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The Secretary proposes to amend the Student Assistance General Provisions regulations by revising the requirement for compliance audits and adding a new subpart establishing financial responsibility standards. The proposed regulations would improve the S

FR part
III
Attachments:
PublicationDate: 9/20/96
FRPart: III
RegPartsAffected:
PageNumbers: 49551-49574
Summary: The Secretary proposes to amend the Student Assistance General Provisions regulations by revising the requirement for compliance audits and adding a new subpart establishing financial responsibility standards. The proposed regulations would improve the Secretary's oversight of institutions participating in programs authorized by title IV of the Higher Education Act of 1965, as amended.
CommentDueDate: 11/4/96

  
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[


[Federal Register: September 20, 1996 (Volume 61, Number 184)]
[Proposed Rules]
[Page 49551-49574]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr20se96-19]


[[Page 49551]]


_______________________________________________________________________

Part III





Department of Education





_______________________________________________________________________



34 CFR Part 668



Student Assistance General Provisions; Proposed Rule


[[Page 49552]]



DEPARTMENT OF EDUCATION

34 CFR Part 668

RIN 1840-AC36


Student Assistance General Provisions

AGENCY: Department of Education.

ACTION: Notice of Proposed Rulemaking.

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

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

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

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

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

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

Background

Statutory and Regulatory History

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

[[Page 49553]]

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

Improving Financial Responsibility Standards

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

The KPMG Report

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

[[Page 49554]]

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

Definitions of the Proposed Ratios
Viability Ratio
------------------------------------------------------------------------
Public Public
institutions institutions Private non-
following the following a profit Proprietaries For-profit
1973 AICPA government hospitals and hospitals
audit guide <SUP>1 model institutions
------------------------------------------------------------------------
Expendable
Fund
Balances <SUP>2..
<divide>.....
Plant Debt... Gov't and
Proprietary
Fund Equity
<divide>
General Long-
Term Debt Expendable
Net Assets <SUP>3
<divide>
Long-Term
Debt <SUP>4 Adjusted
Equity <SUP>5
<divide>
Total Long-
Term Debt Expendable
Fund
Balances
<divide>
Long-Term
Debt
------------------------------------------------------------------------
<SUP>1 Public institutions have the option of preparing their statements
according to the 1973 AICPA Guide for Colleges and Universities, or
the governmental model.
<SUP>2 Expendable Fund Balances are computed as follows: General, specific
purpose, and quasi-endowment fund balances--plant equity. True
endowments are specifically excluded from the numerator.
<SUP>3 Expendable Net Assets are calculated as follows:
Unrestricted Net Assets.
Plus Temporarily Restricted Net Assets.
Minus Property, plant and equipment.
Minus Plant debt (including all notes, bonds, and leases payable to
finance those fixed assets).
Equals Expendable Net Assets.
<SUP>4 Long-term debt is defined as all amounts borrowed for long-term
purposes from third parties and includes: (1) Notes payable, (2) Bonds
payable, and (3) Leases payable.
<SUP>5 Adjusted equity is computed as follows:
Total Owner(s) or Shareholders Equity.

[[Page 49555]]


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


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


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

The Secretary's Use of the KPMG Report

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

Summary of Proposed Changes

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

Sec. 668.23 Compliance Audits and Audited Financial Statements

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

[[Page 49556]]

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

Subpart L--Financial Responsibility

Sec. 668.171 Scope and Purpose

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

Sec. 668.172 Financial Standards

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

[[Page 49557]]

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

Sec. 668.173 Financial Ratios

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

Sec. 668.174 Alternate Standards and Requirements

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

[[Page 49558]]

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

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

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

668.176 Foreign Institutions

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

[[Page 49559]]

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

Sec. 668.177 Past Performance

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

Sec. 668.178 Additional Requirements and Administrative Actions

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

Appendix F

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

Executive Order 12866

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

[[Page 49560]]

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

Summary of Potential Costs and Benefits

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

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

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

Definition and Identification of Small Entities

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

Compliance Costs of the Proposed Rule for Small Governmental Entities

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

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

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

[[Page 49561]]

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

Discussion of Adverse Economic Impacts

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

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

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

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

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

[[Page 49562]]

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

Conclusion

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

Paperwork Reduction Act of 1995

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

Collection of Information: Financial Responsibility

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

[[Page 49563]]

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

Invitation to Comment

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

List of Subjects in 34 CFR Part 668

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

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

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

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

PART 668--STUDENT ASSISTANCE GENERAL PROVISIONS

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

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


Sec. 668.13 [Amended]

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


Sec. 668.15 [Removed and reserved]

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


Sec. 668.23 Compliance audits and audited financial statements.

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

[[Page 49564]]

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

[[Page 49565]]

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

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

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

Subpart L--Financial Responsibility

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

Subpart L--Financial Responsibility


Sec. 668.171 Scope and purpose.

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

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


Sec. 668.172 Financial standards.

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

[[Page 49566]]

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

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


Sec. 668.173 Financial ratios.

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

Viability ratio=Expendable Fund Balances<divide>Plant Debt
Primary Reserve ratio=Expendable Fund Balances<divide>Total
Expenditures and Mandatory Transfers
Net Income ratio=Net Total Revenues<divide>Total Revenues

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

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

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

Viability ratio=Expendable Net Assets<divide>Long-term Debt
Primary Reserve ratio=Expendable Net Assets<divide>Total Expenses
Net Income ratio=Change in Unrestricted Net Assets<divide>Unrestricted
Income

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

Viability ratio=Adjusted Equity<divide>Total Long-term Debt
Primary Reserve ratio=Adjusted Equity<divide>Total Expenses
Net Income ratio=Income Before Taxes<divide>Total Revenues

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

Viability ratio=Expendable Net Assets<divide>Long-term Debt
Primary Reserve ratio=Expendable Net Assets<divide>Total Expenses
Net Income ratio=Change in Unrestricted Net Assets<divide>Unrestricted
Income

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

Viability ratio=Expendable Fund Balances<divide>Long-term Debt
Primary Reserve ratio=Expendable Fund Balances<divide>Total Expenses
Net Income ratio=Revenue & Gains in Excess of Expenses and Losses (Net
Total Revenue)<divide>Total Revenues

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

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


Sec. 668.174 Alternate standards and requirements.

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

[[Page 49567]]

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

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


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

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

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


Sec. 668.176 Foreign institutions.

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

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


Sec. 668.177 Past performance.

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

[[Page 49568]]

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

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


Sec. 668.178 Additional requirements and administrative actions.

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

[[Page 49569]]

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

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

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

Appendix F--Financial Responsibility

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

(1) Public Institutions
----------------------------------------------------------------------------------------------------------------
Strength factor 1 2 3 4 5
----------------------------------------------------------------------------------------------------------------
Viability Ratio............................. <.50 .50-.99 1.0-1.99 2.0-3.99 <gr-thn-eq>
4.0
Primary Reserve Ratio....................... <.10 .10-.19 .20-.44 .45-.69 <gr-thn-eq>
.70
Net Income Ratio............................ <0 0-.009 .01-.029 .03-.049 <gr-thn-eq>
.05
----------------------------------------------------------------------------------------------------------------

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

(2) Private Non-Profit Institutions That Have Adopted FASB Statements 116 and 117
----------------------------------------------------------------------------------------------------------------
Strength factor 1 2 3 4 5
----------------------------------------------------------------------------------------------------------------
Viability Ratio............................. <.75 .75-1.74 1.75-2.74 2.75-4.74 <gr-thn-eq>
4.75
Primary Reserve Ratio....................... <.30 .30-.49 .50-.99 1.00-1.49 <gr-thn-eq>
1.5
Net Income Ratio............................ <0 0-.019 .02-.049 .05-.079 <gr-thn-eq>
.08
----------------------------------------------------------------------------------------------------------------

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

(3) Private Non-Profit Institutions That Have Not Adopted FASB Statements 116 and 117
----------------------------------------------------------------------------------------------------------------
Strength factor 1 2 3 4 5
----------------------------------------------------------------------------------------------------------------
Viability Ratio............................. <.50 .50-.99 1.0-1.99 2.0-3.99 <gr-thn-eq>
4.0
Primary Reserve Ratio....................... <.10 .10-.29 .30-.64 .65-.99 <gr-thn-eq>
1.00
Net Income Ratio............................ <0 0-.009 .01-.029 .03-.049 <gr-thn-eq>
.05
----------------------------------------------------------------------------------------------------------------

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

(4) Proprietary Institutions
----------------------------------------------------------------------------------------------------------------
Strength factor 1 2 3 4 5
----------------------------------------------------------------------------------------------------------------
Viability Ratio............................. <.50 .50-.99 1.0-1.99 2.0-3.99 <gr-thn-eq>
4.0
Primary Reserve Ratio....................... <.10 .10-.29 .30-.49 .50-.69 <gr-thn-eq>
.70
Net Income Ratio............................ <.02 .02-.049 .05-.079 .08-.119 <gr-thn-eq>
.12
----------------------------------------------------------------------------------------------------------------

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

(5) Independent Hospitals
----------------------------------------------------------------------------------------------------------------
Strength factor 1 2 3 4 5
----------------------------------------------------------------------------------------------------------------
Viability Ratio....................... <.50 .50-.99 1.0-1.99 2.0-3.99 <gr-thn-eq>
4.0
Primary............................... <.10 .10-.29 .30-.64 .65-.99 <gr-thn-eq>
1.00
Net Income............................ <0 0-.009 .01-.029 .03-.049 <gr-thn-eq>
.05
----------------------------------------------------------------------------------------------------------------


[[Page 49570]]

B. Weighting Factors:

----------------------------------------------------------------------------------------------------------------
Private non- Public non-
Institutions profits profits Proprietaries Hospitals
(percent) (percent) (percent) (percent)
----------------------------------------------------------------------------------------------------------------
Viability Ratio........................................... 35 35 30 40
Primary Reserve Ratio..................................... 55 55 20 20
Net Income Ratio.......................................... 10 10 50 40
Totals.............................................. 100 100 100 100
----------------------------------------------------------------------------------------------------------------

Additional Adjustments

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

Procedure

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

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

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

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

4. The weighted results are then summed:

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


D. Technical Definitions.

For Private Non-Profit Institutions

Expendable Net Assets are calculated as follows:

Unrestricted Net Assets.
Plus Temporarily Restricted Net Assets.
Minus Property, plant and equipment.
Minus Plant debt (including all notes,
bonds, and leases payable to
finance those fixed assets).
------------------------------------------------------------------------
Equals Expendable Net Assets.


For Proprietary Institutions

Adjusted Equity is computed as follows:

Total Owner(s) or Shareholders
Equity.
Minus Intangible Assets.
Minus Unsecured Related Party Receivables.
Minus Property, Plant and Equipment (Net
of Accumulated Depreciation).
Plus Total Long-Term Debt.
------------------------------------------------------------------------
Equals Adjusted Equity.


If Total Long-Term Debt exceeds the value of Net Property, Plant
and Equipment, then the asset is not subtracted from equity nor is the
liability added back to equity
Total Long-Term Debt is comprised of all debt obtained for long-
term purposes. The short-term portion of any long-term debt is
included.

For Independent Hospitals

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

Appendix to the NPRM

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

Summary of the KPMG Report Commissioned by the Department

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

[[Page 49571]]

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

Problems of Reporting and Accounting Standards for Different Business
Segments

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

Problems of Exclusive Tests

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

Proposed Solution

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

Methodology

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

[[Page 49572]]

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

Results: Ratios

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

Strength Factors

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

[[Page 49573]]

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

Weighting Percentages

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

[[Page 49574]]

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

Composite Scores and the Identification of Problematic Institutions

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

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




]

Last Modified: 06/24/1998