Report of the

NAICU

Financial

Responsibility

Task Force

November 2012 

National Association of

Independent Colleges and

Universities 

Table of Contents

Letter from Task Force Chair Kent Chabotar 1

Executive Summary 5

Background 5

Summary of Recommendations and Findings 6

The NAICU Task Force on Financial Responsibility 11

Structure and Process 11

Members of the Task Force/Task Force Staff and Consultants 12

Recommendations and Findings 15

About the Research 27

Appendices

A. Definition of Composite Score Ratios A-1

B. Will Your Institution Pass the Financial-Responsibility Test? B-1

(AGB Trusteeship, July/August 2011)

C. Higher Education Act: Financial Responsibility Standards C-1

D. Department of Education Federal Student Aid Handbook, D-1

2012-13, pages 2-62 to 2-73

Supplemental Reading

A. 149 Nonprofit Colleges Fail Education Department's Test of Financial Supp. A-1

Strength (Chronicle of Higher Education, August 11, 2010)

B. Education Dept. Miscalculates 'Financial Responsibility' Scores, Private Supp. B-1

Colleges Say (Chronicle of Higher Education, September 7, 2011) 

Glossary Glossary 1

1

Dear Reader:

The process of ensuring students that the college they attend has the financial resources necessary to protect

against sudden closure, and that the institution has the funds required to deliver a quality education, is challenging

but essential work. 

This nation’s diverse array of higher education institutions is unparalleled in the world, and stands as one of the

crowning achievements of our pluralistic society. They range from major research universities to small beauty

schools; from public colleges to mission-specific institutions; from family businesses to publicly traded companies;

and of course, to the incredible diversity within just the nonprofit private sector. Their financing structures also

are varied, reflecting their primary purposes as charitable, profit-making, or public. As a result, this mix of missions

across higher education means that institutions operate under differing accounting rules for different sources of

revenue, in meeting their different financial goals. Trying to address this broad variance through a simple and

comparable accountability formula is not easy.

In accommodating these differences, the federal system of assessing financial stability has worked fairly well for

the past 20 years, since first being mandated under the 1992 Higher Education Act. In general, the system has

given students and taxpayers a reasonable measure of fiscal integrity at institutions, built upon professionally

accepted accounting principles. 

The economic downturn that began in late 2007, however, revealed the limitations of the existing system. In the

years that followed, an unusually large number of otherwise stable nonprofit institutions failed the ratios test that

is an integral part of the federal Financial Responsibility Standards (FRS). The findings often came as a surprise to

institutions’ chief financial officers and outside accountants whose own professional assessments didn’t indicate

institutions at risk of closure, nor ones where the quality of students’ education was suffering. The fallout from

these “false negatives” created further problems for the institutions. In addition to alarmist media reports, many

had to expend precious resources on such measures as costly letters of credit as part of an alternate FRS test,

when those funds would have been better used in helping families meet the financial pressures of the economic

downturn. 

After consultation with the U.S. Department of Education, the National Association of Independent Colleges and

Universities (NAICU) established a task force to examine the disparity between the federal formula results and

professional assessments of institutional stability. The following report summarizes the task force’s findings. We

offer these recommendations to both the Department of Education and Congress as possible avenues for

improving the federal system so that it better aligns with current professional accounting practices.

We owe a special debt of gratitude to the National Association of College and University and Business Officers

(NACUBO), the Council of Independent Colleges (CIC), and the several financial experts who lent their extensive

professional knowledge to this complex challenge. 

The public and the federal government alike must be assured that the institutions accepting federal student aid are

fiscally prudent and financially stable. Our hope is that these findings lead to an improved federal system for such

an assessment -- a system that ultimately will serve our nation’s students and taxpayers more efficiently and

effectively.

Sincerely, 

Kent Chabotar

Chair, NAICU Task Force on Financial Responsibility Standards

President, Guilford College

Member, NAICU Board of Directors

EXECUTIVE

SUMMARY

5

EXECUTIVE SUMMARY 

In November 2010, following the unexpected

failure of more than 100 nonprofit colleges on the

financial ratios test -- an integral part of federal

Financial Responsibility Standards -- the National

Association of Independent Colleges and

Universities (NAICU) Board of Directors

established a task force to review the process. The

task force met regularly throughout 2011 and

2012. Ultimately, it found the Department of

Education’s process in need of improvement, and

this report recommends several actions to

overcome the issues it identified.

The recent economic downturn exposed

significant shortcomings with the current

administration of the financial responsibility

ratios test. The negative consequences for

institutions with failing composite scores were

further exacerbated by the publication of the list

of failed institutions. Many colleges with failing

composite scores have had to obtain letters of

credit, which can be costly, draining precious

financial resources from their budgets. For

institutions that are not at risk of precipitous

closure, these resources could have been better

directed to helping the institutions and their

students cope with the economic recession. 

Nonprofit colleges and accounting experts for

nonprofit institutions expressed widespread

concern about the accuracy and appropriateness

of the financial responsibility test. However, the

Department indicated that it lacked the resources

to systematically study the problem. This led

NAICU to establish a task force of higher

education and accounting experts for nonprofit

institutions to examine the current system and

suggest possible areas of reform. 

Background

Section 498(c) of the Higher Education Act (HEA)

requires the Secretary of Education to determine

the financial responsibility of post-secondary

institutions, and was enacted following the

unannounced closures of several for-profit

institutions in the late 1980s that left students in

the lurch. The primary purpose of the law is to

guard against the precipitous, or sudden, closure

of post-secondary institutions. The statute

provides several ways for institutions to

demonstrate financial responsibility.

The current regulations implementing this section

of the law were developed in 1996-97 with broad

higher-education community collaboration. Since

that time, accounting standards have evolved, and

it is no longer clear that the current regulatory

process is meeting its intended goal.

The Department’s regulations provide the details

of the primary method for determining a

nonprofit institution’s financial responsibility,

which is to assess the value of three financial

ratios, then combine them into a composite score

that must reach a prescribed threshold. The ratios

were designed to take into account the total

financial resources of the institution. 

Financial responsibility is determined using

accounting principles appropriate for each of the

various sectors of higher education -- public, forprofit, and nonprofit. The ratios are calculated

from information in the audited financial

statements and the eZ-Audits institutions provide

to the Department at the end of an institution’s

fiscal year. Institutions with composite scores

below the threshold may alternatively establish

their financial responsibility through methods

such as obtaining a letter of credit. 
6

SUMMARY OF 

RECOMMENDATIONS AND FINDINGS

Recommendation 1: Ensure that the Department

conforms to the HEA statute, follows the current

financial responsibility regulations, and uses

standard accounting definitions when

determining nonprofit colleges’ financial

responsibility.

Related findings: 

A. The Department does not consistently follow

its own regulations for financial

responsibility. If the Department had

complied with its own rules, many of the

institutions that recently failed the federal test

would have achieved scores that were different

than those published, and in certain cases,

colleges that received failing scores would

have received passing scores. 

B. Despite the fact that the law indicates that

“generally accepted auditing standards” will

be followed, the Department has not updated

its definitions to reflect changes to accounting

standards as articulated by the Financial

Accounting Standards Board (FASB). There

are seven major items that are utilized in the

composite score calculations that the

Department often misinterprets, with a

significant negative effect on institutions’

composite scores.

C. Contrary to current regulations, the

Department has erroneously been classifying

losses reported in the income statement as

expenses. This includes losses on all

investments (endowment and other

investments), as well as other types of losses.

This was a significant factor in the failing

composite financial responsibility scores

received by many nonprofit institutions in

2010. 

Recommendation 2: If the Department continues

to treat endowment and other losses as expenses

for nonprofit institutions, then the primary

reserve ratio should be expanded to include all

net assets (unrestricted, temporarily restricted and

permanently restricted) of the institution in the

formula for expendable net assets.

Related findings: Such an adjustment

would make the nonprofit financial

responsibility formula comparable to that used

by for-profit institutions. Including

endowment net assets when evaluating the

current fiscal health of a nonprofit institution

is as justifiable as including owner equity for

proprietary schools.

Recommendation 3: Retain the alternative

methods for demonstrating financial

responsibility as currently defined in statute and

the regulations, even if other changes are made in

the calculation of financial responsibility

composite score.

Related finding: When a college receives a

failing composite score, the law provides

alternative paths for affirming its financial

responsibility, such as (1) submitting an

irrevocable letter of credit to the Department;

or (2) agreeing that the college’s operations,

including its administration of the federal

student aid programs, be monitored more

closely by the Department -- which includes

either receiving funds under the cash

monitoring or reimbursement payment

methods and additional reporting to the

Department. These options are important for

institutions, while also protecting the federal

fiscal interest in student aid funds.
7

Recommendation 4: The Department of

Education should establish a uniform appeals

process as part of the financial responsibility

procedures. This would assure institutions of the

opportunity to correct or update financial

information before their composite financial

responsibility scores are made final and released

to the public. 

Related finding: There are significant

differences in how the Department of

Education’s regional offices calculate financial

responsibility scores, and in the offices’

willingness to address individual colleges’

concerns about the accuracy of their

institutional scores.

Recommendation 5: The Secretary of Education

should fully implement the legal requirement,

under Section 498(c)(3)(C) of the Higher

Education Act, to step back and examine the “total

financial circumstances” of institutions that fail

the ratios test before assessing penalties. 

Related finding: A number of private higher

education institutions that have received

failing financial responsibility composite

scores were financially viable, and continued

to provide quality education for years

afterward. The Secretary should take into

account the “total financial circumstances” of

an institution before labeling it as failing, and

causing the institution to incur unnecessary

expenses or suffer adverse public relations .

Recommendation 6: Establish an advisory panel

of objective nonprofit accounting experts to

provide technical guidance to the Department.

Related findings: There is pervasive

misinterpretation by the Department of its

own regulations on financial responsibility

and of generally accepted accounting

principles (GAAP). Updating and training

staff, especially non-accountants, could

enhance and improve the financial

responsibility analysis of nonprofit colleges

without added expense for the Department.
8

How the Financial Responsibility Test Works

C The financial health of institutions is assessed based

on three ratios: primary reserve, equity, and net

income. An institution's raw scores are converted to

strength factors, weighted, and combined into a

composite score. 

C Composite scores range from -1.0 to +3.0. 

Institutions with scores of 1.5 or above “pass.” The

Department considers them financially responsible

without the need for further oversight. Institutions

below 1.5 “fail.”

C The Department does not permit those below 1.0 to

continue participation in Title IV programs without

providing additional surety, e.g., a letter of credit that

guarantees at least 50% of its Title IV funding or 10%

combined with additional constraints imposed under

provisional certification.

C Institutions with composite scores between 1.0 and

1.4 are allowed to participate in Title IV under a "zone

alternative," under which they are subject to special

disbursement requirements and enhanced

monitoring. 

C Public institutions are not evaluated using the ratio

methodology. A public institution is considered

financially responsible if it submits a letter from an

official of a state or other government entity

confirming that the institution is public.

Even if a college or university passes the test with a

composite score of 1.5 or above, the Department has

other standards that institutions must meet. They must

have sufficient cash reserves to make refunds and

repayments of Title IV funds. They must be current in

paying debt service. They must not have a statement by

the auditor in its audited financial statements expressing

doubt about the survival of the institution as a “going

concern” or, unless the Department grants an exception,

anything other than an unqualified opinion that the

audited statement is presented in accordance with

generally accepted accounting principles.
THE NAICU

TASK FORCE ON

FINANCIAL

RESPONSIBILITY

11

THE NAICU TASK FORCE 

ON FINANCIAL RESPONSIBILITY

The NAICU financial responsibility task force met

regularly throughout 2011 and 2012. It analyzed

the current law and regulations, compared the

Department determinations of financial

responsibility with the results obtained when

using current accounting standards consistently,

and developed a set of recommendations based

on the findings of its work.

Structure and Process

In November 2010, the NAICU Board of Directors

established a task force to review the federal

government’s system for determining the

financial responsibility of nonprofit colleges. 

Financial responsibility is an institutional

requirement for participation in the Title IV

federal student aid programs. The task force was

composed of NAICU members and staff,

independent accountants, campus financial

experts, as well as staff from the National

Association of College and University Business

Officers (NACUBO) and the Council of

Independent Colleges (CIC). The chair of the task

force was Kent Chabotar, president of Guilford

College, who is an expert in the field and a

member of the NAICU Board. Additional experts

were consulted for assistance, especially in

modeling exercises. 

Following initial discussions of the various issues

in the financial responsibility formula and

Department procedures, the chair formed three

working groups to assemble and analyze

information on identified problem areas and to

test alternatives to existing formulas. The three

working groups and their purposes were:

1) Inconsistent Application of the

Regulations, to review the varying

accounting and oversight practices among

the regional offices of the Department of

Education.

2) Accounting Inaccuracies and

Misinterpretations, to review the

Department’s use of standard nonprofit

accounting rules and definitions.

3) Financial Analysis, to model and test

alternative financial responsibility

formulas less susceptible to external

economic factors that might yield more

accurate results.

In addition, ad hoc subgroups were established as

specific questions arose. For example, one

subgroup researched the correlation between

failing scores and precipitous school closure, and

another looked at the possibility of adding an

appeals process for reviewing financial

responsibility scores before they are published. 

The working and ad hoc subgroup areas of

investigation and their results are provided in

more detail in the About Research section (see page

21). 
12

Members of the Task Force

Kent John Chabotar, President and Professor of

Political Science, Guilford College, Chair

Karen Angell, Partner, Baker Tilly Virchow Krause,

LLP

Susanna Baxter, President, Georgia Independent

College Association, Inc.

James F. Galbally, Jr., President, The Galbally Group

Anne Gross, Vice President, Regulatory Affairs,

National Association of College and University

Business Officers

Harold V. Hartley III, Senior Vice President, Council

of Independent Colleges

Susan Menditto, Director, Accounting Policy,

National Association of College and University

Business Officers

David Mowen, Senior Vice President for Business

and Finance, Mary Baldwin College

John Palmucci, Vice President for Finance and

Treasurer, Emeritus, Loyola University of Maryland

Gary Steinke, President, Iowa Association of

Independent Colleges and Universities

Task Force Staff

Maureen Budetti, Director of Student Aid Policy,

NAICU

Sarah Flanagan, Vice President for Government

Relations and Policy Development, NAICU

Additional Consultants

Ron Saluzzo, Partner, Higher Education and

Academic Medical Centers, Attain LLC

Nick Wallace, Partner, CapinCrouse LLP

Mike Williams, President, The Austen Group

Principal Authors and Contributors to the Final

Report

Kent Chabotar, Task Force Chair; Karen Angell;

Maureen Budetti; Sarah Flanagan; Anne Gross;

Harold Hartley; Roland King, Vice President for

Public Affairs, NAICU; Sue Menditto; and Tony

Pals, Director of Communications, NAICU.
RECOMMENDATIONS

AND FINDINGS

15

RECOMMENDATIONS AND FINDINGS

The task force considered a number of issues,

including the lack of consistency in the

Department’s application of regulations, changes

to financial accounting standards, the lack of a

uniform appeals process, and equitability in the

methodology for calculating scores. The task

force also reviewed a variety of formulas for

assessing financial responsibility that would

reliably provide more accurate scores for

nonprofit institutions than the current

methodology (see box, page 8). The task force

understood that any formula for financial

responsibility scores must provide a true and

reliable picture of nonprofit colleges’ financial

strength -- to protect students, federal student aid

funds, and institutions from inaccurate or unfair

assessments that could waste their resources or

threaten their existence. 

The following six recommendations emerged

from that effort.

Recommendation # 1: 

Ensure that the Department conforms to the HEA

statute, follows the current financial

responsibility regulations, and uses standard

accounting definitions when determining

nonprofit colleges’ financial responsibility. 

Issue A: The Department does not

consistently follow its own regulations

for financial responsibility. 

Discussion: Through its analysis, the task

force has found that if the Department had

complied with its own rules, many

institutions’ scores would have been

different than their published score, and

certain institutions that recently failed the

federal test would have passed. 

The financial responsibility regulations

establish a process for determining the

financial stability of an institution that was

intentionally designed to be simple and

efficient. The standardized method calls

for institutions to provide financial data to

the Department through submission of

audited financial statements and

completion of an online eZ-Audit

template that pulls out relevant data

elements. 

This process was intended to enable the

Department to use the information, as

audited by independent accountants in

accordance with professional standards, to

calculate the various financial

responsibility ratios. Unfortunately, the

Department has not always followed this

process. At times, its analysts have

adjusted or defined certain key financial

elements from the financial statements in

ways that are at variance with generally

accepted accounting standards.

 S P O T L I G H T

A 200-year-old private liberal arts college, which has received

passing financial responsibility composite scores since the current

regulation took effect in the late 1990s, was surprised to learn it

had received a failing score from the Department of Education in FY

2011. It was even more surprised when the Department

retroactively changed the college's FY 2010 score from passing score

to failing. Its independent auditor's calculation, using the

Department's own formula, showed the college receiving passing

scores in both cases. 

The problem resulted from the Department analyst's interpretation

of the "spendability" of the college's temporarily restricted net

assets. In 2009, FASB had made a change in its guidance on

classification of spendable endowment funds. While the

classification of such funds had been changed (from "unrestricted

net assets" to "temporarily restricted net assets"), the assets still

could be spent by the college upon the decision of the board - that

did not change. 

The definition of "expendable net assets" in the Department's

regulation explicitly includes temporarily restricted net assets. With

an endowment of $77.9 million in FY 2011, and an operating budget

of only $25 million, the college was not in financial trouble, but had

to spend $56,000 on a letter of credit.
16

In general, these adjustments fail to reflect

the differences between nonprofit and forprofit accounting procedures. Although

the regulations contain clear and distinct

definitions and financial responsibility

formulas for the two sectors, Department

analysts sometimes inappropriately apply

for-profit definitions in the calculations of

the primary reserve and net income ratios

for nonprofits. 

There are four areas where this problem is

most often manifested. 

1. Endowments (which don’t exist at

for-profits) and related

gains/losses on endowment

investments

2. Plant infrastructure and related

long-term liabilities

3. Pledges (contributions receivable)

to the institution

4. Retirement plans (pensions and

health care)

Impact: The kinds of accounting errors in

the calculations that were noted by the

task force have a significant negative

effect on the composite scores of many

institutions. Correcting these financial

adjustments and misclassifications can

raise a failing score to a passing one, or

vice versa. The task force identified seven

components that the Department often

misapplied in its calculations of financial

responsibility scores. (See matrix, page

18.) Each of these has been shown to be

problematic. 

Issue B: The Department’s accounting

practices do not consistently conform to

GAAP.

Discussion: According to their

professional code, certified public

accountants must adhere to a set of

specific principles when reviewing and

providing opinions on financial

statements or other financial data for

federal financial reporting. GAAP is

compiled and kept current by FASB. The

task force has found that changes in

GAAP since 1997 are being overlooked or

misinterpreted by the Department, to the

detriment of nonprofit institutions. (See

matrix, page 18.)

Impact: The Department’s nonconformity

with GAAP has resulted in some

nonprofit schools receiving failing, or

inaccurate, scores when they otherwise

would have passed.

Issue C: Of particular note, in

determining the financial responsibility of

nonprofit institutions, the Department

often treats decreases in endowment

investments, as well as other losses, as

expenses. 

Discussion: The Department’s failure to

follow GAAP when it classifies

endowment losses as expenses (money

spent for the day-to-day operations of the

institution) has perhaps the most

significant negative impact on an

institution’s financial responsibility score

of any of the misapplied accounting

elements in the financial responsibility

formula. 
17

The Department’s treatment is not in

conformity with accounting practices for

nonprofit institutions, nor is it in

conformity with the Department’s own

nonprofit financial responsibility formula

and regulations. Under the definitions in

the financial responsibility regulations,

and also under GAAP, such losses are not

considered expenses. 

It is incorrect to consider endowment

losses in the denominator of the primary

reserve ratio. Just as with a decrease in

the value of an individual’s retirement

funds, the loss is not immediate and

doesn’t affect the ability to cover current

expenses. 

Impact: The task force identified more

than a half-dozen areas in which the

Department is not in conformity with

GAAP standards. (See matrix, page 18.)

This particular misapplication warrants

added attention since it is the largest

identifiable contributor to failing 

composite scores -- particularly in the

period following the market decline that

began in 2008. 

GAAP

The term generally accepted accounting principles (GAAP) has a

specific meaning for accountants and auditors. The American

Institute of Certified Public Accountants (AICPA) Code of

Professional Conduct prohibits members from expressing an

opinion or stating affirmatively that financial statements or other

financial data "present fairly...in conformity with generally

accepted accounting principles," if such information contains any

material departures from GAAP. 

Since 1973, the Financial Accounting Standards Board (FASB) has

been the designated organization in the private sector for

establishing standards of financial accounting that govern the

preparation of financial reports by nongovernmental entities. The

Financial Accounting Foundation is the independent, private

sector organization that is responsible for the oversight,

administration, and finances of the FASB, the GASB, and their

advisory councils FASAC and GASAC. The Foundation's primary

duties include protecting the independence and integrity of the

standards-setting process and appointing members of the FASB,

GASB, FASAC, and GASAC. In 1973, the Foundation established

the Financial Accounting Standards Board (FASB) to establish and

improve standards of financial accounting and reporting for

nongovernmental entities. Consistent with that mission, the FASB

maintains the FASB Accounting Standards CodificationTM

(Accounting Standards Codification) which represents the source

of authoritative standards of accounting and reporting, other than

those issued by the SEC, recognized by the FASB to be applied by

nongovernmental entities. 

(From FASB website)

The American Institute of Certified Public Accountants, founded in

1887, is the world's largest association representing the

accounting profession, with nearly 386,000 members in 128

countries. AICPA members represent many areas of practice,

including business and industry, public practice, government, and

education, and offers specialty credentials for CPAs who

concentrate on personal financial planning; fraud and forensics;

business valuation; and information technology. Through a joint

venture with the Chartered Institute of Management Accountants

(CIMA), it has established Chartered Global Management

Accountant (CGMA) designation to elevate management

accounting globally. The AICPA sets ethical standards for the

profession and U.S. auditing standards for audits of private

companies, non-profit organizations and federal, state and local

governments. It develops and grades the Uniform CPA

Examination.

(From AICPA website)
18

Misused Ratio Components that Negatively Impact

 Nonprofit Institutions

Except where noted, each of the items below is:

· Highly significant to the overall score

· Not compliant with current regulations

· Not compliant with GAAP

· Not applied consistently

Ratio Component

Location in the Audited

Financial Statements

Department 

of Education

Interpretation Result

1. Total expenses Nonprofit institutions,

defined as “total unrestricted

expenses” taken directly

from the statement of

activities.

Uses the definition for

proprietary institutions

(which includes expenses and

losses). 

Decreases the primary

reserve ratio

2. Long-term debt From the statement of

financial position (balance

sheet) or found in the notes

to the financial statements.

Excludes long-term lines of

credit, working capital loans

or certain other debt (which

mature in more than one

year), and other facilitiesrelated liabilities identified

by FASB since 1997. 

Decreases the primary

reserve ratio

3. Total unrestricted

revenue

Taken directly from the

statement of activities, and

includes net assets released

from restrictions during the

fiscal year.

Includes gains with revenue. 

Also occasionally nets losses

(investments, swaps,

actuarial losses) against

revenue.

Increases or decreases the

primary reserve ratio

4. Post-employment and

retirement benefits

From the statement of

financial position (balance

sheet) or found in the notes

to the financial statements. In

some cases, it may need to be

obtained from the institution.

Excludes the liability for

pension benefits.

Decreases the primary

reserve ratio

5. Unsecured related party

receivables (pledges

receivable for nonprofit

entities)

In the notes to the financial

statements. In some cases, it

may need to be obtained

from the institution.

Does not allow the pledge

receivable exclusion granted

to nonprofits in the preamble

to the 11/25/97 rule. Thus,

considers pledges from board

members to be unsecured

related party receivables.

Decreases the equity ratio

and the primary reserve ratio

Note: This is not a GAAP

issue.

6. Annuities, term

endowments, and life

income funds included in

temporarily restricted net

assets

In the notes to the financial

statements. In some cases, it

may need to be obtained

from the institution.

Assumes all endowment net

assets included in

temporarily restricted net

assets are term endowments

(including accumulated gains

on endowments). 

Decreases the primary

reserve ratio

7. Net property, plant and

equipment (PPE)

From the statement of

financial position (balance

sheet). Construction in

progress (CIP) is found on

the statement of position or

in the notes to the financial

statements or obtained from

the institution.

Subtracts CIP from total net

PPE. Does not consider CIP

to be part of PPE until the

asset is placed in service.

Increases the primary reserve

ratio
19

Uniform Prudent Management 

of Institutional Funds Act

Over the past decade, all states except Pennsylvania and

Puerto Rico have adopted a major update of the Uniform

Management of Institutional Funds Act (UMIFA) of 1972,

which governs the expenditure and investment practices

of charitable institutions. The recent amendments are

referred to as UPMIFA (Uniform Prudent Management of

Institutional Funds Act) and bring the law governing the

financing of nonprofit institutions more in line with

modern investment and expenditure practices. 

Perhaps the most significant change, for purposes of the

Department of Education's financial responsibility

standards, is that UPMIFA provides institutions of higher

education greater flexibility in using restricted endowment

funds, thus making it even more compelling for the

Department to consider the value of these funds when

considering the overall financial viability of a nonprofit

institution.

Recommendation # 2: 

If the Department continues to treat endowment

and other losses as expenses for nonprofit

institutions, then the primary reserve ratio

should be expanded to include all net assets

(unrestricted, temporarily restricted and

permanently restricted) of the institution in the

formula for expendable net assets. 

Issue: The Department often classifies decreases

in college endowments (realized and unrealized

losses) as a component of total expenses -- in lay

terms, an institution’s “operating expenses” -- in

the calculation of the nonprofit primary reserve

ratio. 

Discussion: If Recommendation #1 is not

adopted, and the Department persists in counting

an institution’s endowment declines as a

component of total expenses, then the institution

should also be able to count the value of its

endowment (across all net asset classes) in the

formula for calculating the primary reserve ratio. 

If the Department includes endowment losses in

the denominator of the primary reserve ratio, then

logically all equity (net assets) generating such

losses -- including the donor-restricted

endowment -- should be included in the

numerator of the ratio. Supporting the rationale

for such consideration of endowments are recent

changes to the state laws governing endowment

funds. Under the Uniform Prudent Management

of Institutional Funds Act, which has been

adopted by a majority of the states (see box, right),

institutions are allowed more flexibility over

spending related to the donor-restricted

endowment funds, since the requirement to

maintain historic gift value was removed from the

law. 

Such an adjustment to the ratios would make the

nonprofit financial responsibility formula

comparable to that used by for-profit institutions,

which allows adjusted equity to be used to

calculate the primary reserve ratio. For nonprofit

institutions, endowment principal would be

included because it is as justifiable a source to

cover the expenses and obligations of nonprofit

institutions, as owner net assets (adjusted equity)

are for proprietary schools. 

Impact: The incorrect interpretation of nonprofit

colleges’ income statements, particularly adjusting

“total expenses” to include endowment losses,

creates an imbalance between the numerator and

the denominator of the primary reserve ratio, and

produces false-negative results for nonprofit

colleges, with a significant negative impact on the

financial responsibility scores of many

institutions. As such, it has resulted in an

increased number of institutions failing the

financial responsibility test after the precipitous

market decline of 2008. 
20

"The composite financial score is one measure of a

school's financial responsibility and is meant to gauge a

school's ability to meet its financial obligations. The

composite financial score is not a reflection of the quality

of education at a given school. If a school does not

achieve a passing financial composite score, it does not

mean that the school is in danger of closing. 

"The Department may still consider the school to be in

compliance with the standards of financial responsibility if

the school agrees to additional reporting, financial aid

monitoring or administrative oversight requirements

and/or agrees to take steps that mitigate the risk that the

school may not be able to meet its financial obligations,

such as posting a letter of credit to insure the financial

obligations of the school.... "

The U.S. Department of Education to the 

Hartford Courant, August 23, 2010

Recommendation # 3: 

Retain the alternative methods for demonstrating

financial responsibility as currently defined in

statute and the regulations, even if other changes

are made in the calculation of financial

responsibility composite score. 

Issue: Alternative routes to demonstrate financial

responsibility have provided important flexibility

and stability for schools.

Discussion: When an institution receives a failing

financial responsibility score, or otherwise fails to

meet a standard of financial responsibility, the law

provides alternative paths which, depending upon

the circumstances, enable an institution to affirm

financial responsibility. One “fall back”

alternative allows a failing institution to submit an

irrevocable letter of credit to the Department. The

letter of credit must be for an amount not less than

one-half of the Title IV funds received by the

institution in the most recently completed fiscal

year, in order for the institution to be considered

financially responsible. (A letter of credit

functions like an insurance policy with a bank,

covering the federal funds if the school actually

closes.) 

Institutions with scores under the 1.5 threshold for

passage but equal to at least 1.0 -- or “in the zone”

-- may be considered financially responsible for

the next three years if they continue to maintain a

score within that range (1.0-1.4), and if the college

meets specific monitoring requirements. They

must agree to operate under the Department’s

cash monitoring or reimbursement payment

methods, and to provide timely information on

such items as adverse actions by the institution’s

accrediting agency, certain negative financial

events, and extraordinary losses. 

Alternatively, some institutions deemed not

financially responsible may be provisionally

certified by providing a letter of credit that

protects from 10 to 100 percent of the Title IV

funds received by the institution in the most

recently completed fiscal year. They also must

comply with the provisions of financial

responsibility for schools that are “in the zone,” as

noted above. With additional monitoring, the

Department can track financial changes more

closely. 

Impact: These alternatives represent an important

set of options for institutions in responding to their

specific situations -- enabling the institutions to

improve their financial condition over time, while

protecting the federal fiscal interest in their

student aid funds. 

In the recent economic downturn, many colleges

used one of the alternative methods to establish

their financial responsibility. The Department

has made it clear that such an institution is

financially responsible (see box, below). However,

institutions that met the alternative requirements

for demonstrating financial responsibility were

still listed as having failing scores.
21

Recommendation # 4: 

The Department of Education should establish a

uniform appeals process as part of the financial

responsibility procedures. This would assure

institutions of the opportunity to correct or

update financial information before their

composite financial responsibility scores are

made final and released to the public.

Issue: Colleges have no consistent way to appeal

inaccurate assessments, to update financial

information, or to find out how the Department

arrived at its score for the institution. 

Discussion: There is no official appeal process for

contesting or correcting a financial responsibility

score, nor do institutions consistently receive a

draft score for review before the Department

finalizes and releases the score. In other areas of

regulation, procedures exist for such review. For

example, several months prior to publication of

the final cohort default rate (CDR) for Stafford

Student Loans, institutions receive a draft CDR

rate. 

Task force members reviewed the Department’s

calculations of numerous nonprofit colleges’

composite scores and compared them to the

institutions’ financial statements and notes. This

examination revealed errors, inappropriate

inclusion of financial data in the ratios, and

improper application of for-profit accounting

standards in the calculation of the nonprofit

institutions’ scores. In addition, the independent

review revealed significant inconsistencies in the

interpretation of the regulations by Department

analysts, and in the willingness of the regional

offices and Department headquarters to address

inaccuracies in calculating the scores.

The task force working group on this issue

developed a list of accounting items in which the

differing interpretations of the regions and

headquarters could affect an institution’s financial

responsibility score (see box, page 24). These

inconsistencies included, among other items, the

way in which losses on investments and interest

rate swaps, maturities of long-term debt,

retirement obligations, and lines of credit were

factored into the financial responsibility

calculations. 

Department analysts often appear to be seeking

information that is not part of the official financial

statements or the eZ-Audit submission template. 

Department reviewers have sometimes

extrapolated beyond the financial statement

elements. Unfortunately, these interpretations

frequently are not consistent with definitions

either in the regulations or generally accepted

accounting principles (GAAP). (See matrix, page

18.) 

Impact: Incorrect or inconsistent interpretation of

an institution‘s financial data can determine if a

college passes or fails the financial responsibility

test. The Department may, on a case-by-case basis,

informally review and -- depending on the

evidence -- make changes to a financial

responsibility score; however, the practice varies

from region to region. Publishing inaccurate

scores can unfairly harm the financial viability of

an institution, and syphon off resources from

students. 

An alternative to establishing an appeals process

through administrative action would be to amend

the statute to provide for such a process. Since

financial responsibility scores are lagging

indicators of an institution’s financial situation, it

might also be possible to design a method for

updating scores when an institution’s financial

situation improves prior to publication of the next

year’s financial responsibility score. The task force

has developed suggested language for the

structure of an appeals process (see box, next page).
22

Appeals Process 

Possible Statutory Language

The Secretary shall:

(1) Provide annually to each institution subject

to the requirements of 498(c) a notification

of its preliminary score under such section;

(2) Provide to each institution, a description of

the method used and complete copies of all

the calculations performed to determine the

institution's score, provided such institution

makes the request within 45 days of

receiving the notice under (1);

(3) Within 45 days of each institution receiving

information under (2),

(A) Permit the institution to correct or cure

an administrative, accounting, or

recordkeeping error if the error is not

part of a pattern of error and there is no

evidence of fraud or misconduct related

to the error;

(B) Make corrections to the Secretary's

calculation if the institution

demonstrates that the Secretary has

made errors in its determination of the

initial score or has used non-standard

accounting practices in reaching its

determination;

(C) Take into consideration any subsequent

change in the institution's overall fiscal

health, the consideration of which,

would raise the institution's score;

(4) Maintain and preserve at all times the

confidentiality of any review until such score

is determined to be final; and

(5) Ensure that such scores are developed in

accordance with accepted principles of

accounting.
23

Recommendation # 5 : 

The Secretary of Education should fully

implement the legal requirement, under Section

498(c)(3)(C) of the Higher Education Act (HEA),

to step back and examine the “total financial

circumstances” of institutions that fail the ratios

test before assessing penalties.

Issue: Private institutions that do not pass the

ratios test have no alternative to prove their

financial responsibility that does not impose

significant costs.

Discussion: HEA Section 498(c)(3) (see Appendix

C), provides four alternatives to the ratios test for

institutions to establish financial responsibility. 

Three of these alternatives have been fully

implemented, but not the fourth, which would

offer a less expensive alternative than third-party

guarantees or reimbursement for institutions to

establish that they are financially sound. This

option, establishing that the institution will not

precipitously close and can meet all its financial

obligations, should be fully implemented. 

Section 498 (c) (3) The Secretary shall determine

an institution to be financially responsible,

notwithstanding the institution’s failure to meet

the (ratios test) . . . if — (C) such institution

established to the satisfaction of the Secretary, with

the support of a financial statement audited by an

independent certified public accountant in

accordance with general accepted auditing

standards, that the institution has sufficient

resources to ensure against the precipitous closure

of the institution, including the ability to meet all

of its financial obligations (including refunds of

institutional charges and repayments to the

Secretary for liabilities and debts incurred in

programs administered by the Secretary) . . . 

Impact: This would provide consistency across

higher education sectors under the law, in that the

alternative for public institutions (of having the

institution’s liabilities backed by the full faith and

credit of the state) has been implemented. 

 S P O T L I G H T

A liberal arts college had received top financial responsibility

composite scores prior to the current recession. Like most colleges,

it saw a decline in its endowment as a result of the market collapse.

Despite the loss, the college calculated that it would still receive a

passing score of 1.5. It didn't. 

The Department gave the college a failing score, resulting in the

college's having to buy an expensive letter of credit. The failing

score resulted from several improper calculations of the college's

composite score by the Department. 

C It doubled the negative impact of the endowment loss by adding

it to "total expenses" in the denominator of the primary reserve

ratio, while at the same time legitimately decreasing the

"expendable net assets" by the loss amount in the numerator.

C It further skewed the primary reserve ratio negatively by

improperly classifying a long-term debt as a current debt,

because the loans in question were "due on demand" if the

college violated provisions of the loan agreement. GAAP

classifies this type of debt as "noncurrent debt." 

C It also excluded a very sizeable pledge from a trustee, saying it

was a "related party receivable," from the college's "expendable

net assets" -- the numerator in the primary reserve ratio, despite

the fact that a trustee is not a related party according to

accounting rules.
24

Recommendation # 6: 

Establish an advisory panel of objective

nonprofit accounting experts to provide technical

guidance to the Department.

Issue: The Department would benefit from a

panel of independent, nonprofit accounting

experts. 

Discussion: There has been longstanding

disagreement between the Department’s staff and

outside accounting experts on the interpretation of

the financial responsibility regulations and

provisions in GAAP, as well as Departmental

disagreement with institutions over the

interpretation of their financial statements. Given

this divergence of views, it might be useful to

convene a body of accounting experts for

nonprofit institutions to provide technical

guidance to the Department in this area. 

Such a group could review the Department’s

current methodology, make recommendations,

and assist with incorporating future changes in

accounting standards. The Department uses

advisors in various aspects of its work – from

technical review panels, to negotiated rulemaking. Such outside assistance might be useful

in this area as well.

Impact: An outside body of experts could assist

the Department, at little or no cost to the

Administration, in updating its practices and

improving staff training. Consistent practices and

a consistent knowledge base across the regions

would prevent the regional inconsistencies noted

in the table below.

Regionally Inconsistent

Accounting Elements

1. Construction-in-progress (CIP) excluded from

property, plant, and equipment (PPE). 

2. Losses on investments and interest rate

swaps included in expenses. 

3. Institutional share of the Perkins loan fund

moved from unrestricted net assets (URNA).

to permanently restricted net assets (PRNA)

by the Department of Education.

4. Contributions receivable from board

members were considered unsecured related

party receivables. 

5. Lines of credit – due before the end of the

next fiscal year (short-term) were classified

as long-term debt and lines of credit due in

the next fiscal year (i.e., long term) were

excluded from long-term credit.

6. Current maturities of long-term debt were

not included as part of long-term debt.

7. Defined benefit plan liabilities were excluded

from "post-retirement benefit plan liabilities"

for calculating expendable net assets. 

8. All amounts shown in brackets on the

Statement of Activities (SOA) were included

in expenses.
ABOUT THE

RESEARCH

27

ABOUT THE RESEARCH

The task force explored a number of ways to

address the concerns of financially viable

institutions that received failing composite scores. 

These included testing alternative methods that

might be used to categorize or calculate financial

responsibility for nonprofits, an analysis of the

accuracy of the current composite score

methodology in predicting precipitous closure of

institutions, and a review of specific problems

associated with the application of the current

formula to individual institutions. In conducting

their work, task force subcommittees analyzed

various institutions’ financial information.

Examinations consisted of reviewing audited

financial statements, eZ audit submissions,

appeals to the Department of Education on

financial responsibility composite scores, and

applying alternative ratio formulas. The

information was derived from a variety of sources

including data voluntarily submitted to task force

members and their organizations, and various

publicly available databases. Additional

background on the task force’s data sources and

research efforts are described below. 

Data Sources

1. Institutions with Low Composite Scores

NAICU invited member institutions that had

financial responsibility scores below 1.5, as

reported on the Department’s FY 2010 published

list, to submit their audited financial statements

and eZ-Audit information for fiscal years 2009

through 2011 to NACUBO, in order for the task

force to perform a more detailed analysis of their

scores. In all, 21 private, nonprofit institutions

accepted the invitation and submitted their

financial information. 

2. The Council of Independent Colleges

Database

The Council of Independent Colleges (CIC) has a

database of FY 2007, 2008, and 2009 financial data

on more than 800 nonprofit baccalaureate and

master’s level private colleges. The data were

collected from two public sources: the U.S.

Department of Education’s Integrated

Postsecondary Data System (IPEDS) and Internal

Revenue Service Form 990s obtained from

GuideStar. CIC member institutions verify their

data prior to CIC analysis. CIC produces an

annual financial benchmarking report for its

members that utilizes KPMG’s Composite

Financial Index (CFI) as a tool that compares

multiple indicators to help its member institutions

assess their fiscal strength. As part of the

benchmarking tool, CIC encourages institutions to

compare their CFI scores with the Financial

Responsibility Test scores, noting the similarities

and differences between the two scores. The CIC

data set enabled the task force to model alternative

formulas to the existing financial responsibility

method.

3. Private Higher Education Database

One task force member who works with over 150

higher education institutions located throughout

the country had access to a financial database for

those institutions. The database included the

calculation of the three financial ratios from which

the composite scores are derived, for institutions

ranging from ones that would be considered

financially stable, to ones that were dealing with

significant financial challenges. As a result, it

provided a good mix of nonprofit institutions. 

The task force believed this database was a

particularly useful tool in analyzing the

Department’s inconsistent application of the

formulas, and its inconsistent adherence to

generally accepted accounting standards.
28

Assessments Conducted

1. Examination of 21 Institutions with Low

Composite Scores

The financial information for each of the 21

participating NAICU institutions was entered into a

database, and was assessed using three steps:

A. Determined if the Department (a) followed

the formulas as defined in the financial

responsibility regulations; (b) consistently

applied the formulas defined in the

financial responsibility regulations; and (c)

followed generally accepted accounting

principles (GAAP) and accounting

definitions when performing the

calculations.

This was done to illustrate how the

inconsistent application of the formulas,

combined with inaccurate interpretations

of nonprofit accounting definitions, caused

variances in the composite score results

published by the Department.

B. Re-calculated the composite score by

following the formula for nonprofit

colleges as defined in the Department’s

regulations.

This was done to illustrate how the use of

the correct nonprofit accounting definitions

in the regulation affects the composite

score. In our study of more than 20

nonprofit institutions, none of them passed

the test even when correct definitions were

used. Upon further analysis, this made

sense because, for the most part, these

institutions did not have large endowments

so were not impacted as much by

investment market losses as wealthier

institutions. 

Beyond this test sample, the task force

more importantly looked at certain

otherwise financially healthy institutions

that nonetheless had fallen below a score

of 1.5, based on the Department’s

calculation, but passed when the

definitions for nonprofit institutions in the

regulation were correctly applied. In

addition, based on a review of the

available databases, the task force found

that, if the formulas were applied correctly

and in accordance with GAAP, a number

of institutions’ actual composite scores

would differ from their published scores. 

C. Applied an alternative formula for the

primary reserve ratio that parallels the

method used with for-profit institutions. 

This was suggested by the task force to

level the playing field among nonprofit

and for-profit institutions. The

Department has consistently applied a

portion of the for-profit definition to

nonprofits when calculating the primary

reserve ratio. In the for-profit sector, the

primary reserve ratio includes expenses

and losses in the denominator and total

equity in the numerator. For nonprofits,

the primary reserve ratio is defined as

expendable net assets divided by total

expenses. The Department has often

incorrectly added losses to expenses in the

denominator. However, the Department

does not use a calculation comparable to

total equity (i.e., total net assets including

permanently restricted net assets) in the

numerator for nonprofit institutions. This

creates a significant difference between

the nonprofit sector and the for-profit

sector in the calculation of the scores. By

allowing all net asset classes to be

considered expendable, the for-profit

definition is applied in both the numerator

and denominator of the primary reserve

ratio; this compensates for the

Department’s insistence that losses must

be added to expenses. 
29

Another rationale for including all net asset

classes, or total equity, as expendable in the

nonprofit formula is that a new model law

– Uniform Prudent Management of

Institutional Funds Act, or UPMIFA (see box

on page 19) enacted in 49 states allows

greater flexibility in the use of donor

restricted endowments. While each state

has passed its own version of the law,

under the general law an institution may

appropriate for expenditure or accumulate

so much of an endowment fund as the

institution determines is prudent for the

uses, benefits, purposes, and duration for

which the endowment was established.

UPMIFA eliminates former requirements of

a permanent corpus that cannot, under any

circumstances, be spent.

2. Consideration of Alternative Methods for

Calculating Scores

The task force considered whether certain

adjustments to the existing method of calculating

the financial responsibility scores would produce

results less likely to yield false-negatives. The tests

were run on the CIC database using FY 2007 and

2008 financial data from 752 nonprofit

baccalaureate and master’s level private colleges.

The task force considered three scenarios: (1)

revising the capping convention to eliminate the

ceilings and floors of the ratio strength factors; (2)

using a three-year rolling average of the Net

Income Ratio; and (3) combining alternative

calculations (1) and (2) in the same scenario.

A. Capping the Financial Responsibility Scale

The task force considered whether

adjusting or removing the floor and ceiling

caps on the ratio strength factors and

composite scores (the range of -1.0 to +3.0

described in the box on page 8) would provide

a more accurate picture of an institution’s

financial situation relative to other

institutions. 

The subgroup tested several scenarios in

which the caps were removed. The results

of the modeling showed that institutions’

scores with the caps removed were similar

to the existing methodology used by the

Department. The FY 2007 pass rate using

the current method was 94.1 percent. It

increased .6 to 94.7 % when the caps were

used. The FY 2008 pass rates were 91.2

percent versus 91.0 percent.

After some analysis, the task force

determined that the existing capped scale

was preferable to eliminating the score’s

floor and/or ceiling. While the

Department’s capped score had some

problems -- e.g., it produced some

counter-intuitive results such as Harvard

having a worse score than a regional

beauty school -- the capped score did

avoid the even more misleading problem

of creating the appearance of a precise

rating scale. 

B. Use a Three-year Average

Using the same CIC database, the task

force tested the use of a three-year rolling

average of the Net Income Ratio (the ratio

used in the financial responsibility

composite score that is most subject to

changes in external market conditions,

such as endowment loses or gains). The

results were similar to those produced

using a single year’s data. The FY 2007

pass rate using the current formula was

94.1 percent. Using the three-year average

increased the rate .3 to 94.4 percent. The

change in the FY 2008 pass rate was from

91.2 percent to 91.5 percent.
30

C. Combining Both Alternative Models

The third alternative model combined the

removal of the capping convention along

with a three-year rolling average of the Net

Income Ratio. Again, results were similar to

those produced using the department’s

current methodology. False negative scores

were not significantly reduced. The FY 2007

pass rate was 94.1 percent using the current

method and 94.7 percent combining both

alternatives. The difference in FY 2008 was

between 91.2 percent and 92.4 percent.

3. Possible Benefit of Eliminating Numerical

Scores

The task force considered whether merely using

the Department’s current qualitative terminology -

- “pass,” “fail,” or “in the zone” -- would provide

sufficient information about a nonprofit

institution’s financial status, and whether

numerical, and sometimes misleading, financial

responsibility scores need not be made public. 

While the use of the categories of “pass,” “fail,”

and “in the zone” and elimination of a numerical

ranking system might be marginally beneficial in

avoiding comparison of schools, the task force

ultimately decided that these terms would still be

based on numerical scores derived from

mathematical formulas, and such scores are public

information. In addition, simply being labeled

“failing,” without a relative score, might have

worse implications than the current system. 

4. Use of a “Net Income from Operations’’

Number

The task force considered a methodology that

would include using “net income from

operations” in the Net Income Ratio instead of

“total change in unrestricted net assets.”

While this might provide a more accurate picture

of institutions’ financial status, the task force

determined that its use was currently not feasible

because many colleges do not provide this number

in their audited financial statements. Although

the Financial Accounting Standards Board (FASB)

is currently reviewing the possible use of this

ratio, concern remains because its value can be

artificially inflated if an institution increases its

draw on its endowment. 

5. Use of a Liquidity Measure

The task force discussed the benefits of using a

liquidity measure either as an initial screen, or

double check on the financial responsibility score. 

A basic liquidity measure is one of the most

common-sense tools for determining whether an

 S P O T L I G H T

A small religiously-affiliated college with a $41 million budget and a

$100 million endowment regularly had composite scores above 2.0. 

Then the college was hit hard by the stock market collapse in 2008,

suffering over $25 million in losses on its endowment. 

The Department followed the regulations correctly in calculating

the college's ratios. However, the size of the loss relative to the

college's budget caused both the primary reserve ratio and net

income ratio to fall into negative territory, resulting in a failing

composite score of 0.6. 

Still, the college was not in dire straits nor headed towards closure -

and certainly not precipitous closure. There were no systemic

operational problems and, even after the losses, the college had

endowment assets of more than $70 million -- $140,000 per

student.

If the calculation of the primary reserve ratio had taken into

account all of the institution's assets -- especially the expendability

of its endowment -- the college would have received a higher score

reflecting its actual financial condition. Alternatively, if the college

had been allowed to demonstrate its financial stability to the

Secretary in this special circumstance, it would have avoided both

the unnecessary cost of obtaining a letter of credit, and the damage

to its reputation from the inaccurate portrayal of its overall fiscal

health.
31

institution has the necessary fiscal resources. Upon

analysis, it was determined that since FASB is

currently looking at the possibility of requiring

disclosure of some measure of liquidity in audited

financial statements, any measure used in the

federal system should be consistent with those new

standards, should they emerge. Therefore, the task

force decided not to further pursue the alternative

at this time, but does consider it an important factor

to consider once FASB finishes its work.

6. Closed Schools

Task force members used various information

sources in attempting to compile a list of closed

schools. The intent was to review their past

financial responsibility composite scores, to assess

the predictive value of failing scores. However,

public databases on closed schools turned out to be

extremely problematic, and information on

composite scores prior to recent years is almost

non-existent.

Despite these limitations, the task force does note

that the intent of the federal law was not to prevent

institutions from closing, but rather to ensure that

they do so in an orderly manner that protects

students and federal funds. The intent was to avoid

the precipitous closures of institutions that took

place in the for-profit sector in the late 1980s,

leaving students in the lurch. The task force did

not find any incidences of precipitous closure in the

nonprofit sector, but did note that most schools that

have received failing scores remain open. 

In conducting its work, the subgroup used

currently public, Department data on failing scores

and the names of closed schools provided in the

Higher Education Directory. Additional work in this

area could be conducted by the Department,

through its own data sources. 

7. Use of an Adjusted Net Assets Approach to

the Calculation of the Primary Reserve Ratio

of Nonprofits

The task force considered an alternative formula to

calculate the primary reserve ratio for nonprofit

colleges and universities that parallels the formula

presently used by the Department to calculate the

ratio for proprietary schools. This was done to

determine the effect of including the value of the

institution’s endowment, which is excluded from

the numerator when calculating the nonprofit

primary reserve ratio. While the Department

frequently includes endowment losses in the

denominator (total expenses) of the nonprofit

primary reserve formula, it doesn’t include the

entire value (all net assets) of the endowment in

the numerator. (See Recommendation # 2.)

A. The primary reserve ratio for proprietary

institutions:

Adjusted Equity*

Total Expenses

*Adjusted Equity = (total owner’s equity)

– (intangible assets) – (unsecured relatedparty receivables) – (net property, plant

and equipment) + (post-employment and

retirement liabilities) + (all debt obtained

for long-term purposes)

B. The primary reserve ratio for nonprofit

institutions:

Expendable Net Assets*

Total Expenses

*Expendable Net Assets = (unrestricted

net assets) + (temporarily restricted net

assets) – (annuities, term endowments,

and life income funds that are temporarily

restricted) – (intangible assets) – (net

property, plant and equipment) + (postemployment and retirement liabilities) +

(all debt obtained for long-term purposes)

– (unsecured related-party receivables)
32

C. The alternative primary reserve ratio for

nonprofit institutions:

Adjusted Net Assets*

Total Expenses

*Adjusted Net Assets = (unrestricted net

assets) + (temporarily restricted net assets)

+ (permanently restricted net assets) –

(intangible assets) – (unsecured related

party receivables) – (net property plant and

equipment) + (post-employment and

retirement liabilities) + (all debt obtained

for long-term purposes) 

8. Trials

Two sets of trials were conducted to test the

effect of the alternative primary reserve

formula in calculating the composite score of

nonprofit institutions. 

Trial A

The first test used the CIC database of 687

nonprofit baccalaureate and master’s level

private colleges with data from FY 2007, 2008,

and 2009. (See page 21.) An initial examination

of the financial responsibility test scores

compared the use of the alternative formula for

calculating the primary reserve ratio to the

methodology currently used by the

Department. In contrast to other

methodologies the task force tested (described

above), the use of the alternative formula

provided a significant change in the pass rate of

nonprofit institutions in 2009, the year in which

composite scores reflected the significant losses

from 2008-09 in nonprofit colleges’

endowments. Modest score improvements also

were seen when comparing the Department’s

current methodology for nonprofits and the

alternative method for years that did not reflect

a significant market decline.

FY 2007: Pass rate, current method, 95.9%

/alternate method, 98.3%

FY 2008: Pass rate, current method,

92.0%/alternate method, 97.2%

The rates for 2009, by comparison, were

current method, 78.2%/alternate method,

94.8%.

Trial B

The for-profit formula also was tested using

the group of 22 financially vulnerable schools. 

The pattern was the same as that revealed

when using the CIC database. More schools

received passing financial responsibility

composite scores in 2008, 2010, and 2011 using

the proprietary formula than did using the

nonprofit formula. 

However, the most significant difference was

in the 2009 scores which reflected market

losses that were included in FY 2009 audited

financial statements. Of the 11 schools that

failed using the nonprofit model, nine passed

using the proprietary model. (One of the

schools that passed did close, but not

precipitously. Comparative results were not

available for one school, and one school

improved from a fail to a zone rating.) The

five schools that were “in the zone” on the

nonprofit formula, passed using the

proprietary model. Six schools passed under

both assessments. 
APPENDICES

Title IV Financial Responsibility Standards

Definition of Composite Score Ratios

Independent (Not-for-Profit) Institutions

(34 CFR, Part 668, Subpt. L, App. B)

Primary Reserve Ratio:

• Provides a measure of an institution’s expendable or liquid resource base in relation to its overall operating size

• Measures whether an institution has financial resources sufficient to support its mission:

1. Sufficient financial reserves to meet current and future operating commitments

2. Sufficient flexibility in those reserves to meet changes in its programs, educational activities and spending

patterns

Equity Ratio:

• Provides a measure of the amount of total resources that are financed by contributions or accumulated earnings

• Captures an institution’s overall capitalization structure

• Measures capital resources and ability to borrow

Net Income Ratio:

• Provides a direct measure of an institution’s profitability or ability to operate within its means

Formulas:

• Primary Reserve Ratio = Expendable Net Assets

Total Expenses

• Equity Ratio = Modified Net Assets

Modified Assets

• Net Income Ratio = Change in Unrestricted Net Assets

Total Unrestricted Revenue

Ratio Component Calculations:

Expendable Net Assets = (unrestricted net assets) + (temporarily restricted net assets) – (annuities, term

endowments and life income funds that are temporarily restricted) – (intangible assets) – (net property, plant and

equipment) + (post-employment and retirement liabilities) + (all debt obtained for long term purposes) - unsecured

related party receivables

Total Expenses = the total unrestricted expenses taken directly from the audited financial statement

Modified Net Assets = (unrestricted net assets) + (temporarily restricted net assets) + (permanently restricted net

assets) – (intangible assets) – (unsecured related party receivables)

Modified Assets = (total assets) – (intangible assets) – (unsecured related party receivables)

Change in Unrestricted Net Assets is taken directly from the audited financial statement

Total Unrestricted Revenue is taken directly from the audited financial statement (and includes net assets released

from restriction during the fiscal year).

30 Trus t eeship

s

s

1	In an era of rankings and ratings, the 

Department of Education’s financialresponsibility test is sparking attention. 

If your institution’s score is below 

1.5, you will be subjected to special 

controls and reporting requirements 

to participate in federal financial-aid 

programs.

2	Rather than wait for the score to 

be published each summer, your 

institution should estimate in advance 

what the score will be and decide 

the best ways to inform various 

constituencies.

3	Once you verify that the score is 

accurate for your institution, you should 

use the information that the test 

provides to identify areas of financial 

vulnerability and potential corrective 

actions.

TakeAways

By Ken t John Cha b o ta r

Will Your Institution Pass the

Financial-Responsibility Test?

Last August, the U.S. Department of Education

disclosed that 149 nonprofit private colleges and 

universities had failed its “financial-responsibility 

test” for fiscal year 2008–09. The institution 

where I serve as president, Guilford College, 

was among them. That led me and the board of 

trustees to study the test, its methodology, and its 

results with more than passing interest. 

Although the Education Department 

has performed this test of an institution’s 

fiscal capacity to administer Title IV federal student-aid programs since 1998, 

2010 was only the second year that the 

results were widely available. The Chronicle of Higher Education first made a Freedom of Information Act request to get 

the data in 2009. Only 114 institutions 

failed that year. The significant increase in 

2010, amidst general economic turmoil, 

prompted many news-media inquiries 

and reports that took most of us at private 

colleges by surprise. 

The National Association of College and University Business Officers 

(NACUBO), independent analysts and 

consultants, and institutional financial 

officers have expressed concerns about 

the test, especially since the failing results 

were made public. Among those concerns 

have been misinterpretations or miscalculations of the formulas, use of outdated 

accounting definitions and standards, 

and regional inconsistencies. This article 

explains what the financial-responsibility 

test is and how it is used, explores what 

the implications might be for colleges and 

universities, and suggests how presidents 

and board members can deal most effectively with the test and public disclosure 

of a failing score.

FA

B

CD......

F

?
July/A ugus t 2011 31

and has other financial components that 

aren’t relevant to private nonprofit colleges and universities.

Even if a college or university passes the 

test with a composite score of 1.5 or above, 

the Education Department has other standards that an institution must meet. The 

institution must have sufficient cash reserves 

to make refunds and repayments of Title IV 

funds. It must be current in paying debt 

service. It must not have a statement in its 

audited financial statements expressing 

doubt about its survival as a “going concern” or, unless the department grants an 

exception, anything other than an unqualified opinion that the audited statement 

is presented in accordance with generally 

accepted accounting principles.

How is the test calculated?

For private, nonprofit institutions, the test 

uses the institution’s audited financial 

statements to calculate three ratios that 

the Department of Education defines and 

explains as follows:

Primary reserve ratio. This ratio 

is defined as expendable net assets (or 

expendable equity) divided by total 

expenses. Because this ratio measures 

expendable resources in relation to operating size, it provides a direct measure of an 

institution’s viability and indirect measure 

of its liquidity. An expendable resource is, 

for example, cash, an unrestricted bequest, 

or a restricted student-aid fund that can be 

spent as soon as a student who meets the 

donor’s criteria is identified.

Equity ratio. This ratio is defined 

as net assets (or equity) divided by total 

assets. Net assets or equity represent the 

residual worth of an entity—the value of 

its assets less claims by outside parties. 

The ratio of equity to total assets can be 

viewed as the proportion of an institution’s assets that the institution owns “free 

and clear.” By measuring expendable and 

non-expendable resources, this ratio helps 

to assess an institution’s ability to borrow 

and capital resources. (The permanently 

restricted principal of an endowment fund 

exemplifies a non-expendable resources 

under normal conditions.)

Net income ratio. The net income ratio 

is defined as the excess of revenue over 

expenses divided by total revenue. In the 

for-profit sector, it measures profit or loss. In 

the nonprofit sector, it provides information 

useful in assessing an institution’s ability to 

operate within its means.

Upon review, the Education Department 

may exclude some items from an institution’s financial statements in calculating 

the ratios. Those include extraordinary and 

presumable one-time gains and losses, 

questionable accounting treatments such as 

excessive capitalization or marketing costs, 

and intangible assets like professorships.

After incorporating strength factors and 

weighting percentages that the Education 

Department applies to all private, nonprofit 

colleges and universities, these three ratios 

are combined into one final composite score. 

Strength factors put the scores on a scale 

from -1 to +3. The Education Department 

explains that strength factors are designed to 

assess the extent to which an institution has 

the financial resources to:

• Replace existing technology with newer 

technology; 

• Replace physical capital that wears out 

over time; 

• Recruit, retain, and retrain faculty and 

staff members; and 

• Develop new programs.

Weighting percentages are then applied 

to reflect the relative importance of the 

ratios. Adding the three weighted strength 

factors together yields one final composite 

score as shown in Table 1. 

For example, this hypothetical university 

has $20 million in expendable net assets 

and $100 million in total expenses, or a 

primary reserve ratio of .20. Multiplying 

.20 by the strength factor of 10 yields a 

score of 2 (the score cannot exceed +3. or 

be less than -1) that is weighted 40 percent 

or .80 toward the composite score. The 

total composite score of 1.8 places the institution safely above the 1.5 threshold to be 

“deemed financially responsible without 

further oversight.”

What happens if an 

institution fails the test?

Even if an institution fails, the Education 

Department may consider it to be financially 

responsible and allow continued participation in student-aid programs if an alternative 

standard is met. Such an alternative standard 

might be a:

What is the financialresponsibility test?

The U.S. government spends billions of tax 

dollars each year to support higher education. More than $115 billion was spent in 

FY 2009–10 alone, mostly in the form of 

grant aid and low-interest loans that colleges and universities disburse to students. 

KPMGPeat Marwick designed the financialresponsibility test for the Department of 

Education to identify institutions whose poor 

financial condition could force them to close 

precipitously or otherwise put at risk Title 

IV student-aid funds. The test measures the 

adequacy of cash flow, budget surplus and 

deficits, debt, and net worth.

Some key facts about the test: 

• The financial health of institutions is 

assessed based on three ratios: primary 

reserve, equity, and net income. An 

institution’s raw scores are converted to 

strength factors, weighted, and combined 

into a composite score on which public 

and news-media attention has focused. 

• Composite scores range from -1 to +3. 

Institutions with scores of 1.5 or above 

“pass.” The Department of Education 

considers them financially responsible 

without the need for further oversight. 

• Institutions with composite scores 

between 1 and 1.4 are allowed to participate in Title IV under a “zone alternative,” under which they are subject 

to special requirements and enhanced 

monitoring by the department. 

• The Education Department does not 

permit institutions with scores below 

1 to continue participating in Title IV 

programs without providing additional 

surety—for example, a letter of credit 

that guarantees at least 50 percent of the 

institution’s Title IV funding.

• Although subject to other kinds of 

financial scrutiny, public institutions are 

not evaluated using the ratio methodology. A public institution is considered 

financially responsible if it submits a 

letter from an official of a state or other 

government entity confirming that the 

institution is public.

• Proprietary, for-profit institutions are 

subject to a financial-responsibility 

test, yet it uses ratios and scoring more 

suitable to a business organization that 

recognizes owner’s equity, pays taxes, 
32 Trus t eeship

• Letter of credit. A college or university 

may be considered financially responsible by submitting an irrevocable letter 

of credit from a bank or other financial 

institution. The letter guarantees repayment of federal student-aid funds in an 

amount equal to 50 percent of funds that 

the institution received during its most 

recently completed fiscal year. 

• Zone alternative. Institutions that have 

a composite score between 1 and 1.4 

for the fiscal year may choose the zone 

alternative for up to three consecutive fiscal years. Under this alternative, a college 

or university must request and receive 

student-aid funds under special cashmonitoring or reimbursement methods. 

For example, it must disburse funds 

to eligible students and parents before 

requesting reimbursement of those 

funds from the Department of Education. The institution will also be subject 

to increased reporting and monitoring. 

Other sanctions will be imposed if the 

institution falls below 1 in any one fiscal 

year or fails to score at least 1.5 at the end 

of three years.

• Provisional certification. If an institution fails to meet one or more of the 

general standards or is not financially 

responsible because of an unacceptable 

audit opinion, the Education Department may permit it to continue participating in student-aid programs under a 

provisional certification for up to three 

years. The institution must obtain a letter 

of credit with a value equivalent of 10 

percent or more of the program funds 

that it received in the prior fiscal year. 

The institution must also prove that it has 

met all of its financial obligations and 

has been current on debt payments for 

the two most recent fiscal years. Finally, 

it must submit to greater monitoring of 

cash, reimbursements, and other financial events. If an institution is still not 

deemed financially responsible when 

the provisional certification is scheduled 

to end, the Education Department may 

renew the certification but also impose 

additional controls and monitoring. The 

department may also declare the institution ineligible for federal student-aid 

funds, but that rarely happens.

What are concerns about the 

Education Department test?

Most financial experts agree that the federal 

government needs to identify institutions in 

dire financial straits so that Title IV funds are 

not lost or misappropriated. But many doubt 

whether the responsibility test actually does 

that. They have concerns about:

• The role of endowment losses in a bad 

economic environment. Many financially sound colleges and universities had 

precipitous rating slides simply because 

an extraordinary market downturn 

depressed endowment values and total 

net assets in 2008 and 2009. How else 

do you explain Harvard University and 

Yale University at 2.2, Georgetown University at 1.6, and Leon’s Beauty School 

in North Carolina at 3.0? 

• The limits that the financial-responsibility test places on the strength-factor scores 

of -1 to +3 may distort such results.Those 

limits do not allow majestic strength or 

catastrophic weakness in one ratio to have 

its full effect on the other ratios. For example, in fiscal year 2009–10, Harvard’s 

primary reserve strength-factor score was 

actually 54.3, but it was capped by the 

financial-responsibility test at 3.

• Accounting standards. Others question 

whether the test conforms to the latest 

accounting standards, is interpreted 

consistently by Department of Education financial analysts, and defines 

terms in conformity with the latest generally accepted accounting principles. 

For example, among the issues that 

NACUBO has cited with the financialresponsibility standards are:

1. By adding unrealized investment 

losses to total expenses in the primary 

reserve ratio, the Education Department is double counting losses 

because both expenses and losses 

have already reduced unrestricted net 

assets.

2. The department does not consider 

revolving lines of credit, state working-capital loan programs, and other 

debt as long term, even though the 

debt is not scheduled to be repaid 

within the next fiscal year and it has 

been classified as long-term debt on 

the audited financial statements.

3. The department fails to include 

pension benefits as part of “postemployment and retirement benefits.” 

The long-term portion of such obligations is added to the institution’s 

spendable assets in calculating the 

ratios.

4. The department will disallow 

pledges from board members unless 

trustees perform the role of trustee 

only and do not have other business 

relationships with the institution.

• Other issues. In addition, people have 

cited the misinterpretation of the test’s 

purpose and results. Rather than identifying institutions in financial crisis 

on what is essentially a pass/fail basis, 

journalists and others have used the test 

results as a financial version of the U.S. 

News & World Report rankings. They 

have compared colleges and universities 

as if institution X with a score of 2.3 

is more financially sound than institution Y with a score of 2. But rankings 

and other summary judgments about 

relative financial health should not be 

based on small differences, especially 

when many aspects of the financialresponsibility test are questionable. 

Such uncertainties led the National 

Association of Independent Colleges and 

Universities (NAICU) to issue a statement 

Table 1. Sample Ratio Methodology

Ratio Inputs Result

Strength

Factor Score Weight

Weighted

Score

Primary Reserve Expendable Net Assets/Total Expenses 0.20 10 2.00 40% 0.80

Equity Modified Net Assets/Modified Assets 0.30 6 1.80 40% 0.72

Net Income Change in Unrestricted Net Assets/

Unrestricted Revenue

0.003 1+(50 X Result)1 1.15 20% 0.23

Composite Score 1.75

Final Score(rounded) 1.80

A

B

CD......

F

?
July/A ugus t 2011 33

following the publication of the fiscal year 

2008–09 list in August 2010. 

The financial-responsibility list issued 

by the U.S. Department of Education 

today confirms what most Americans 

have known the past few years: we have 

an economic downturn that has affected 

investment portfolios throughout America, 

whether the portfolios are those of families, 

businesses, colleges, or other organizations.... In many cases, colleges only 

appear on the list because of accounting 

methods that do not consider the institution’s overall resources .... Others appear 

on the list based on the day the snapshot 

was taken, and today would pass the test 

with flying colors.

NAICU has appointed a task force that I

chair to study the accuracy and reliability of 

the financial-responsibility test and to recommend improvements to the Department 

of Education. Members of the task force 

include senior officials from NACUBO, the 

Council of Independent Colleges, state independent college associations, and individual 

institutions. We expect to have recommendations later in 2011.

What should trustees 

and presidents do?

Regardless of whether the financialresponsibility test is changed, institutional 

leaders should pay attention to it. The 

three ratios can disclose important information about financial conditions. And 

even though the composite score may be 

questionable, it can affect your institution’s 

federal student aid and public perceptions 

of its solvency and creditworthiness. If your 

institution fails or falls into the “zone,” you 

will have to answer questions from the newsmedia, students and families, faculty and 

staff members, and other constituencies. 

Some recommendations for dealing with 

the test are:

Avoid surprises by estimating your 

own composite score.Given that the 

scores for FY 2008–09 were not made 

public until August 2010, your institution 

should have sufficient time to estimate its 

composite score and be prepared to deal 

with the results. The term “estimate” is used 

purposely because the Department of Education financial analysts compute the actual 

score with possibly different or inconsistent 

interpretation of accounting terms. In any 

case, your administration and board can be 

alerted, news-media materials can be developed, and, if your institution fails the test, 

corrective measures can be identified.

Plan what to do if your institution gets 

a letter from the Education Department 

with a failing score. The first thing your 

institution should do is to verify the accuracy 

of the finding by double-checking all the 

numbers. If administrators spot an outright 

error or a possible misinterpretation, they 

should inform the department and consider 

an appeal. Depending on the score and 

other financial circumstances, they can then 

decide whether to take on a letter of credit or 

another alternative to be considered “financially responsible.” 

Develop a communications plan. Your 

board should be informed as soon as possible. The institution should then prepare a 

news release and offer interview opportunities with the president and chief financial 

officer. A college or university with a transparent financial data and budgeting processes has a better chance of faculty and staff 

members understanding what the score 

means and of less panic. Guilford College 

announced on our Web site that, at 1.4, we 

were in the “zone” for FY 2008–09, and 

we invited news-media scrutiny. Of course, 

the fact that we also disclosed that the 

auditors estimated a 2.4 for FY 2009–10 

received much less attention.

Use individual ratios to understand 

your institution’s financial condition.

Despite methodological questions, the 

ratios can suggest areas of potential strength 

or weakness. For example, a strength-factor 

score of 3 on the primary reserve ratio indicates that the institution has expendable 

resources equal to about 30 percent of total 

expenses. Put another way, the institution 

has about 100 days worth of resources to 

cover current operations. At -1, the institution’s liabilities exceed its assets. It suggests potentially debilitating weaknesses in 

liquidity and viability.

Use an accurate failing score as a 

springboard for meaningful reforms.

If you agree that the score has revealed 

systemic financial weaknesses, rather than 

one-time problems caused by extraordinary 

circumstances, your institution can use the 

public attention to spur action. Ensuring a 

balanced budget, aggressive fund-raising, 

control over expenses and positions, avoiding debt not supported by new revenue, and 

other steps are elements of sound financial 

management as well as ways to improve the 

score.

Colleges and universities will continue 

to see increasing interest in institutional 

accountability for costs and outcomes. 

The financial-responsibility test is another 

manifestation of that trend, albeit one with 

potentially high consequences for federal 

financial aid and public image. Just as 

French Prime Minister Georges Clemenceau once remarked, “War is too important to be left to the generals,” it is also true 

that the financial-responsibility test is too 

important to be left to the accountants. 

Understanding how the test is constructed 

and used—and how an institution can 

best respond—should be on the learning 

agenda of every governing board member. n

Author: Kent John Chabotar is president of 

Guilford College and a faculty member at the 

Harvard Institutes for Higher Education.

E-mail: chabotar@guilford.edu

T’ship Links: Scott Schulick and Cynthia 

E. Anderson,“On Track for the Future: A

Case Study in Strategic Finance.”November/

December 2010. Terry W. Hartle,“Coming 

Soon: Lots More Federal Regulations.” 

November/December 2008.

Other Resource: NACUBO Composite 

Financial Index Worksheet, http://www.nacubo.

org/documents/business_topics/CFI_Other_

Ratios_and_Trend_table.xls

Questions for Trustees

• What is the Department of Education financial-responsibility test 

and how might it affect federal 

financial aid at my institution?

• Besides the composite score, what 

are the other standards that the 

institution must meet to be considered financially responsible?

• What concerns have been 

expressed about the test that 

may change how we interpret the 

results and our financial condition?

• What should the board and the 

president do if the department 

informs us we have failed the test?
HIGHER EDUCATION ACT

Subpart 3—Eligibility and Certification Procedures

SEC. 498. [20 U.S.C. 1099c]. ELIGIBILITY AND CERTIFICATION 

PROCEDURES.

(c) FINANCIAL RESPONSIBILITY STANDARDS.—(1) The Secretary shall 

determine whether an institution has the financial responsibility required by this title 

on the basis of whether the institution is able—

(A) to provide the services described in its official publications and 

statements;

(B) to provide the administrative resources necessary to comply with 

the requirements of this title; and

(C) to meet all of its financial obligations, including (but not limited to) 

refunds of institutional charges and repayments to the Secretary for liabilities 

and debts incurred in programs administered by the Secretary.

(2) Notwithstanding paragraph (1), if an institution fails to meet criteria 

prescribed by the Secretary regarding ratios that demonstrate financial responsibility, 

then the institution shall provide the Secretary with satisfactory evidence of its 

financial responsibility in accordance with paragraph (3). Such criteria shall take into 

account any differences in generally accepted accounting principles, and the financial 

statements required thereunder, that are applicable to for-profit, public, and nonprofit 

institutions. The Secretary shall take into account an institution’s total financial 

circumstances in making a determination of its ability to meet the standards herein 

required.

(3) The Secretary shall determine an institution to be financially responsible, 

notwithstanding the institution’s failure to meet the criteria under paragraphs (1) and 

(2), if—

(A) such institution submits to the Secretary third-party financial 

guarantees that the Secretary determines are reasonable, such as performance 

bonds or letters of credit payable to the Secretary, which third-party financial 

guarantees shall equal not less than one-half of the annual potential liabilities of 

such institution to the Secretary for funds under this title, including loan 

obligations discharged pursuant to section 437, and to students for refunds of 

institutional charges, including funds under this title;

(B) such institution has its liabilities backed by the full faith and credit 

of a State, or its equivalent;

(C) such institution establishes to the satisfaction of the Secretary, with

the support of a financial statement audited by an independent certified public 

accountant in accordance with generally accepted auditing standards, that the 

institution has sufficient resources to ensure against the precipitous closure of 

the institution, including the ability to meet all of its financial obligations 

(including refunds of institutional charges and repayments to the Secretary for 

liabilities and debts incurred in programs administered by the Secretary); or

(D) such institution has met standards of financial responsibility, 

prescribed by the Secretary by regulation, that indicate a level of financial 

strength not less than those required in paragraph (2).

(4) If an institution of higher education that provides a 2-year or 4-year program 

of instruction for which the institution awards an associate or baccalaureate degree 

fails to meet the criteria imposed by the Secretary pursuant to paragraph (2), the 

Secretary shall waive that particular requirement for that institution if the institution 

demonstrates to the satisfaction of the Secretary that—

(A) there is no reasonable doubt as to its continued solvency and ability 

to deliver quality educational services;
(B) it is current in its payment of all current liabilities, including student 

refunds, repayments to the Secretary, payroll, and payment of trade creditors and 

withholding taxes; and

(C) it has substantial equity in school-occupied facilities, the acquisition 

of which was the direct cause of its failure to meet the criteria.

(5) The determination as to whether an institution has met the standards of 

financial responsibility provided for in paragraphs (2) and (3)(C) shall be based on an 

audited and certified financial statement of the institution. Such audit shall be 

conducted by a qualified independent organization or person in accordance with

standards established by the American Institute of Certified Public Accountants. Such 

statement shall be submitted to the Secretary at the time such institution is considered 

for certification or recertification under this section. If the institution is permitted to 

be certified (provisionally or otherwise) and such audit does not establish compliance 

with paragraph (2), the Secretary may require that additional audits be submitted.

(6) (A) The Secretary shall establish requirements for the maintenance by an 

institution of higher education of sufficient cash reserves to ensure repayment of any 

required refunds.

(B) The Secretary shall provide for a process under which the Secretary shall 

exempt an institution of higher education from the requirements described in 

subparagraph (A) if the Secretary determines that the institution—

(i) is located in a State that has a tuition recovery fund that ensures that 

the institution meets the requirements of subparagraph (A);

(ii) contributes to the fund; and

(iii) otherwise has legal authority to operate within the State.
Vol. 2—School Eligibility and Operations 2012–2013

2–62

FSA HB JUL 2012

AUDIT & AUDIT REVIEW PROCESS

Having the audit performed

The school or servicer must make its program and fiscal records, 

as well as individual student records, available to the auditor. (Required 

recordkeeping is discussed in Chapter 7.) Both the financial aid and business 

offices should be aware of the dates the auditors will be at the school, and 

make sure that someone is on hand to provide requested documents and 

answer questions during that period.

At the end of the on-site review, the auditor conducts an exit interview. 

At a school, this exit interview is usually conducted with the personnel from 

the school’s financial aid and other relevant offices. The exit interview is not 

only an opportunity for the auditor to suggest improvements in procedures, 

but it also gives the school or servicer a chance to discuss the draft report and 

review any discrepancies cited in the report. The exit interview is a good time 

to resolve any disagreements before the final report is prepared.

The final report is prepared by the auditor and submitted to the school or 

servicer. 

Review of FSA audit submissions

The Department reviews the audit report for format and completeness 

and to ensure that it complies with the government’s auditing standards.

We will use the general information to make an initial determination of 

whether the audits are materially complete and conducted in accordance with 

applicable accounting standards. Based on the financial data, we will also 

make a preliminary determination as to whether your school is financially 

responsible with respect to the financial responsibility ratios, or in the case of 

a change in ownership resulting in a change in control, whether the school 

satisfies the financial ratio requirements (discussed later in this chapter). 

Later, the Department will review submissions to determine whether the 

school must provide additional information or ED should take further action.

Based on the audit findings and the school’s or servicer’s written 

explanation, the Department will determine if any funds were spent 

improperly. Unless the school or servicer has properly appealed the decision, 

the school or servicer must repay any improperly spent funds within 45 days.

Access to records

Once the audit is complete, the school or servicer must give the 

Department and the OIG access to all records and documents needed to 

review the audit. A school that uses a third-party servicer must give the 

Department and the OIG access to all records and documents needed to 

review a third-party servicer’s compliance or financial statement audit. In 

addition, the school’s or servicer’s contract with the auditor must specify that 

the auditor will give the Department and the OIG access to the records and 

documents related to the audit, including work papers. Cooperation includes 

providing timely and reasonable access to records (including computer 

records) for examination and copying, and to personnel for the purpose of 

obtaining relevant information. 

Use of eZ-Audit required

Schools are required to submit their 

compliance audits, audited financial 

statements, and letters confirming their status 

as public schools through the Department’s 

eZ-Audit Electronic Financial Reporting 

System.

This requirement applies to any compliance 

audits or financial statements required under 

34 CFR 600.20(a) or (b) to begin or continue 

participating in the FSA programs, any 

financial statements required due to a change 

in ownership resulting in a change in control 

as provided under 34 CFR 600.20(g), any 

compliance audits and financial statements 

required annually under 34 CFR 668.23, 

and any compliance audits and financial 

statements required when a school ceases to 

participate in the FSA programs as provided 

under 34 CFR 668.26(b).

Information about eZ-audit

Website: http://ezaudit.ed.gov

E-mail contact: fsaezaudit@ed.gov 

eZ-Audit Help Desk: 877-263-0780.

Cooperation with audit & review 

process

Throughout the audit process, and for other 

examinations such as program reviews and 

state reviews, the school or servicer is required 

to cooperate fully with its independent 

auditor, the Department and its Inspector 

General, the Comptroller General of the 

United States, its accrediting agency, and the 

appropriate guaranty agency.
Ch. 4—Audits, Financial Standards, Limitations & Cohort Rates

2–63

FSA HB JUL 2012

eZ-Audit

The eZ-Audit website provides a paperless single point of submission for financial statements and 

audits (i.e., compliance reports). eZ-Audit provides automatic error checking as you enter the data 

and before submission. In addition, it gives you instant acknowledgment of receipt. 

All schools that participate in the FSA programs must use eZ-Audit to submit financial statements 

and compliance audits (including copies of the A-133 reports that nonprofit and public institutions 

file with the Federal Audit Clearinghouse). 

Nonprofit and public institutions are still required to submit their A-133 audits in writing to the federal 

clearinghouse. 

The eZ-Audit process 

To access the eZ-Audit website you must be a registered user. Each school must select an eZ-Audit 

institution administrator who will be responsible for managing your school’s access to the eZ-Audit 

website. This institution administrator will receive the user name and password necessary for your 

school’s access and will be responsible for granting access to others you name as additional users. 

Each registered user must sign and retain the eZ-Audit rules of behavior. (For registration 

instructions and to download the rules of behavior, please visit ezaudit.ed.gov).

Once you have obtained your school ID, you will access the appropriate page on the audit website, 

and—

1. enter general information about your school’s compliance audit and financial statement;

2. enter specific financial data directly from its audited financial statement; and 

3. attach authentic electronic copies of the audit originals.

After you have entered the required information, you must attach a copy of the audit prepared and 

signed by the independent auditor. The copy must be in a non-editable, portable document format 

(PDF) created using Adobe Acrobat version 5.0 or higher.
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AUDITS FOR THIRD-PARTY SERVICERS

Audit requirements also apply to third-party servicers. If a servicer 

contracts with several FSA schools, a single compliance audit can be 

performed that covers its administrative services for all schools. If a servicer 

contracts with only one FSA school and that school’s own audit sufficiently 

covers the functions performed by the servicer, the servicer does not have 

to submit a compliance audit. A servicer must submit its compliance 

audit within six months after the last day of the servicer’s fiscal year. The 

Department may require a servicer to provide a copy of its compliance 

audit report to guaranty agencies, lenders, state agencies, the Department of 

Veterans Affairs, or accrediting agencies.

In addition to submitting a compliance audit, a 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 must submit annually audited 

financial statements. The financial statements must be prepared on an accrual 

basis in accordance with GAAP and audited by an independent auditor in 

accordance with GAGAS and any other guidance contained in audit guides 

issued by the Department’s Office of the Inspector General.

If the Department determines that, based on audit findings and 

responses, a third-party servicer owes a liability for its administration of 

the FSA programs, the servicer must notify each school with which it has a 

contract of the liability. Generally, unless they submit an appeal, schools and 

servicers owing liabilities must repay those liabilities within 45 days of being

notified by the Department.

As noted earlier, a school may never use a third-party servicer’s audit 

in place of its own required audit because the school is ultimately liable for 

its own violations as well as those incurred by its third-party servicers. (See 

Chapter 3 for more information on third-party servicers.)

Third-party servicers

Guidance for audits of third-party servicers 

is found in the January 2000 Department of 

Education’s “Audit Guide, Audits of Federal 

Student Aid Programs at Participating 

Institutions and Institution Servicers.”

34 CFR 668.23(a)(3) and (c) 

34 CFR 668.23(d)(5)
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DEMONSTRATING FINANCIAL RESPONSIBILITY

To participate in the FSA programs, a school must demonstrate that it 

is financially responsible. To provide the Department with the information 

necessary to evaluate a school’s financial responsibility, schools are required 

to submit financial information to the Department every year. A school 

must provide this financial information in the form of an audited financial 

statement as part of a combined submission that also includes the school’s 

compliance audit. For-profit schools have six months from the end of the 

schools’ fiscal year to provide the combined submission; other schools have 

nine months. 

What follows is an overview of the financial responsibility standards. 

Schools should refer to Subpart L of the Student Assistance General 

Provisions for complete information. 

The Department determines whether a school is financially responsible 

based on the school’s ability to: 

•	 provide the services described in its official publications and

statements;

•	 properly administer the FSA programs in which the school

participates; and

•	 meet all of its financial obligations. 

The financial responsibility standards can be divided into two categories: 

(1) general standards, which are the basic standards used to evaluate a 

school’s financial health, and (2) performance and affiliation standards,

which are standards used to evaluate a school’s past performance and to 

evaluate individuals affiliated with the school.

Financial reponsibility for public schools

A public school is financially responsible if its debts and liabilities are 

backed by the full faith and credit of the state or another government entity. 

The Department considers a public school to have that backing if the school 

notifies the Department that it is designated as a public school by the state, 

local, or municipal government entity, tribal authority, or other government 

entity that has the legal authority to make that designation. The school must 

also provide the Department with a letter from an official of the appropriate 

government entity confirming the school’s status as a public school. A letter 

from a government entity may include a confirmation of public school status 

for more than one school under that government’s purview. The letter is a 

onetime submission and should be submitted as a separate document.

Public schools also must meet the past performance and affiliation 

standards discussed later and must submit financial statements prepared 

in accordance with generally accepted accounting principles (GAAP) and 

prepared on the accrual basis. 

Financial responsibility for proprietary or 

private nonprofit schools

A proprietary or private nonprofit school is financially responsible if the 

Department determines that—

Financial responsibility

Sec. 498(c) of the Higher Education Act 

34 CFR 668 Subpart L

Change in ownership 

When a change in ownership occurs, the 

Department applies the standards in 

34 CFR 668.15. 
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•	 the school has a composite score of at least 1.5;

•	 the school has sufficient cash reserves to make the required refunds,

including the return of Title IV funds (these requirements are 

known as the refund reserve standards); 

•	 the school is meeting all of its financial obligations, including

making required refunds, including the return of Title IV funds and 

making repayments to cover FSA program debts and liabilities; and

•	 the school is current in its debt payments.

These requirements are discussed in more detail in the next section.

Even if a school meets all of the general requirements, the Department 

does not consider the school to be financially responsible if—

•	 in the school’s audited financial statement the opinion expressed

by the auditor was adverse, qualified, or disclaimed, or the auditor 

expressed doubt about the continued existence of the school as a 

going concern (unless the Department determines that a qualified 

or disclaimed opinion does not have a significant bearing on the 

school’s financial condition), or

•	 the school violated one of the past performance requirements

discussed later in this chapter.

STANDARDS FOR FINANCIAL RESPONSIBILITY

Composite score

The composite score standard combines different measures of 

fundamental elements of financial health to yield a single measure of a 

school’s overall financial health. This method allows financial strength in 

one area to make up for financial weakness in another area. In addition, this 

method provides an equitable measure of the financial health of schools of 

different sizes.

The composite score methodology takes into account the differences 

between proprietary schools and private nonprofit schools. The variance 

takes into account the accounting differences between these sectors of 

postsecondary schools. However, the basic steps used to arrive at the 

composite score are the same. These steps are described later in this section.

Refund reserve standards

One of the standards that a school must satisfy to be considered 

financially responsible is that it must have sufficient cash reserves to return 

FSA funds when a student withdraws. A school is considered to have 

sufficient cash reserves if it:

•	 is located in a state that has an ED-approved tuition recovery fund 

and the school contributes to that fund, or

•	 for its two most recently completed fiscal years, the school made all 

required returns in a timely manner (see Volume 5, Chapter 2 for 

more information on returns, including timely payment). 

Additional information on 

composite scores 

For complete information on the calculation 

of the composite score, schools should refer 

to Appendices A and B of Subpart L in the 

General Provisions regulations.

The Department issued guidance on the 

treatment of long-term and other debt in 

calculating these ratios in DCL GEN-01-02, 

which was subsequently replaced by 

DCL GEN-03-08. 

Tuition recovery funds

When a state submits a tuition recovery 

fund for approval by the Department, the 

Department will consider the extent to which 

the recovery fund:

• provides returns to both in-state and out-ofstate students;

• complies with FSA requirements for the order 

of return of funds to sources of assistance; and

• is replenished if any claims arise that deplete 

the fund.

Financial responsibility

Treatment of long-term debt

DCL GEN 03-08, July 2003

34 CFR 668, Subpart L, Appendices A & B

Ratios

34 CFR 668.171(b)(3)

Refund reserve standard

34 CFR 668.173

Returning funds

34 CFR 668.172(c)

For withdrawn students, returns funds in a 

timely manner

34 CFR 668.22
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FSA HB JUL 2012

The first step in calculating a school’s composite score 

is to determine the school’s primary reserve, equity, 

and net income ratios by using information from the 

school’s audited financial statement. These ratios take 

into account the total financial resources of the school. 

The Primary Reserve Ratio represents a measure of 

a school’s viability and liquidity. The Equity Ratio 

represents a measure of a school’s capital resources 

and its ability to borrow. The Net Income Ratio 

represents a measure of a school’s profitability. 

Upon review, some items from a school’s audited 

financial statement may be excluded from the 

calculation of the ratios. For example, the Department 

may exclude the effects of questionable accounting 

treatments, such as excessive capitalization of 

marketing costs, from the ratio calculations. (See the 

regulatory exclusions below.) 

All long-term debt obtained for the school’s purposes 

may be included for purposes of the Primary Reserve 

Ratio calculation. However, it is important to note 

that the overall level of debt obtained for long-term 

purposes that can be included in the numerator of the 

Primary Reserve Ratio is limited under the regulations. 

It cannot exceed the amount of the school’s net 

property, plant, and equipment.

A strength factor score is then calculated for each 

ratio using equations established by the Department. 

A strength factor score reflects a school’s relative 

strength or weakness in a fundamental element 

of financial health, as measured by the ratios. 

Specifically, the strength factor scores reflect the 

extent to which a school has the financial resources 

to: 1) replace existing technology with newer 

technology; 2) replace physical capital that wears 

out over time; 3) recruit, retain, and retrain faculty 

and staff (human capital); and 4) develop new 

programs. 

A weighting percentage is applied to each strength 

factor score to obtain a weighted score for each 

ratio. The weighting percentages reflect the relative 

importance that each fundamental element has for 

a school in a particular sector (proprietary or private 

nonprofit).

The sum of the weighted scores equals the school’s 

composite score. Because the weighted scores 

reflect the strengths and weaknesses represented 

by the ratios and take into account the importance 

of those strengths and weaknesses, a strength in 

the weighted score of one ratio may compensate for 

a weakness in the weighted score of another ratio.

Once a composite score is calculated, it is measured 

along a common scale from negative 1.0 to positive 

3.0 as indicated in the diagram on page 72. This 

scale reflects the probability a school will be able 

to continue operations and meet its obligations to 

students and the Department.

Calculating a composite score

 Excluded items. In calculating an institution’s ratios, 

the Secretary—

(1) Generally excludes extraordinary gains or losses, 

income or losses from discontinued operations, prior 

period adjustments, the cumulative effect of changes 

in accounting principles, and the effect of changes in 

accounting estimates;

(2) May include or exclude the effects of questionable 

accounting treatments, such as excessive capitalization 

of marketing costs;

(3) Excludes all unsecured or uncollateralized relatedparty receivables;

(4) Excludes all intangible assets defined as intangible 

in accordance with generally accepted accounting 

principles; and

(5) Excludes from the ratio calculations Federal 

funds provided to an institution by the Secretary 

under program authorized by the HEA only if—

(i) In the notes to the institution’s audited 

financial statement, or as a separate attestation, 

the auditor discloses by name and CFDA number, 

the amount of HEA program funds reported as 

expenses in the Statement of Activities for the 

fiscal year covered by that audit or attestation; 

and

(ii) The institution’s composite score, as 

determined by the Secretary, is less than 1.5 

before the reported expenses arising from 

those HEA funds are excluded from the ratio 

calculations.

34 CFR 172(c)

Exclusions 
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FSA HB JUL 2012

Returning funds in a timely manner

Unearned funds must be returned no later than 45 days after the date

of the school’s determination that the student withdrew. ED considers the 

school to have returned funds, depending upon the method it uses to return 

them. Specifically, the regulations provide that a school has returned funds 

when it has: 

•	 deposited or transferred the funds into the bank account it

maintains for federal funds (see sidebar) no later than 45 days after

the date it determines that the student withdrew,

•	 initiated an electronic funds transfer (EFT) no later than 45 days

after the date it determines that the student withdrew, or 

•	 issued a check no later than 45 days (as supported by the school’s

records) after the date it determines that the student withdrew.

If a check is used to return unearned funds, the Department requires 

that the check be endorsed by ED no later than 60 days after the school’s

determination that a student withdrew to be considered a timely return.

Compliance thresholds for timely return of funds 

The Department provides for a small margin of error in determining that 

a school has paid all required refunds and returns on time. The Department 

considers a school to have paid returns in a timely manner if—

•	 there is less than a 5% error rate in a sample of returns (composed

of students for whom the school was required to return unearned 

funds) examined in a compliance audit, an audit conducted by 

the Office of the Inspector General (OIG), or a program review 

conducted by the Department or guaranty agency, or

•	 there are no more than two late returns in the sample (regardless of

the number or percentage of late returns in the sample). 

In addition, if the reviewer or auditor finds a material weakness or 

reportable condition in the school’s report on internal controls relating to the 

return of unearned Title IV aid, the Department considers the school to have 

not paid returns in a timely manner. 

Letter of credit required when funds 

are not returned in timely manner

Public schools and schools covered by a state tuition recovery fund that 

has been approved by the Department are not subject to the letter of credit 

requirements. If any other school exceeds the compliance thresholds in either 

of its two most recently completed fiscal years, the school must submit an 

irrevocable letter of credit acceptable and payable to the Department. The 

letter of credit must be equal to 25% of the returns the school made or should

have made during its most recently completed fiscal year.

A school that is required to submit a letter of credit must do so no later 

than 30 days after the earlier of the date that:

Address for Letters of Credit

Letters of credit are submitted to: 

Director

Performance Improvement & Procedures 

U.S. Department of Education

Federal Student Aid

830 First Street, NE

UCP-3, MS 5435 

Washington, DC 20002-8019

Deposit to operating account or 

separate federal bank account

A school that maintains a separate federal 

bank account must deposit to that account, 

or transfer from its operating account to its 

federal account, the amount of unearned 

program funds, as determined under the 

Return of Title IV funds regulations. The date 

the school makes that deposit or transfer 

is the date used to determine whether the 

school returned the funds within the 45-day 

timeframe permitted in the regulations. 

Unless the Department requires a school 

to use a separate account, the school may 

use its operating account for FSA purposes. 

In this case the school must designate that 

account as its federal bank account and have 

an auditable system of records showing that 

the funds have been allocated properly and 

returned in a timely manner. If there is no clear 

audit trail, the Department can require the 

school to begin maintaining FSA funds in a 

separate bank account.

34 CFR 668.163(a)

Making new awards with 

returned funds

After a school has returned unearned funds 

to its federal account, provided those funds 

were originally received from the Department 

or from an FFEL lender under a process that 

allows the school to reuse the unearned 

funds, the school can use the funds to make 

disbursements to other eligible students.

Return of Title IV funds

The requirements for return of Title IV funds for 

students who withdraw from the educational 

program are described in Volume 5.
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FSA HB JUL 2012

•	 the school is required to submit its compliance audit;

•	 the OIG issues a final audit report;

•	 the designated department official issues a final program review

determination;

•	 the Department issues a preliminary program review report or

draft audit report, or a guaranty agency issues a preliminary report 

showing that the school did not return unearned funds for more 

than 10% of the sampled students; or

•	 ED sends a written notice to the school requesting the letter of

credit that explains why the school has failed to return unearned 

funds in a timely manner.

If the finding in the preliminary report is that the school did not return 

unearned funds in a timely manner for 10% or fewer of the sampled students,

a school would generally be required to submit the letter of credit only if the 

final report shows that the school did not return unearned funds in a timely 

manner for 5% or more of all the students in the sample. If the final report

indicates that a letter of credit is required, the school would have to submit it 

no later than 30 days after the final report is issued.

Exceptions to the letter of credit requirement

A school is not required to submit a letter of credit of less than $5,000.

However, to meet the reserve requirement, such a school would need to 

demonstrate that it has available at all times cash reserves of at least $5,000 to

make required returns.

In addition, a school may delay submitting a letter of credit while it asks 

for reconsideration of a finding that it failed to return unearned FSA funds 

in a timely manner. A school may request that the Department reconsider its 

finding if the school submits documents showing that:

•	 the unearned FSA funds were not returned in a timely manner

solely because of exceptional circumstances beyond the school’s 

control and that the school would not have exceeded the applicable 

threshold had it not been for the exceptional circumstances; or 

•	 it did not fail to make timely returns.

A school that submits an appeal, together with all required supporting 

documents, by the date the letter of credit would be due is not required to 

submit a letter of credit unless the Department notifies the school that its 

request has been denied.

Current in debt payments

A school is not current in its debt payments if

•	 it is in violation of any existing loan agreement at its fiscal year end,

as disclosed in a note to its audited financial statements or audit 

opinion, or

•	 it 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.
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Example: Calculation of a composite score 

 for a proprietary institution* 

Calculation of Ratios

Primary Reserve = = = 0.080

Ratio

 

Equity Ratio = = = 0.332

Net Income = = = 0.051

Ratio

Calculation of Strength Factor Score

Primary Reserve Strength Factor Score = 20 x Primary Reserve Ratio

 20 x 0.080 = 1.600

Equity Strength Factor Score = 6 x Equity Ratio

 6 x 0.332 = 1.992

Net Income Strength Factor Score = 1 + (33.3 x Net Income Ratio)

 1 + (33.3 x 0.051) = 2.698

Calculation of Weighted Score

Primary Reserve Weighted Score = 30% x Primary Reserve Strength Factor Score

 0.30 x 1.600 = 0.480

Equity Weighted Score = 40% x Equity Strength Factor Score

 0.40 x 1.992 = 0.797

Net Income Weighted Score = 30% x Net Income Strength Factor Score

 0.30 x 2.698 = 0.809

Composite Score

Sum of All Weighted Scores 0.480 + 0.797 + 0.809 = 2.086 rounded to 2.1

* The definition of terms used in the ratios and the applicable strength factor algorithms and weighting 

percentages are found in the Student Assistance General Provisions (regulations) (34 CFR 668) Subpart L, 

Appendix A for proprietary schools and Appendix B for private nonprofit schools.

Composite score scale

1.5 to 3.0 Financially responsible without further oversight.

1.0 to 1.4 In the “Zone.” The school is considered financially 

responsible, but additional oversight is required.

–1.0 to .9 Not financially responsible. The school must submit a letter of 

credit of at least 50% of its FSA funding. The school may be 

permitted to participate under provisional certification with 

a smaller letter of credit—with a minimum of 10% of its FSA 

funding and additional oversight.

1.5 –

3.0

–1.0 – .9

1.0 – 1.4

Adusted equity

Total expenses

Modified equity

Modified expenses

Income before taxes

Total revenues

$760,000

$9,500,000

$810,000

$2,440,000

$510,000

$10,010,000
Ch. 4—Audits, Financial Standards, Limitations & Cohort Rates

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FSA HB JUL 2012

ALTERNATIVES TO THE GENERAL FINANCIAL STANDARDS

If a school does not meet the general standards for financial 

responsibility, the Department may still consider the school to be financially 

responsible or may allow the school to participate under provisional 

certification if the school qualifies for an alternative standard.

If the Department determines that a school that does not meet one or 

more of the general standards and does not qualify for an alternative, the 

Department may initiate a limitation, suspension, or termination action 

against the school (see Chapter 9 for more information on corrective actions 

and sanctions).

Letter of credit alternative for new school

A new school (a school that seeks to participate in the FSA programs 

for the first time) that does not meet the composite score standard (i.e., 

has a composite score of less than 1.5) but meets all other standards may

demonstrate financial responsibility by submitting an irrevocable letter of 

credit to the Department. The letter of credit must be acceptable and payable 

to the Department and equal to at least 50% of the FSA program funds that

the Department determines that the school will receive during its initial year 

of participation.

Letter of credit alternative for participating school 

A participating proprietary or private nonprofit school that fails to meet 

one or more of the general standards or is not financially responsible because 

it has an adverse audit opinion may demonstrate financial responsibility by 

submitting an irrevocable letter of credit to the Department. The letter of 

credit must be acceptable and payable to the Department and equal to at least 

50% of the FSA program funds that the school has received during its most

recently completed fiscal year. The school is then considered to be financially 

responsible.

Zone alternative 

A participating school that fails to meet the composite score standard 

(i.e., has a composite score of less than 1.5) but meets all other standards may

demonstrate financial responsibility for up to three consecutive fiscal years 

if the Department determines that the school’s composite score is equal to 

1.0 to 1.4 for each of those years and the school meets specific monitoring

requirements.

This alternative gives a school the opportunity to improve its financial 

condition over time without requiring the school to post a letter of credit 

or participate under provisional certification. Under the zone alternative, a 

school’s operations, including its administration of the FSA programs, are 

monitored more closely. If a school does not score at least 1.0 in one of the

three subsequent fiscal years or does not improve its financial condition to 

attain a composite score of at least 1.5 by the end of the three-year period, the

school must satisfy another alternative standard to continue participating. 

In addition, if a school fails to comply with the information reporting or 

payment method requirements, the Department may determine that the 

school no longer qualifies under this alternative. 

Alternative standards and 

requirements

34 CFR 668.175

Information to be provided under 

the zone alternative

The school must provide timely information 

regarding any of the following oversight and 

financial events:

• Any adverse action, including a probation or 

similar action, taken against the institution by 

its accrediting agency;

• Any event that causes the institution, or 

related entity as defined in the Statement 

of Financial Accounting Standards (SFAS) 

57, to realize any liability that was noted as 

a contingent liability in the institution’s or 

related entity’s most recent audited financial 

statement;

• Any violation by the institution of any loan 

agreement;

• Any failure of the institution to make 

a payment in accordance with its debt 

obligations that results in a creditor filing suit 

to recover funds under those obligations;

• Any withdrawal of owner’s equity from 

the institution by any means, including by 

declaring a dividend; or

• Any extraordinary losses, as defined in 

accordance with Accounting Principles Board 

(APB) Opinion No. 30.

The school may also be required to:

• submit its financial statement and 

compliance audits earlier than the time 

specified under 34 CFR 668.23(a)(4); and

• provide information about its current 

operations and future plans.

34 CFR 668.175(d)(2)
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FSA HB JUL 2012

Under the zone alternative, a school—

•	 must request and receive funds under the cash monitoring or

reimbursement payment methods, as specified by the Department 

(see Volume 4, Chapter 2);

•	 must provide timely information regarding certain oversight and

financial events (see sidebar);

•	 may be required to submit its financial statement and compliance

audit earlier than normally required (see the discussion of audit 

submission deadlines earlier in this chapter); and

•	 may be required to provide information about its current

operations and future plans.

The school must also require its auditor to express an opinion, as 

part of the school’s compliance audit, on the school’s compliance with the 

requirements of the zone alternative, including the school’s administration 

of the payment method under which the school received and disbursed FSA 

program funds. 

Provisional certification for school not meeting standards

If a participating proprietary or private nonprofit school fails to meet one 

or more of the general standards or is not financially responsible because it 

has an unacceptable audit opinion, the Department may permit the school to 

participate under provisional certification for up to three years. 

The Department may permit a school that is not financially responsible 

to participate under provisional certification if the school is not financially 

responsible because it:

•	 does not satisfy the general standards;

•	 has an unacceptable audit opinion; or

•	 has a past performance problem that has been resolved.

If the Department permits a school to participate under provisional 

certification, the Department will require the school:

•	 to submit to the Department a letter of credit, payable and

acceptable to the Department, for a percentage (10%–100%) of the

FSA program funds received by the school during its most recent 

fiscal year.

•	 to demonstrate that it has met all of its financial obligations and

was current on its debt payments for its two most recent fiscal 

years. 

Moreover, the school must comply with the requirement under the zone 

alternative that it provide timely information regarding certain oversight and 

financial events. Finally, a school that is required to post a letter of credit will 

be placed on heightened cash monitoring or reimbursement. 

If a school is still not financially responsible at the end of a period of 

provisional certification, the Department may again permit provisional 

certification. However, the Department may require the school or persons or 
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FSA HB JUL 2012

entities that exercise substantial control over the school to submit financial 

guarantees to the Department to satisfy any potential liabilities arising from 

the school’s FSA program participation. The same persons may be required 

to agree to be jointly and severally liable for any FSA program liabilities.

The Department is not required to offer provisional certification to 

a school. It is an alternative that the Department may choose to offer in 

exceptional circumstances.

Provisional certification for school where persons 

or entities owe liabilities 

If a school is not financially responsible because the persons or entities 

that exercise substantial control over the school owe an FSA program 

liability, the Department may permit the school to participate under 

provisional certification if:

•	 the persons or entities that owe the liability repay or enter into an

agreement with the Department to repay the liability (or the school 

assumes the liability and repays or enters into an agreement to 

repay the liability); 

•	 the school meets all the general standards of financial responsibility

and demonstrates that it has met all of its financial obligations 

and was current on its debt payments for its two most recent fiscal 

years; and 

•	 the school submits to the Department a letter of credit, payable and

acceptable to the Department, for an amount determined by the 

Department (at least 10% of the FSA program funds received by the

school during its most recent fiscal year).

The school also must comply with the requirements under the zone 

alternative.

In addition, the Department may require the school or persons or 

entities that exercise substantial control over the school to submit financial 

guarantees to the Department to satisfy any potential liabilities arising from 

the school’s FSA program participation. The same persons may be required 

to agree to be jointly and severally liable for any FSA program liabilities.
SUPPLEMENTAL

READING

Chronicle of Higher Education

August 11, 2010

149 Nonprofit Colleges Fail 

Education Department's Test of Financial Strength

By Goldie Blumenstyk and Alex Richards

A total of 149 private nonprofit colleges failed the U.S. Department of Education's "financialresponsibility test" based on their condition in the 2009 fiscal year, data released on Thursday 

show. That's 23 more than the 126 that failed the test in the 2008 fiscal year, and an increase of 

about 70 percent over the number of degree-granting institutions that failed two years ago.

The colleges include small, religious institutions like Crossroads College, in Minnesota, and 

Concordia Seminary, in Missouri; specialized institutions like the Pennsylvania Academy of the 

Fine Arts, the Milwaukee Institute of Art & Design, and the Dorothea Hopfer School of Nursing, 

at Mount Vernon Hospital, in New York; and several residential and liberal-arts colleges, 

including Belmont Abbey, Bethel, Guilford, Harcum, Keuka, and Ripon.

Among for-profit colleges, 37 failed the test for 2009, 11 fewer than for 2007. Nine of them had 

the lowest possible score.

Colleges that fail the test are subject to additional federal scrutiny of student-aid funds and, in 

cases of the lowest scores, extra financial obligations.

More than a third of the nonprofit colleges that failed the test in 2009 are located in nine states in 

the Midwest, with 13 in Illinois, the analysis showed. Another 13 are in Pennsylvania, 12 in New 

York, and 11 in California. (See interactive map for details on past three years.)

A Chronicle analysis also found that 34 of the nonprofit institutions on the list for 2009 failed the 

test in each of the previous two years as well. (The accompanying interactive table shows scores 

for all degree-granting institutions that failed the test in any of the three years, as well as the 

number of years in which they've done so.)

Failing the test is typically an indicator of a college's overall financial fragility. But for 2009, 

several of the nonprofit institutions said their presence on the list was due chiefly to steep 

declines in their endowment values. "If the market hadn't gone down, we wouldn't be a one," said 

Mary M. de Regnier, vice president for finance at Ripon College, referring to its score. Ripon fell 

below the passing score of 1.5 but above the level at which it would be required to post a letter of 

credit with the Department of Education. The college said it could do so without hurting its 

liquidity.

Rockhurst University, in Missouri, which scored 0.9, said endowment losses, the way it accounts 

for interest contracts on its debt, and a training company it owns that "racked up a loss last year," 

as the economy faltered, were all factors in its low score. "We'll be better this year," said Guy 

Swanson, vice president for business and finance.
Scores, which run from minus 1.0 to 3, are based on a calculation that takes several factors into 

account, including debt, assets, and operating deficits and surpluses.

Takeover Targets?

A failing score has also become a signal to investors that an institution could be ripe for a forprofit takeover. At least one of the colleges that appeared on the list of "failed" institutions first 

published by The Chronicle, in June 2009, doesn't appear on the list for the 2009 fiscal year; the 

institution, National Hispanic University, in California, was sold to Laureate Education Inc. 

Waldorf College, in Iowa was also sold. Its purchase, by the for-profit Columbia Southern 

University took place after the end of the fiscal year and the college appears on the nonprofit list 

for 2009.

The list for 2009 includes Dana College, in Nebraska, which recently announced that it would 

close, after its accreditor said it would not automatically continue its accreditation under the 

corporate owners that had hoped to buy it. (Two other institutions known to be in talks with 

buyers, Lambuth University, in Tennessee, and Rochester College, in Michigan, don't appear in 

the Education Department's data files for 2009, presumably because they are among the 115 or 

so degree-granting for-profit and nonprofit institutions whose scores are still being processed by 

the department.)

Last year the Chronicle obtained its list of 114 degree-granting nonprofit institutions in response 

to a Freedom of Information Act request. That list was based on Education Department data that 

did not reflect all colleges' most current fiscal year, or adjustments to scores the department was 

in the process of compiling. This year the department did not release scores until all colleges had 

submitted current information and had a chance to resolve questions about their scores. )

In addition, the department also released all scores for all nonprofit and for-profit colleges for the 

previous two years. The information is available at the department's data center Web site. 

Officials said they were releasing the data to give the public more information about colleges and 

in response to the interest resulting from the Chronicle's publication of the list last year. Public 

colleges, because of their government support, typically aren't subject to the assessment, which is 

designed to assure taxpayers that their money is not at risk.

Colleges that score 1 to 1.4 on the test are considered to have failed but are "in the zone," 

meaning they can continue to participate in federal financial-aid programs, but with restrictions 

on how student-aid funds are disbursed to them.

Colleges with scores below 1 are subject to extra requirements. They must post letters of credit 

equal to at least 10 percent of the federal student-aid funds they receive and face additional 

restrictions, or post letters of credit equal to at least 50 percent of the funds they receive and 

operate as if they had passed the test. Colleges that score 1 through 1.4 for three consecutive 

years become subject to the extra requirements.
Department officials said they rarely kicked colleges out of student-aid programs altogether, 

because the restrictions and letter-of-credit requirements are adequate protections for taxpayers' 

money if a college falls into dire financial straits.

In 2009 more than half of the failing nonprofit colleges—80 of them—scored low enough to 

trigger the extra requirements, up from 71 in 2008 and 48 in 2007. Among for-profit colleges, 

the trend was reversed; 24 scored that low in 2009, down from 33 in 2008 and 39 in 2007.

Trying to Improve

Several of the colleges with low scores said they were taking steps to improve their financial 

situation. A branch of City College, in Casselberry, Fla., scored the lowest possible score in each 

of the past three years. The college's lawyer said that it had been a separately owned two-year 

institution managed by City College, but that this year City College has absorbed it, and its 

enrollment, which had fallen to about 73 in 2006, is now above 300.

Officials of Ave Maria School of Law, which has failed the test for three years and had a score of 

minus 0.9 in 2009, issued a statement that its relocation to Naples, Fla., was helping to improve 

both its appeal to students and its fund raising. The law school, which has graduated just seven 

classes, said that its asset-to-debt ratio was still low, but that it expected the ratio to "reverse 

itself over time" as the school builds its endowment.

The vice president for finance at Eureka College, Marc P. Pasteris, said the Illinois institution has 

struggled with finances for decades and had been on course for a turnaround since 2005, under a 

tuition-pricing plan designed to eliminate most discounts, and improve retention. In the previous 

two years, Eureka reached scores of 1.4, but it fell to 0.8 in 2009 because of endowment losses. 

"We are not out of the woods," Mr. Pasteris said, "but on the right track."

As in the past, some institutions end up being subject to extra scrutiny by the department or 

additional student-aid-disbursement requirements because of the way the department accounts 

for particular transactions.

The president of Bryant & Stratton College, one of the for-profit institutions that reached the list 

in 2009 (with a score of 0.2), said it did so because of the way it accounts for the capital brought 

in by new investors and the equity granted to them.

A nonprofit, Alliant International University, said a building on its San Francisco campus, which 

it sold a few years ago and is now leasing back from the owner, pushed down its score. Alliant 

appeared on the list last year with a score of 1.4 and this year with 1.3. It's "not a list we want to 

be on," said Geoffrey M. Cox, the president.

In a recent Chronicle commentary, Mr. Cox noted that his university had received at least six 

unsolicited inquiries from investors in the past few months. It's not interested in selling itself, he 

added.
August 13, 2010: This article has been revised to reflect the following correction: Because of 

inaccurate information provided by the Education Department, Harding College, in Arkansas, 

was mistakenly included on the list of institutions that failed the department's test of financial 

strength in 2008-9. Harding received a composite score of 1.7, not 1.1, and has been removed 

from the list.
Chronicle of Higher Education

September 7, 2011

Education Dept. Miscalculates 

'Financial Responsibility' Scores, Private Colleges Say

By Goldie Blumenstyk

Washington

This month, the U.S. Department of Education will publish the annual financial-responsibility 

scores of thousands of private colleges. The scores are one of the few publicly available, broadbased indicators of individual institutions' financial health. Or are they?

According to three major higher-education associations and several colleges and private 

accountants, the scores are often inaccurate and misleading, because the department misapplies 

its own rules when making its calculations.

The critics also contend that aspects of the 14-year-old formula used to calculate the scores are 

flawed and outdated.

For more than a year, groups including the National Association of College and University 

Business Officers and the National Association of Independent Colleges and Universities have 

pressed the department to re-examine how it calculates the scores. They are derived from the 

audited financial statements that colleges are required to submit annually to the department. The 

scores are important because they help determine whether and how freely colleges can 

participate in federal student-aid programs.

The business officers' group has documented five areas where, it contends, the department is 

miscalculating the scores. And the private-college association says the department's inconsistent 

application of formulas among its 10 regional offices compounds the unreliability of the scores 

as a measure of colleges' financial health.

"There could be schools on the list that shouldn't be on the list, and there could be schools that 

should be on the list that aren't," says Sarah A. Flanagan, vice president for government relations 

and policy at the private-college group, known as NAICU.

The scores, which run from 3.0 to minus 1.0, were devised to identify colleges in financial 

trouble. Over the past two years, several colleges with low scores have been acquired by other 

parties, suggesting that the list has become a tool for private investors seeking financially ailing 

colleges that could be ripe for a takeover.

But NAICU contends that the Education Department's misapplication of its own rules has given 

a false impression of the number of colleges on the brink. The data for the 2009 fiscal year 

showed 149 private degree-granting institutions received composite scores of 1.5 or below, the 
cutoff for passing the test. "There's just not 150 schools that are at the risk of closure, or even 

close to that," Ms. Flanagan says.

She and other critics say that, for 2009 in particular—a year of significant losses for investors—

the department's treatment of endowment declines (it counts a decline in endowment value as if 

it were an expenditure) improperly put many more colleges on the "failed" list than should have 

been there.

The department maintains that it applies the regulations consistently with its interpretation of 

them. In a letter to NACUBO, the business officers' group, it provided a point-by-point rebuttal 

to the arguments raised by that organization.

Serious Consequences

Although the higher-education groups' disagreements with the department over the scores focus 

largely on arcane principles best understood by accountants—whether to classify a college's line 

of credit as short-term or long-term debt, whether endowment losses should count as "total 

unrestricted expenses"—the ramifications are much bigger.

Colleges with scores below 1.5 are subject to tighter monitoring for their federal student-aid 

funds. Those with scores below 1.0 are required to post costly letters of credit to remain eligible 

for financial-aid programs. Colleges that consistently fail the test can be denied the right to issue 

federal aid to their students.

For some institutions, the publication of the scores becomes a public-relations concern as well.

When Guilford College, in North Carolina, showed up on the list for 2009 with a score of 1.4, 

"we were on the front page" of the local newspaper, says its president, Kent J. Chabotar. A 

former college finance officer, Mr. Chabotar is part of a group organized by NAICU, NACUBO, 

and the Council of Independent Colleges that is studying the financial-responsibility score and 

the department's application of it.

There is value in the scores if they're accurate, he says, but as currently applied, the scores are a 

source of "misplaced public scrutiny."

The department has produced the scores since 1998, but the higher-education groups say it was 

only after the scores were made public, two years ago, that the critics began to discover what 

they say are widespread problems. In 2009, The Chronicle obtained scores for all colleges under 

a Freedom of Information Act request and published a comprehensive list of those with failing 

scores. Last year the department decided to release the scores annually for all institutions on its 

own Web site. (The release of the latest round of scores, covering the 2010 fiscal year, is 

expected this month, but the date has not yet been set.)

Before the publication of the scores, colleges often didn't even know how the calculation had 

turned out unless they failed, Ms. Flanagan says. Colleges don't even necessarily know how the 

department crunches the numbers, she adds.
Problem Areas

In conducting its own analysis, NACUBO says it has identified five areas where it believes the 

department is misapplying its own formula in ways that are "contrary to the letter and spirit" of 

the 1997 rules that established the scores.

In addition to the questions over how endowment losses are treated, most of the disagreements 

involve whether colleges are improperly penalized for things like the way they've structured their 

debt, or how they account for such liabilities as the long-term cost of pensions.

Dale C. Larson, chief financial officer at the Dallas Theological Seminary, says he has no dispute 

with counting an institution's annual cost of providing those pensions. But he says it is wrong to 

treat the entire unfunded liability of a pension as a single year's expense—as the Education 

Department did for his institution in 2009. That resulted in a score of 1.0. "I never should have 

been in the failed category," he says.

In its rebuttal to NACUBO, the department says it is following the law in accounting for 

pensions.

NACUBO has also taken issue with the department's hard line on counting pledged donations 

from trustees. If the trustee is also doing business with the college, the department may consider 

the pledge as a transaction from a "related party" and not count the entire pledge as an asset. 

NACUBO says the department is applying a standard for "related-party transactions" that is 

appropriate in the for-profit sector, but not for nonprofit institutions.

The Association of Private Sector Colleges and Universities says its members have raised no 

issues about how the department calculates scores for their institutions.

Ms. Flanagan, of NAICU, argues that the rules themselves need to be updated. For example, she 

says, while laws enacted in the past few years in most states allow nonprofit organizations 

greater flexibility in how they spend their endowments, the department's formula doesn't reflect 

that new leeway in its calculation of colleges' assets.

Department officials have said they are willing to consider changes in the formula but haven't 

made it a top priority. Ms. Flanagan says the groups are frustrated by the inaction but understand 

the situation. "Right now, they've got a lot to worry about that we also want them to worry about, 

like the student-aid programs," she says. "Our hope is that if we come up with an alternate 

solution," department officials will consider it.

Meanwhile, endowments at many colleges are gradually recovering from their 2009 lows, and 

the groups expect fewer institutions to find themselves on the hot seat when the scores for 2010 

become public. This year, says Ms. Flanagan, "we are guessing the list will be smaller."

GLOSSARY

GLOSSARY OF TERMS

Accrediting Agency - Legal entity that conducts

accrediting activities through voluntary,

non-Federal peer review and makes decisions

concerning the educational quality of institutions

or programs, or both. In order to be eligible to

participate in federal student aid programs, an

institution must be accredited by an agency that

is recognized by the Department of Education.

Actuarial Losses - Loss arising from the difference

between estimates and actual experience in an

entity's pension plan. (Actuarial gains and losses

are used when accounting for pension plans

because of the need to make assumptions about

the future rate of salary increases, the length of

employee tenure, an appropriate discount rate

for the plan obligations and the expected rate of

return on plan assets.) 

Annuities - A contract between a contributor and

a financial entity that is designed to meet

retirement and other long-range goals, under

which the contributor receives a lump-sum

payment or series of payments at some future

point. In planned giving annuity arrangements, a

donor may transfer assets to a college or

university with an agreement that the institution

will make payments to a designated beneficiary

or beneficiaries, for a certain period of time, or

until the death of the beneficiary/ies. The assets

are general assets of the institution and the

liability to the beneficiary/ies is a general liability

of the institution. Adjustments to the liability to

reflect amortization of the discount, revaluations

of the present value of the estimated future

payments to the beneficiaries, and changes in

actuarial assumptions is recognized in the

statement of activities as a change in the value of

split-interest agreements.

Cash Monitoring - The Department of

Education's cash monitoring payment method is

similar to the reimbursement payment method,

but less onerous. A school placed on Heightened

Cash Monitoring (HCM) must make

disbursements to eligible students and parents

before it may request or receive funds for those

disbursements from the Department. However,

unlike the reimbursement payment method,

where a school must provide detailed

documentation for each student, the Department

provides funds to a school in a less restrictive

way.

Cohort Default Rate (CDR) - Percentage of an

institution's loans that went into repayment in

one fiscal year, that then defaulted before the

end of a subsequent fiscal year (or two

succeeding years for new three-year rates). 

Institutions participating in Title IV programs may

face sanctions if their CDR is above a

pre-determined level.

Composite Score - In the Department of

Education's financial responsibility standard, the

composite score combines three financial ratios

which are weighted and assigned strength factors

to yield a single measure of a school's overall

financial health. (See Appendix D: Department of

Education Handbook, page D-6.)

Construction in Progress (CIP) - The classification

of a long-lived asset that is being built/assembled

before being placed in service. Entities track

expenditures incurred, or funds disbursed, in a

special "construction in progress" general ledger

account until the asset is completed and placed

in service. CIP totals are typically part of the

"property, plant and equipment" asset category

on the statement of financial position (balance

sheet).

Debt Service - An agreed amount of principal and

interest a borrower pays periodically on a loan

over an agreed amount of time until the loan is

repaid.

Disbursement Requirements - The rules

according to which an institution pays federal

student aid to its students.
Donor-restricted Gifts - Gifts provided to a

nonprofit entity that must be used for a specific

purpose or over a specific time period. Donor

restricted gifts increase either temporarily

restricted net assets or permanently restricted

net assets. There are often significant accounting,

legal, tax, and integrity issues associated with

such gifts. 

Endowment Fund - An investment fund set up by

an institution to provide future financial support.

The use of the assets of the fund may be

permanently restricted, temporarily restricted, or

unrestricted. Endowment funds generally are

established by donor-restricted gifts and

bequests to provide (a) a permanent

endowment, which is to provide a permanent

source of income, or a (b) term endowment,

which is to provide income for a specified period.

Typically, the original gift amount must be

maintained in perpetuity (for the perpetual

support of the entity) while a portion of earnings

or appreciation are withdrawn to support

ongoing operations or other specified purposes.

Endowment funds are unique to nonprofit

organizations.

Equity - On a company's balance sheet, the

amount of the funds contributed by the owners

(or stockholders if the company is publicly

traded) plus the retained earnings (or losses). 

(See Net Assets.)

Equity Ratio - One of the ratios used to compute

the Department of Education's financial responsibility composite score, intended to measure an

institution's capital resources, ability to borrow,

and financial viability. (See Appendix A.)

Expendable Net Assets - Expendable net assets

are those assets that an institution can access

and spend to satisfy its obligations. (See

Appendix A.)

eZ-Audit - A web application that provides

institutions with a paperless, single point of

submission for financial statements and

compliance audits. The Department of Education

provides an on-line template for use in

submitting financial data via the application.

Failing Composite Score - A score that is less

than 1.5. 

Financial Accounting Standards Board (FASB) --

The designated private sector organization in the

United States that establishes financial

accounting and reporting standards. FASB

standards are recognized as authoritative

guidance for the preparation of financial reports

by nongovernmental entities. 

Financial Ratios - Financial ratios are calculated

from an entity's financial statements (and/or

other financial information) as indicators of

financial performance. Ratios are analytical tools

that can help quantify the status, sources, and

uses of an entity's financial resources. There are

many standard ratios used to try to evaluate the

overall financial condition of an entity. In the

case of the Department of Education's financial

responsibility scores, three ratios are calculated,

assigned strength factors and weights and

combined into a single composite score. (See

Appendix D: Department of Education

Handbook.)

Financial Responsibility Standards - Department

of Education's financial requirements for

institutions that provide or seek to provide

federal student aid to their students. (See

Appendix D: Department of Education

Handbook.) 

For-profit School (or proprietary school) - A

school with the goal and financial structure to

make a profit through the business of educating

students. Proprietary institutions are not public,

nor are they private nonprofit institutions. (They

sometimes are referred to as "private," which

can cause them to be confused with nonprofit

private institutions.) Due to variations in
accounting standards for for-profit and nonprofit

entities, the Department of Education's financial

responsibility standards set different calculations

for the two sectors.

GAAP - See Generally Accepted Accounting

Principles.

Gainful Employment - The Higher Education Act

requires that most for-profit programs and

certificate programs at nonprofit private and

public institutions prepare students for gainful

employment in a recognized occupation. The

Department of Education recently developed

standards for such programs measuring debt

levels and repayment rates of students. 

Generally Accepted Accounting Principles

(GAAP) - The standards of financial accounting

that govern financial statement reporting in the

United States. GAAP is not a single accounting

rule but rather a comprehensive body of many

rules that address various transactions. The

Financial Accounting Standards Board (FASB)

establishes GAAP for nonprofit and commercial

entities (including for-profit educational

institutions). The rules and procedures that

encompass GAAP are complex, have grown in

number over time, and continue to evolve

annually. Definitions and terminology within

these standards for nonprofit and commercial

entities sometimes differ based on items that are

unique to the specific industry. (See box on page

12 for additional information.)

Historical Gift Value (or historical dollar value) -

A term used in relation to an endowment fund to

quantify the original value of a gift that is

directed by a donor to be held in perpetuity by

the receiving organization. Additional gifts by the

donor that are also directed to be held in

perpetuity add to the historical gift value. Over

time, accumulated earnings and appreciation on

the original (historical) gift are considered

spendable depending on the restrictions placed

on the gift by the donor. Prior to the enactment

of UPMIFA, nonprofit colleges and universities

reflected the spendable portion of the

endowment in either (or both) the unrestricted

and temporarily restricted net asset classes.

Since the enactment of UPMIFA the spendable

portion of the fund is reflected in the temporarily

restricted net asset class until spent. UPMIFA

increases flexibility to maintain spending even in

times of market downturn – even if the value of

the endowment falls below its historical gift

value ("underwater"). 

Intangible Asset - A nonphysical asset, such as a

patent, trademark, copyright, goodwill or name

recognition. (See Tangible Asset.) 

Interest Rate Swap - A derivative in which

counterparties exchange cash flow of one party's

financial instrument for those of the other party's

financial instrument. For example, an institution

with variable rate long-term debt may use an

interest rate swap to protect against the risk that

the variable rate on the debt will increase to a

point where the debt service is no longer

affordable.

Letter of Credit - Correspondence issued by a

bank guaranteeing payment for goods and

services; e.g., federal student financial aid

received by a school, purchased by the one

requesting the letter. An irrevocable letter of

credit cannot be cancelled or modified without

explicit consent of the affected parties. Letters

of credit are in effect only for a specified time

period and expire at a pre-determined point. 

Cost can vary. In the case of federal student

financial aid, it is usually based on a percentage

of the federal student aid received by the

institution and its students.

Liabilities - Obligations of an entity arising from

past transactions or events, the settlement of

which may result in the transfer or use of assets,

provision of services or other yielding of

economic benefits in the future. Some liabilities

are long-term, such as notes payable that mature

over more than a year.
Life Income Funds - A type of planned giving

arrangement between a donor and a nonprofit

organization. The organization is named as a

beneficiary of a trust that generates income to

the donor. When the donor dies, the remainder

of the trust is released to the organization for

restricted or unrestricted use, as determined by

the agreement.

Monitoring Requirements - Additional

requirements the Department of Education may

impose on an institution that does not meet the

applicable financial responsibility standards.

Net Assets - A measure of the net worth of a

nonprofit organization, defined as total assets

less total liabilities, which is classified into three

mutually exclusive classes according to the

existence or absence of donor-imposed

restrictions. (See unrestricted, temporarily

restricted, and permanently restricted net assets.)

Net Income Ratio - One of the three ratios used

to determine the Department of Education's

financial responsibility composite score. It

measures an institution's ability to operate within

its means for the year. (See Appendix A.)

Net Property, Plant, and Equipment (PPE) -

Tangible, long-lived assets used in an

organization's mission related activities that have

an estimated useful life longer than one year,

typically comprised of the land, buildings, and

their contents owned by the institution, as well

as library books. The carrying value of the PPE is

shown net of accumulated depreciation.

Nonprofit (Not-for-profit) - An organization that

uses earned revenue and unearned support

(gifts) to achieve its goals or accomplish its

mission. While nonprofit organizations are

permitted to generate surplus revenues, they

must be retained by the organization for its

self-preservation, expansion, or plans (rather

than distributing them as profit or dividends to

owners or shareholders). They have controlling

members or boards of directors. Nonprofit

colleges and universities are exempt from federal

income taxes under Section 501(c)(3) of the

Internal Revenue Code.

Paper Loss - A decline in the value of an

endowment (or other such financial fund) that

may or may not ultimately be realized at the time

that asset is spent or sold.

Passing Composite Score - A score of +1.5 to

+3.0.

Perkins Loan Fund - An institutional, revolving

student loan fund initially funded by

contributions from the federal government and

the participating institution. 

Permanently Restricted Net Assets (PRNA) -

Permanently restricted net assets is the part of

the net assets of a not-for-profit organization

resulting from contributions and other inflows of

assets whose use by the organization is limited

by donor-imposed stipulations that neither

expire by passage of time nor can be fulfilled or

otherwise removed by actions of the

organization. 

Pledge - A promise made by a donor to provide a

future contribution to a nonprofit organization.

Because pledges are "promises to give" they are

a type of receivable of a nonprofit organization.

The maker has a social and moral obligation, and

sometimes a legal obligation, to make the

promised transfer. Nonprofit organizations are

the only types of entities that recognize and

record pledges. 

Post-employment and Retirement Plan

Liabilities - Benefits (such as health care and

pensions) provided to former or inactive

employees, their beneficiaries, and covered

dependents, creating a long-term liability on the

entity's financial statements. 
Primary Reserve Ratio - One of the three ratios

used to determine the Department of

Education's financial responsibility composite

score. This ratio measures an institution's

expendable resources in relation to its overall

operating size. The ratio indicates how long an

institution can function using expendable

resources and/or reserves without relying on

additional net assets generated by operations. 

(See Appendix A.)

Proprietary School - See For-profit Institution.

Provisional Certification - Certification of an

institution to participate in the Department of

Education's student aid programs, with

restrictions specified in the institution's program

participation agreement. It is usually in effect for

three years, and is used in a number of

circumstances; e.g., when an institution initially

applies to participate or when an institution is

judged by the Department to be in an

administrative or financial condition that might

jeopardize its ability to perform its

responsibilities.

Ratios Test - Tests used to calculate the financial

responsibility score of an institution. Three ratios

are used: the primary reserve ratio, the equity

ratio, and the net income ratio. (See Appendix A

or Composite Score.)

Realized and Unrealized Losses - A realized loss

stems from a completed transaction such as the

sale of an asset for less than its cost. Unrealized

losses are those that are shown on an

institution’s financial statement when the fair

market value of investment assets has declined,

but the assets have not been sold. 

Reimbursement Payment Method - Method

under which an institution must first disburse to

students and parents the amount of funds those

students and parents are eligible to receive under

the Federal Pell Grant, Stafford Loan, and

campus-based programs before the institution

may seek reimbursement from the Secretary of

Education for those disbursements. The

institution requests the amount of the actual

disbursements from the Secretary, identifies the

students for whom reimbursements are sought,

and shows that students and parents were

eligible for the aid.

Related Party Receivables - Money owed to an

organization from a related party. Related parties

are those that have a common control

relationship with an organization's management,

principal owners, or family members.

Restricted Net Assets - Net assets with

constraints placed on them either externally by

creditors, grantors, and contributors, or by law.

Rolling Average - An average calculated over a

specified period of time, where the next

increment of data is added in and the oldest

increment is dropped out.

Stafford Student Loans - Federal student loans

available to college and university undergraduate

and graduate students who are attending college

at least half-time. 

Tangible Asset - An asset that has a physical

form. Tangible assets include both fixed assets,

such as machinery, buildings and land, and

current assets, such as inventory. (See Intangible

Asset.) 

Temporarily Restricted Net Assets (TRNA) - The

part of the net assets of a nonprofit organization

that result from donor gifts or investment

income on donor restricted endowment funds

that are available for future spending. Except for

term endowments (see below), net assets within

this class are considered to be spendable

reserves that support the organization. 

Term Endowments - Funds for which the donor

stipulates that the principal may be expended

after a stated period of time or upon the

occurrence of a certain event. Term endowments

are included in temporarily restricted net assets

until the term expires. 
Title IV - The section of the Higher Education Act

that authorizes federal student aid, including

student grants, loans, and work study.

Total Assets - The summation of an

organization's tangible and intangible economic

resources.

Total Expenses - Outflows of funds, using up of

assets, or incurring liabilities from delivering

goods, rendering services, or carrying out

activities that constitute an entity's ongoing

major or central operations. Expenses result

from the decisions of an entity's managers about

the activities to be carried out and about how

and when particular resources are to be used.

Expenses do not include losses, which are

decreases in net assets from peripheral or

incidental transactions, e.g., endowment losses,

losses on the value of pension trust funds, losses

on the fair value of interest rate swaps. (See

Appendix A.)

Uniform Prudent Management of Institutional

Funds Act (UPMIFA) - Model state law which

governs the expenditure and investment

practices of charitable institutions related to

donor-restricted endowment funds. (See box,

page 19.)

Unrestricted Net Assets (URNA) - The part of the

net assets of a nonprofit organization that is

neither permanently nor temporarily restricted

by donor-imposed stipulations. Unrestricted net

assets generally result from revenues from

providing services; producing and delivering

goods; unrestricted contributions; and dividends

or interest from investing in income-producing

assets, less liabilities. (See Temporarily Restricted

Net Assets, and Permanently Restricted Net

Assets.)

UPMIFA - See Uniform Prudent Management of

Institutional Funds Act. 

Zone Alternative ("In the Zone") - Provisions in

the financial responsibility standards under which

an institution that receives a financial score of

1.0 to 1.4 ("In the Zone") may continue to

participate in the Department of Education's

student aid programs but with certain

restrictions. This is regarded as a failing score,

but the institution is considered sufficiently

financially responsible to participate with

additional oversight. (See Appendix D: 

Department of Education Handbook, page D-10.)

Sources of Information: Various Department of

Education publications; online accounting

definition sources; practicing accountants; and

accompanying appendices, as cited.