When Operating Measures Don't Add Up
Considerable variance in financial reporting styles among independent institutions increases the burden of financial statement users and complicates the benchmarking of performance against one's peers.
By Mary Fischer, Teresa P. Gordon, Elizabeth Keating, and Janet Greenlee
Accordingly, in September 2000, NACUBO and the National Postsecondary Education Cooperative hosted a Higher Education Institutional Operating Measures Forum. The goal: to examine the issue of a standard operating measure and subsequently define a standard that would be most meaningful and acceptable to higher education. Forum participants concluded that:
- In addition to information about changes in net assets, investment growth, and philanthropy, higher education financial statements should communicate information that allows users to assess operating performance.
- Given the latitude allowed by the FASB, higher education has an opportunity to self-manage operating performance reporting rather than leaving room for an externally imposed standard.
- Increased comparability and transparency could benefit higher education.
Forum discussions led to a survey of 1,100 NACUBO member independent institutions. (For survey results, see "Inching Toward an Operating Measure" in the August 2002 issue of Business Officer.) Of the 293 respondents to that survey, 207 (71 percent) provided requested audited financial statements. An investigation of those financial statements examined whether reporting an operating measure could affect the decisions made by users of financial statements.
Who Reports an Operating Measure?
Our financial statement analysis found that 59 percent report a measure of operations. Institutions that choose to report a measure of operations tend to be significantly larger on dimensions ranging from total assets to enrollment, charge significantly higher tuition per student, and are less tuition dependent. Using the Carnegie Classification to segregate the institutions into comparable groups, we found that 80 percent of the research universities and well over half of the doctoral (66 percent), masters (60 percent), and baccalaureate (57 percent) institutions report an operating measure. Specialized institutions (25 percent) were least likely to report a measure of operations.
Who Uses Financial Statements, and to What End?
The user groups of college and university financial statements fall into three primary categories:
Vendors, creditors, and other resource-related decision makers whose decisions are based on the financial condition or viability of the institution. This group includes bond-rating agencies, the U. S. Department of Education (ED), and trade contractors and vendors.
Academic accrediting agencies, industry groups, and the institutions themselves. These users perform assessment, inter-institutional comparisons, or managerial analysis.
Donors, parents, students, faculty, staff, alumni, and other stakeholders.
Academic research has found that those in the third group rarely request or receive an institution s financial statement and generally do not base their decisions on financial statement information. However, research indicates that the first and second groups often use financial statement data to compute various ratios. Ratios are commonly used for comparison because they automatically adjust for size differences among institutions.
Our financial statement analysis focused on the first two user groups. With regard to the first group, both the ED and the bond rating agencies publish descriptions of the ratios they use for analysis of higher education. For ratios commonly used for institutional comparisons made by those within the second user group, we consulted the latest edition of Ratio Analysis in Higher Education (KPMG et al., 1999).
Bond rating is a complex decision process that involves a thorough analysis of many factors. For example, operating performance is only one of five areas listed by Moody's. We selected a subset of ratios for analysis that includes revenues, expenses, or change in net assets in the numerator or denominator, and accordingly, that might be affected by the way institutions classify revenues and expenses. All ED ratios analyzed are used to assess financial responsibility. Institutions must meet financial responsibility criteria to continue receiving funding for student financial aid under Title IV of the Higher Education Act. For inter-institutional comparisons and self-evaluation, the selected KPMG ratios require separation of operating and non-operating revenues and expenses.
We have included three common types of ratios in our analysis: liquidity, operating performance, and debt and leverage. The particular ratios selected in each category were somewhat arbitrary and should not be interpreted as a critique of the techniques used by the bond rating agencies. We computed ratios from information in the audited financial statements of the 207 institutions that responded to our request. For the discussion of this analysis, we've included three tables that report separately the averages for the 85 reports that did not identify operating revenues and expenses and the 122 reports that did make this distinction.
Table 1: Liquidity Ratios. Table 1 presents the averages for five liquidity ratios. In all cases, the averages were significantly different between those institutions that do not identify an operating measure and those that do. Certain ratios used by the bond rating agencies are not easily computed from financial statements prepared in accordance with generally accepted accounting principles (GAAP). For example, unless an institution voluntarily prepares a balance sheet with columns for the three net asset categories, it is impossible to determine the portion of investments associated with unrestricted and temporarily restricted net assets. For the Fitch ratio, the closest we could get was total cash and investments divided by unrestricted expenses. Because this produces a ratio equivalent to one used by Standard and Poor's, we were comfortable with our approach.
Table 2: Operating Performance Ratios. Table 2 presents a comparable analysis of operating performance ratios. Because operating performance ratios look at revenues and expenses for the current period, it is among this set of ratios that one might expect to find the most differences between institutions with and without an operating measure.
All of the ratios included in Table 2 were computed on the basis of unrestricted revenues. The averages for the ED net income ratio were not significantly different because this ratio ignores the operating/non-operating distinctions an institution might make. The KPMG variation of the net income ratio considers only revenues and expenses classified as operating, and accordingly, the ratios were significantly different. The focus on only the unrestricted net assets seems to be a partial cure for inter-institutional comparisons.
Because institutions do not consistently report operating information, bond rating agencies make many adjustments to an institution s numbers to implement their own versions of what operating means. For example, analysts at Moody's adjust revenues by removing both sponsored and institutional scholarships and the portion of net assets released from restrictions related to gifts for capital projects. Moody's also substitutes 4.5 percent of beginning cash and investments for any reported investment income. Accordingly, it is not surprising that there was no significant difference between the averages for institutions with and those without an operating section in their statement of activities. The adjustments made by S&P and Fitch appear to be somewhat less successful in leveling the playing field.
Table 3: Debt and Leverage Ratios. Table 3 presents five ratios that are used to analyze debt and the ability to repay debt. We did not expect the ED equity ratio to differ between institutions with and without an operating measure because the ratio includes no numbers from the statement of activities. This ratio was included in the analysis because it is a weighted component of the ED composite indicator of an institution s financial health. However, the remaining four ratios in the table include expenses, revenues, or the difference between them, and would potentially be impacted by financial reporting choices. Only the S&P's ratio was statistically different at even a marginal (.08) level. It appears that the operating/non-operating distinction is unlikely to affect decisions made regarding the level of debt carried by an institution. Rather, operating results across time are more likely to impact debt capacity decisions.
Implications for Institutional Reporting
Two of the three KPMG ratios examined were significantly different for institutions that presented an operating measure as compared to those that do not identify operating revenues and expenses. On the other hand, only one of the three ratios used by the ED was significantly different. The findings for the bond rating agencies were also mixed. This group of organizations has been quite vocal about the problems created by inconsistent financial reporting practices. They have had to cope by making numerous adjustments to the figures on the financial statements, which is costly and time consuming.
The adjustments to the ratios we examined were not always successful in eliminating differences between institutions. The problem is most significant when performing peer-group analysis and self-evaluation (the second user group). Without a clear display of the components of an operating measure, users must guess at the information needed to perform a comparative analysis. This complicates benchmarking of performance against peers.
Overall, when classifying revenues and expenses as operating versus non-operating, our investigation revealed that revenue categories were much less consistent than expense categories. Revenue differences were especially prevalent in areas that concern endowments, gifts, investments, actuarial gains and losses, and disposition of plant assets. Because peer analysis is important to users of financial information and the higher education industry itself, there appears to be room, especially concerning revenue, for clearer definitions and specific guidance. Precise definitions could assist both preparers and users of financial statements and would minimize the need for the ED and bond rating agencies to make adjustments. As such, it would seem the next step is to propose definitions of operating revenues and expenses and assess the reaction.
NACUBO's Higher Education Accounting Forum
These are extremely challenging times: congressional calls for accountability and price setting, standards boards proposing performance measurement, and the public demand to understand costs. Now in its second year, the Higher Education Accounting Forum is an essential educational event for accounting and finance professionals in higher education.
The forum, which sold out in 2003, will be held April 25-27, 2004, at the InterContinental Chicago. The program is tailored to mid-to advanced-level professionals; accounting managers; assistant and associate vice presidents; budget directors; chief financial officers; controllers; financial reporting managers; and internal auditors.
Meet representatives from the financial and governmental accounting standards boards. Choose from sessions offered on business ethics; endowment returns; Sarbanes-Oxley guidance for higher education; financial viability; risk management; GASB and FASB updates; financial reporting trends; tax changes; performance measurement; and college costs. The forum will also offer topical discussion groups with ample opportunity to share experiences with and meet new colleagues.
For registration and program information, visit http://www.nacubo.org/professional_dev or call NACUBO Professional Development Programs at 202.861.2520.
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; Elizabeth Keating is an assistant professor of public policy at Harvard University; and Janet Greenlee is an associate professor of accounting at University of Dayton, Ohio.
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