Inching Toward An Operating Measure
Here's what independent institutions said when surveyed about financial reporting practices and the desirability of an operating measure.
By MARY FISCHER AND TERESA P. GORDON
Here's what independent institutions said when surveyed about financial reporting practices and the desirability of an operating measure.
Much work lies ahead in determining a standard for financial reporting practices, according to a survey of private colleges and universities. The research's roots are in a forum hosted in September 2000 by NACUBO and the National Postsecondary Education Cooperative to explore institutional operating measures. (See the previous article, "To Measure or Not to Measure—That's Still in Question.") The forum examined the differences in the reporting standards used by various groups—including analysts, bond rating agencies, and accounting firms—that result in incompatible operating measures being reported by and for higher education.
One consensus that forum participants reached was that operating measures are not the only message that institutions should communicate. Colleges and universities must communicate the overall change in net assets with growth from long-term investing, philanthropy, and operations. While little emphasis exists on operating measures for institutions that are well endowed, the positions of the standard setters have resulted in many people focusing on operating measures. Although it may be relatively easy to propose operating measures, it is extraordinarily difficult to develop a universal definition that could be supported by all institutions.
This lack of a consistent definition is a problem for a number of user groups, including financial analysts in the bond rating agencies and the Department of Education (ED), which uses ratio analysis for determining whether an institution has met the criteria for financial responsibility. The lack of a consistent definition also hampers benchmarking and other peer-group comparisons that would be helpful to administrators.
As a result of the forum and other discussions, NACUBO's Accounting Principles Council representatives teamed with Jack McCarthy, partner with PricewaterhouseCoopers, to develop a survey that would query independent institutions about their campus financial reporting practices. The survey, sent to 1,100 NACUBO member private colleges and universities, also solicited opinions about whether a required operating measure should be used and what should be done regarding reporting inconsistencies among institutions.
Of the 1,100 NACUBO member private colleges and universities receiving the questionnaire, slightly more than one fourth (293 institutions) returned useable responses to questions regarding operating measures and classification of various revenues and expenses and related accounting practices. A majority of respondents (55 percent) were opposed to the idea of making an intermediate operating measure mandatory. However, 79 percent agreed that colleges and universities need a consistent operating measure definition, although less agreement existed regarding the use of such a definition. What follows are the survey's highlights.
Who Reports an Operating Measure?
Table 1 shows that almost 40 percent of respondents reported that their institutions currently present an operating measure on the statement of activities. These institutions tended to be larger in terms of enrollment, operating expenses, research expenditures, and investments.
The survey asked whether the institution included a footnote that 1) described the components of the "measure of operations", or 2) described what was excluded from operations. Slightly more than half (58 of 113) of the institutions that presented an operating measure said that they include one or both of the disclosures. For those institutions reporting only one version of the disclosure, the exclude version was more common than the "include" version (17 to 12 ratio).
Since almost half of the institutions that report an operating measure failed to explain their definition, it would be difficult for a financial statement user or stakeholder to make adjustments needed for a valid inter-institutional comparison. Single institution comparisons over time appear to be less of a problem since only 6 of the 113 institutions that report an operating measure said they had made a significant change in the components of the intermediate operating measure since its initial adoption.
What's Included As Operating Revenue?
Table 2 summarizes which items are most commonly reported as operating revenues. Responses from the institutions reporting an operating measure indicate existing practice, while responses from the institutions not reporting an operating measure indicate opinion as to how the item would be classified if an operating measure were provided. For the sample as a whole, general agreement exists regarding several types of revenue that either are or should be classified as operating revenue. The only item to score higher than 90 percent was revenue from auxiliary enterprises. In addition to auxiliary enterprises, the other items that at least 80 percent of the respondents said they would classify as operating revenue include tuition and fees, investment income from operating funds, and academic medical centers. Most institutions (93 percent) would include at least some unrestricted gifts and bequests in operating revenue. Those institutions reporting an operating measure more commonly exclude small gifts or classify gifts as non-operating unless the donor specifies that they be classified as operating.
What's Included As Operating Expense?
As Table 3 indicates, most institutions consider interest expense and depreciation expense as operating expenses. Less agreement occurs when it comes to reporting losses on sales of fixed assets, and the responses are similar to those for reporting gains on sales of fixed assets (see Table 2). The larger institutions were less likely to include these losses in operating expense, possibly since many institutions report losses as contra-revenue rather than expense. The classification of actuarial losses parallels that of actuarial gains (see Table 2), with less than half of the institutions responding that such gains and losses are classified as operating. More than half of the respondents would include unusual (but not extraordinary) losses as operating, similar to the responses for unusual gains (64.5 percent for losses and 65.1 percent for gains). Very few institutions reported that they allocated investment management expenses or fundraising expenses between operating and non-operating categories.
According to FASB, expenses are defined as outflows or other using up of assets or incurrence of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operation. The statement of activities is concerned with only those transactions that increase or decrease net assets. The statement of activities or the notes to the financial statement must provide information about the institution's expenses reported on a functional basis. Classification to provide information about expenses broken out by natural classification is encouraged.
How Are Related Disclosures Handled?
More than 80 percent of institutions that report an operating measure also report their expenses by natural classification and include a note disclosing the expenses by functional classification. These institutions tend to have more than $200 million in expenses, investments exceeding $800 million, and research activities of $55 million or more. Of those institutions that report their expenses in the statement of activity by functional classification, only one fifth also include a note disclosing the expenses by natural classification. Most (90 percent) of the institutions that do not report an operating measure tend to report their expenses by functional classification, and only one sixth of them include a natural classification matrix in the notes to the financial statements.
According to FASB's Statement No. 117, donor-restricted contributions whose restrictions are met in the same reporting period may be reported as unrestricted support provided that an organization reports consistently from period to period and discloses its accounting policy. Using this option, institutions avoid having the same contribution amount displayed on the statement of activities in three different places. Institutions electing this option also tend to characterize resources with broad or general restrictions as unrestricted revenue. In this study, this method of recognizing restricted gifts was not the popular choice. Sixty percent of all institutions reported that all restricted contributions were recognized as temporarily restricted revenues and released from restrictions when the restriction was met, even if it was met in the same year that the revenues were received.
Some 40 percent of the private institutions report that they recognize investment income on unexpended restricted gifts as unrestricted operating revenue and only report the income as restricted if instructed to do so by the donor. A comparable percent specifically designate the amount of unrestricted gifts used for operations and those internally designated as funds functioning as endowments and added to the long-term investment portfolio.
A small percentage of institutions reported gifts to acquire long-lived assets as operating revenue. Three quarters of the institutions said they considered such gifts restricted until the related long-lived asset is placed in service. The transfer from restricted to unrestricted would be classified as non-operating by all but the 12 percent who reported releasing the restriction through depreciation expense as the asset is used. Reclassifications of net assets caused by a donor changing the original stipulations were disclosed separately by a few institutions (within operating revenues by 6.8 percent and within nonoperating revenues by 14.1 percent). The prevailing reported practice (by 64.1 percent of respondents) simply commingled the reclassification with other net assets released from restrictions in the operating revenue section. Institutions reporting an operating measure compared to those not classifying their statement of activity responded quite differently to questions regarding classification of endowment yield and gain or loss. A majority of the institutions with an operating measure (58 percent) reported that they did not include endowment income as operating revenue.
The institutions without an operating measure were more likely to leave this question blank or respond that endowment income would be considered operating even if in excess of the institution's endowment spending formula (30 percent). Treatment of endowment gains was also strikingly different. Almost 70 percent of the institutions that reported an operating measure said that endowment gains would be included in operating only to the extent that endowment income fell short of the spending formula. By contrast, 57 percent of the institutions not classifying their statement of activities would classify realized or unrealized gains as operating revenue under at least some circumstances.
Potential Impact on Statement Users?
Bond rating agencies now must cope with the new GASB formats in addition to the FASB financial statement formats for colleges and universities. In a special report issued in February 1999, Moody's Investors Service declared that capital market participants are frustrated with higher education's inconsistent and inadequate classification of non-operating revenues and expenses. An analysis of decision tools used by bond rating agencies and ED suggest that several key ratios are affected by the choices institutions make as to what they include or exclude from operating revenues and operating expenses. The adjustments that the bond rating organizations make to the numbers reported under generally accepted accounting principles (GAAP) provide "user group" evidence as to how an intermediate operating measure might be calculated. Unfortunately, considerable variation exists in both the ratios considered important and the specifics of how a particular ratio is computed.
Two of the three ratios used by ED would be affected by the classification of revenue or expense as operating or non-operating. Since 1998, ED has used a composite index based on three ratios to assess financial responsibility. This evaluation is very important in higher education since Congress had mandated that ED's secretary scrutinize closely the financial condition of institutions in determining whether they should continue to receive student financial aid funding under Title IV HEA programs (Pub. L. 94-482). All three of the bond rating agencies consider at least one of these ratios (or variations) in their evaluations. Standard and Poor's generally specifies operating expenses or operating revenues rather than the total figures in their ratios. Moody's ratios specify total expenses with no mention of adjustments for non-operating items, but they exclude from unrestricted revenues investment income in excess of 4.5 percent of the previous year's ending value of cash and investments. Both Moody's and Fitch subtract temporarily restricted net assets released from restrictions if related to construction or acquisition of plant assets and other non-operating purposes. In other words, all of the bond rating analysts use or compute operating figures in evaluating the financial statements of colleges and universities. However, it's likewise clear that each agency may be computing operating revenues or operating income differently.
The most comprehensive system under the FASB accounting model directed toward institutional self-evaluation is the 1999 edition of the series on Ratio Analysis in Higher Education, published by KPMG and Prager, McCarthy & Sealy. According to the accounting firm, understanding whether an institution has lived within its means requires that operating and non-operating activities be separated into distinct components. However, they make only two specific recommendations for items to be excluded from operations: 1) investment gains or income in excess of the institution's spending policy, and 2) gifts to be used for capital purposes.
Two major user groups exist for private college and university financial statements. The first group is comprised of the institutions themselves and their associations, including accreditation agencies, the American Council on Education, and NACUBO. These users are interested in making peer group and other inter-institutional comparisons. The second major user group is composed of entities that base lending and resource decisions on financial condition. In particular, this group includes ED and bond rating agencies. Individual donors are not a significant user group because they seldom request or receive financial statements and, it is believed, rarely base their decisions to give on financial information.
The latitude in FASB Statement No. 117 was intended to let nonprofit organizations make distinctions that they believe will provide more meaningful information for the users of their financial statements (¶ 66-68). However, the diversity in practice appears to make inter-institutional comparisons problematic. The new GASB reporting model also makes a distinction between operating and non-operating revenues and expenses, but the primary guidance provided is that classification should be consistent with the statement of cash flows. Since the GASB classification of items such as interest paid and investment income received is very different from what is found on a FASB statement of cash flows, confusion surrounding the definition of operating revenues and operating expenses is probably going to get worse before it gets better. The lack of guidance from both standard setters will only exacerbate the existing difficulties involved in comparing private and public institutions of higher education.
Given the information provided by survey respondents, it appears that those who prepare and those who use the financial statements of private colleges and universities need a consistent definition for what constitutes operating revenues, operating expenses, and a measure of operating income. This need is particularly acute given the different interpretations inherent in the FASB and GASB standards.
To help meet this need, it seems the logical next step is to analyze private college and university financial statements to determine the exact extent of the problem with respect to both the frequency of operating measure display and the extent of variation in its composition and computation. Using this data could help determine the significance of the operating measure display problems as well as their impact on ratios used by decision makers including bond rating agencies and ED. Such additional analysis might also yield further GAAP guidance and identify best practices in private college and university financial reporting.
Author Bios Mary Fischer is professor of accounting at the University of Texas at Tyler. Teresa P. Gordon is professor of accounting at the University of Idaho, Moscow.
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