[Federal Register Volume 61, Number 184 (Friday, September 20, 1996)]
[Proposed Rules]
[Pages 49552-49574]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-24014]



[[Page 49551]]


_______________________________________________________________________

Part III





Department of Education





_______________________________________________________________________



34 CFR Part 668



Student Assistance General Provisions; Proposed Rule

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

[[Page 49552]]



DEPARTMENT OF EDUCATION

34 CFR Part 668

RIN 1840-AC36


Student Assistance General Provisions

AGENCY: Department of Education.

ACTION: Notice of Proposed Rulemaking.

-----------------------------------------------------------------------

SUMMARY: The Secretary proposes to amend the Student Assistance General 
Provisions regulations by revising the requirement for compliance 
audits and adding a new subpart establishing financial responsibility 
standards. The proposed regulations would improve the Secretary's 
oversight of institutions participating in programs authorized by title 
IV of the Higher Education Act of 1965, as amended.

DATES: Comments must be received on or before November 4, 1996.

ADDRESSES: All comments concerning these proposed regulations should be 
addressed to: Mr. David Lorenzo, U.S. Department of Education, P.O. Box 
23272, Washington, D.C. 20026, or to the following internet address: 
[email protected]
    A copy of any comments that concern information collection 
requirements should also be sent to the Office of Management and Budget 
at the address listed in the Paperwork Reduction Act section of this 
preamble.
    A copy of the report prepared by the firm of KPMG Peat Marwick, LLP 
(KPMG) referred to in this Notice of Proposed Rulemaking (NPRM) is 
available for inspection during regular business hours at the following 
address: U.S. Department of Education, 7th and D Streets S.W., Room 
3045, ROB-3, Washington, D.C.

FOR FURTHER INFORMATION CONTACT: Mr. Francis Meyer or Mr. Keith 
Kistler, U.S. Department of Education, Financial Analysis Branch, 
Institutional Participation and Oversight Service, 600 Independence 
Avenue, S.W., Room 3522 ROB-3, Washington, D.C. 20202, telephone (202) 
708-4906, for questions regarding financial analysis and other 
technical questions related to accounting and audits. For other 
information contact Mr. John Kolotos or Mr. David Lorenzo, U.S. 
Department of Education, 600 Independence Avenue, S.W., Room 3045 ROB-
3, Washington, D.C. 20202, telephone (202) 708-7888. Individuals who 
use a telecommunications device for the deaf (TDD) may call the Federal 
Information Relay Service (FIRS) at 1-800-877-8339 between 8 a.m. and 8 
p.m., Eastern standard time, Monday through Friday.

SUPPLEMENTARY INFORMATION: The Student Assistance General Provisions 
regulations (34 CFR part 668) apply to all institutions that 
participate in the student financial assistance programs authorized by 
title IV of the Higher Education Act of 1965, as amended (title IV, HEA 
programs).
    The Secretary proposes to revise subpart B as follows: the proposed 
regulations would eliminate the financial report currently required in 
Sec. 668.15; revise Sec. 668.23, and include the audit exceptions and 
repayments requirements now contained in Sec. 668.24 in the new 
Sec. 668.23. The Secretary also proposes to add a new Subpart L to part 
668 by replacing and significantly changing the current ratio standards 
contained in Sec. 668.15 to include an expanded financial ratio 
analysis, and standards based on that analysis, as primary tests of 
financial responsibility; clarify guidance on the entity required to 
demonstrate financial responsibility; set standards for submitting 
documentation and demonstrating financial responsibility for foreign 
institutions; set standards for submitting documents and demonstrating 
financial responsibility for institutions undergoing a change of 
ownership; clarify the type of late-refund finding that triggers the 
refund letter of credit provisions; and make changes to one alternative 
means of demonstrating financial responsibility.
    Tests of financial responsibility based on audited financial 
statements are necessary to ensure that institutions participating in 
the title IV, HEA programs possess sufficient financial resources to 
provide the educational services for which students contract, provide 
the human and capital resources necessary to administer the title IV, 
HEA programs, and provide the financial and technical resources 
necessary to act as a fiduciary for title IV, HEA program funds.
    The Secretary intends to issue final rules that will make technical 
amendments to the appropriate sections of part 668 on or before 
December 1, 1996, to eliminate conflicting references between those 
regulations and the proposed Sec. 668.23 and the proposed subpart L of 
the General Provisions regulations, and to otherwise harmonize the 
requirements of the proposed Sec. 668.23 and the proposed subpart L 
with other Federal audit and financial responsibility requirements. In 
this regard, the Secretary has identified throughout the discussion of 
proposed changes the major sections of part 668 that would be amended 
and consolidated.

Background

Statutory and Regulatory History

    The authority to establish reasonable standards of financial 
responsibility for purposes of determining an institution's eligibility 
to participate in title IV, HEA programs was first granted the 
Commissioner of Education by the Education Amendments of 1976--Pub. L. 
94-482. The statute was subsequently amended in 1983, 1987, and 1992, 
mostly with regard to the nature and provision of financial audits.
     As a result of the 1992 amendments, the statute currently requires 
the Secretary to:
     Develop standards to ensure that an institution is able to 
provide educational services and the necessary administrative resources 
to comply with program requirements, and that the institution meets its 
financial obligations (particularly in the area of refunds);
     Determine an institution's financial responsibility on the 
basis of an examination of operating losses, net worth, operating fund 
deficits, and asset to liability ratios that takes into account the 
differences in generally accepted accounting principles that are 
applicable to for-profit and non-profit institutions;
     Determine whether an institution is financially 
responsible, despite its failure to meet standards based on the above 
measures, if that institution can meet certain other criteria, such as 
the posting of a letter of credit, demonstrating that it is not in 
danger of recipitous closure, or demonstrating that its liabilities are 
backed by the full faith and credit of a state or by an equivalent 
governmental entity;
     Require the annual submission of an audited and certified 
financial statement as a means of gathering information about financial 
responsibility and other requirements.
    The statute also allows the Secretary, when necessary, and to the 
extent necessary to protect the financial interests of the United 
States, to require financial guarantees from institutions, and the 
assumption of personal liabilities on the part of persons who exercise 
substantial control over an institution.
    Current regulations contain the following requirements:
     That institutions must meet general standards of financial 
responsibility, including the ability to provide contracted services, 
to provide necessary administrative resources, to meet all financial 
obligations with regard to debts, and to meet obligations with regard 
to federal funds,

[[Page 49553]]

particularly refunds. The test for refund responsibility can be met in 
several different ways.
     That institutions must meet or exceed specific financial 
tests as indicated on an annual audited financial statement. Some, but 
not all, of these tests are differentiated among those that apply to 
for-profit institutions, those that apply to non-profit institutions, 
and those that apply to public institutions.
     That institutions must meet tests of past performance of 
an institution, or persons affiliated with the institution.
     That institutions, if they fail to meet particular 
criteria, must demonstrate financial responsibility according to an 
alternative method, including posting a letter of credit, demonstrating 
they are not in danger of precipitous closure, demonstrating they are 
backed by the full faith and credit of a state or equivalent government 
entity, or agreeing to be provisionally certified, in order to continue 
to be eligible to participate in title IV, HEA programs.

Improving Financial Responsibility Standards

    The Department is continually evaluating the measures it uses to 
exercise its statutory oversight of the institutions participating in 
title IV, HEA programs. In this regard, the Department is interested in 
improving its oversight of such institutions, based on its experiences 
with the application of current tests and standards to financial 
statements. The HEA requires the annual submission of audited financial 
statements from all institutions that participate in any of the federal 
student financial assistance programs. Financial statements may be 
presented in any of several formats depending on the reporting entity's 
legal status and general purpose financial reporting requirements. 
Public institutions typically prepare financial statements conforming 
to the American Institute of Certified Public Accountants (AICPA) Audit 
Guide for Colleges and Universities, or a governmental accounting model 
described in Governmental Accounting Standard Board Statement 15. 
Private nonprofit institutions will follow an accounting model 
consistent with the Financial Accounting Standards Board (FASB) 
Statements of Financial Accounting Standards (SFAS) 116 and 117. 
Additionally, independent hospitals (i.e, medically-related 
institutions) report under a hospital model, while proprietary 
institutions, ranging in size and complexity from sole proprietorships 
to publicly traded multi-national corporations, each employ a financial 
reporting model consistent with the complexity of the reporting entity 
and in conformity with commercial Generally Accepted Accounting 
Principles (GAAP).
    Currently the Secretary, at the direction of Congress, has 
established specific regulatory tests with respect to certain assets to 
liability ratios and net worth that measure an institution's financial 
capabilities. When applied uniformly across the universe of 
participating proprietary vocational schools, private non-profit 
colleges and universities, public colleges and universities, and profit 
and non-profit independent hospitals and health maintenance 
organizations, these tests provide generally reliable information about 
the financial health of the institutions examined. The Secretary, 
however, believes that the kind of information that the Department can 
extract from financial statements, and standards of financial 
responsibility based on that information, can be further improved. Such 
improvements would take into account both the total financial situation 
of the institution, and the different financial and operational 
characteristics that exist among commercial enterprises, 
municipalities, states, private nonprofit organizations and hospitals, 
each of which may be subject to fundamentally different accounting 
standards and financial reporting requirements.
    For example, the Secretary now employs a limited type of ratio 
analysis as the principal means of assessing financial responsibility. 
Generally, these ratios address fundamental concepts such as liquidity, 
profitability and net worth. Current regulations require institutions 
to meet certain requirements for each one of these components 
separately. An institution that fails one test is deemed not 
financially responsible. In practice, however, the uniform application 
of independent sets of ratio measures across the universe of 
participating institutions reduces the reliability of the information 
gathered, because such an application does not always capture in a 
comparable fashion all relevant information about the fiscal 
responsibility of the respective institutions. Differences in 
accounting classifications and standards among different types of 
institutions exaggerate the perceived differences in financial strength 
of those institutions when they are measured under independent 
standards, even though those institutions may be identical with respect 
to fiscal responsibility when their total financial situation is taken 
into account. The current requirements therefore do not consider 
whether a weakness in one particular financial component is offset by 
financial strengths in the other components. For example, there may be 
instances in which an institution may fail a single measure or test 
(such as the acid test ratio) but could compensate for that failure by 
exhibiting strengths in other areas. Accordingly, the Secretary 
proposes to expand the scope of ratio analysis to take into account a 
greater range of financial data.
    The Secretary also recognizes that the unique characteristics that 
distinguish the various business segments from one another are 
significant. As such, while it is appropriate to evaluate institutions 
within a given business segment by applying a general standard to that 
business segment, and it is also appropriate to evaluate the same 
elements of financial health across all business segments, it is 
difficult to establish comparable financial responsibility levels when 
applying a single standard across all business segments. The Secretary 
is committed to developing financial responsibility guidelines that 
take these differences into consideration. The Secretary is also 
committed to establishing fair and reasonable standards that measure 
the common, fundamental elements of financial health of all 
postsecondary institutions, such that standards developed according to 
sector-sensitive guidelines can be applied equitably across all 
sectors.

The KPMG Report

    As part of its overall effort to improve its measures of financial 
responsibility, and as part of the Secretary's overall commitment to 
improve the quality, efficiency, and effectiveness of its oversight 
responsibility, the Department of Education commissioned in the Fall of 
1995 the accounting firm of KPMG Peat Marwick, LLP to examine the 
current regulatory measures, and recommend improvements to those 
measures, especially in terms of taking into account the institution's 
business sector and total financial condition. The goal of the study 
was the development of processes, measures and standards the Secretary 
could use to better assess risk to federal funds through the analysis 
of financial statements and other documentation.
    Over the past 20 years, KPMG has developed a methodology that uses 
ratios to measure key elements common across all business sectors. 
These ratios are constructed so that the individual numerators and 
denominators are defined in such a way that they can be easily drawn 
from the financial

[[Page 49554]]

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

                   Definitions of the Proposed Ratios                   
                             Viability Ratio                            
------------------------------------------------------------------------
    Public         Public                                               
 institutions   institutions   Private non-                             
following the   following a       profit     Proprietaries   For-profit 
  1973 AICPA     government   hospitals and                   hospitals 
audit guide 1      model       institutions                             
------------------------------------------------------------------------
Expendable                                                              
 Fund                                                                   
 Balances 2..                                                           
.....                                                           
Plant Debt...     Gov't and                                             
                Proprietary                                             
                Fund Equity                                             
                                                                
               General Long-                                            
                  Term Debt     Expendable                              
                              Net Assets 3                              
                                                                
                                 Long-Term                              
                                    Debt 4       Adjusted               
                                                 Equity 5               
                                                                
                                              Total Long-               
                                                Term Debt    Expendable 
                                                                   Fund 
                                                               Balances 
                                                                
                                                              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 governmental model.                                               
2 Expendable Fund Balances are computed as follows: General, specific   
  purpose, and quasi-endowment fund balances--plant equity. True        
  endowments 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
  payable, and (3) Leases payable.                                      
5 Adjusted equity is computed as follows:                               
        Total Owner(s) or Shareholders Equity.                          

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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  Publics using   Private non-                             
   the 1973          a            profit                     For-profit 
 AICPA audit    governmental  hospitals and  Proprietaries    hospitals 
    guide          model       institutions                             
------------------------------------------------------------------------
Expendable                                                              
 Fund                                                                   
 Balances....                                                           
.....                                                           
Total                                                                   
 Expenditures                                                           
 and                                                                    
 Mandatory                                                              
 Transfers...  Governmental                                             
                        and                                             
                Proprietary                                             
                Fund Equity                                             
                                                                
                      Total                                             
                 Government                                             
               Expenditures                                             
                  and other                                             
                  Financing                                             
                       Uses                                             
                 (Excluding                                             
                 Transfers)                                             
                  and Total                                             
                Proprietary                                             
                   Expenses     Expendable                              
                                Net Assets                              
                                                                
                                     Total                              
                                  Expenses       Adjusted               
                                                   Equity               
                                                                
                                                    Total               
                                                 Expenses    Expendable 
                                                                   Fund 
                                                               Balances 
                                                                
                                                                  Total 
                                                               Expenses 
------------------------------------------------------------------------


                            Net Income Ratio                            
------------------------------------------------------------------------
               Publics using   Private non-                             
Publics using        a            profit                     For-profit 
  1973 AICPA    governmental  hospitals and  Proprietaries    hospitals 
 audit guide       model       institutions                             
------------------------------------------------------------------------
Net Total                                                               
 Revenues                                                               
                                                                
 Total                                                                  
 Revenues....   Proprietary                                             
               Income Before                                            
                  Operating                                             
               Transfers, +                                             
                    Gov'tal                                             
               Revenues and                                             
                      Other                                             
                  Financing                                             
               Sources (exc.                                            
               transfers)--G                                            
                       ov't                                             
               Expenditures                                             
                  and Other                                             
                  Financing                                             
                       Uses                                             
                 (excluding                                             
                 transfers)                                             
                                                                
                      Total                                             
               Governmental                                             
                        and                                             
                Proprietary                                             
               Revenues and                                             
                      other                                             
                  Financing                                             
                    Sources                                             
                 (excluding                                             
                 transfers)               Change in                     
                              Unrestricted                              
                                Net Assets                              
                                                                
                                     Total                              
                              Unrestricted                              
                                    Income   Income Before              
                                                    Taxes               
                                                                
                                                    Total               
                                                 Revenues     Revenue & 
                                                               Gains in 
                                                              Excess of 
                                                             Expenses & 
                                                            Losses (Net 
                                                                  Total 
                                                              Revenues) 
                                                                
                                                                  Total 
                                                               Revenues 
------------------------------------------------------------------------

The Secretary's Use of the KPMG Report

    The Secretary proposes adopting the methodology recommended in the 
KPMG report to replace the ratio methodology now contained in 
Sec. 668.15. For the most part, the Secretary proposes this methodology 
without change in order to seek comment from the community on the 
merits of this approach. However, in its final report KPMG concluded 
that a composite score below 1.75 indicates an immediate financial 
problem, but acknowledged that the identification of a bright line 
standard for passing or failing the financial responsibility standards 
was a policy decision that should be made by the Secretary. The 
Secretary is therefore proposing to adopt the composite score standard 
of 1.75 as the bright line standard for the ratio test, and to equate a 
failure to demonstrate financial responsibility with the threshold that 
KPMG identified as posing a significant risk of immediate financial 
problems. The Secretary believes that including this methodology in the 
proposed regulations in this fashion will best utilize the KPMG study, 
and that any adjustments to the KPMG recommendations and the 
Secretary's designation of 1.75 as the cutoff score would best be made 
with the benefit of public comments.
    In addition, the Secretary proposes in this NPRM a number of other 
changes to the financial responsibility regulations, and to the audit 
requirements contained in section 668.23. A summary of all these 
changes follows.

Summary of Proposed Changes

    In proposing to move the financial responsibility regulations from 
Sec. 668.15 to the new Subpart L of Part 668, the Secretary proposes 
that certain segments of the existing regulations be kept intact, and 
that significant changes be made in others. A part of these proposed 
changes is also a revision of Sec. 668.23. A summary of the new 
locations of existing regulations, proposed changes to regulations, and 
issues on which the Secretary particularly invites comments follows 
below.

Sec. 668.23  Compliance Audits and Audited Financial Statements

    In this section, the Secretary proposes to revise the provisions of 
the current Sec. 668.23 and the audited financial statement 
requirements formerly located in Sec. 668.15(e). The Secretary retains 
the requirement that an institution submit financial statements audited 
by an independent certified public accountant, and the provision for 
the submission of working and other papers on demand from the 
Secretary. However, the Secretary believes that it is possible to 
provide relief to institutions without compromising the ability of the 
Department to perform its oversight responsibilities. One way that this 
may be accomplished is to require institutions to submit a single 
audit, prepared on a fiscal year basis and audited under Generally 
Accepted Government Auditing Standards (GAGAS) and including the 
compliance information. A single compliance audit, prepared on a fiscal 
year basis rather than on an award year basis, would provide the basic 
information required by the Secretary for purposes of making a 
determination of financial responsibility. The Student Financial 
Assistance Audit Guide (SFA Audit Guide) now requires that all 
institutions submit audited financial statements as part of their 
compliance audits. For some institutions, particularly those in

[[Page 49556]]

the proprietary sector, this has resulted in a requirement that 
institutions submit these two audited financial statements to the 
Secretary annually, but at two different times. These audits differ in 
at least two ways. One way in which they differ is that the financial 
statement required under the current Sec. 668.15 is to be performed in 
accordance with Generally Accepted Auditing Standards (GAAS) and the 
financial statement that is required as part of the compliance audit is 
to be performed under GAGAS. Under the GAGAS standard, the auditor must 
go beyond GAAS standards to perform additional tests and express an 
opinion on the internal control structure and on compliance with all 
laws and title IV, HEA program regulations. The other difference is 
that the financial statement required under the current Sec. 668.15 is 
to be conducted on a fiscal year basis, and the compliance audit is 
performed on an award year basis.
    Thus the Secretary proposes to eliminate the submission of a 
separate financial statement four months after the end of the entity's 
fiscal year, as now required in Sec. 668.15. Instead the Secretary 
proposes that the Department require institutions or third-party 
servicers to submit the A-128 or A-133 report in the timeframe provided 
by that guidance, or six months after the end of the institution's or 
servicer's fiscal year for entities that follow the SFA Audit Guide, as 
required in the proposed Sec. 668.23. This compliance report would now 
include both the compliance audit and the audited financial statement, 
would be prepared on a fiscal year basis, and be prepared in accordance 
with GAGAS. It would be on the basis of the audited financial statement 
contained in the compliance report, as well as other documentation, 
that the Secretary would make determinations of financial 
responsibility by applying this proposed ratio test and other forms of 
analysis. As a result of this change, the compliance audit of an 
institution whose fiscal year does not coincide with an award year 
would cover parts of two award years. The Secretary recognizes that 
such a change may pose difficulties associated with providing a 
compliance audit spanning two different award years, but believes that 
the overall burden reduction for institutions from combining the two 
audits more than compensates for these difficulties.
    The Secretary also proposes a modification of the treatment of the 
entity covered by the financial statement by clarifying the 
requirements that trigger the submission of consolidated statements. 
The Secretary proposes that an institution, as part of its audited 
financial statement, provide information regarding the institution's 
financial relationship with related entities, and that on request the 
institution must submit consolidated audited financial statements of 
the institution and related entities.
    This proposed section contains audit submission requirements for 
foreign institutions, discussed below under the heading Sec. 668.176 
Foreign Institutions. The Secretary also proposes adding a paragraph 
regarding questionable accounting treatments. Under this proposal, if 
the Secretary questions an accounting treatment, the Secretary may 
submit the audit statements that contain those treatments to various 
bodies, including the AICPA, for review or resolution.
    This proposed section contains requirements for a proprietary 
institution to disclose in a note to its financial statement the 
proportion of revenues it receives from title IV, HEA programs. This 
disclosure represents no added burden to the institution, since the 
auditor will have already prepared the information contained in the 
note to fulfill the requirements of Sec. 600.5(d) and (e) within 90 
days of the end of the institution's fiscal year.
    This proposed section also includes the requirements regarding 
audit exceptions and repayments now contained in Sec. 668.24. Section 
668.24 is now being separately amended by the Secretary to include 
requirements regarding record retention.

Subpart L--Financial Responsibility

Sec. 668.171  Scope and Purpose

    In this section the Secretary proposes to revise the scope and 
purpose statement currently in Sec. 668.15(a) to more accurately 
reflect the purpose and intent of the law, to clarify the 
responsibilities of third-party servicers under this subpart, and to 
include a special transition rule discussed below.

Sec. 668.172 Financial Standards

    This section incorporates the requirements currently in 
Sec. 668.15(b)(1)-(5), and Sec. 668.15(d) regarding financial 
obligations, refund standards and the alternatives to meeting the 
statutory refund reserve requirement, as well as the requirement that 
the institution must submit its compliance report by the date and in 
the manner prescribed in Sec. 668.23 in order to be considered 
financially responsible.
    The Secretary proposes in this section that a composite score of 
1.75, calculated in accordance with Sec. 668.173, be the minimum score 
an institution can achieve and still be determined financially 
responsible using the new ratio analysis.
    The Secretary is proposing this composite score as a measure of 
financial responsibility because this score takes into consideration 
many important variables, with particular emphasis on expendable 
capital and profitability. A score of less than 1.75 suggests that the 
overall financial circumstance of the institution is such that one or 
more of the measured elements is at or below the minimum strength 
factor value and neither remaining measure is higher than the median 
strength factor value. Generally, this implies that the institution is 
having difficulty maintaining a marginal position with respect to 
financial health and, by at least one measure, it is failing to perform 
at even a minimal acceptable level. Conversely, marginal institutions 
that achieve a strength factor value indicating superior performance in 
any one of the measured elements are likely to achieve a composite 
score of 1.75 or more despite overall marginal performance. This is 
based on the assumption that superior performance in any one of the 
measured elements will, over time, lead to improvements in the other 
measured elements.
    The use of a composite score encompasses the total financial 
circumstances of the institution examined. Each of the three principal 
measures attempts to identify a fundamental strength or weakness 
related to the institution's overall fiscal health. In particular, each 
factor isolates a critical aspect of fiscal responsibility and measures 
that element against an established benchmark. It is important to note, 
however, that no single measure is used. Rather, the measures are 
blended into a composite score that recognizes the basic differences 
that exist among the several types of institutions. By taking these 
differences into consideration, the Secretary is better able to make a 
determination as to overall institutional fiscal health. The 
differences among the institutions examined are recognized explicitly 
through the weighting methodology.
    The use of a composite measure represents a departure from the 
Secretary's current approach to measuring fiscal responsibility. 
Currently, the Secretary applies similar measures, but individual 
compliance thresholds for each element are measured exclusively from 
one another, and not in combination. Under the current regulations, the 
Secretary implicitly recognizes the relationship among variables and 
established compliance thresholds for each element separately. The 
proposed regulations are similar in that poor performance in any one 
element may lead to a finding of

[[Page 49557]]

non-compliance unless other measures are at least at the median 
performance level. What differs in relation to the current regulations 
is the recognition that superior performance in one or more fundamental 
elements of financial health adds a dimension to any analysis of fiscal 
responsibility that warrants consideration. Thus, with one exception 
discussed below, strength in one area may be considered to the extent 
that it offsets weakness in another. The Secretary believes that this 
better takes into consideration the total financial circumstances of an 
institution.
    There is one proposed exception to the use of the composite score 
rather than individual ratios as the test of financial responsibility. 
Because KPMG recommended that a public or private non-profit 
institution that has a negative Primary Reserve Ratio be deemed an 
immediate financial problem despite its composite score, the Secretary 
proposes that in such circumstances the institution not be considered 
financially responsible under the ratio test. This adjustment is in 
recognition that a public or private non-profit institution that has a 
negative Primary Reserve Ratio is in such grave financial difficulty 
that even exemplary performance in other areas cannot cover for this 
deficiency.
    The Secretary intends to publish on or by December 1, 1996 final 
regulations resulting from these proposed rules. Because the final 
regulations would become effective on July 1, 1997, the Secretary is 
proposing a special transition rule with regard to the implementation 
of the 1.75 composite score standard. The Secretary would allow an 
institution under proposed Sec. 668.171(c) a one-year exemption from 
the new composite score standard if that institution passes the 
applicable ratio standard test now in place in Sec. 668.15(b)(7)-(9). 
Thus an institution, for its fiscal year that began on or before June 
30, 1997, that fails the 1.75 composite score standard but passes the 
appropriate ratio standard test contained in the current Sec. 668.15, 
would still be considered financially responsible for one year. The 
Secretary believes it is appropriate to allow an institution to prove 
financial responsibility under the current standards based on the 
financial condition of the institution during the fiscal year that 
begins before these proposed rules become effective. Moreover, this 
one-time transition rule would give the institution at least 12 months 
to adjust its operations to meet the new standards.
    In this section the Secretary also proposes a modification in the 
refund reserve requirement performance alternative. Section 498(c)(6) 
of the HEA requires that institutions maintain a cash reserve to pay 
required refunds. Current Sec. 668.15(b)(5), and these proposed 
regulations, require institutions, unless they meet the provisions of 
specific exceptions, to provide the Secretary with a letter of credit 
equal to not less than 25% of the title IV, HEA program refunds for 
their previous fiscal year. One exception to this requirement is the 
provision for performance standards, in which the institution 
demonstrates that it has made required refunds, as attested to by the 
previous two years' compliance audits, and it has not had a finding of 
failure to make timely refunds. The Secretary wishes to address the 
issue of a finding of failure to make timely refunds. Without a 
standard under which such a finding is made, even one late refund may 
be interpreted as a failure to make timely refunds, and could trigger 
this requirement. While the Secretary expects all institutions to make 
all refunds in accordance with the regulations in Sec. 668.22, and will 
enforce those regulations for every refund, the Secretary did not 
intend for isolated instances of late refunds to trigger the 
requirement for the provision of the letter of credit. Therefore, the 
Secretary is proposing that an institution would be eligible for the 
performance standard exception to the requirement to providing a 25% 
letter of credit, if (1) the independent CPA who audited the 
institution's financial statements and compliance audits, or the 
Secretary, a State or a guarantee agency that conducted a review of the 
institution, did not find that the institution made 5 percent or more 
of its refunds late, based on a sample of records audited and reviewed, 
and (2) the auditor did not note a material weakness or a reportable 
condition in the institution's report on internal controls that is 
related to refunds. The Secretary believes that these standards are 
reasonable and particularly requests comments on this proposal.

Sec. 668.173  Financial Ratios

    This proposed section incorporates the methodology recommended by 
the KPMG study and contains the definitions of ratios by sector, and 
the procedure by which composite ratio scores are calculated. Specific 
strength factors for normalizing ratio scores and weighting the 
normalized ratios by sector are contained in the proposed Appendix F to 
Part 668. The Secretary proposes that these ratios and the resulting 
composite score replace the definition of ratios currently contained in 
Sec. 668.15(b).
    This proposed section also contains a definition of ``independent 
hospital'' for these purposes, and the accounting rules for calculating 
ratios previously in Sec. 668.15(b) regarding the treatment of 
intangibles, extraordinary gains and losses, the income or losses from 
discontinued operations, cumulative effects of changes in accounting 
principles, prior period adjustments, and temporarily restricted 
assets.
    The Secretary is particularly interested in comments regarding the 
definition and utility of these ratios. Are the terms used in defining 
them clear? Do the ratios themselves provide meaningful and useful 
information regarding the financial health of an institution? Are the 
ratios correctly constituted with relation to the different audit 
requirements of the various sectors of participating institutions? Are 
the weightings and strength factor levels appropriate for each sector? 
Will the composite scores give accurate pictures of financial health 
for all types of institutions? Will the composite scores give relevant 
and useful information regarding the financial health of institutions? 
Is the 1.75 composite score an appropriate bright line for determining 
the financial responsibility of an institution?
    Also, the financial strength factors and weightings for hospitals 
currently reflect the situation of for-profit hospitals. The Secretary 
is interested in comments addressing the situation of non-profit 
hospitals, and whether the strength factors and weightings for those 
institutions should be different from those for for-profit hospitals.

Sec. 668.174  Alternate Standards and Requirements

    The Secretary is proposing to modify and relocate the provisions 
permitting institutions to demonstrate financial responsibility under 
an alternative to the proposed composite score. All of the exceptions 
formerly located in Sec. 668.15(d) are relocated to this section.
    In this section the Secretary proposes to modify the method by 
which an institution demonstrates that it has sufficient assets to 
ensure against precipitous closure. The existing regulatory provisions 
implement the statutory exception in section 498(c)(3)(C) of the HEA 
that permits an institution otherwise failing prescribed ratios to 
demonstrate financial responsibility by showing that it has sufficient 
resources to ensure against its precipitous closure. Current 
regulations mirror certain statutory requirements that the institution 
demonstrate that it is

[[Page 49558]]

meeting its financial obligations, and then require the institution to 
make specific demonstrations that it has not engaged in certain 
identified practices that could have caused the institution's 
deteriorated financial strength. The proposed regulations differ from 
this detailed analysis by establishing a lower threshold (represented 
by a composite score of 1.25) in order to qualify for this one-year 
exception, and then simply requiring the owners (or other persons who 
exercise substantial control over the institution) to assume personal 
liability for the institution's title IV obligations, rather than 
requiring a detailed analysis of the business dealings between the 
institution and its owners. The Secretary believes that this system 
will improve the administrative efficiency of implementing this 
exception and decrease the burden on the institutions using the 
exception by avoiding the detailed analysis of the business 
transactions between an institution and its owners. Furthermore, by 
establishing a separate minimum performance standard for institutions 
that seek to use this exception, the Secretary intends to ensure that 
more significant protections will be required for institutions whose 
financial condition has deteriorated during the preceding year to the 
point where the institution cannot meet those minimum thresholds. In 
such circumstances, these institutions must either use one of the other 
alternative means of demonstrating financial responsibility or be 
provisionally certified under the provisions for institutions that are 
not financially responsible.
    With regard to financial standards and alternative standards for 
new institutions, the Secretary proposes that two alternatives 
enumerated in the statute--the provision of a letter of credit for at 
least 50% of the proposed title IV program funds that the Secretary 
determines the institution will receive during its initial year of 
participation, or proof that the institution is backed by the full 
faith and credit of a State or equivalent governmental entity--be 
utilized for new institutions. The requirement of meeting prior year 
standards precludes new institutions from availing themselves of the 
revised precipitous closure alternative. The Secretary believes this is 
warranted due to the greater uncertainty presented by institutions that 
have not established a track record of properly administering the title 
IV, HEA programs.

Sec. 668.175  Special Rules for an Institution That Undergoes a Change 
in Ownership

    In this section the Secretary proposes to specify the requirements 
by which an institution that undergoes a change of ownership is deemed 
financially responsible, as well as establishing the audit submission 
requirements for applications for approval of changes of ownership.
    The Secretary is proposing that entities applying for changes of 
ownership initially demonstrate financial responsibility in one of two 
ways. Either the new owners of the institution must submit personal 
financial guarantees, in an amount and form acceptable to the 
Secretary, or submit a letter of credit payable to the Secretary in an 
amount of not less than one half the amount of title IV, HEA program 
funds the Secretary determines the institution will receive during the 
year following the new ownership's opening day. A requirement for both 
these methods is that the institution submit a consolidated date of 
acquisition balance sheet for the institution as part of the 
institution's application for a change of ownership. The Secretary is 
also proposing that the personal guarantees or letter of credit remain 
in place until the institution submits audited financial statements 
that show that the institution meets the 1.75 composite score standard 
that is part of the general standards for demonstrating financial 
responsibility required of all participating institutions.
    Historically, the Secretary has encountered difficulties in making 
comparable assessments of the financial resources for institutions 
seeking approval under new ownership. Sometimes the institution was 
sold because of an eroded or deteriorating financial condition. Without 
an opportunity to evaluate an audited financial statement that includes 
the operation of the newly acquired institution, the Secretary has had 
to make case-by-case examinations of the financial resources of the 
institution under its new ownership. Sometimes, this additional 
analysis has significantly delayed the approval of the applicant or 
such approval has been premised upon unaudited financial information 
that differed significantly from the audited financial statement that 
was later provided by the institution. The proposed regulations would 
streamline the approval process and provide greater protection to the 
taxpayers, while permitting the institution to participate and later 
demonstrate financial responsibility under the new proposed ratio 
analysis.
    In addition, the Secretary is concerned that some entities seek 
multiple approvals for changes of ownership during one fiscal year, and 
this rapid growth increases the difficulty of assessing the financial 
resources that would be available to those institutions. The Secretary 
intends that such applicants will have to provide audited financial 
statements that incorporate all institutions for which they have 
already obtained approval to operate as part of the application for a 
new change of ownership. These proposed regulations therefore require 
the entity seeking the change of ownership to demonstrate that it has 
submitted audited financial statements to the Secretary that include 
all other institutions participating in title IV, HEA programs in which 
the entity has an ownership interest or over which it exercises 
substantial control, or to submit a current audited financial statement 
reflecting such operations and ownership interests. This means that for 
every change of ownership, the entity seeking the change in ownership 
would provide personal guarantees or a letter of credit until audited 
financial statements are submitted to the Secretary showing all the 
institutions that the entity owns or controls, including the 
institution or institutions that are the subject of the change of 
ownership application.
    The Secretary is also considering requiring owners to post personal 
financial guarantees when institutions add additional locations, and 
these would remain in place until annual audits are submitted showing 
that the institution demonstrates financial responsibility under its 
expanded operations. The Secretary specifically invites comments on 
this proposal.

668.176  Foreign Institutions

    In this section the Secretary proposes to clarify financial 
responsibility standards for foreign institutions. Under the proposed 
regulation, foreign institutions whose annual title IV participation is 
less than $500,000 per year will be permitted to submit their financial 
statement audits in accordance with the generally accepted accounting 
principles of each institution's home country. These audits will then 
be examined to determine financial responsibility. Foreign institutions 
whose annual title IV participation exceeds $500,000 per year will be 
required to have their financial statement audits translated as well as 
presented for analysis under U.S. GAAP and GAGAS, and would have to 
meet all

[[Page 49559]]

regulatory requirements applicable to domestic institutions.
    The Secretary is proposing this standard for foreign institutions 
to take into consideration several important distinguishing factors. 
First, foreign institutions are only eligible to participate in the 
student loan programs, and the relative size of such title IV funding 
at most institutions is relatively small when compared with their total 
financial operations. Second, foreign institutions with such relatively 
low volumes of title IV participation have not historically experienced 
compliance problems that appear to have resulted from impaired 
financial capability. Under the proposed regulations, these foreign 
institutions will provide annual financial statement audits and annual 
compliance audits that can be evaluated to determine whether an 
institution's operations are posing a risk to the taxpayers. The 
Secretary believes that the additional burden of translating the 
financial statement audits and presenting them under U.S. GAAP and 
GAGAS should only be imposed where significant amounts of title IV 
funds are expended at the foreign institution on an annual basis.

Sec. 668.177  Past Performance

    This proposed section contains the requirements for past 
performance for an institution or persons affiliated with an 
institution that were formerly contained in Sec. 668.15(c).

Sec. 668.178  Additional Requirements and Administrative Actions

    This proposed section contains an outline of the administrative 
actions the Secretary takes when an institution fails any one of the 
various standards of financial responsibility, and specifies that 
failure to meet general standards of financial responsibility may 
subject institutions to the Limitation, Suspension, Termination, and 
Emergency Action provisions of Subpart G of Part 668. This proposed 
section also contains the portions of Sec. 668.13(d) dealing with 
requirements and standards pertaining to provisional certification of 
institutions that are not financially responsible. The Secretary 
invites comments on whether the Department should include other types 
of requirements for institutions that are provisionally certified 
because they are not financially responsible, for example the 
development of teach-out plans.
    With regard to this section, the following clarifies the 
consequences of not meeting the proposed 1.75 composite score standard 
(these consequences are also those that currently affect institutions 
that fail to meet one of the current ratio standards):
    A certified institution whose financial statement is undergoing its 
annual review, or an institution that is undergoing recertification, 
would have the opportunity to meet one of the following alternate 
standards. If it had demonstrated financial responsibility in the 
previous year, it could prove that it is not in danger of precipitous 
closure by attaining a composite score of at least 1.25, and showing 
that it is current in its debt obligations, and if its owners or board 
of trustees submit personal financial guarantees and agree to be 
jointly and severally liable for any liabilities arising from the 
institution's participation in title IV, HEA programs. It could also 
submit to the Secretary an irrevocable letter of credit for at least 
50% of the total title IV, HEA program funds the institution received 
during its latest fiscal year. A public institution would also have the 
opportunity to demonstrate that it is backed by the full faith and 
credit of a State or an equivalent government entity. An institution 
that meets any of these alternatives would be considered financially 
responsible. If an institution referred to above cannot or does not 
meet one of these alternatives, it may be offered provisional 
certification by the Secretary. In this case the institution would be 
required to submit to the Secretary an irrevocable letter of credit for 
at least 10% of the total title IV, HEA program funds the institution 
received during its latest fiscal year, demonstrate that it met all its 
financial obligations and was current on its debt payments for its two 
most recent fiscal years, and demonstrate that it is capable of 
participating under a funding arrangement other than the Department's 
advance funding method. An institution that participates under 
provisional certification in these circumstances is not considered to 
be financially responsible. If the institution is not offered 
provisional certification, or turns down provisional certification, the 
institution would then be subject to termination proceedings.
    An institution seeking to participate for the first time in the 
title IV, HEA programs would have the opportunity to meet one of the 
following alternate standards. It could submit to the Secretary an 
irrevocable letter of credit for at least one-half of the amount of 
title IV, HEA program funds that the Secretary determines the 
institution will receive during its initial year of participation. A 
public institution would have the opportunity to demonstrate that it is 
backed by the full faith and credit of a State or an equivalent 
government entity. If the institution could not meet one of these 
alternative standards, it may be offered provisional certification, the 
terms of which are described above. If the institution is not offered 
provisional certification, or turns down provisional certification, it 
would not be eligible to participate in any title IV, HEA program.

Appendix F

    This proposed appendix contains the strength factors and sector 
weightings for the new ratio analysis, an example of how composite 
scores are calculated, and a section for technical terms, all adopted 
from the KPMG report.
    In enumerating the strength factors for institutions, the Secretary 
proposes following KPMG's adjustments by specifying that public and 
private non-profit institutions that have a negative Primary Reserve 
Ratio be deemed to fail the composite score test. The Secretary also 
proposes following KPMG's recommendation that for a proprietary 
institution that earns a (2) or (1) strength factor for its Primary 
Reserve Ratio, the strength factor for the Viability Ratio be no 
greater than the result of the Primary Reserve Ratio. The purpose of 
this adjustment is to prevent insignificant amounts of debt from 
significantly affecting the categorization of an institution.

Executive Order 12866

1. Assessment of Costs and Benefits
    These proposed regulations have been reviewed in accordance with 
Executive Order 12866. Under the terms of the order the Secretary has 
assessed the potential costs and benefits of this regulatory action.
    The potential costs associated with the proposed regulations are 
those resulting from statutory requirements and those determined by the 
Secretary to be necessary for administering this program effectively 
and efficiently. To the extent there are burdens specifically 
associated with information collection requirements, they are 
identified and explained elsewhere in this preamble under the heading 
Paperwork Reduction Act of 1995.
    Thus, in assessing the potential costs and benefits--both 
quantitative and qualitative--of these proposed regulations, the 
Secretary has determined that the benefits of the proposed regulations 
justify the costs.
    The Secretary has also determined that this regulatory action does 
not interfere unduly with State and local governments in the exercise 
of their governmental functions.
    To assist the Department in complying with the specific

[[Page 49560]]

requirements of Executive Order 12866, the Secretary invites comment on 
how to minimize potential costs or to increase potential benefits 
resulting from these proposed regulations consistent with the purposes 
of sections 487(c) and 498(c) of the HEA.

Summary of Potential Costs and Benefits

    The Department has assessed the costs and benefits of the proposed 
regulations. This information is provided under the Initial Flexibility 
Analysis (below), and Summary of the KPMG Report Commissioned by the 
Department (appended to this NPRM).
2. Clarity of Regulations
    Executive Order 12866 requires each agency to write regulations 
that are easy to understand.
    The Secretary invites comments on how to make these regulations 
easier to understand, including answers to questions such as the 
following: (1) Are the requirements in the regulations clearly stated? 
(2) Do the regulations contain technical terms or other wording that 
interferes with their clarity? (3) Does the format of the regulations 
(grouping and order of sections, use of headings, paragraphing, etc.) 
aid or reduce their clarity? Would the regulations be easier to 
understand if they were divided into more (but shorter) sections? (A 
``section'' is preceded by the symbol ``Sec. '' and a numbered heading: 
For example, Sec. 668.174 Alternate standards and requirements). (4) Is 
the description of the proposed regulations in the ``Supplementary 
Information'' section of the preamble helpful in understanding the 
proposed regulations? How could this description be more helpful in 
making the proposed regulations easier to understand? (5) What else 
could the Department do to make the regulations easier to understand?
    A copy of any comments that concern how the Department could make 
these proposed regulations easier to understand should be sent to Mr. 
Stanley Cohen, Regulations Quality Officer, U.S. Department of 
Education, 600 Independence Avenue, S.W., Room 5121, FOB-10, 
Washington, D.C. 20202-2241.
3. Initial Flexibility Analysis
    The Secretary has determined that a substantial number of small 
entities may experience significant economic impacts from this proposed 
regulation. In accordance with the Regulatory Flexibility Act (RFA), an 
Initial Flexibility Analysis (IRFA) of the adverse economic impact on 
small entities has been performed. A summary of the IRFA appears below.

Description of the Objectives of, and Legal Basis for, the Rule

    The Secretary is directed by section 498(b) of the HEA to 
establish, on an annual basis, that institutions participating in title 
IV, HEA programs are financially responsible. As part of the 
Department's regulatory reinvention process, the Department has 
analyzed the current standards whereby institutions can demonstrate 
financial responsibility and found that improvements can be made. The 
proposed improvements are discussed at length in the preamble to this 
proposed rule.

Definition and Identification of Small Entities

    The Secretary has adopted the U.S. Small Business Administration 
(SBA) Size Standards for this analysis. RFA directs that small entities 
are the sole focus of the Regulatory Flexibility Analysis. There are 
three types of small entities that are analyzed here. They are: for-
profit entities with total annual revenue below $5,000,000; non-profit 
entities with total annual revenue below $5,000,000; and entities 
controlled by governmental entities with populations below 50,000. An 
estimate of the proportion of entities in each of these categories was 
calculated using the best available data, the National Center for 
Education Statistics IPEDS survey for the academic year 1993-1994. 
These estimates were applied to Department administrative files where 
no data element for total revenue is available. The estimates are that 
1,690 small for-profit entities, 660 small non-profit entities and 140 
small governmental entities will be covered by the proposed rule. Where 
exact data were not available to estimate the proportion of small 
entities, data elements were chosen that would have overestimated, 
rather than underestimated, the proportion. The Secretary particularly 
invites comments on the definition of small entity and the estimate of 
the number of small entities that would be covered by the proposed 
rule.
    The component of the proposed rule that could potentially cause a 
small entity to be economically affected is the proposed modification 
of the tests for financial responsibility that are applied to the 
submitted financial statements. The proposed consolidation of the 
financial statement audit with the compliance audit that must be 
submitted to the Secretary would have a positive economic impact on all 
small (and large) entities. The proposed changes to one of the 
alternative methods of demonstrating financial responsibility would 
have a positive economic impact on those institutions that choose this 
alternative (otherwise it would not be chosen) and the Secretary 
believes that most institutions that would have been able to use the 
existing alternative method set out in the current regulations would be 
able to use the modified version. The costs of this alternative and the 
other existing alternatives are discussed below in the context of those 
institutions that experience adverse economic impacts.

Compliance Costs of the Proposed Rule for Small Governmental Entities

    Small (and large) governmental entities that participate in the SFA 
programs have a statutory (section 498(c)(3)(B) of the HEA) alternative 
to the existing and proposed tests for demonstrating financial 
responsibility. This alternative allows for entities that are backed by 
the full faith and credit of a State to be considered financially 
responsible, and to be relieved of any costs of demonstrating financial 
responsibility. It is the Secretary's practice to identify financial 
statements from public institutions that appear to fail the numeric 
financial responsibility standards, and then to determine on a case by 
case basis whether that institution is backed by the full faith and 
credit of the state in which it is located. This alternative method of 
demonstrating financial responsibility is not changed under the 
proposed regulations, so the proposed rule will not have an increased 
significant economic impact on small governmental entities.

Compliance Costs of the Proposed Rule for Small For-profit and Small 
Non-profit Entities

    Some small (and large) for-profit and non-profit entities will 
experience adverse economic impacts from this proposed rule, to the 
extent that they may fail the proposed standards (including the 
alternative measures for demonstrating financial responsibility) but 
would have been able to pass the current standards. Using the KPMG 
analysis described elsewhere, it was estimated that between 456 and 625 
small for-profit entities and between 18 and 80 small non-profit 
entities would pass the existing test but fail the new proposed tests, 
and the Secretary seeks to minimize these adverse economic impacts by 
including in the regulations a provision that will treat an institution 
that passes the old standards as being financially responsible for any 
fiscal year that begins prior to the effective

[[Page 49561]]

date of the final regulation. To the extent that some of these small 
entities will be unable to adjust their operations to come into 
compliance with the new standards beyond that transition period, the 
negative economic impact on these entities are those costs associated 
with employing the alternative methods for demonstrating financial 
responsibility. Costs for adjusting the operation of the institution to 
come into compliance may, in some cases, be significant, although more 
difficult to estimate.
    The Secretary seeks comments on alternative ways of minimizing 
burden on small entities. One possible alternative for which the 
Secretary seeks comment is to delay the effective date of these rules 
for small entities.
    To the extent that an institution that passed the current standards 
of financial responsibility could no longer do so without posting a 
surety, a rough estimate of the calculable costs of each of these 
alternative methods for a typical small entity was calculated. The 
typical small entity was proposed as one with $2,000,000 in total 
revenue, 84% of which comes from the SFA programs. It was not 
practicable to estimate the cost of obtaining external financing if the 
required capital was not readily available. This would depend on the 
risk profile of the particular entity and reliable estimates of this 
feature were not practicable. This rough estimate is that it could cost 
a typical small institution as much as $56,500 to secure a 50% letter 
of credit, although the actual costs to most institutions would be less 
if available credit lines or other assets could be pledged against the 
letter of credit. Similarly, if the institution were allowed to post a 
smaller surety in conjunction with provisional certification, the 10% 
letter of credit could cost as much as $20,500, or less depending on 
the other available resources that were used to secure the letter of 
credit. The Secretary notes that the relative cost of providing these 
letters of credit will correspond to the relative risk assessments made 
by the banks that provide the letters of credit to the institutions.
    The amount it would cost a typical small entity to avail itself of 
the revised alternative standard for financial responsibility where the 
institution demonstrates that it has sufficient resources to ensure 
against its precipitous closure could not be reasonably estimated, but 
it is assumed that the costs would be smaller than those listed above 
for institutions that choose this method. These estimates are for the 
typical institution and the costs experienced by the actual 
institutions will undoubtedly be different. These estimates are 
provided to satisfy the RFA requirements that costs of compliance be 
described and should be used as illustrative examples only. The 
Secretary particularly invites comments on these estimates of each of 
these alternatives for small entities.

Discussion of Adverse Economic Impacts

    This analysis has determined that between an estimated 456 and 625 
small for-profit entities and between an estimated 18 and 80 small non-
profit entities may not initially pass the proposed standards to 
demonstrate financial responsibility even though these institutions 
might have passed the current standards. This estimate was derived from 
information used in the KPMG study that had selectively included a 
number of schools that had a demonstrated lack of financial 
responsibility, so the projections in this analysis may overstate the 
expected number of institutions that are in this category. In order to 
ameliorate the effects of implementing a new standard for financial 
responsibility, the proposed regulations include a proposed alternative 
means to demonstrate financial responsibility under the current 
standards for fiscal years that began prior to the effective date of 
the proposed regulation. Institutions not able to come into compliance 
with the proposed standards following this transition period will 
experience adverse economic impacts from this proposed regulation, and 
the relative economic costs these institutions may face if they are 
required to post a letter of credit are discussed above. Since the 
proposed regulations provide a better measure of an institution's 
financial responsibility, the Secretary believes it is necessary to 
impose these additional costs on institutions that are unable to adjust 
their operations to meet these ratios, because failure to meet these 
ratios indicates a heightened risk to students and taxpayers.
    The adverse economic impacts experienced by some small (and large) 
entities is balanced by the positive economic impacts experienced by 
some small (and large) entities. These positive impacts arise from the 
ability of the proposed tests to better judge financial responsibility. 
Between an estimated 138 and 369 small entities that failed the 
existing tests will pass the new tests because the proposed regulation 
determines financial responsibility by blending more financial 
information together into a composite score. These entities that have 
resources that were not adequately measured under the regulation will 
be spared the expense of pursuing alternative demonstrations of 
financial responsibility.
    The negative economic impacts from this proposed regulation will 
only be felt by those additional entities that are judged to be not 
financially responsible by the proposed tests but may have been 
determined to be financially responsible under the current regulations. 
The Secretary believes that the proposed tests, developed by KPMG 
through extensive consultations with small (and large) entities, are 
better determinants of financial responsibility than the existing 
tests. The use of the proposed tests will enable the Secretary to 
better meet the responsibilities of section 498(c) of the HEA and to 
better safeguard the Federal fiscal interests and the interests of 
students.

Identification of Relevant Federal Rules Which May Duplicate, Overlap, 
or Conflict With the Proposed Rule

    This rule reduces the number of audits which must be submitted to 
the Secretary by consolidating the financial statement audit with the 
compliance audit, removing some redundancy in these reporting 
requirements because financial information about the institution was 
being gathered separately through both of these submissions. The 
Secretary has not found any other Federal rules which duplicate, 
overlap, or conflict with the proposed rule. The Secretary particularly 
invites comments on other Federal rules which might meet these 
criteria.

Significant Alternatives That Would Satisfy the Same Legal and Policy 
Objectives While Minimizing the Economic Impact on Small Entities

    The proposed changes to the financial responsibility regulations 
would satisfy the same legal and policy objectives that are addressed 
by the current regulations in a manner that the Secretary believes more 
accurately measures the financial strength of institutions 
participating in the title IV, HEA programs. This adoption of ratio 
analysis in conjunction with the revised alternative means for 
demonstrating financial responsibility will minimize the adverse 
economic impact on small (and large) entities that choose this 
alternative. Other alternatives, such as those that would establish 
differing compliance or reporting requirements or timetables based upon 
the size of the institution rather than the type of institution, or the 
use of performance standards rather than establishing baseline 
measures, or an exemption from coverage of the rule or any part thereof 
for small entities,

[[Page 49562]]

would not adequately discharge the Secretary's obligation under section 
498(c) of the HEA to determine the financial responsibility of 
participating institutions and guard the Federal fiscal interest. The 
Secretary has determined that there are no other significant 
alternatives that would satisfy the same legal and policy objectives 
while minimizing the economic impact on small entities. This 
determination is based, in part, on the extensive consultation that the 
Department and KPMG performed with small (and large) entities in 
developing these proposed revisions. The Secretary particularly invites 
comments on this determination.

Conclusion

    The Secretary concludes that a number of small entities that are 
able to demonstrate financial responsibility under the current 
regulations may experience significant adverse economic impacts if they 
are unable to adjust their operations over time to meet the financial 
responsibility standards in the proposed rule. However, as discussed in 
the section referring to the cost-benefit assessment of the proposed 
rule pursuant to Executive Order 12866, the Secretary has concluded 
that the costs are outweighed by the benefits of putting in place a 
better system for measuring financial responsibility. In this case, the 
benefits are better protection of the Federal fiscal interest due to an 
improved numerical measure, and a transition to a system that will 
recognize some small entities as being financially responsible even 
though they would not pass the tests required under the current 
regulations.
    The Secretary invites comments on any aspect of this analysis, 
particularly comments on the definition of small entity, the estimated 
number of institutions that are expected to experience adverse economic 
impacts, the estimated costs of alternative demonstration of financial 
responsibility, and any significant alternatives that would satisfy the 
same legal and policy objectives while minimizing the economic impact 
on small entities.

Paperwork Reduction Act of 1995

    Sections 668.23 and 668.175 contain information collection 
requirements. As required by the Paperwork Reduction Act of 1995, the 
Department of Education has submitted a copy of these sections to the 
Office of Management and Budget (OMB) for its review.

Collection of Information: Financial Responsibility

    These regulations affect the following types of entities eligible 
to participate in the title IV, HEA programs: Educational institutions 
that are public or nonprofit institutions, and businesses and other 
for-profit institutions. The information to be collected are audited 
financial statements, and, for institutions undergoing changes of 
ownership, consolidating date of acquisition balance sheets. 
Institutions of higher education that participate in title IV, HEA 
programs will need this information required by these regulations to 
meet the eligibility requirements for participation set forth in 
sections 487 and 498 of the HEA. Institutions must submit annually 
audited financial statements to the Secretary in accordance the time 
limits established in either the relevant OMB circular or the SFA Audit 
Guide. This annual submission, already required of institutions and 
already reflected in the burden hour inventory, will also serve for the 
separate submission of an annual audited financial statement currently 
required under Sec. 668.15. For-profit institutions undergoing a change 
of ownership must also submit consolidating date of acquisition balance 
sheets with their application for approval of change of ownership. The 
Secretary needs and uses these audits and balance sheets (in the case 
of institutions undergoing a change of ownership) to analyze the 
financial situation of institutions and to determine whether particular 
institutions have sufficient financial strength to provide the 
educational services which they have contracted to provide, and to act 
as fiduciaries for federal student aid.
    Information is to be collected, audited, and reported to the 
Secretary once each year for institutions and third-party servicers 
covered by Sec. 668.23 and formerly covered by Sec. 668.15. Annual 
public reporting and recordkeeping burden is estimated to average 1 
hour for each response for 8,000 respondents for Sec. 668.23. These 
hours include the time needed for searching existing data sources, and 
gathering, maintaining, and disclosing the data. Educational 
institutions that are public or nonprofit institutions or businesses or 
other for-profit institutions may participate in the title IV, HEA 
programs. Institutions of higher education that participate in title 
IV, HEA programs will need and use the information required by these 
regulations to meet the eligibility requirements for participation in 
programs contained in sections 487 and 498 of the HEA.
    Because these proposed regulations would eliminate the separate 
financial statement submission in Sec. 668.15 there is a reduction in 
recordkeeping burden of 1 hour per institution, or a total reduction of 
10,000 burden hours for the elimination of Sec. 668.15.
    Information is to be collected and reported to the Secretary with 
applications for changes of ownership for institutions covered by 
Sec. 668.175. Annual public reporting and recordkeeping burden is 
estimated to average 0.25 hours for each response for an average of 200 
responses annually for Sec. 668.175. These hours include the time 
needed for searching existing data sources, and gathering, maintaining, 
and disclosing the data. Educational institutions that are businesses 
or other for-profit institutions will need and use the information 
required by these regulations to meet the eligibility requirements for 
participation in programs contained in section 498 of the HEA.
    Organizations and individuals desiring to submit comments on the 
information collection requirements should direct them to the Office of 
Information and Regulatory Affairs, OMB, Room 10235, New Executive 
Office Building, Washington, DC 20503; Attention: Desk Officer for U.S. 
Department of Education.
    The Department considers comments by the public on these proposed 
collections of information in--
      Evaluating whether the proposed collections of 
information are necessary for the proper performance of the functions 
of the Department, including whether the information will have 
practical use;
      Evaluating the accuracy of the Department's estimate of 
the burden of the collection of information are necessary for the 
proper performance of the functions of the Department, including 
whether the information will have practical use;
      Enhancing the quality, usefulness, and clarity of the 
information to be collected; and
      Minimizing the burden of the collection of information on 
those who are to respond, including the use of appropriate automated, 
electronic, mechanical, or other technological collection techniques, 
or other forms of information technology; e.g., permitting electronic 
submission of responses.
    OMB is required to make a decision concerning the collection of 
information contained in these proposed regulations between 30 and 60 
days after publication of this document in the

[[Page 49563]]

Federal Register. Therefore, a comment to OMB is best assured of having 
its full effect if OMB receives it within 30 days of publication. This 
does not affect the deadline for the public to comment to the 
Department on the proposed regulations.

Invitation to Comment

    Interested persons are invited to submit comments and 
recommendations regarding these proposed regulations.
    All comments submitted in response to these proposed regulations 
will be available for public inspection, during and after the comment 
period, in Room 3045, Regional Office Building 3, 7th and D Streets 
S.W., Washington, D.C. between the hours of 8:30 a.m. and 4 p.m., 
Monday through Friday of each week except Federal Holidays. A copy of 
the KPMG report will also be available for inspection at this location.

List of Subjects in 34 CFR Part 668

    Administrative practice and procedures, Colleges and universities, 
Reporting and Recordkeeping requirements, Student aid.

    Dated: September 11, 1996.
Richard W. Riley,
Secretary of Education.

(Catalog of Federal Domestic Assistance Number: 84.007 Federal 
Supplemental Educational Opportunity Grant Program; 84.032 Federal 
Family Educational Loan Program; 84.032 Federal PLUS Program; 84.032 
Federal Supplemental Loans for Students Program; 84.033 Federal 
Work-Study Program; 84.038 Federal Perkins Loan Program; 84.063 
Federal Pell Grant Program; 84.069 Federal State Student Incentive 
Grant Program, and 84.268 Direct Loan Program)

    The Secretary proposes to amend part 668 of title 34 of the Code of 
Federal Regulations as follows:

PART 668--STUDENT ASSISTANCE GENERAL PROVISIONS

    1. The authority citation for part 668 continues to read as 
follows:

    Authority: 20 U.S.C. 1085, 1088, 1091, 1092, 1094, 1099c and 
1141, unless otherwise noted.


Sec. 668.13  [Amended]

    2. Under Sec. 668.13, paragraph (d) is being removed and paragraphs 
(e) and (f) are redesignated as paragraphs (d) and (e).


Sec. 668.15  [Removed and reserved]

    3. Section 668.15 is removed and reserved.
    4. Section 668.23 is revised to read as follows:


Sec. 668.23  Compliance audits and audited financial statements.

    (a) General--(1) Institutions. An institution that participates in 
any title IV, HEA program must at least annually have an independent 
auditor conduct a compliance audit of its administration of that 
program. As part of that compliance audit the institution must also 
have an independent auditor conduct an audit of the institution's 
general purpose financial statement.
    (2) Third-party servicers. Except as provided under this part or 34 
CFR part 682, with regard to complying with the provisions under this 
section a third-party servicer must follow the procedures contained in 
the SFA Audit Guide for third-party servicers. A third-party servicer 
is defined under Sec. 668.2 and 34 CFR 682.200. (The SFA Audit Guide is 
available from the Department of Education's Office of Inspector 
General.)
    (3) Submission deadline. Except as provided by the Single Audit 
Act, Chapter 75 of title 31, United States Code, an institution must 
submit annually to the Secretary its compliance audit (including its 
audited financial statement) no later than six months after the last 
day of the institution's fiscal year.
    (4) Audit submission requirements. In general, the Secretary 
considers the compliance audit submission requirements (including those 
of the audited financial statement) of this section to be satisfied by 
an audit conducted in accordance with the Office of Management and 
Budget Circular A-133, ``Audits of Institutions of Higher Education and 
Other Nonprofit Organizations''; Office of Management and Budget 
Circular A-128, ``Audits of State and Local Governments'', or the SFA 
Audit Guide, whichever is applicable to the entity. (Both circulars are 
available by calling OMB's Publication Office at (202) 395-7332, or 
they can be obtained in electronic form on the OMB Home Page at (http:/
/www.whitehouse.gov).)
    (b) Compliance audits for institutions. (1) An institution's 
compliance audit must cover, on a fiscal year basis, all title IV, HEA 
program transactions, and must cover all of those transactions that 
have occurred since the period covered by the institution's last 
compliance audit.
    (2) The compliance portion of the audit required under this section 
must be conducted in accordance with--
    (i) The general standards and the standards for compliance audits 
contained in the U.S. General Accounting Office's (GAO's) Government 
Auditing Standards. (This publication is available from the 
Superintendent of Documents, U.S. Government Printing Office, 
Washington, DC 20402); and
    (ii) Procedures for audits contained in audit guides developed by, 
and available from, the Department of Education's Office of Inspector 
General. (These audit guides do not impose any requirements beyond 
those imposed under applicable statutes and regulations and GAO's 
Government Auditing Standards.)
    (3) The Secretary may require an institution to provide a copy of 
its compliance audit report to guaranty agencies or eligible lenders 
under the FFEL programs, State agencies, the Secretary of Veterans 
Affairs, or nationally recognized accrediting agencies.
    (4) An institution that has a compliance audit conducted under this 
section must--
    (i) Give the Secretary and the Inspector General access to records 
or other documents necessary to review the audit; and
    (ii) Require an individual or firm conducting a compliance audit to 
give the Secretary and the Inspector General access to records, audit 
work papers, or other documents necessary to review the audit.
    (5) An institution must give the Secretary and the Inspector 
General access to records or other documents necessary to review a 
third-party servicer's audit.
    (c) Compliance audits for third-party servicers. (1) A third-party 
servicer that administers title IV, HEA programs for institutions does 
not have to have a compliance audit performed if--
    (i) The servicer contracts with only one institution; and
    (ii) The audit of that institution's administration of the title 
IV, HEA programs involves every aspect of the servicer's administration 
of that program for that institution.
    (2) A third-party servicer that contracts with more than one 
participating institution may submit a single compliance audit report 
that covers the servicer's administration of the title IV, HEA programs 
for each institution with which the servicer contracts.
    (3) A third-party servicer must submit annually to the Secretary 
its compliance audit no later than six months after the last day of the 
servicer's fiscal year.
    (4) A third-party servicer must give the Secretary and the 
Inspector General access to records or other documents necessary to 
review an institution's compliance audit.

[[Page 49564]]

    (5) The Secretary may require a third-party servicer to provide a 
copy of its audit report to guaranty agencies or eligible lenders under 
the FFEL programs, State agencies, the Secretary of Veterans Affairs, 
or nationally recognized accrediting agencies.
    (6) A third-party servicer that has a compliance audit conducted 
under this section must--
    (i) Give the Secretary and the Inspector General access to records 
or other documents necessary to review the audit; and
    (ii) Require an individual or firm conducting an audit described in 
this section to give the Secretary and the Inspector General access to 
records, audit work papers, or other documents necessary to review the 
audit.
    (d) Audited financial statements--(1) General. To enable the 
Secretary to make a determination of financial responsibility, as part 
of its compliance audit an institution must submit to the Secretary a 
set of financial statements for it latest complete fiscal year. These 
financial statements must be prepared on an accrual basis in accordance 
with generally accepted accounting principles, and audited by an 
independent certified public accountant in accordance with generally 
accepted government auditing standards and other guidance contained in 
the Office of Management and Budget Circular A-133, ``Audits of 
Institutions of Higher Education and Other Nonprofit Organizations''; 
Office of Management and Budget Circular A-128, ``Audits of State and 
Local Governments'', or the SFA Audit Guide, whichever is applicable. 
As part of these statements, the institution shall include a detailed 
description of related entities consistent with the definitions in SFAS 
57, describing in detail the extent and nature of the related entity's 
interest, and the structure of the relationship between the institution 
and the related entity. The Secretary may also require the institution 
to submit or otherwise make available the accountant's work papers, and 
to submit additional substantive information.
    (2) Resolution of questionable accounting treatments. In the event 
that the Secretary objects to accounting treatments contained in an 
institution's audited financial statements, the Secretary notifies the 
institution of the Secretary's concerns, and may refer those financial 
statements, along with other relevant documents, to the AICPA Committee 
on Accounting Standards, and other professional bodies and accounting 
experts for review or resolution.
    (3) Submission of additional financial statements. (i) To determine 
whether an institution is financially responsible, the Secretary may 
also require the institution to submit the audited financial statements 
of related entities, consolidated financial statements, or full 
consolidating financial statements based upon the institution's 
economic relationship to those entities.
    (ii) If the Secretary requires the submission of a related entity's 
financial statement, the Secretary may also require that the statement 
be supplemented with consolidating schedules showing the consolidation 
of each of the parent corporation's subsidiaries and divisions (each 
separate institution participating in the title IV, HEA programs shown 
separately) intercompany eliminating entries, and derived consolidated 
totals.
    (4) Audited financial statements for foreign institutions. As part 
of an annual compliance audit, a foreign institution must submit--
    (i) Audited financial statements conducted in accordance with the 
generally accepted accounting principles of the institution's home 
country, if the institution received less than $500,000 in title IV, 
HEA program funds during its most recently completed fiscal year; or
    (ii) Audited financial statements translated to meet the 
requirements of paragraph (d) of this section, if the institution 
received $500,000 or more in title IV, HEA program funds during its 
most recently completed fiscal year.
    (5) Disclosure of title IV HEA program revenue. A proprietary 
institution must disclose in a footnote to its financial statement the 
percentage of the title IV, HEA program revenue the institution 
received during that fiscal year, as calculated in accordance with 
Sec. 600.5(d);
    (6) Audited financial statements for third party servicers. A 
third-party servicer that enters into a contract with a lender or 
guaranty agency to administer any aspect of the lender's or guaranty 
agency's programs, as provided under 34 CFR part 682, must submit 
annually an audited financial statement. This financial statement must 
be prepared on an accrual basis in accordance with generally accepted 
accounting principles, and audited by an independent certified public 
accountant in accordance with generally accepted government auditing 
standards and other guidance contained in the third party servicer 
audit guide issued by the Department of Education's Office of Inspector 
General.
    (e) Notification of questioned expenditures or compliance. (1) As a 
result of a Federal audit or an audit performed at the direction of an 
institution or third-party servicer, if an expenditure made by the 
institution or servicer is questioned, or the institution's or 
servicer's compliance with an applicable requirement (including the 
lack of proper documentation) is questioned, the Secretary notifies the 
institution or servicer of the questioned expenditure or compliance.
    (2) If the institution or servicer believes that the questioned 
expenditure or compliance was proper, the institution or servicer shall 
notify the Secretary in writing of the institution's or servicer's 
position and the reasons for that position.
    (3) The institution's or servicer's response must be based on 
performing an attestation engagement in accordance with the Standards 
for Attestation Engagements of the American Institute of Certified 
Public Accountants and must be received by the Secretary within 45 days 
of the date of the Secretary's notification to the institution or 
servicer.
    (f) Determination of liabilities. (1) Based on the audit finding 
and the institution's or third-party servicer's response, the Secretary 
determines the amount of liability, if any, owed by the institution or 
servicer and instructs the institution or servicer as to the manner of 
repayment.
    (2) If the Secretary determines that a third-party servicer owes a 
liability for its administration of an institution's title IV, HEA 
programs, the servicer must notify each institution under whose 
contract the servicer owes a liability of that determination. The 
servicer must also notify every institution that contracts with the 
servicer for the same service that the Secretary determined that a 
liability was owed.
    (g) Repayments. (1) An institution or third-party servicer that 
must repay funds under the procedures in this section shall repay those 
funds at the direction of the Secretary within 45 days of the date of 
the Secretary's notification, unless--
    (i) The institution or servicer files an appeal under the 
procedures established in subpart H of this part; or
    (ii) The Secretary permits a longer repayment period.
    (2) Notwithstanding paragraphs (f) and (g)(1) of this section--
    (i) If an institution or third-party servicer has posted surety or 
has provided a third-party guarantee and the Secretary questions 
expenditures or compliance with applicable requirements and identifies 
liabilities, then the Secretary may determine that

[[Page 49565]]

deferring recourse to the surety or guarantee is not appropriate 
because--
    (A) The need to provide relief to students or borrowers affected by 
the act or omission giving rise to the liability outweighs the 
importance of deferring collection action until completion of available 
appeal proceedings; or
    (B) The terms of the surety or guarantee do not provide complete 
assurance that recourse to that protection will be fully available 
through the completion of available appeal proceedings; or
    (ii) The Secretary may use administrative offset pursuant to 34 CFR 
part 30 to collect the funds owed under the procedures of this section.
    (3) If, under the proceedings in subpart H, liabilities asserted in 
the Secretary's notification, under paragraph (e)(1) of this section, 
to the institution or third-party servicer are upheld, the institution 
or third-party servicer must repay those funds at the direction of the 
Secretary within 30 days of the final decision under subpart H of this 
part unless--
    (i) The Secretary permits a longer repayment period; or
    (ii) The Secretary determines that earlier collection action is 
appropriate pursuant to paragraph (g)(2) of this section.
    (h) An institution is held responsible for any liability owed by 
the institution's third-party servicer for a violation incurred in 
servicing any aspect of that institution's participation in the title 
IV, HEA programs and remains responsible for that amount until that 
amount is repaid in full.

(Authority: 20 U.S.C. 1088, 1094, 1099c, 1141 and section 4 of Pub. 
L. 95-452, 92 Stat. 1101-1109)

    5. A new Subpart L is added to read as follows:

Subpart L--Financial Responsibility

Sec.
668.171  Scope and purpose.
668.172  Financial standards.
668.173  Financial ratios.
668.174  Alternate standards and requirements.
668.175  Special rules for an institution that undergoes a change in 
ownership.
668.176  Foreign institutions.
668.177  Past performance.
668.178  Additional requirements and administrative actions.

Subpart L--Financial Responsibility


Sec. 668.171  Scope and purpose.

    (a) General. To begin and to continue to participate in any title 
IV, HEA program, an institution must demonstrate to the Secretary that 
it is financially responsible under the standards established in this 
subpart. These standards are intended to ensure that a participating 
institution has the financial resources to--
    (1) Deliver its education and training programs to students without 
interruption; and
    (2) Meet its financial and administrative responsibilities to 
students and to the Secretary.
    (b) Third-party servicers. (1) The general standards in this 
subpart apply to a third-party servicer that enters into a contract 
with a lender or guaranty agency to administer any aspect of the 
lender's or guaranty agency's programs, as provided under 34 CFR part 
682; and
    (2) The provisions regarding past performance contained in 
Sec. 668.177 apply to all third-party servicers.
    (c) Special transition-year rule. (1) If an institution fails to 
satisfy the general standards under this subpart solely because it did 
not achieve a composite score of at least 1.75, as determined under 
Sec. 668.173, the institution may demonstrate that it is financially 
responsible under the standards formerly codified under Sec. 668.15 
(b)(7) through (b)(9).
    (2) An institution may demonstrate that it is financially 
responsible under the former standards only once, and only for the 
institution's fiscal year that began on or before June 30, 1997.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.172  Financial standards.

    (a) General standards. In general, the Secretary considers an 
institution to be financially responsible if the Secretary determines 
that--
    (1)(i) The institution's Viability, Primary Reserve, and Net Income 
ratios yield a composite score of at least 1.75, as calculated under 
Sec. 668.173; and
    (ii) For a public or private non-profit institution, that 
institution has a positive Primary Reserve ratio;
    (2) The institution is meeting all of its financial obligations, 
including but not limited to--
    (i) Refunds that it is required to make; and
    (ii) Repayments to the Secretary for liabilities and debts incurred 
in programs administered by the Secretary;
    (3) The institution is current in its debt payments. The 
institution is not current in its debt payments if--
    (i) The institution is in violation of any existing loan agreement 
at its fiscal year end, as disclosed in a note to its audited financial 
statement; or
    (ii) The institution fails to make a payment in accordance with 
existing debt obligations for more than 120 days, and at least one 
creditor has filed suit to recover funds under those obligations; and
    (4) In the institution's audited financial statements, the opinion 
expressed by the auditor was not an adverse opinion or disclaimed 
opinion, or the auditor did not express doubt about the continued 
existence of the institution as a going concern.
    (b) Refund standards. (1) Letter of credit. In addition to 
satisfying the general standards, an institution must submit an 
irrevocable letter of credit, acceptable and payable to the Secretary, 
equal to 25 percent of the total amount of title IV, HEA program 
refunds paid by the institution during its most recently completed 
fiscal year, unless the institution qualifies for an exemption under 
this section.
    (2) Exemptions. An institution is not required to submit the letter 
of credit described in paragraph (b)(1) of this section, if--
    (i) The institution's liabilities are backed by the full faith and 
credit of the State, or by an equivalent government entity;
    (ii) The institution is located in a State that has a tuition 
recovery fund approved by the Secretary and the institution contributes 
to that fund; or
    (iii) The institution demonstrates that it made its title IV, HEA 
program refunds within the time permitted under Sec. 668.22 during its 
two most recently completed fiscal years. The Secretary considers an 
institution to qualify for this exemption if the independent CPA who 
audited the institution's financial statements and compliance audits 
for either of those fiscal years, or the Secretary or a State or 
guaranty agency that conducted a review of the institution during those 
fiscal years--
    (A) Did not find that the institution made 5 percent or more of its 
refunds late, based on the sample of records audited or reviewed; and
    (B) Did not note a material weakness or a reportable condition in 
the institution's report on internal controls that is related to 
refunds.
    (3) Failure to make timely refunds. (i) If the Secretary or a State 
or guaranty agency determines in a review conducted of the institution 
that the institution no longer qualifies for an exemption under this 
section, the institution must--
    (A) Submit the irrevocable letter of credit to the Secretary no 
later than 30 days after the Secretary, or State or guaranty agency 
notifies the institution of that determination; and
    (B) Notify the Secretary of the guaranty agency or State that 
conducted that review.

[[Page 49566]]

    (ii) If an auditor determines in the institution's annual 
compliance audit that the institution no longer qualifies for an 
exemption under this section, the institution must submit the 
irrevocable letter of credit to the Secretary no later than 30 days 
after the date the institution's compliance audit must be submitted to 
the Secretary.
    (4) State tuition recovery funds. In determining whether to approve 
a State's tuition recovery fund, the Secretary considers the extent to 
which that fund--
    (i) Provides refunds to both in-State and out-of-State students;
    (ii) Allocates all refunds in accordance with the order required 
under Sec. 668.22; and
    (iii) Provides a reliable mechanism for the State to replenish the 
fund should any claims arise that deplete the fund's assets.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.173  Financial ratios.

    (a) Composite score. As detailed in Appendix F, the Secretary 
determines an institution's composite score by--
    (1) Calculating the Viability, Primary Reserve, and Net Income 
ratios, as described in paragraph (b) of this section;
    (2) Assigning a strength factor to each ratio that corresponds to 
the value of each of those ratios;
    (3) Multiplying the assigned strength factor by the appropriate 
weighting percentage for each ratio; and
    (4) Summing the resulting products of all three ratios.
    (b) Ratios. (1) Public institutions. (i) As detailed in Appendix, 
F, the ratios for public institutions using the 1973 AICPA Audit Guide 
for Colleges and Universities are calculated as follows:

Viability ratio=Expendable Fund BalancesPlant Debt
 Primary Reserve ratio=Expendable Fund BalancesTotal 
Expenditures and Mandatory Transfers
Net Income ratio=Net Total RevenuesTotal Revenues

(ii) As detailed in Appendix F, the ratios for public institutions 
using a governmental accounting model are calculated as follows:

Viability Ratio=Governmental and Proprietary Fund EquityGeneral 
Long-Term Debt
Primary Reserve Ratio=Governmental and Proprietary Fund 
EquityTotal Governmental Expenditures and Other Financing Uses 
(excluding transfers) and Total Proprietary Expenses
Net Income Ratio=Proprietary Income Before Operating 
Transfers,+Governmental Revenues and Other Financing Sources (excluding 
transfers)-Governmental Expenditures and Other Financing Uses 
(excluding transfers)Total Governmental and Proprietary 
Revenues and Other Financing Sources (excluding transfers)

    (2) Private non-profit institutions. As detailed in Appendix F, the 
ratios for private non-profit institutions are calculated as follows:

Viability ratio=Expendable Net AssetsLong-term Debt
Primary Reserve ratio=Expendable Net AssetsTotal Expenses
Net Income ratio=Change in Unrestricted Net AssetsUnrestricted 
Income

    (3) Proprietary institutions. As detailed in Appendix F, the ratios 
for proprietary institutions are calculated as follows:

Viability ratio=Adjusted EquityTotal Long-term Debt
Primary Reserve ratio=Adjusted EquityTotal Expenses
Net Income ratio=Income Before TaxesTotal Revenues

    (4) Independent hospitals. (i) As detailed in Appendix F, the 
ratios for non-profit independent hospitals are calculated as follows:

Viability ratio=Expendable Net AssetsLong-term Debt
Primary Reserve ratio=Expendable Net AssetsTotal Expenses
Net Income ratio=Change in Unrestricted Net AssetsUnrestricted 
Income

    (ii) As detailed in Appendix F, the ratios for for-profit 
independent hospitals are calculated as follows:

Viability ratio=Expendable Fund BalancesLong-term Debt
Primary Reserve ratio=Expendable Fund BalancesTotal Expenses
Net Income ratio=Revenue & Gains in Excess of Expenses and Losses (Net 
Total Revenue)Total Revenues

    (c) Ratio values, strength factors and weighting percentages. 
Appendix F contains--
(1) The ratio values and corresponding strength factors and weighting 
percentages for each type of institution under paragraph (b) of this 
section;
(2) Additional information regarding the calculation of certain ratios; 
and
(3) The conditions under which an adjustment may be made to the 
strength factors or weighting percentages in determining an 
institution's composite score.
    (d) Special definition. For purposes of this subpart, an 
independent hospital is an institution that--
    (1) Is not controlled by, or included in the financial statement 
of, another institution; and
    (2) Prepares its financial statements under the accounting 
standards established in the AICPA's audit guide for Audits of Health 
Care Organizations.
    (e) Special rules for calculating ratios and determining financial 
responsibility. For purposes of calculating the ratios defined in this 
section, and for purposes of determining whether an institution 
qualifies as financially responsible under an alternative method 
contained in this subpart, the Secretary--
    (1) Excludes all unsecured or uncollateralized related-party 
receivables;
    (2) Excludes all intangible assets defined as intangible in 
accordance with generally accepted accounting principles; and
    (3) May exclude--
    (i) Extraordinary gains or losses;
    (ii) Income or losses from discontinued operations;
    (iii) Prior period adjustment; and
    (iv) The cumulative effect of changes in accounting principles.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.174  Alternate standards and requirements.

    (a) Alternatives for participating institutions. A currently 
participating institution that fails to achieve a composite score of at 
least 1.75 may demonstrate to the Secretary that it is nevertheless 
financially responsible if--
    (1) The institution's liabilities are backed by the full faith and 
credit of a State, or by an equivalent government entity;
    (2) The institution submits an irrevocable letter of credit, that 
is acceptable and payable to the Secretary, for an amount equal to not 
less than one-half of the title IV, HEA program funds received by the 
institution during its most recently completed fiscal year; or
    (3)(i) The owners, board of trustees, or other persons or entities 
who under Sec. 668.177(c) exercise substantial control over the 
institution--
    (A) Submit to the Secretary personal financial guarantees 
acceptable to the Secretary; and
    (B) Agree to be jointly and severally liable for any liabilities 
that may arise from the institution's participation in the title IV, 
HEA programs.

[[Page 49567]]

    (ii) The Secretary considers an institution to qualify under this 
alternative only if--
    (A) The institution achieves a composite score of at least 1.25, 
based on its current fiscal year audited financial statements;
    (B) The institution satisfied all of the general standards under 
Sec. 668.172(a) in its previous fiscal year, based on that year's 
audited financial statements;
    (C) The persons or entities providing financial guarantees submit 
to the Secretary their personal financial statements; and
    (D) The institution convinces the Secretary that it will not close 
precipitously by demonstrating to the Secretary that it has sufficient 
resources to meet all of its financial obligations, including its 
obligations to students and to the Secretary, based on the 
institution's current fiscal year audited financial statements and the 
personal financial statements of the persons or entities providing 
personal financial guarantees.
    (b) Alternatives for new institutions. If an institution seeking to 
participate for the first time in the title IV, HEA programs fails to 
satisfy any of the general standards, the institution may demonstrate 
that it is financially responsible if--
    (1) The institution's liabilities are backed by the full faith and 
credit of a State, or by an equivalent government entity; or
    (2) The institution submits an irrevocable letter of credit 
acceptable and payable to the Secretary, for at least one-half of the 
amount of title IV, HEA program funds that the Secretary determines the 
institution will receive during its initial year of participation.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.175  Special rules for an institution that undergoes a change 
in ownership.

    (a) General standards for financial responsibility. The Secretary 
considers an institution that undergoes a change in ownership that 
results in a change of control, as described under 34 CFR 600.31, to be 
financially responsible only if the persons or entities that acquired 
an ownership interest in the institution, or that exercise substantial 
control over the institution, submit a consolidating date of 
acquisition balance sheet for the institution with their application 
for approval, and--
    (1)(i) Submit to the Secretary personal financial guarantees from 
the owners, supported by personal financial statements, in an amount 
and form acceptable to the Secretary; or
    (ii) Submit an irrevocable letter of credit acceptable and payable 
to the Secretary, for at least one-half of the amount of title IV, HEA 
program funds that the Secretary determines the institution will 
receive during the year following its date of acquisition.
    (2) Personal financial guarantees or letters of credit submitted 
under this section will remain in place until the institution submits 
audited financial statements, prepared in the manner prescribed by 
Sec. 668.23, showing that the institution attains a composite score of 
at least 1.75.
    (b) Audit requirements for changes of ownership applications. An 
entity that seeks approval of a change in ownership--
    (1) Must demonstrate that it has submitted to the Secretary an 
audited financial statement fulfilling the requirements of Sec. 668.23 
that includes all entities in which it holds an ownership interest, or 
over which it exercises substantial control; or
    (2) Must submit a current audited financial statement acceptable to 
the Secretary that includes all entities in which it holds an ownership 
interest or over which it exercises substantial control, if the latest 
financial statement it submitted to the Secretary in fulfillment of the 
requirements of Sec. 668.23 does not include, as of the date of the 
acquisition of the institution for which it seeks an approval of change 
of ownership, all entities in which it holds an ownership interest or 
over which it exercises substantial control .

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.176  Foreign institutions.

    The Secretary makes a determination of financial responsibility for 
a foreign institution on the basis of financial statements submitted 
under the following requirements--
    (a) If the institution received less than $500,000 U.S. in title 
IV, HEA program funds during its most recently completed fiscal year, 
the institution must submit its audited financial statement for that 
year. For purposes of this paragraph, the audited financial statements 
may be prepared under the auditing standards and accounting principals 
used in the institution's home country; or
    (b) If the institution received $500,000 U.S. or more in title IV, 
HEA program funds during its most recently completed fiscal year, the 
institution must submit its audited financial statement in accordance 
with the requirements of Sec. 668.23, and satisfy the general standards 
or qualify under an alternate standard under this subpart.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.177  Past performance.

    (a) Past performance of an institution or persons affiliated with 
an institution. The Secretary does not consider an institution to be 
financially responsible if--
    (1) A person who exercises substantial control over the institution 
or any member or members of the person's family alone or together--
    (i)(A) Exercises or exercised substantial control over another 
institution or a third-party servicer that owes a liability for a 
violation of a title IV, HEA program requirement; or
    (B) Owes a liability for a violation of a title IV, HEA program 
requirement; and
    (ii) That person, family member, institution, or servicer does not 
demonstrate that the liability is being repaid in accordance with an 
agreement with the Secretary; or
    (2) The institution has been limited, suspended, terminated, or 
entered into a settlement agreement to resolve a limitation, 
suspension, or termination action initiated by the Secretary or a 
guaranty agency (as defined in 34 CFR part 682) within the preceding 
five years; or
    (3) The institution had--
    (i) An audit finding, during its two most recent compliance audits 
of its conduct of the title IV, HEA programs, that resulted in the 
institution's being required to repay an amount greater than five 
percent of the funds that the institution received under the title IV, 
HEA programs for any fiscal year covered by the audit;
    (ii) A program review finding, during its two most recent program 
reviews of its conduct of the title IV, HEA programs, that resulted in 
the institution's being required to repay an amount greater than five 
percent of the funds that the institution received under the title IV, 
HEA programs for any year covered by the program review;
    (iii) Been cited during the preceding five years for failure to 
submit acceptable audit reports required under this part, or individual 
title IV, HEA program regulations, in a timely fashion; or
    (iv) Failed to resolve satisfactorily any compliance problems 
identified in program review or audit reports based upon a final 
decision of the Secretary issued pursuant to subpart G or subpart H of 
this part.

[[Page 49568]]

    (b) Correcting past performance. The Secretary may determine an 
institution to be financially responsible even if the institution is 
not otherwise financially responsible under paragraph (a) of this 
section if--
    (1) The institution notifies the Secretary, in accordance with 34 
CFR 600.30, that the person referenced in paragraph (a)(1)(i) of this 
section exercises substantial control over the institution; and
    (2)(i) The person repaid to the Secretary a portion of the 
applicable liability, and the portion repaid equals or exceeds the 
greater of--
    (A) The total percentage of the ownership interest held in the 
institution or third-party servicer that owes the liability by that 
person or any member or members of that person's family, either alone 
or in combination with one another;
    (B) The total percentage of the ownership interest held in the 
institution or servicer that owes the liability that the person or any 
member or members of the person's family, either alone or in 
combination with one another, represents or represented under a voting 
trust, power of attorney, proxy, or similar agreement; or
    (C) Twenty-five percent of the applicable liability, if the person 
or any member of the person's family is or was a member of the board of 
directors, chief executive officer, or other executive officer of the 
institution or servicer that owes the liability, or of an entity 
holding at least a 25 percent ownership interest in the institution 
that owes the liability, and provided that the person or any member of 
the person's family did not hold more than a twenty-five percent 
ownership interest in the institution or servicer that owes the 
liability.
    (ii) The applicable liability described in paragraph (a)(1) of this 
section is currently being repaid in accordance with a written 
agreement with the Secretary; or
    (iii) The institution demonstrates why--
    (A) The person who exercises substantial control over the 
institution should nevertheless be considered to lack that control; or
    (B) The person who exercises substantial control over the 
institution and each member of that person's family nevertheless does 
not or did not exercise substantial control over the institution or 
servicer that owes the liability.
    (c) Ownership Interest. (1) An ownership interest is a share of the 
legal or beneficial ownership or control of, or a right to share in the 
proceeds of the operation of, an institution, institution's parent 
corporation, a third party servicer, or a third party servicer's parent 
corporation. The term ``ownership interest'' includes, but is not 
limited to--
    (i) An interest as tenant in common, joint tenant, or tenant by the 
entireties;
    (ii) A partnership; and
    (iii) An interest in a trust.
    (2) The term ``ownership interest'' does not include any share of 
the ownership or control of, or any right to share in the proceeds of 
the operation of a profit-sharing plan, provided that all employees are 
covered by the plan.
    (3) The Secretary generally considers a person to exercise 
substantial control over an institution or third party servicer, if the 
person--
    (i) Directly or indirectly holds at least 20 percent ownership 
interest in the institution or servicer;
    (ii) Holds together with other members of his or her family, at 
least a 20 percentownership interest in the institution or servicer;
    (iii) Represents either alone or together with other persons, under 
a voting trust, power of attorney, proxy, or similar agreement one or 
more persons who hold, either individually or in combination with the 
other persons represented or the person representing them, at least a 
20 percent ownership in the institution or servicer; or
    (iv) Is a member of the board of directors, the chief executive 
officer, or other executive officer of--
    (A) The institution or servicer; or
    (B) An entity that holds at least a 20 percent ownership interest 
in the institution or servicer; and
    (4) The Secretary considers a member of a person's family to be a 
parent, sibling, spouse, child, spouse's parent or sibling, or 
sibling's or child's spouse.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)


Sec. 668.178   Additional requirements and administrative actions.

    (a) Limitations, Suspensions, and Terminations. The Secretary may 
initiate an action under subpart G of this part to limit, suspend, or 
terminate an institution's participation in the title IV, HEA programs 
if--
    (1) The institution does not submit its audited financial 
statements by the date permitted and in the manner required under 
Sec. 668.23; or
    (2) The institution does not demonstrate that it is financially 
responsible under this subpart by satisfying the general standards or 
qualifying under an alternative standard, unless the Secretary permits 
the institution to participate under a provisional certification, as 
provided under Sec. 668.13(c).
    (b) Participation of institutions that are not deemed financially 
responsible. (1) The Secretary may permit an institution that is not 
financially responsible under paragraph (a)(2) of this section to 
participate under a provisional certification if--
    (i) The institution submits to the Secretary an irrevocable letter 
of credit, that is acceptable and payable to the Secretary, for an 
amount equal not less than 10 percent of the title IV, HEA program 
funds received by the institution during its most recently completed 
fiscal year; and
    (ii) If the institution demonstrates that it met all of its 
financial obligations and was current on its debt payments, as required 
under Sec. 668.172(a)(2), for its two most recent fiscal years.
    (2) The Secretary provides title IV, HEA program funds to an 
institution provisionally certified under this paragraph by 
reimbursement, as described under subpart K of this part, or under a 
funding arrangement other than the advance funding method.
    (c) Financial responsibility standards under provisional 
certification. The Secretary may permit an institution described under 
paragraph (d) of this section to participate or to continue to 
participate under a provisional certification, only if the owners, 
board of trustees, or other persons or entities who under 
Sec. 668.177(c) exercise substantial control over the institution--
    (1) Submit to the Secretary their personal financial statements and 
personal financial guarantees for an amount acceptable to the 
Secretary;
    (2) Agree to be jointly and severally liable for any liabilities 
that may arise from the institution's participation in the title IV, 
HEA programs; and
    (3) Convince the Secretary that the institution will not close 
precipitously by demonstrating to the Secretary that it has sufficient 
resources to meet all of its financial obligations, including its 
obligations to students and to the Secretary, based on the 
institution's current fiscal year audited financial statements and the 
personal financial statements of the persons or entities providing 
personal financial guarantees.
    (d) Provisional certification for failure to meet financial 
responsibility standards. The institution referred to under paragraph 
(c) of this section is an institution that--
    (1) Is not financially responsible because of an adverse action 
taken by the Secretary, a material finding in prior audit or review, or 
because the institution failed to resolve satisfactorily

[[Page 49569]]

any compliance problems, as described under Sec. 668.177(a) (2) and 
(3); or
    (2) Is not currently financially responsible because it failed to 
satisfy all the general standards or qualify under an alternate 
standard under this subpart, and for this reason was certified 
provisionally at any time during the preceding 5 years.

(Authority: 20 U.S.C. 1094 and 1099c and Section 4 of Pub. L. 95-
452, 92 Stat. 1101-1109)

    5. A new Appendix F is added to part 668 to read as follows:

Appendix F--Financial Responsibility

    This appendix contains the strength factors and weightings used to 
calculate composite ratio scores, the procedure for and an example of 
calculating a composite score, and technical definitions.
    A. Strength Factors:

                                             (1) Public Institutions                                            
----------------------------------------------------------------------------------------------------------------
               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 Sec. 668.172(a).

                (2) Private Non-Profit Institutions That Have Adopted FASB Statements 116 and 117               
----------------------------------------------------------------------------------------------------------------
               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 Sec. 668.172(a).

              (3) Private Non-Profit Institutions That Have Not Adopted FASB Statements 116 and 117             
----------------------------------------------------------------------------------------------------------------
               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 Sec. 668.172(a)

                                          (4) Proprietary Institutions                                          
----------------------------------------------------------------------------------------------------------------
               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.

                                            (5) Independent Hospitals                                           
----------------------------------------------------------------------------------------------------------------
            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
----------------------------------------------------------------------------------------------------------------


[[Page 49570]]

    B. Weighting Factors:

----------------------------------------------------------------------------------------------------------------
                                                            Private non- Public non-                            
                       Institutions                           profits      profits    Proprietaries   Hospitals 
                                                             (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

    Private and Public Non-Profits--If the institution has no debt, 
only the Primary Reserve and Net Income ratios are used, weighted 90% 
and 10% respectively.
    Proprietaries--If the institution has no debt, only the Primary 
Reserve and Net Income ratios are used, weighted 50% each.
    Hospitals: If the institution has no debt, only the Primary Reserve 
and Net Income ratios are used, weighted 60% and 40% respectively.
    C. Computing the Composite Score.

Procedure

    1. Calculate the Viability, Primary Reserve, and Net Income ratios.
    2. Assign the appropriate strength factor to each ratio.
    3. Multiply the assigned strength factors by the appropriate 
weighting percentage for each ratio.
    4. Sum the resulting products of all three ratios to derive the 
composite score.
    Example:
    1. A public institution has the following ratio results:

Viability Ratio: Expendable Fund Balances  Plant Debt = 0.60
Primary Reserve Ratio: Expendable Fund Balances  Total 
Expenditures & Mandatory Transfers = 0.40
Net Income Ratio: Net Total RevenuesTotal Revenues = -0.008

    2. These results are assigned a strength factor in accordance with 
the appropriate chart in part A of this appendix. Thus, for the public 
institution in this example:
    A Viability Ratio of 0.60 corresponds to a strength factor of 2.
    A Primary Reserve Ratio of 0.40 corresponds to a strength factor of 
3.
    A Net Income Ratio of -0.008 corresponds to a strength factor of 1.
    3. The strength factors are then weighted in accordance with the 
chart in part B of this appendix. For the public institution in this 
example:

The Viability Ratio strength factor of 2 is weighted at 35%: 
2 x .35=0.70
The Primary Reserve Ratio strength factor of 3 is weighted at 55%: 
3 x .55=1.65
The Net Income Ratio strength factor is weighted at 10%: 1 x .10=0.10

    4. The weighted results are then summed:

Weighted Viability Ratio.......................................      .70
Weighted Primary Reserve Ratio.................................     1.65
Weighted Net Income Ratio......................................     +.10
                                                                --------
      Composite Score..........................................     2.45
                                                                        

    D. Technical Definitions.

For Private Non-Profit Institutions

    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.              
                                                                        

For Proprietary Institutions

    Adjusted Equity is computed as follows:

                                    Total Owner(s) or Shareholders      
                                     Equity.                            
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 to equity
    Total Long-Term Debt is comprised of all debt obtained for long-
term purposes. The short-term portion of any long-term debt is 
included.

For Independent Hospitals

    Expendable Net Assets are the general, specific purpose and quasi-
endowment fund balances, less plant equity. True endowments are 
specifically excluded from the numerator.
    Long-term Debt is notes payable, bonds payable, leases payable, and 
other long-term debt. Total Expenses are retrieved from the Statement 
of Revenue and Expenses of General Funds and is comprised of all 
expenses.

Appendix to the NPRM

    Note: This appendix wll not appear in the Code of Federal 
Regulations.

Summary of the KPMG Report Commissioned by the Department

    As part of its overall effort to improve its measures of 
financial responsibility, and as part of the Department's overall 
commitment to improve the quality, efficiency, and effectiveness of 
its oversight responsibility, the Department, in the Fall of 1995, 
commissioned the accounting firm of KPMG Peat Marwick, LLP to 
examine the current regulatory measures, and recommend improvements 
to those measures. KPMG was to assist the Department in developing 
an improved methodology, using financial ratios, that could be used 
as a screening device to identify financially troubled institutions 
and as a mechanism for efficiently exercising its financial 
oversight responsibility. For such a methodology to be effective, it 
would have to measure an institution's total financial condition, 
accommodate different organizational structures and missions of 
participating institutions, and reflect the different accounting and 
reporting requirements to which participating institutions are 
subject. The overall goal of the study was the development of 
processes, measures and standards the Department could use to better 
assess risk to federal funds through the analysis of financial 
statements and other documentation.
    This study included the following elements:
     Analyses of existing financial reports using current 
standards, and using an alternative, expanded ratio analysis;
     The development of a new methodology that includes the 
use of an expanded set of specific ratios;
     The submission of that methodology to a task force and 
other outside reviewers for comment regarding the applicability of 
the ratios as measures, the definitions of the ratios, the treatment 
of particular accounting statements, the weighting of ratios in the 
construction of a composite score, and a ranking of composite scores 
that yields a category denoting institutions that would be 
considered, in the professional judgment of accountants, to be 
financial risks. More than a dozen reviewers participated, and 
included representatives from accounting firms, professional 
accounting associations, financial experts from the business 
community, officers of professional

[[Page 49571]]

education associations, and institutional financial officers and 
auditors.
     The subsequent refinement and retesting of the 
recommended methodology and standards, and the resubmission of that 
methodology and set of standards to the reviewers.

Problems of Reporting and Accounting Standards for Different Business 
Segments

    One of the problems to be dealt with in the study was that of 
different reporting standards for different business segments. The 
financial responsibility regulations cover four segments in its 
regulation of participating institutions: public institutions, 
private non-profit institutions, proprietary institutions, and 
independent hospitals. The following summarizes differences in 
reporting standards.
    Public institutions generally prepare financial statements in 
accordance with Statement No. 15 of the Governmental Accounting 
Standards Board.
    Private non-profit institutions historically have prepared their 
financial statements consistent with the 1973 AICPA Audit Guide for 
Colleges and Universities. Those financial statements were similar, 
in most respects, to those prepared by public institutions. However, 
in 1993 the Financial Accounting Standards Board (FASB) issued two 
statements, Statement of Financial Accounting Standards (SFAS) No. 
116, Accounting for Contributions Received and Contributions Made, 
and SFAS No. 117, Financial Statements of Non-for-Profit 
Organizations, that significantly redefined financial accounting and 
reporting for private non-profit institutions. As a result, these 
institutions are currently in a state of transition in complying 
with these new standards. Most private non-profit institutions are 
required to adopt these new standards during their 1996 fiscal year.
    Proprietary institutions prepare their financial statements in 
accordance with accounting standards promulgated by FASB and the 
AICPA.
    Independent hospitals prepare their financial statements by 
following guidelines set forth by the AICPA Audit Guide, Providers 
of Health Care Services. Similar to private non-profit institutions, 
many hospitals will also be subject to FASB Statements 116 and 117, 
but the financial statements of these institutions will not be as 
dramatically affected.
    Also problematic are differences in GAAP among different 
business segments. Institutions of higher education have followed 
different accounting models for many years. For-profit institutions 
prepare their financial statements with GAAP applicable to 
commercial entities promulgated by FASB. Non-profit entities and 
public entities have generally used fund accounting models 
promulgated by industry groups and the AICPA. There have been 
obvious differences over the years, such as non-profits and publics 
not recording depreciation, nor being required to present a cash 
flow statement like their for-profit counterparts. To date, the 
financial statements of both public and private non-profit 
institutions have remained similar in most respects. However, recent 
actions by the FASB and GASB (primarily the issuance of FASB 
Statements 116 and 117) have substantially increased the differences 
in accounting and financial reporting between public and private 
non-profit institutions.
    Some of the resulting differences in these various reporting and 
accounting standards are as follows. Under FASB Statements 116 and 
117, three basic financial statements--a statement of financial 
position, a statement of activities, and a cash flow statement--are 
required for private non-profit institutions. These statements are 
prepared on an accrual basis and measure economic resources and 
changes therein. Prepared as they are on a highly aggregated basis, 
these statements include certain required minimum information. 
Generally, matters of format are left to the discretion of the 
institution. Public institutions, on the other hand, will for the 
foreseeable future prepare the statements called for by the 1973 
AICPA Guide--a statement of financial position, a statement of 
changes in fund balances, and a statement of current funds revenue, 
expenditures, and other changes. (A limited number of institutions 
may also report financial results using the government reporting 
model--an option allowed under GASB Statement 15). These statements 
under the 1973 AICPA Guide are prepared on a highly desegregated 
basis and follow the traditional managed funds structure. As such, 
they include changes in fund balances arising from expenditures and 
disposals of fixed assets rather than any capital usage charge such 
as historical cost depreciation. The format of each statement must 
generally conform to the example financial statements in the AICPA 
Guide, which are considered by GASB Statement 15 to be prescriptive 
rather than illustrative.
    Thus, with each statement issued under FASB and GASB standards, 
there are differences between the accounting and reporting 
requirements for institutions that affect the information the 
Department uses to assess financial responsibility. The most 
significant differences have arisen in the following areas: (1) 
Consolidation/reporting entity; (2) Recording of contributions; (3) 
Accounting for pension and postretirement benefits, and (4) 
Recording of depreciation. KPMG took these different reporting 
standards into account when recommending a methodology.

Problems of Exclusive Tests

    Another problem KPMG was to examine was that of exclusive tests. 
The current regulations measure and establish minimum acceptable 
standards for liquidity, net worth, and profitability. Each is 
measured separately and the results are considered independently. 
For example, the liquidity standard for a for-profit institution is 
an acid test with a minimum acceptable result of 1:1. If the acid 
test (or any of the other ratio tests) is not met, the institution 
may not be considered financially responsible. In such situations, 
the institution would be required to demonstrate financial 
responsibility by another method even if it had exhibited strengths 
in other tests.
    This problem is further complicated by the accounting and 
reporting differences across the business sectors, as described 
above. The current ratio tests and basic thresholds for non-profit 
and for-profit institutions are common, leading to gaps in necessary 
information where certain information necessary to evaluate an item 
is not required under that entity's general reporting format. One 
example is the use of the same acid test requirement of 1:1 for non-
profit and for profit institutions. GAAP does not require non-profit 
institutions to prepare financial statements that classify assets 
and liabilities as current and noncurrent. Therefore, calculation of 
the acid test cannot be accurately performed without additional 
information. Moreover, differing cash management and investment 
strategies (investing excess cash in other than short-term 
instruments) may result in an institution failing the acid test 
requirement, when sufficient expendable resources are available in 
unrestricted investments to support operations for more than one 
year without any additional revenue.

Proposed Solution

    KPMG proposed a ratio methodology that, similar to the current 
regulations, takes into account liquidity, profitability, and 
viability, but attempts to improve on the current regulations in 
three ways. First, it would consider all ratio results together, 
instead of as independent tests. The calculation of a composite 
score that blends the results of the individual tests would allow 
the Department to form a conclusion about the institution's total 
financial condition, instead of three separate conclusions 
concerning liquidity, profitability, and net worth. Second, the 
proposed methodology would establish a range of results for each 
ratio in contrast to the one minimum standard embodied in the 
current regulations. This range would assist the Department in 
allocating resources toward financially risky institutions. Finally, 
the proposed methodology takes into consideration the accounting and 
reporting differences of the different business segments by 
establishing different ratio definitions and strength factors for 
the same element of financial health (e.g., viability) for each 
business segment.

Methodology

    KPMG introduced its first edition of Ratio Analysis in Higher 
Education in the 1970's to use as a tool to better understand and 
interpret an institution's financial situation. Today many 
industries, rating agencies and investors, and accrediting bodies 
use key ratios from GAAP financial statements to compare similar 
institutions' basic financial performance. In particular, KPMG and 
others developed this analysis to help them answer three fundamental 
questions with regard to the financial condition of institutions of 
postsecondary education:
     Is the reporting institution clearly financially 
healthy or not as of the reporting date?
     Is the reporting institution financially better off or 
not at the end than it was at the beginning of the year reported on?
     Did the reporting institution live within its means 
during the year being reported on?
    While these questions were originally posed as a way of better 
informing such

[[Page 49572]]

responsible parties as institutional administrators and trustees of 
the financial condition of the institution, they also serve the same 
purpose for the Department in its statutory responsibility to assess 
the financial health of a participating institution. Like 
administrators and trustees, the Department has a vital interest in 
assessing whether or not an institution can survive financially into 
the near future.
    Ratio analysis provides answers to these questions by comparing 
sets of relevant numbers from the institution's financial report. 
Conceptually, this comparison describes the status, sources, and 
uses of an institution's financial resources in relation to its 
liabilities in such a way as to quantify the institution's relative 
ability to repay current and future debt and other obligations. 
Ratio analysis assumes that this comparison is necessary based on 
the fact that when considered in isolation, or as compared with 
absolute dollar standards, the dollar amounts representing assets 
and liabilities included in financial statements are not always 
meaningful measures of financial health. For example, the burden of 
debt and liabilities for an institution of any one size and 
operation and having access to a particular amount of resources will 
be different from another institution of a different size and 
operation and with access to a different amount of resources. Thus 
to provide an accurate measure of financial health, dollar amounts 
taken from an institution's financial statement should be analyzed 
in context of the institution's size, operations, and resources.
    In turn, using ratios in tandem with one another depicts the 
institution in its financial totality. When the results of the 
application of a series of ratios are assigned to strength factors, 
weighted in accordance to sector, and then summed, the composite 
score that results provides an overall measure of financial 
responsibility. It is this overall measure, in the form of a 
composite score, that allows an investigator using professional 
judgement to determine the risk associated with the financial 
structure of the institution, and to develop a relative scale to 
compare institutions, and thus judge the magnitude of the risk, by 
comparing the institution's current position with similarly placed, 
comparable institutions. This approach avoids the possibility that 
failure to pass one test in isolation will automatically result in 
the conclusion that an institution is not financially responsible.
    KPMG initially proposed the application of nine ratios to a 
random sample of the Department's financial reports as the empirical 
vehicle upon which to test the usefulness of ratio analysis as a 
gatekeeping tool, and to check the results of the application for 
reasonableness. Comments from reviewers at this point led KPMG to 
modify this research agenda. While all respondents believed that the 
overall approach was generally acceptable, some commenters 
recommended that KPMG revise its sampling approach to include a 
selection of financial reports from institutions that have failed 
financially, or are known to be in perilous financial health, in 
order to check that the measures not only accurately mark financial 
health, but also financial distress. It was believed that using as a 
test a random sample of only those institutions that are still 
continuing to participate in title IV, HEA programs without the 
check provided by the assured presence of distressed or closed 
schools in the sample, would lead to indicators that could not 
provide sufficient information for analysts to identify the point at 
which the risk of closure is so great that the Department would 
determine that the institution was not financially responsible. KPMG 
responded by constructing a judgmental sample that included 
institutions selected by reference to sector and financial history.
    A summary of this sample is as follows. KPMG selected a purely 
random sample of public institutions. For private non-profit 
institutions, KPMG selected a group of institutions that included 
large research institutions, large and small liberal arts schools, 
institutions with going concern statements on their most recently 
audited financial statements, and some other randomly selected 
institutions. KPMG also randomly selected a group of private non-
profit institutions that have adopted FASB statements 116 and 117. 
For proprietary institutions, KPMG selected institutions that passed 
and institutions that failed the standards set forth by the 
Accrediting Commission of Career Schools and Colleges of Technology. 
KPMG also selected proprietary institutions that were on the 
Department's list of institutions subject to surety requirements. 
KPMG then randomly selected some additional proprietary 
institutions. For the hospital sector, KPMG randomly selected a 
group of institutions.
    Accordingly, KPMG applied nine ratios--Viability, Primary 
Reserve, Net Income, Liquidity, Leverage, Debt Burden, Debt 
Coverage, Secondary Reserve, and Plant Equity--to the financial 
reports of the institutions in this sample.

Results: Ratios

    The first result was a confirmation of some of the reviewers' 
initial comments. Some respondents had expressed the belief that, 
for practical purposes, a total of nine ratios was excessive for an 
initial analysis. The process of applying the ratios to the 
financial reports confirmed that use of all nine ratios provided 
additional detail as to the source of financial problems, but added 
little value for purposes of differentiating clearly financially 
healthy institutions from the group of institutions whose financial 
health is uncertain. In light of the reviewers' comments and these 
results, KPMG reexamined the range and scope of ratios needed as an 
initial test of financial health, and determined that three--
Viability, Primary Reserve, and Net Income would be sufficient to 
identify institutions that are of immediate financial concern.
    KPMG conceptualizes these ratios as follows:
     Viability Ratio: the ability of the institution to 
liquidate debt from its expendable resources. If the ratio is 
greater than 1 to 1, existing debt could be repaid from expendable 
resources available today.
    In the short term, substantial amounts of expendable capital, as 
measured by the Viability Ratio (and Primary Reserve Ratio, as 
discussed below) can counter the effects of poor profitability, 
liquidity, or an inability to borrow. Likewise, insufficient 
expendable capital is a clear warning sign of poor financial health. 
While a ratio of 1:1 or greater indicates that an institution is 
clearly healthy, no absolute strength factor is likely to indicate 
whether an institution is no longer financially viable. Most debt 
relating to plant assets is long term and does not have to be paid 
off at once. Yet it is clear that the lower the institution's 
viability ratio is below 1:1, the more likely that an institution 
must live with no margin for error and meet severe cash flow needs 
by obtaining short-term loans. Ultimately, such a financial 
condition will impair the ability of an institution to fulfill its 
mission and meet its service obligations to students. An institution 
that is continually experiencing a perilous financial situation will 
usually find itself driven primarily by financial rather than 
programmatic decisions.
     Primary Reserve Ratio: measures the ability to support 
current operations from expendable resources.
    This ratio provides a snapshot of financial strength and 
flexibility by comparing expendable resources to total expenditures 
or expenses, or operating size. This snapshot indicates how long the 
institution could operate using its expendable reserves without 
relying on additional net assets generated by operations. A ratio of 
1:1 or greater would indicate that an institution could operate for 
one year without any additional revenue being generated. A ratio of 
.5 to 1 (reserves necessary to operate for 6 months) would probably 
give an institution the flexibility needed to transform itself by 
means of a capital expansion, or a change in mission. A negative or 
decreasing trend over time indicates a weakening financial 
condition.
     Net Income Ratio: measures the ability of an 
institution to live within its means in a given operating cycle.
    A positive Net Income Ratio indicates a surplus or profit for 
the year. Generally speaking, the larger the surplus or profit, the 
stronger the institution's financial position as a result of the 
year's operations. A negative ratio indicates a deficit or loss for 
the year. Small deficits may not be significant if the institution 
has large expendable capital. However, continued or large deficits 
or losses are usually a warning sign that major program or 
operational adjustments should be made. Because of its direct effect 
on viability, this ratio is one of the primary indicators of the 
underlying causes of a change in an institution's financial 
condition.

Strength Factors

    In assigning the strength factors (called ``threshold factors'' 
in the KPMG report) for each applicable ratio, KPMG posed the 
question: What is the minimum result for each ratio that would 
indicate acceptable financial health? The answer to that question 
established the lower end of the neutral or mid range for which a 
strength factor of three (3) would be assigned. For example, KPMG's 
experience with for private colleges and universities indicates that 
a Primary Reserve Ratio of less than .30 indicates a less than

[[Page 49573]]

healthy financial position. This conclusion is consistent with 
standard bond rating practices. Hence in order to receive a strength 
factor of (3) in its Primary Reserve Ratio, the result for a private 
college or university must be at least .30.
    To establish the upper strength factor of five (5), the risk 
associated with the Department's overall objective of separating 
financially responsible institutions from those that appear 
financially unhealthy had to be considered. Assigning the highest 
strength factor to a ratio correlates to a very good financial 
condition. The process of assessing that institution for financial 
responsibility may be shortened. If the financial condition of such 
an institution were to be subsequently affected, the Department and 
students could suffer unanticipated financial losses. Accordingly, 
the range for such a rating should be high enough to minimize that 
risk. The nature of each ratio and what it represents also had to be 
considered. A Primary Reserve Ratio result of 1.00 or more indicates 
that the institution can continue to operate at its present level 
for at least one year without any additional revenue. If analysis 
were limited to the Primary Reserve Ratio, one would have to 
conclude that such an institution is in a strong financial position.
    The minimum strength factors were established to clearly reflect 
financial problems. For example, a negative Net Income Ratio result 
for an institution demonstrates that during its fiscal year, the 
institution spent more than it received. Such activity will 
eventually create a financial problem. Accordingly, a negative Net 
Income ratio would be assigned a strength factor of one (1).
    The recommended strength factors described in the proposed 
Appendix F have been customized for each sector. A discussion of the 
strength factors for each ratio follows.
    Viability Ratio: (Expendable Net Assets  Long-Term Debt) 
Because a ratio of 1:1 or greater indicates that, as of the balance 
sheet date, an institution is clearly healthy because it has 
sufficient expendable resources to satisfy debt obligations, the 
lower end of middle category (3) is a 1:1 ratio. The lowest category 
(1) is established at .5:1 and below. The highest categories (4 and 
5) were established as greater than 2:1 and 4:1, respectively.
    The same strength factors will be used for all sectors except 
for private non-profit institutions that have adopted the new 
accounting standards FASB Statements 116 and 117. A comparison of 
data from private non-profit institutions under the fund accounting 
model and those under the FASB Statements 116 and 117 model indicate 
that these strength factors should be approximately 30%-50% higher, 
because under the FASB model realized and unrealized endowment gains 
are generally classified as expendable funds.
    Primary Reserve Ratio: (Expendable Net Assets  Total 
Expenses) This ratio measures financial strength by comparing 
expendable resources to operating size (total expenditures or 
expenses). It is reasonable to expect that in a healthy institution, 
expendable resources would increase at least in proportion to the 
rates of growth of operating size. If they do not, the same dollar 
amount of expendable resources will provide a smaller margin of 
protection against adversity as the institution grows.
    KPMG's experience and empirical testing indicate that a ratio of 
.3:1 or better indicates a financially healthy institution, and 
therefore the lower end of the middle strength factor of (3) is set 
as a ratio of .3:1. The lowest strength factor of (1) was 
established at .1:1 and below because having little more than one 
month or even negative expendable reserves indicates a financially 
risky institution. The strength factor (5) was established as 
greater than 1:1 because of the institution's ability to operate one 
year on existing reserves without an additional dollar of revenue.
    Because operating and institutional differences exist among the 
different sectors of participating institutions, strength factors 
were modified for some business segments. Under the GASB reporting 
model, certain related entities and assets are not required to be 
reflected in the general purpose financial statements. In addition, 
many states will not allow significant unrestricted expendable 
reserves to build up in public institutions. It was also noted that 
published bond rating averages for public institutions rated Aa and 
A were 30-50% lower than private institutions rated Aa and A. Based 
on these factors and input from industry task force members, the 
strength factors for public institutions categories (2) through (5) 
were lowered by approximately 30%. A strength factor of (1) for 
public institutions remains at .1:1 because certain minimum reserves 
are necessary and .1:1 would still indicate an institution that is 
financially at risk.
    With regard to proprietary institutions, owners of such 
institutions invest capital with the ultimate intent of returning 
that capital at a profit. Non-profit organizations, on the other 
hand, are generally precluded from distributing capital to 
contributors. It follows therefore that less capital will generally 
be left in proprietary institutions than in non-profit institutions. 
Therefore, the strength factor of (4) for this ratio has been 
lowered to .5 or greater, and strength factor (5) has been adjusted 
to .7 or greater. Furthermore, while a non-profit's Primary Reserve 
strength factor is automatically (1) if that result is less than 
zero, this adjustment is not made for proprietary institutions. The 
absence of this adjustment for the proprietary sector is in 
recognition of the fact that prudent business decisions may require 
an institution to have a negative capital balance for brief periods 
of time.
    The strength factor factors for private institutions adopting 
FASB Statements 116 and 117 have been increased by 66% over private 
institutions using the fund accounting model. The inclusion of 
realized and unrealized gains on investments held as endowments in 
unrestricted and temporarily restricted net assets for the FASB 
model should lead to higher strength factors than those used to 
evaluate institutions following the AICPA Audit Guide financial 
reporting model where such gains are treated as nonexpendable.
    Net Income Ratio: (Change in Unrestricted Net Assets  
Total Unrestricted Income) In the non-profit sectors (including 
public and private institutions and hospitals), this ratio measures 
whether institutions operate within their means. In the public 
sector, institutions are not necessarily encouraged to be 
``profitable'', and in fact legislation may prohibit them from 
operating at anything other than a break-even level. In the for-
profit sector, however, the capacity to generate operating funds 
through income is an important indicator of financial health.
    Private and public non-profit institutions which maintain 
operating margins of 3% of revenue are usually able to add to their 
expendable resources over time. Clearly, deficits over time will 
erode these same expendable resources. The lower end of the middle 
strength factor (3) is therefore 3%. The lowest strength factor (1) 
is established at zero and below, which indicates an operating 
deficit. The highest strength factor (5) was established at the 
level of greater than 5%.
    It should be noted that the Net Income Ratio for proprietaries 
measures pre-tax income, in comparison to total revenue. Therefore, 
the strength factors for proprietary institutions are increased by 
an estimated tax effect.

Weighting Percentages

    Weighting percentages for the calculation of overall scores are 
also contained in the proposed Appendix F.
    By applying different weighting percentages to each sector, 
certain ratios and the elements they measure receive greater 
importance than others. As with the ratios and strength factors, the 
weighting percentages are customized to accommodate structural and 
accounting differences found in each of the different sectors. Non-
profit institutions retain expendable resources, and a strong 
balance sheet generally correlates to strong financial health. For-
profit institutions, on the other hand, do not necessarily retain 
expendable funds in the institution. Accordingly, higher weighting 
percentages have been allocated to the Viability Ratios for non-
profit institutions, as compared with proprietary institutions. A 
more detailed explanation of weighting for each sector follows.
    Private and Public Non-Profits: For these institutions, balance 
sheet strength as evidenced by expendable fund balances or net 
assets correlates directly with a strong financial position. Tests 
using the sample group described above indicate that institutions 
with large expendable fund balances compared to operating size were 
among the strongest financially. There was a less direct correlation 
between the ability of an institution to operate within its means 
and financial strength based on a single-year snapshot. A review of 
rating agency medians by category also demonstrated a strong 
correlation between financial health and large expendable fund 
balances. The industry task force agreed that more emphasis should 
be placed on the Primary Reserve Ratio for this sector, as compared 
with the emphasis on the Net Income Ratio. It should be noted, 
however, that over time, profitability must be

[[Page 49574]]

maintained even for these institutions, so as not to adversely 
affect other ratios.
    Proprietaries: By their nature, proprietary institutions are 
expected to generate a return for their investors. This means both 
that a strong Net Income Ratio is important, and that one would 
expect that the Primary Reserve Ratio would be low as compared with 
non-proprietaries, since the investment return may not be retained 
within the business. While some amounts of expendable resources are 
necessary to fund ongoing operations, many different financing 
alternatives are available. Therefore, the Net Income Ratio is 
accorded the greatest weight for this sector.
    Hospitals: Independent hospitals fall into two categories--for 
profit and non-profit. While most hospitals do rely on 
profitability, many also have some endowments or other similar 
resources. The weightings provided in Appendix F reflect the 
situation of for-profit hospitals. Therefore the Net Income Ration 
for this sector is weighted less than for the proprietary sector, 
but weighted more than for private non-profit and public 
institutions. Additionally, since hospitals have significant 
physical capital relative to operating size and generally use debt 
to finance capital additions, the Viability Ratio receives greater 
weight than the Primary Reserve Ratio. Adjustments to the 
weightings, and financial strength factors for non-profit 
independent hospitals will be considered in the final regulations in 
response to comments on this issue.

Composite Scores and the Identification of Problematic Institutions

    The final step in the analysis of financial responsibility using 
these financial ratios is to add the weighted scores to derive a 
composite score. KPMG recommended dividing institutions into several 
categories denoting comparative levels of financial strength based 
on these composite scores. For these regulatory purposes, however, 
the relevant category is that which KPMG identified as representing 
an immediate financial risk. For all business sectors, this category 
is defined as those institutions that have a composite score of less 
than 1.75. This determination is based on the fact that the 
individual weighted scores are calibrated to measure relative 
financial responsibility. A composite score of less than 1.75 means 
that collectively, the individual ratio scores resulted in strength 
factors that together indicate a potentially weak financial 
position.
    This composite score takes into consideration many variables 
with particular emphasis on expendable capital and profitability. A 
score of less than 1.75 suggests that the overall financial 
circumstance of the institution is such that one or more of the 
measured elements is at or below the minimum strength factor value 
and neither remaining measure is higher than the median strength 
factor value. Generally, this implies that the institution is having 
difficulty maintaining a marginal position with respect to financial 
health and, by at least one measure, it is failing to perform at 
even a minimal acceptable level. Conversely, marginal institutions 
that achieve a strength factor value indicating superior performance 
in any one of the measured elements are likely to achieve a 
composite score of 1.75 or more despite overall marginal 
performance. This is based on an assumption that superior 
performance in any one of the measured elements will, over time, 
lead to improvements the other measured elements.
    The use of a composite score encompasses the total financial 
circumstances of the institution examined. Each of the three 
principle measures attempts to identify a fundamental strength or 
weakness related to the institution's overall fiscal health. In 
particular, each factor isolates a critical aspect of fiscal 
responsibility and measures that element against an established 
benchmark. It is important to note, however, that no single measure 
is used. Rather, the measures are blended into a composite score 
that explicitly recognizes the basic differences that exist among 
the several types of institutions. By taking these differences into 
consideration, the Secretary is better able to make a determination 
as to overall institutional fiscal health. The differences among the 
institutions examined are recognized explicitly through the 
weighting methodology.
    The use of a composite measure represents a departure from the 
Secretary's prior approach to measuring fiscal responsibility. 
Previously, the Secretary applied similar measures, but individual 
compliance thresholds for each element were measured exclusively 
from one another, and not in combination. Under the prior 
regulations, the Secretary implicitly recognized the relationship 
among variables and established compliance thresholds for each 
element separately. The proposed regulations are similar in that 
poor performance in any one element may lead to a finding of non-
compliance unless other measures are at least at the median 
performance level. What differs in relation to the previous 
regulations is the recognition that superior performance in one or 
more fundamental elements of financial health adds a dimension to 
any analysis of fiscal responsibility that warrants consideration. 
Thus, with one exception discussed below, strength in one area may 
be considered to the extent that it offsets weakness in another. The 
Secretary believes that this better takes into consideration the 
total financial circumstances of an institution.
    There is one proposed exception to the use of the composite 
score rather than individual ratios as the test of financial 
responsibility. Based on the KPMG study, the Secretary proposes that 
a public or private non-profit institution would not be considered 
financially responsible, despite its composite score, if it has a 
negative Primary Reserve Ratio. This adjustment is in recognition 
that a public or private non-profit institution that has a negative 
Primary Reserve Ratio is in such grave financial difficulty that 
even exemplary performance in other areas cannot cover for this 
deficiency.

[FR Doc. 96-24014 Filed 9-19-96; 8:45 am]
BILLING CODE 4000-01-P