B) The terms of the surety or administrative responsibilities to about the continued existence of the
guarantee do not provide complete students and to the Secretary. institution as a going concern.
assurance that recourse to that (b) Third-party servicers. (1) The (b) Refund standards. (1) Letter of
protection will be fully available general standards in this subpart apply credit. In addition to satisfying the
through the completion of available to a third-party servicer that enters into general standards, an institution must
appeal proceedings; or a contract with a lender or guaranty submit an irrevocable letter of credit,
(ii) The Secretary may use agency to administer any aspect of the acceptable and payable to the Secretary,
administrative offset pursuant to 34 CFR lender’s or guaranty agency’s programs, equal to 25 percent of the total amount
part 30 to collect the funds owed under as provided under 34 CFR part 682; and of title IV, HEA program refunds paid by
the procedures of this section. (2) The provisions regarding past the institution during its most recently
(3) If, under the proceedings in performance contained in § 668.177 completed fiscal year, unless the
subpart H, liabilities asserted in the apply to all third-party servicers. institution qualifies for an exemption
Secretary’s notification, under (c) Special transition-year rule. (1) If under this section.
paragraph (e)(1) of this section, to the an institution fails to satisfy the general (2) Exemptions. An institution is not
institution or third-party servicer are standards under this subpart solely required to submit the letter of credit
upheld, the institution or third-party because it did not achieve a composite described in paragraph (b)(1) of this
servicer must repay those funds at the score of at least 1.75, as determined section, if—
direction of the Secretary within 30 under § 668.173, the institution may (i) The institution’s liabilities are
days of the final decision under subpart demonstrate that it is financially backed by the full faith and credit of the
H of this part unless— responsible under the standards State, or by an equivalent government
(i) The Secretary permits a longer formerly codified under § 668.15 (b)(7) entity;
repayment period; or through (b)(9). (ii) The institution is located in a
(ii) The Secretary determines that (2) An institution may demonstrate State that has a tuition recovery fund
earlier collection action is appropriate that it is financially responsible under approved by the Secretary and the
pursuant to paragraph (g)(2) of this the former standards only once, and institution contributes to that fund; or
section. only for the institution’s fiscal year that (iii) The institution demonstrates that
(h) An institution is held responsible began on or before June 30, 1997. it made its title IV, HEA program
for any liability owed by the refunds within the time permitted under
(Authority: 20 U.S.C. 1094 and 1099c and
institution’s third-party servicer for a Section 4 of Pub. L. 95–452, 92 Stat. 1101– § 668.22 during its two most recently
violation incurred in servicing any 1109) completed fiscal years. The Secretary
aspect of that institution’s participation considers an institution to qualify for
in the title IV, HEA programs and § 668.172 Financial standards. this exemption if the independent CPA
remains responsible for that amount (a) General standards. In general, the who audited the institution’s financial
until that amount is repaid in full. Secretary considers an institution to be statements and compliance audits for
(Authority: 20 U.S.C. 1088, 1094, 1099c, 1141
financially responsible if the Secretary either of those fiscal years, or the
and section 4 of Pub. L. 95–452, 92 Stat. determines that— Secretary or a State or guaranty agency
1101–1109) (1)(i) The institution’s Viability, that conducted a review of the
Primary Reserve, and Net Income ratios institution during those fiscal years—
5. A new Subpart L is added to read yield a composite score of at least 1.75, (A) Did not find that the institution
as follows: as calculated under § 668.173; and made 5 percent or more of its refunds
Subpart L—Financial Responsibility (ii) For a public or private non-profit late, based on the sample of records
Sec. institution, that institution has a audited or reviewed; and
668.171 Scope and purpose. positive Primary Reserve ratio; (B) Did not note a material weakness
668.172 Financial standards. (2) The institution is meeting all of its or a reportable condition in the
668.173 Financial ratios. financial obligations, including but not institution’s report on internal controls
668.174 Alternate standards and limited to— that is related to refunds.
requirements. (i) Refunds that it is required to make; (3) Failure to make timely refunds. (i)
668.175 Special rules for an institution that and If the Secretary or a State or guaranty
undergoes a change in ownership. (ii) Repayments to the Secretary for agency determines in a review
668.176 Foreign institutions. liabilities and debts incurred in conducted of the institution that the
668.177 Past performance.
668.178 Additional requirements and
programs administered by the Secretary; institution no longer qualifies for an
administrative actions. (3) The institution is current in its exemption under this section, the
debt payments. The institution is not institution must—
Subpart L—Financial Responsibility current in its debt payments if— (A) Submit the irrevocable letter of
(i) The institution is in violation of credit to the Secretary no later than 30
§ 668.171 Scope and purpose. any existing loan agreement at its fiscal days after the Secretary, or State or
(a) General. To begin and to continue year end, as disclosed in a note to its guaranty agency notifies the institution
to participate in any title IV, HEA audited financial statement; or of that determination; and
program, an institution must (ii) The institution fails to make a (B) Notify the Secretary of the
demonstrate to the Secretary that it is payment in accordance with existing guaranty agency or State that conducted
financially responsible under the debt obligations for more than 120 days, that review.
49566 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

(ii) If an auditor determines in the Net Income Ratio=Proprietary Income (d) Special definition. For purposes of
institution’s annual compliance audit Before Operating this subpart, an independent hospital is
that the institution no longer qualifies Transfers,+Governmental Revenues an institution that—
for an exemption under this section, the and Other Financing Sources (1) Is not controlled by, or included in
institution must submit the irrevocable (excluding the financial statement of, another
letter of credit to the Secretary no later transfers)¥Governmental institution; and
than 30 days after the date the Expenditures and Other Financing (2) Prepares its financial statements
institution’s compliance audit must be Uses (excluding transfers)÷Total under the accounting standards
submitted to the Secretary. Governmental and Proprietary established in the AICPA’s audit guide
(4) State tuition recovery funds. In Revenues and Other Financing for Audits of Health Care Organizations.
determining whether to approve a Sources (excluding transfers) (e) Special rules for calculating ratios
State’s tuition recovery fund, the (2) Private non-profit institutions. As and determining financial
Secretary considers the extent to which detailed in Appendix F, the ratios for responsibility. For purposes of
that fund— private non-profit institutions are calculating the ratios defined in this
(i) Provides refunds to both in-State calculated as follows: section, and for purposes of determining
and out-of-State students; Viability ratio=Expendable Net whether an institution qualifies as
(ii) Allocates all refunds in Assets÷Long-term Debt financially responsible under an
accordance with the order required Primary Reserve ratio=Expendable Net alternative method contained in this
under § 668.22; and Assets÷Total Expenses subpart, the Secretary—
(iii) Provides a reliable mechanism for Net Income ratio=Change in (1) Excludes all unsecured or
the State to replenish the fund should Unrestricted Net uncollateralized related-party
any claims arise that deplete the fund’s Assets÷Unrestricted Income receivables;
assets. (3) Proprietary institutions. As (2) Excludes all intangible assets
(Authority: 20 U.S.C. 1094 and 1099c and detailed in Appendix F, the ratios for defined as intangible in accordance with
Section 4 of Pub. L. 95–452, 92 Stat. 1101– proprietary institutions are calculated as generally accepted accounting
1109) follows: principles; and
§ 668.173 Financial ratios. Viability ratio=Adjusted Equity÷Total (3) May exclude—
Long-term Debt (i) Extraordinary gains or losses;
(a) Composite score. As detailed in Primary Reserve ratio=Adjusted (ii) Income or losses from
Appendix F, the Secretary determines Equity÷Total Expenses discontinued operations;
an institution’s composite score by— Net Income ratio=Income Before (iii) Prior period adjustment; and
(1) Calculating the Viability, Primary Taxes÷Total Revenues (iv) The cumulative effect of changes
Reserve, and Net Income ratios, as
(4) Independent hospitals. (i) As in accounting principles.
described in paragraph (b) of this
detailed in Appendix F, the ratios for (Authority: 20 U.S.C. 1094 and 1099c and
non-profit independent hospitals are Section 4 of Pub. L. 95–452, 92 Stat. 1101–
(2) Assigning a strength factor to each
calculated as follows: 1109)
ratio that corresponds to the value of
each of those ratios; Viability ratio=Expendable Net
§ 668.174 Alternate standards and
(3) Multiplying the assigned strength Assets÷Long-term Debt
factor by the appropriate weighting Primary Reserve ratio=Expendable Net
Assets÷Total Expenses (a) Alternatives for participating
percentage for each ratio; and institutions. A currently participating
Net Income ratio=Change in
(4) Summing the resulting products of institution that fails to achieve a
Unrestricted Net
all three ratios. composite score of at least 1.75 may
Assets÷Unrestricted Income
(b) Ratios. (1) Public institutions. (i) demonstrate to the Secretary that it is
As detailed in Appendix, F, the ratios (ii) As detailed in Appendix F, the
ratios for for-profit independent nevertheless financially responsible if—
for public institutions using the 1973 (1) The institution’s liabilities are
AICPA Audit Guide for Colleges and hospitals are calculated as follows:
Viability ratio=Expendable Fund backed by the full faith and credit of a
Universities are calculated as follows: State, or by an equivalent government
Viability ratio=Expendable Fund Balances÷Long-term Debt
Primary Reserve ratio=Expendable Fund entity;
Balances÷Plant Debt (2) The institution submits an
Balances÷Total Expenses
Primary Reserve ratio=Expendable Fund irrevocable letter of credit, that is
Net Income ratio=Revenue & Gains in
Balances÷Total Expenditures and acceptable and payable to the Secretary,
Excess of Expenses and Losses (Net
Mandatory Transfers for an amount equal to not less than
Total Revenue)÷Total Revenues
Net Income ratio=Net Total one-half of the title IV, HEA program
Revenues÷Total Revenues (c) Ratio values, strength factors and
weighting percentages. Appendix F funds received by the institution during
(ii) As detailed in Appendix F, the ratios contains— its most recently completed fiscal year;
for public institutions using a (1) The ratio values and corresponding or
governmental accounting model are strength factors and weighting (3)(i) The owners, board of trustees, or
calculated as follows: percentages for each type of other persons or entities who under
Viability Ratio=Governmental and institution under paragraph (b) of § 668.177(c) exercise substantial control
Proprietary Fund Equity÷General this section; over the institution—
Long-Term Debt (2) Additional information regarding the (A) Submit to the Secretary personal
Primary Reserve Ratio=Governmental calculation of certain ratios; and financial guarantees acceptable to the
and Proprietary Fund Equity÷Total (3) The conditions under which an Secretary; and
Governmental Expenditures and adjustment may be made to the (B) Agree to be jointly and severally
Other Financing Uses (excluding strength factors or weighting liable for any liabilities that may arise
transfers) and Total Proprietary percentages in determining an from the institution’s participation in
Expenses institution’s composite score. the title IV, HEA programs.
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49567

(ii) The Secretary considers an (ii) Submit an irrevocable letter of general standards or qualify under an
institution to qualify under this credit acceptable and payable to the alternate standard under this subpart.
alternative only if— Secretary, for at least one-half of the (Authority: 20 U.S.C. 1094 and 1099c and
(A) The institution achieves a amount of title IV, HEA program funds Section 4 of Pub. L. 95–452, 92 Stat. 1101–
composite score of at least 1.25, based that the Secretary determines the 1109)
on its current fiscal year audited institution will receive during the year
financial statements; following its date of acquisition. § 668.177 Past performance.
(B) The institution satisfied all of the (2) Personal financial guarantees or (a) Past performance of an institution
general standards under § 668.172(a) in letters of credit submitted under this or persons affiliated with an institution.
its previous fiscal year, based on that section will remain in place until the The Secretary does not consider an
year’s audited financial statements; institution submits audited financial institution to be financially responsible
(C) The persons or entities providing statements, prepared in the manner if—
financial guarantees submit to the prescribed by § 668.23, showing that the (1) A person who exercises substantial
Secretary their personal financial institution attains a composite score of control over the institution or any
statements; and at least 1.75. member or members of the person’s
(D) The institution convinces the (b) Audit requirements for changes of family alone or together—
Secretary that it will not close ownership applications. An entity that (i)(A) Exercises or exercised
precipitously by demonstrating to the seeks approval of a change in substantial control over another
Secretary that it has sufficient resources ownership— institution or a third-party servicer that
to meet all of its financial obligations, (1) Must demonstrate that it has owes a liability for a violation of a title
including its obligations to students and submitted to the Secretary an audited IV, HEA program requirement; or
to the Secretary, based on the financial statement fulfilling the (B) Owes a liability for a violation of
institution’s current fiscal year audited requirements of § 668.23 that includes a title IV, HEA program requirement;
financial statements and the personal all entities in which it holds an and
financial statements of the persons or ownership interest, or over which it (ii) That person, family member,
entities providing personal financial exercises substantial control; or institution, or servicer does not
guarantees. demonstrate that the liability is being
(2) Must submit a current audited
(b) Alternatives for new institutions. If repaid in accordance with an agreement
financial statement acceptable to the
an institution seeking to participate for with the Secretary; or
Secretary that includes all entities in
the first time in the title IV, HEA (2) The institution has been limited,
which it holds an ownership interest or
programs fails to satisfy any of the suspended, terminated, or entered into
over which it exercises substantial
general standards, the institution may a settlement agreement to resolve a
control, if the latest financial statement
demonstrate that it is financially limitation, suspension, or termination
it submitted to the Secretary in
responsible if— action initiated by the Secretary or a
(1) The institution’s liabilities are fulfillment of the requirements of
§ 668.23 does not include, as of the date guaranty agency (as defined in 34 CFR
backed by the full faith and credit of a
of the acquisition of the institution for part 682) within the preceding five
State, or by an equivalent government
which it seeks an approval of change of years; or
entity; or
(2) The institution submits an ownership, all entities in which it holds (3) The institution had—
irrevocable letter of credit acceptable an ownership interest or over which it (i) An audit finding, during its two
and payable to the Secretary, for at least exercises substantial control . most recent compliance audits of its
one-half of the amount of title IV, HEA (Authority: 20 U.S.C. 1094 and 1099c and conduct of the title IV, HEA programs,
program funds that the Secretary Section 4 of Pub. L. 95–452, 92 Stat. 1101– that resulted in the institution’s being
determines the institution will receive 1109) required to repay an amount greater
during its initial year of participation. than five percent of the funds that the
§ 668.176 Foreign institutions. institution received under the title IV,
(Authority: 20 U.S.C. 1094 and 1099c and The Secretary makes a determination HEA programs for any fiscal year
Section 4 of Pub. L. 95–452, 92 Stat. 1101–
of financial responsibility for a foreign covered by the audit;
institution on the basis of financial (ii) A program review finding, during
§ 668.175 Special rules for an institution statements submitted under the its two most recent program reviews of
that undergoes a change in ownership. following requirements— its conduct of the title IV, HEA
(a) General standards for financial (a) If the institution received less than programs, that resulted in the
responsibility. The Secretary considers $500,000 U.S. in title IV, HEA program institution’s being required to repay an
an institution that undergoes a change funds during its most recently amount greater than five percent of the
in ownership that results in a change of completed fiscal year, the institution funds that the institution received under
control, as described under 34 CFR must submit its audited financial the title IV, HEA programs for any year
600.31, to be financially responsible statement for that year. For purposes of covered by the program review;
only if the persons or entities that this paragraph, the audited financial (iii) Been cited during the preceding
acquired an ownership interest in the statements may be prepared under the five years for failure to submit
institution, or that exercise substantial auditing standards and accounting acceptable audit reports required under
control over the institution, submit a principals used in the institution’s this part, or individual title IV, HEA
consolidating date of acquisition home country; or program regulations, in a timely fashion;
balance sheet for the institution with (b) If the institution received $500,000 or
their application for approval, and— U.S. or more in title IV, HEA program (iv) Failed to resolve satisfactorily any
(1)(i) Submit to the Secretary personal funds during its most recently compliance problems identified in
financial guarantees from the owners, completed fiscal year, the institution program review or audit reports based
supported by personal financial must submit its audited financial upon a final decision of the Secretary
statements, in an amount and form statement in accordance with the issued pursuant to subpart G or subpart
acceptable to the Secretary; or requirements of § 668.23, and satisfy the H of this part.
49568 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

(b) Correcting past performance. The operation of, an institution, institution’s the institution to participate under a
Secretary may determine an institution parent corporation, a third party provisional certification, as provided
to be financially responsible even if the servicer, or a third party servicer’s under § 668.13(c).
institution is not otherwise financially parent corporation. The term (b) Participation of institutions that
responsible under paragraph (a) of this ‘‘ownership interest’’ includes, but is are not deemed financially responsible.
section if— not limited to— (1) The Secretary may permit an
(1) The institution notifies the (i) An interest as tenant in common, institution that is not financially
Secretary, in accordance with 34 CFR joint tenant, or tenant by the entireties; responsible under paragraph (a)(2) of
600.30, that the person referenced in (ii) A partnership; and this section to participate under a
paragraph (a)(1)(i) of this section (iii) An interest in a trust. provisional certification if—
exercises substantial control over the (2) The term ‘‘ownership interest’’ (i) The institution submits to the
institution; and does not include any share of the Secretary an irrevocable letter of credit,
(2)(i) The person repaid to the ownership or control of, or any right to that is acceptable and payable to the
Secretary a portion of the applicable share in the proceeds of the operation of Secretary, for an amount equal not less
liability, and the portion repaid equals a profit-sharing plan, provided that all than 10 percent of the title IV, HEA
or exceeds the greater of— employees are covered by the plan. program funds received by the
(A) The total percentage of the (3) The Secretary generally considers institution during its most recently
ownership interest held in the a person to exercise substantial control completed fiscal year; and
institution or third-party servicer that over an institution or third party (ii) If the institution demonstrates that
owes the liability by that person or any servicer, if the person— it met all of its financial obligations and
member or members of that person’s (i) Directly or indirectly holds at least was current on its debt payments, as
family, either alone or in combination 20 percent ownership interest in the required under § 668.172(a)(2), for its
with one another; institution or servicer; two most recent fiscal years.
(B) The total percentage of the (ii) Holds together with other (2) The Secretary provides title IV,
ownership interest held in the members of his or her family, at least a HEA program funds to an institution
institution or servicer that owes the 20 percentownership interest in the provisionally certified under this
liability that the person or any member institution or servicer; paragraph by reimbursement, as
or members of the person’s family, (iii) Represents either alone or described under subpart K of this part,
either alone or in combination with one together with other persons, under a or under a funding arrangement other
another, represents or represented under voting trust, power of attorney, proxy, or than the advance funding method.
a voting trust, power of attorney, proxy, similar agreement one or more persons (c) Financial responsibility standards
or similar agreement; or who hold, either individually or in under provisional certification. The
(C) Twenty-five percent of the combination with the other persons Secretary may permit an institution
applicable liability, if the person or any represented or the person representing described under paragraph (d) of this
member of the person’s family is or was them, at least a 20 percent ownership in section to participate or to continue to
a member of the board of directors, chief the institution or servicer; or participate under a provisional
executive officer, or other executive (iv) Is a member of the board of certification, only if the owners, board
officer of the institution or servicer that directors, the chief executive officer, or of trustees, or other persons or entities
owes the liability, or of an entity other executive officer of— who under § 668.177(c) exercise
holding at least a 25 percent ownership (A) The institution or servicer; or substantial control over the institution—
interest in the institution that owes the (B) An entity that holds at least a 20 (1) Submit to the Secretary their
liability, and provided that the person percent ownership interest in the personal financial statements and
or any member of the person’s family institution or servicer; and personal financial guarantees for an
did not hold more than a twenty-five (4) The Secretary considers a member amount acceptable to the Secretary;
percent ownership interest in the of a person’s family to be a parent, (2) Agree to be jointly and severally
institution or servicer that owes the sibling, spouse, child, spouse’s parent or liable for any liabilities that may arise
liability. sibling, or sibling’s or child’s spouse. from the institution’s participation in
(ii) The applicable liability described (Authority: 20 U.S.C. 1094 and 1099c and the title IV, HEA programs; and
in paragraph (a)(1) of this section is Section 4 of Pub. L. 95–452, 92 Stat. 1101– (3) Convince the Secretary that the
currently being repaid in accordance 1109) institution will not close precipitously
with a written agreement with the by demonstrating to the Secretary that it
Secretary; or § 668.178 Additional requirements and has sufficient resources to meet all of its
(iii) The institution demonstrates administrative actions. financial obligations, including its
why— (a) Limitations, Suspensions, and obligations to students and to the
(A) The person who exercises Terminations. The Secretary may Secretary, based on the institution’s
substantial control over the institution initiate an action under subpart G of this current fiscal year audited financial
should nevertheless be considered to part to limit, suspend, or terminate an statements and the personal financial
lack that control; or institution’s participation in the title IV, statements of the persons or entities
(B) The person who exercises HEA programs if— providing personal financial guarantees.
substantial control over the institution (1) The institution does not submit its (d) Provisional certification for failure
and each member of that person’s family audited financial statements by the date to meet financial responsibility
nevertheless does not or did not permitted and in the manner required standards. The institution referred to
exercise substantial control over the under § 668.23; or under paragraph (c) of this section is an
institution or servicer that owes the (2) The institution does not institution that—
liability. demonstrate that it is financially (1) Is not financially responsible
(c) Ownership Interest. (1) An responsible under this subpart by because of an adverse action taken by
ownership interest is a share of the legal satisfying the general standards or the Secretary, a material finding in prior
or beneficial ownership or control of, or qualifying under an alternative audit or review, or because the
a right to share in the proceeds of the standard, unless the Secretary permits institution failed to resolve satisfactorily
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49569

any compliance problems, as described certified provisionally at any time Appendix F—Financial Responsibility
under § 668.177(a) (2) and (3); or during the preceding 5 years. This appendix contains the strength
(2) Is not currently financially (Authority: 20 U.S.C. 1094 and 1099c and factors and weightings used to calculate
responsible because it failed to satisfy Section 4 of Pub. L. 95–452, 92 Stat. 1101– composite ratio scores, the procedure
all the general standards or qualify 1109) for and an example of calculating a
under an alternate standard under this composite score, and technical
subpart, and for this reason was 5. A new Appendix F is added to part definitions.
668 to read as follows: A. Strength Factors:


Strength factor 1 2 3 4 5

Viability Ratio ...................................................................................... <.50 .50–.99 1.0–1.99 2.0–3.99 ≥4.0

Primary Reserve Ratio ....................................................................... <.10 .10–.19 .20–.44 .45–.69 ≥.70
Net Income Ratio ................................................................................ <0 0–.009 .01–.029 .03–.049 ≥.05

Additional Strength Factor Adjustment: If a public institution has a negative (less than zero) Primary Reserve Ratio
result, the institution will be deemed as not financially responsible under the general standards contained in § 668.172(a).

Strength factor 1 2 3 4 5

Viability Ratio ...................................................................................... <.75 .75–1.74 1.75–2.74 2.75–4.74 ≥4.75

Primary Reserve Ratio ....................................................................... <.30 .30–.49 .50–.99 1.00–1.49 ≥1.5
Net Income Ratio ................................................................................ <0 0–.019 .02–.049 .05–.079 ≥.08

Additional Strength Factor Adjustment: If a private non-profit institution has a negative (less than zero) Primary
Reserve Ratio result, the institution will be deemed as not financially responsible under the general standards contained
in § 668.172(a).

Strength factor 1 2 3 4 5

Viability Ratio ...................................................................................... <.50 .50–.99 1.0–1.99 2.0–3.99 ≥4.0

Primary Reserve Ratio ....................................................................... <.10 .10–.29 .30–.64 .65–.99 ≥1.00
Net Income Ratio ................................................................................ <0 0–.009 .01–.029 .03–.049 ≥.05

Additional Strength Factor Adjustment: If a private non-profit institution has a negative (less than zero) Primary
Reserve Ratio result, the institution will be deemed as not financially responsible under the general standards contained
in § 668.172(a)


Strength factor 1 2 3 4 5

Viability Ratio ...................................................................................... <.50 .50–.99 1.0–1.99 2.0–3.99 ≥4.0

Primary Reserve Ratio ....................................................................... <.10 .10–.29 .30–.49 .50–.69 ≥.70
Net Income Ratio ................................................................................ <.02 .02–.049 .05–.079 .08–.119 ≥.12

Additional Strength Factor Adjustment: If a proprietary institution earns a strength factor of two (2) or one (1)
for its Primary Reserve Ratio, the strength factor for the Viability Ratio will be no greater than the strength factor
for its Primary Reserve Ratio. The purpose of this adjustment is to prevent insignificant amounts of debt from significantly
affecting the categorization of an institution.


Strength factor 1 2 3 4 5

Viability Ratio .......................................................................... <.50 .50–.99 1.0–1.99 2.0–3.99 ≥4.0

Primary .................................................................................... <.10 .10–.29 .30–.64 .65–.99 ≥1.00
Net Income ............................................................................. <0 0–.009 .01–.029 .03–.049 ≥.05
49570 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

B. Weighting Factors:

Private non- Public non- Propri- Hospitals

Institutions profits profits etaries (percent)
(percent) (percent) (percent)

Viability Ratio .................................................................................................................... 35 35 30 40

Primary Reserve Ratio ..................................................................................................... 55 55 20 20
Net Income Ratio .............................................................................................................. 10 10 50 40
Totals ..................................................................................................................... 100 100 100 100

Additional Adjustments 4. The weighted results are then and Expenses of General Funds and is
Private and Public Non-Profits—If the summed: comprised of all expenses.
institution has no debt, only the Primary Weighted Viability Ratio ................. .70 Appendix to the NPRM
Reserve and Net Income ratios are used, Weighted Primary Reserve Ratio .... 1.65
Weighted Net Income Ratio ............ +.10 Note: This appendix wll not appear in the
weighted 90% and 10% respectively. Code of Federal Regulations.
Proprietaries—If the institution has no Composite Score ................... 2.45
debt, only the Primary Reserve and Net Summary of the KPMG Report
Income ratios are used, weighted 50% D. Technical Definitions. Commissioned by the Department
each. For Private Non-Profit Institutions As part of its overall effort to improve its
Hospitals: If the institution has no measures of financial responsibility, and as
debt, only the Primary Reserve and Net Expendable Net Assets are calculated part of the Department’s overall commitment
Income ratios are used, weighted 60% as follows: to improve the quality, efficiency, and
and 40% respectively. Unrestricted Net Assets. effectiveness of its oversight responsibility,
C. Computing the Composite Score. Plus Temporarily Restricted Net As- the Department, in the Fall of 1995,
sets. commissioned the accounting firm of KPMG
Procedure Minus Property, plant and equipment. Peat Marwick, LLP to examine the current
Minus Plant debt (including all notes, regulatory measures, and recommend
1. Calculate the Viability, Primary
bonds, and leases payable to improvements to those measures. KPMG was
Reserve, and Net Income ratios. finance those fixed assets). to assist the Department in developing an
2. Assign the appropriate strength improved methodology, using financial
factor to each ratio. Equals Expendable Net Assets. ratios, that could be used as a screening
3. Multiply the assigned strength device to identify financially troubled
factors by the appropriate weighting For Proprietary Institutions
institutions and as a mechanism for
percentage for each ratio. Adjusted Equity is computed as efficiently exercising its financial oversight
4. Sum the resulting products of all follows: responsibility. For such a methodology to be
three ratios to derive the composite Total Owner(s) or Shareholders effective, it would have to measure an
score. Equity. institution’s total financial condition,
Example: Minus Intangible Assets. accommodate different organizational
1. A public institution has the Minus Unsecured Related Party Re- structures and missions of participating
following ratio results: ceivables. institutions, and reflect the different
Viability Ratio: Expendable Fund Minus Property, Plant and Equipment accounting and reporting requirements to
(Net of Accumulated Depre- which participating institutions are subject.
Balances ÷ Plant Debt = 0.60
ciation). The overall goal of the study was the
Primary Reserve Ratio: Expendable development of processes, measures and
Plus Total Long-Term Debt.
Fund Balances ÷ Total Expenditures standards the Department could use to better
& Mandatory Transfers = 0.40 Equals Adjusted Equity. assess risk to federal funds through the
Net Income Ratio: Net Total analysis of financial statements and other
Revenues÷Total Revenues = ¥0.008 If Total Long-Term Debt exceeds the
2. These results are assigned a value of Net Property, Plant and This study included the following
strength factor in accordance with the Equipment, then the asset is not elements:
appropriate chart in part A of this subtracted from equity nor is the • Analyses of existing financial reports
appendix. Thus, for the public liability added back to equity using current standards, and using an
Total Long-Term Debt is comprised of alternative, expanded ratio analysis;
institution in this example: • The development of a new methodology
A Viability Ratio of 0.60 corresponds all debt obtained for long-term
purposes. The short-term portion of any that includes the use of an expanded set of
to a strength factor of 2. specific ratios;
A Primary Reserve Ratio of 0.40 long-term debt is included.
• The submission of that methodology to
corresponds to a strength factor of 3. For Independent Hospitals a task force and other outside reviewers for
A Net Income Ratio of –0.008 comment regarding the applicability of the
Expendable Net Assets are the
corresponds to a strength factor of 1. ratios as measures, the definitions of the
3. The strength factors are then general, specific purpose and quasi-
ratios, the treatment of particular accounting
weighted in accordance with the chart endowment fund balances, less plant statements, the weighting of ratios in the
in part B of this appendix. For the equity. True endowments are construction of a composite score, and a
public institution in this example: specifically excluded from the ranking of composite scores that yields a
numerator. category denoting institutions that would be
The Viability Ratio strength factor of 2 Long-term Debt is notes payable, considered, in the professional judgment of
is weighted at 35%: 2×.35=0.70 bonds payable, leases payable, and other accountants, to be financial risks. More than
The Primary Reserve Ratio strength a dozen reviewers participated, and included
long-term debt. Total Expenses are
factor of 3 is weighted at 55%: representatives from accounting firms,
retrieved from the Statement of Revenue
3×.55=1.65 professional accounting associations,
The Net Income Ratio strength factor is financial experts from the business
weighted at 10%: 1×.10=0.10 community, officers of professional
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49571

education associations, and institutional most respects. However, recent actions by the the business sectors, as described above. The
financial officers and auditors. FASB and GASB (primarily the issuance of current ratio tests and basic thresholds for
• The subsequent refinement and retesting FASB Statements 116 and 117) have non-profit and for-profit institutions are
of the recommended methodology and substantially increased the differences in common, leading to gaps in necessary
standards, and the resubmission of that accounting and financial reporting between information where certain information
methodology and set of standards to the public and private non-profit institutions. necessary to evaluate an item is not required
reviewers. Some of the resulting differences in these under that entity’s general reporting format.
various reporting and accounting standards One example is the use of the same acid test
Problems of Reporting and Accounting are as follows. Under FASB Statements 116 requirement of 1:1 for non-profit and for
Standards for Different Business Segments and 117, three basic financial statements—a profit institutions. GAAP does not require
One of the problems to be dealt with in the statement of financial position, a statement of non-profit institutions to prepare financial
study was that of different reporting activities, and a cash flow statement—are statements that classify assets and liabilities
standards for different business segments. required for private non-profit institutions. as current and noncurrent. Therefore,
The financial responsibility regulations cover These statements are prepared on an accrual calculation of the acid test cannot be
four segments in its regulation of basis and measure economic resources and accurately performed without additional
participating institutions: public institutions, changes therein. Prepared as they are on a information. Moreover, differing cash
private non-profit institutions, proprietary highly aggregated basis, these statements management and investment strategies
institutions, and independent hospitals. The include certain required minimum (investing excess cash in other than short-
following summarizes differences in information. Generally, matters of format are term instruments) may result in an
reporting standards. left to the discretion of the institution. Public institution failing the acid test requirement,
Public institutions generally prepare institutions, on the other hand, will for the when sufficient expendable resources are
financial statements in accordance with foreseeable future prepare the statements available in unrestricted investments to
Statement No. 15 of the Governmental called for by the 1973 AICPA Guide—a support operations for more than one year
Accounting Standards Board. statement of financial position, a statement of without any additional revenue.
Private non-profit institutions historically changes in fund balances, and a statement of
current funds revenue, expenditures, and Proposed Solution
have prepared their financial statements
consistent with the 1973 AICPA Audit Guide other changes. (A limited number of KPMG proposed a ratio methodology that,
for Colleges and Universities. Those financial institutions may also report financial results similar to the current regulations, takes into
statements were similar, in most respects, to using the government reporting model—an account liquidity, profitability, and viability,
those prepared by public institutions. option allowed under GASB Statement 15). but attempts to improve on the current
However, in 1993 the Financial Accounting These statements under the 1973 AICPA regulations in three ways. First, it would
Standards Board (FASB) issued two Guide are prepared on a highly desegregated consider all ratio results together, instead of
statements, Statement of Financial basis and follow the traditional managed as independent tests. The calculation of a
Accounting Standards (SFAS) No. 116, funds structure. As such, they include composite score that blends the results of the
Accounting for Contributions Received and changes in fund balances arising from individual tests would allow the Department
Contributions Made, and SFAS No. 117, expenditures and disposals of fixed assets to form a conclusion about the institution’s
rather than any capital usage charge such as total financial condition, instead of three
Financial Statements of Non-for-Profit
historical cost depreciation. The format of separate conclusions concerning liquidity,
Organizations, that significantly redefined
each statement must generally conform to the profitability, and net worth. Second, the
financial accounting and reporting for private
example financial statements in the AICPA proposed methodology would establish a
non-profit institutions. As a result, these
Guide, which are considered by GASB range of results for each ratio in contrast to
institutions are currently in a state of
Statement 15 to be prescriptive rather than the one minimum standard embodied in the
transition in complying with these new
illustrative. current regulations. This range would assist
standards. Most private non-profit
Thus, with each statement issued under the Department in allocating resources
institutions are required to adopt these new
FASB and GASB standards, there are toward financially risky institutions. Finally,
standards during their 1996 fiscal year. differences between the accounting and the proposed methodology takes into
Proprietary institutions prepare their reporting requirements for institutions that consideration the accounting and reporting
financial statements in accordance with affect the information the Department uses to differences of the different business segments
accounting standards promulgated by FASB assess financial responsibility. The most by establishing different ratio definitions and
and the AICPA. significant differences have arisen in the strength factors for the same element of
Independent hospitals prepare their following areas: (1) Consolidation/reporting financial health (e.g., viability) for each
financial statements by following guidelines entity; (2) Recording of contributions; (3) business segment.
set forth by the AICPA Audit Guide, Accounting for pension and postretirement
Providers of Health Care Services. Similar to benefits, and (4) Recording of depreciation. Methodology
private non-profit institutions, many KPMG took these different reporting KPMG introduced its first edition of Ratio
hospitals will also be subject to FASB standards into account when recommending Analysis in Higher Education in the 1970’s to
Statements 116 and 117, but the financial a methodology. use as a tool to better understand and
statements of these institutions will not be as interpret an institution’s financial situation.
dramatically affected. Problems of Exclusive Tests Today many industries, rating agencies and
Also problematic are differences in GAAP Another problem KPMG was to examine investors, and accrediting bodies use key
among different business segments. was that of exclusive tests. The current ratios from GAAP financial statements to
Institutions of higher education have regulations measure and establish minimum compare similar institutions’ basic financial
followed different accounting models for acceptable standards for liquidity, net worth, performance. In particular, KPMG and others
many years. For-profit institutions prepare and profitability. Each is measured separately developed this analysis to help them answer
their financial statements with GAAP and the results are considered three fundamental questions with regard to
applicable to commercial entities independently. For example, the liquidity the financial condition of institutions of
promulgated by FASB. Non-profit entities standard for a for-profit institution is an acid postsecondary education:
and public entities have generally used fund test with a minimum acceptable result of 1:1. • Is the reporting institution clearly
accounting models promulgated by industry If the acid test (or any of the other ratio tests) financially healthy or not as of the reporting
groups and the AICPA. There have been is not met, the institution may not be date?
obvious differences over the years, such as considered financially responsible. In such • Is the reporting institution financially
non-profits and publics not recording situations, the institution would be required better off or not at the end than it was at the
depreciation, nor being required to present a to demonstrate financial responsibility by beginning of the year reported on?
cash flow statement like their for-profit another method even if it had exhibited • Did the reporting institution live within
counterparts. To date, the financial strengths in other tests. its means during the year being reported on?
statements of both public and private non- This problem is further complicated by the While these questions were originally
profit institutions have remained similar in accounting and reporting differences across posed as a way of better informing such
49572 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

responsible parties as institutional financial health, but also financial distress. It Viability Ratio (and Primary Reserve Ratio, as
administrators and trustees of the financial was believed that using as a test a random discussed below) can counter the effects of
condition of the institution, they also serve sample of only those institutions that are still poor profitability, liquidity, or an inability to
the same purpose for the Department in its continuing to participate in title IV, HEA borrow. Likewise, insufficient expendable
statutory responsibility to assess the financial programs without the check provided by the capital is a clear warning sign of poor
health of a participating institution. Like assured presence of distressed or closed financial health. While a ratio of 1:1 or
administrators and trustees, the Department schools in the sample, would lead to greater indicates that an institution is clearly
has a vital interest in assessing whether or indicators that could not provide sufficient healthy, no absolute strength factor is likely
not an institution can survive financially into information for analysts to identify the point to indicate whether an institution is no
the near future. at which the risk of closure is so great that longer financially viable. Most debt relating
Ratio analysis provides answers to these the Department would determine that the to plant assets is long term and does not have
questions by comparing sets of relevant institution was not financially responsible. to be paid off at once. Yet it is clear that the
numbers from the institution’s financial KPMG responded by constructing a lower the institution’s viability ratio is below
report. Conceptually, this comparison judgmental sample that included institutions 1:1, the more likely that an institution must
describes the status, sources, and uses of an selected by reference to sector and financial live with no margin for error and meet severe
institution’s financial resources in relation to history. cash flow needs by obtaining short-term
its liabilities in such a way as to quantify the A summary of this sample is as follows. loans. Ultimately, such a financial condition
institution’s relative ability to repay current KPMG selected a purely random sample of will impair the ability of an institution to
and future debt and other obligations. Ratio public institutions. For private non-profit fulfill its mission and meet its service
analysis assumes that this comparison is institutions, KPMG selected a group of obligations to students. An institution that is
necessary based on the fact that when institutions that included large research continually experiencing a perilous financial
considered in isolation, or as compared with institutions, large and small liberal arts situation will usually find itself driven
absolute dollar standards, the dollar amounts schools, institutions with going concern primarily by financial rather than
representing assets and liabilities included in statements on their most recently audited programmatic decisions.
financial statements are not always financial statements, and some other • Primary Reserve Ratio: measures the
meaningful measures of financial health. For randomly selected institutions. KPMG also ability to support current operations from
example, the burden of debt and liabilities randomly selected a group of private non- expendable resources.
for an institution of any one size and profit institutions that have adopted FASB This ratio provides a snapshot of financial
operation and having access to a particular statements 116 and 117. For proprietary strength and flexibility by comparing
amount of resources will be different from institutions, KPMG selected institutions that expendable resources to total expenditures or
another institution of a different size and passed and institutions that failed the expenses, or operating size. This snapshot
operation and with access to a different standards set forth by the Accrediting indicates how long the institution could
amount of resources. Thus to provide an Commission of Career Schools and Colleges operate using its expendable reserves without
accurate measure of financial health, dollar of Technology. KPMG also selected relying on additional net assets generated by
amounts taken from an institution’s financial proprietary institutions that were on the operations. A ratio of 1:1 or greater would
statement should be analyzed in context of Department’s list of institutions subject to indicate that an institution could operate for
the institution’s size, operations, and surety requirements. KPMG then randomly one year without any additional revenue
resources. selected some additional proprietary being generated. A ratio of .5 to 1 (reserves
In turn, using ratios in tandem with one institutions. For the hospital sector, KPMG necessary to operate for 6 months) would
another depicts the institution in its financial randomly selected a group of institutions. probably give an institution the flexibility
totality. When the results of the application Accordingly, KPMG applied nine ratios— needed to transform itself by means of a
of a series of ratios are assigned to strength Viability, Primary Reserve, Net Income, capital expansion, or a change in mission. A
factors, weighted in accordance to sector, and Liquidity, Leverage, Debt Burden, Debt negative or decreasing trend over time
then summed, the composite score that Coverage, Secondary Reserve, and Plant indicates a weakening financial condition.
results provides an overall measure of Equity—to the financial reports of the • Net Income Ratio: measures the ability of
financial responsibility. It is this overall institutions in this sample. an institution to live within its means in a
measure, in the form of a composite score, given operating cycle.
that allows an investigator using professional Results: Ratios
A positive Net Income Ratio indicates a
judgement to determine the risk associated The first result was a confirmation of some surplus or profit for the year. Generally
with the financial structure of the institution, of the reviewers’ initial comments. Some speaking, the larger the surplus or profit, the
and to develop a relative scale to compare respondents had expressed the belief that, for stronger the institution’s financial position as
institutions, and thus judge the magnitude of practical purposes, a total of nine ratios was a result of the year’s operations. A negative
the risk, by comparing the institution’s excessive for an initial analysis. The process ratio indicates a deficit or loss for the year.
current position with similarly placed, of applying the ratios to the financial reports Small deficits may not be significant if the
comparable institutions. This approach confirmed that use of all nine ratios provided institution has large expendable capital.
avoids the possibility that failure to pass one additional detail as to the source of financial However, continued or large deficits or losses
test in isolation will automatically result in problems, but added little value for purposes are usually a warning sign that major
the conclusion that an institution is not of differentiating clearly financially healthy program or operational adjustments should
financially responsible. institutions from the group of institutions be made. Because of its direct effect on
KPMG initially proposed the application of whose financial health is uncertain. In light viability, this ratio is one of the primary
nine ratios to a random sample of the of the reviewers’ comments and these results, indicators of the underlying causes of a
Department’s financial reports as the KPMG reexamined the range and scope of change in an institution’s financial condition.
empirical vehicle upon which to test the ratios needed as an initial test of financial
usefulness of ratio analysis as a gatekeeping health, and determined that three—Viability, Strength Factors
tool, and to check the results of the Primary Reserve, and Net Income would be In assigning the strength factors (called
application for reasonableness. Comments sufficient to identify institutions that are of ‘‘threshold factors’’ in the KPMG report) for
from reviewers at this point led KPMG to immediate financial concern. each applicable ratio, KPMG posed the
modify this research agenda. While all KPMG conceptualizes these ratios as question: What is the minimum result for
respondents believed that the overall follows: each ratio that would indicate acceptable
approach was generally acceptable, some • Viability Ratio: the ability of the financial health? The answer to that question
commenters recommended that KPMG revise institution to liquidate debt from its established the lower end of the neutral or
its sampling approach to include a selection expendable resources. If the ratio is greater mid range for which a strength factor of three
of financial reports from institutions that than 1 to 1, existing debt could be repaid (3) would be assigned. For example, KPMG’s
have failed financially, or are known to be in from expendable resources available today. experience with for private colleges and
perilous financial health, in order to check In the short term, substantial amounts of universities indicates that a Primary Reserve
that the measures not only accurately mark expendable capital, as measured by the Ratio of less than .30 indicates a less than
Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules 49573

healthy financial position. This conclusion is expendable resources would increase at least Net Income Ratio: (Change in Unrestricted
consistent with standard bond rating in proportion to the rates of growth of Net Assets ÷ Total Unrestricted Income) In
practices. Hence in order to receive a strength operating size. If they do not, the same dollar the non-profit sectors (including public and
factor of (3) in its Primary Reserve Ratio, the amount of expendable resources will provide private institutions and hospitals), this ratio
result for a private college or university must a smaller margin of protection against measures whether institutions operate within
be at least .30. adversity as the institution grows. their means. In the public sector, institutions
To establish the upper strength factor of KPMG’s experience and empirical testing are not necessarily encouraged to be
five (5), the risk associated with the indicate that a ratio of .3:1 or better indicates ‘‘profitable’’, and in fact legislation may
Department’s overall objective of separating a financially healthy institution, and prohibit them from operating at anything
financially responsible institutions from therefore the lower end of the middle other than a break-even level. In the for-profit
those that appear financially unhealthy had strength factor of (3) is set as a ratio of .3:1. sector, however, the capacity to generate
to be considered. Assigning the highest The lowest strength factor of (1) was operating funds through income is an
strength factor to a ratio correlates to a very established at .1:1 and below because having important indicator of financial health.
good financial condition. The process of little more than one month or even negative Private and public non-profit institutions
assessing that institution for financial expendable reserves indicates a financially which maintain operating margins of 3% of
responsibility may be shortened. If the risky institution. The strength factor (5) was revenue are usually able to add to their
financial condition of such an institution established as greater than 1:1 because of the expendable resources over time. Clearly,
were to be subsequently affected, the institution’s ability to operate one year on deficits over time will erode these same
Department and students could suffer existing reserves without an additional dollar expendable resources. The lower end of the
unanticipated financial losses. Accordingly, of revenue. middle strength factor (3) is therefore 3%.
the range for such a rating should be high Because operating and institutional The lowest strength factor (1) is established
enough to minimize that risk. The nature of differences exist among the different sectors at zero and below, which indicates an
each ratio and what it represents also had to of participating institutions, strength factors operating deficit. The highest strength factor
be considered. A Primary Reserve Ratio were modified for some business segments. (5) was established at the level of greater than
result of 1.00 or more indicates that the Under the GASB reporting model, certain 5%.
institution can continue to operate at its related entities and assets are not required to It should be noted that the Net Income
present level for at least one year without any be reflected in the general purpose financial Ratio for proprietaries measures pre-tax
additional revenue. If analysis were limited statements. In addition, many states will not income, in comparison to total revenue.
to the Primary Reserve Ratio, one would have allow significant unrestricted expendable Therefore, the strength factors for proprietary
to conclude that such an institution is in a reserves to build up in public institutions. It institutions are increased by an estimated tax
strong financial position. was also noted that published bond rating effect.
The minimum strength factors were averages for public institutions rated Aa and
established to clearly reflect financial A were 30–50% lower than private Weighting Percentages
problems. For example, a negative Net institutions rated Aa and A. Based on these Weighting percentages for the calculation
Income Ratio result for an institution factors and input from industry task force of overall scores are also contained in the
demonstrates that during its fiscal year, the members, the strength factors for public proposed Appendix F.
institution spent more than it received. Such institutions categories (2) through (5) were By applying different weighting
activity will eventually create a financial lowered by approximately 30%. A strength percentages to each sector, certain ratios and
problem. Accordingly, a negative Net Income factor of (1) for public institutions remains at the elements they measure receive greater
ratio would be assigned a strength factor of .1:1 because certain minimum reserves are importance than others. As with the ratios
one (1). necessary and .1:1 would still indicate an and strength factors, the weighting
The recommended strength factors institution that is financially at risk. percentages are customized to accommodate
described in the proposed Appendix F have With regard to proprietary institutions, structural and accounting differences found
been customized for each sector. A owners of such institutions invest capital in each of the different sectors. Non-profit
discussion of the strength factors for each with the ultimate intent of returning that institutions retain expendable resources, and
ratio follows. capital at a profit. Non-profit organizations, a strong balance sheet generally correlates to
Viability Ratio: (Expendable Net Assets ÷ on the other hand, are generally precluded strong financial health. For-profit
Long-Term Debt) Because a ratio of 1:1 or from distributing capital to contributors. It institutions, on the other hand, do not
greater indicates that, as of the balance sheet follows therefore that less capital will necessarily retain expendable funds in the
date, an institution is clearly healthy because generally be left in proprietary institutions institution. Accordingly, higher weighting
it has sufficient expendable resources to than in non-profit institutions. Therefore, the percentages have been allocated to the
satisfy debt obligations, the lower end of strength factor of (4) for this ratio has been Viability Ratios for non-profit institutions, as
middle category (3) is a 1:1 ratio. The lowest lowered to .5 or greater, and strength factor compared with proprietary institutions. A
category (1) is established at .5:1 and below. (5) has been adjusted to .7 or greater. more detailed explanation of weighting for
The highest categories (4 and 5) were Furthermore, while a non-profit’s Primary each sector follows.
established as greater than 2:1 and 4:1, Reserve strength factor is automatically (1) if Private and Public Non-Profits: For these
respectively. that result is less than zero, this adjustment institutions, balance sheet strength as
The same strength factors will be used for is not made for proprietary institutions. The evidenced by expendable fund balances or
all sectors except for private non-profit absence of this adjustment for the proprietary net assets correlates directly with a strong
institutions that have adopted the new sector is in recognition of the fact that financial position. Tests using the sample
accounting standards FASB Statements 116 prudent business decisions may require an group described above indicate that
and 117. A comparison of data from private institution to have a negative capital balance institutions with large expendable fund
non-profit institutions under the fund for brief periods of time. balances compared to operating size were
accounting model and those under the FASB The strength factor factors for private among the strongest financially. There was a
Statements 116 and 117 model indicate that institutions adopting FASB Statements 116 less direct correlation between the ability of
these strength factors should be and 117 have been increased by 66% over an institution to operate within its means and
approximately 30%–50% higher, because private institutions using the fund financial strength based on a single-year
under the FASB model realized and accounting model. The inclusion of realized snapshot. A review of rating agency medians
unrealized endowment gains are generally and unrealized gains on investments held as by category also demonstrated a strong
classified as expendable funds. endowments in unrestricted and temporarily correlation between financial health and
Primary Reserve Ratio: (Expendable Net restricted net assets for the FASB model large expendable fund balances. The industry
Assets ÷ Total Expenses) This ratio measures should lead to higher strength factors than task force agreed that more emphasis should
financial strength by comparing expendable those used to evaluate institutions following be placed on the Primary Reserve Ratio for
resources to operating size (total the AICPA Audit Guide financial reporting this sector, as compared with the emphasis
expenditures or expenses). It is reasonable to model where such gains are treated as on the Net Income Ratio. It should be noted,
expect that in a healthy institution, nonexpendable. however, that over time, profitability must be
49574 Federal Register / Vol. 61, No. 184 / Friday, September 20, 1996 / Proposed Rules

maintained even for these institutions, so as have a composite score of less than 1.75. This institutional fiscal health. The differences
not to adversely affect other ratios. determination is based on the fact that the among the institutions examined are
Proprietaries: By their nature, proprietary individual weighted scores are calibrated to recognized explicitly through the weighting
institutions are expected to generate a return measure relative financial responsibility. A methodology.
for their investors. This means both that a composite score of less than 1.75 means that The use of a composite measure represents
strong Net Income Ratio is important, and collectively, the individual ratio scores a departure from the Secretary’s prior
that one would expect that the Primary resulted in strength factors that together approach to measuring fiscal responsibility.
Reserve Ratio would be low as compared indicate a potentially weak financial Previously, the Secretary applied similar
with non-proprietaries, since the investment position. measures, but individual compliance
return may not be retained within the This composite score takes into thresholds for each element were measured
business. While some amounts of expendable consideration many variables with particular
resources are necessary to fund ongoing exclusively from one another, and not in
emphasis on expendable capital and
operations, many different financing combination. Under the prior regulations, the
profitability. A score of less than 1.75
alternatives are available. Therefore, the Net Secretary implicitly recognized the
suggests that the overall financial
Income Ratio is accorded the greatest weight relationship among variables and established
circumstance of the institution is such that
for this sector. compliance thresholds for each element
one or more of the measured elements is at
Hospitals: Independent hospitals fall into separately. The proposed regulations are
or below the minimum strength factor value
two categories—for profit and non-profit. similar in that poor performance in any one
and neither remaining measure is higher than
While most hospitals do rely on profitability, the median strength factor value. Generally, element may lead to a finding of non-
many also have some endowments or other this implies that the institution is having compliance unless other measures are at least
similar resources. The weightings provided difficulty maintaining a marginal position at the median performance level. What
in Appendix F reflect the situation of for- with respect to financial health and, by at differs in relation to the previous regulations
profit hospitals. Therefore the Net Income least one measure, it is failing to perform at is the recognition that superior performance
Ration for this sector is weighted less than for even a minimal acceptable level. Conversely, in one or more fundamental elements of
the proprietary sector, but weighted more financial health adds a dimension to any
marginal institutions that achieve a strength
than for private non-profit and public analysis of fiscal responsibility that warrants
factor value indicating superior performance
institutions. Additionally, since hospitals consideration. Thus, with one exception
in any one of the measured elements are
have significant physical capital relative to discussed below, strength in one area may be
likely to achieve a composite score of 1.75 or
operating size and generally use debt to considered to the extent that it offsets
finance capital additions, the Viability Ratio more despite overall marginal performance.
This is based on an assumption that superior weakness in another. The Secretary believes
receives greater weight than the Primary that this better takes into consideration the
Reserve Ratio. Adjustments to the performance in any one of the measured
elements will, over time, lead to total financial circumstances of an
weightings, and financial strength factors for
improvements the other measured elements. institution.
non-profit independent hospitals will be
considered in the final regulations in The use of a composite score encompasses There is one proposed exception to the use
response to comments on this issue. the total financial circumstances of the of the composite score rather than individual
institution examined. Each of the three ratios as the test of financial responsibility.
Composite Scores and the Identification of principle measures attempts to identify a Based on the KPMG study, the Secretary
Problematic Institutions fundamental strength or weakness related to proposes that a public or private non-profit
The final step in the analysis of financial the institution’s overall fiscal health. In institution would not be considered
responsibility using these financial ratios is particular, each factor isolates a critical financially responsible, despite its composite
to add the weighted scores to derive a aspect of fiscal responsibility and measures score, if it has a negative Primary Reserve
composite score. KPMG recommended that element against an established Ratio. This adjustment is in recognition that
dividing institutions into several categories benchmark. It is important to note, however, a public or private non-profit institution that
denoting comparative levels of financial that no single measure is used. Rather, the has a negative Primary Reserve Ratio is in
strength based on these composite scores. For measures are blended into a composite score such grave financial difficulty that even
these regulatory purposes, however, the that explicitly recognizes the basic exemplary performance in other areas cannot
relevant category is that which KPMG differences that exist among the several types cover for this deficiency.
identified as representing an immediate of institutions. By taking these differences
financial risk. For all business sectors, this into consideration, the Secretary is better [FR Doc. 96–24014 Filed 9–19–96; 8:45 am]
category is defined as those institutions that able to make a determination as to overall BILLING CODE 4000–01–P