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Measuring Operations: An Analysis of the Financial Statements of U.S. Private Colleges and Universities By Mary Fischer, Teresa P. Gordon, Janet Greenlee, & Elizabeth K. Keating The Hauser Center for Nonprofit Organizations The John F. Kennedy School of GovernmentHarvard University March 2003 Working Paper No. 17 Mary Fischer is a Professor of Accounting at the College of Business Administration at the University of Texas at Tyler. Teresa P. Gordon is a Professor of Accounting at the College of Business & Economics at theUniversity of Idaho. Janet Greenlee is an Associate Professor of Accounting at the University of Dayton. Elizabeth K. Keating is an Assistant Professor of Public Policy at the John F. Kennedy School of Government at Harvard University. Acknowledgements: We wish to thank David Coy for his comments on an earlyversion of this paper.
Abstract
As events in the business sector have highlighted, companies can play by the rules and yet produce misleading financial statements. This study examines the nongovernmental organizations that provide a substantial portion of higher education in the United States. We seek to determine whether private colleges and universities take advantage of the discretion available to them under accounting and auditing standards by presenting an operating measure in their statement of activities. We find that nearly 60 percent of schools report an operating measure but the items included or excluded from operations vary widely.
only exceptions relate to the separate reporting of income from discontinued operations, extraordinary gains and losses, and the cumulative effect of a change in an accounting principle. This flexibility in guidance has led to variations in reporting of key summary numbers, such as an operating measure. The change in unrestricted net assets is the only measure of current operating performance specifically mentioned in the generally accepted accounting principles (GAAP) that apply to nonprofit organizations (FASB 1993b, ¶112).
In this study, we focus on a single nonprofit industry: colleges and universities. In 2001 some 15.3 million students enrolled in U.S. colleges and universities, thereby comprising the world’s largest sector of higher education (NCES 2001). These students comprise a group so large that they virtually constitutes a world of their own with a population greater than the total population of Chile, Greece and the Netherlands and just less than that of Australia and Syria (Population Reference Bureau 2002). Collectively, the financial activities of these institutions represent some two percent of the gross national product (Avery 2001). The size of the U.S. higher education industry is matched by its diversity. While there are a few federal government institutions (military academies) and a small but growing number of degree-granting for-profit schools, the bulk of students attend one of the 1,729 degree-granting public institutions operated by state or local governments or one of the 1,732 private nonprofit institutions (NCES, 2001). Substantial numbers of foreign students are attracted to the U.S. for undergraduate or graduate study. The public institutions tend to have larger enrollments and lower tuition rates as compared to the private institutions. 1
The reporting requirements for private and public institutions of higher education are not identical. Public institutions, such as state universities, are subject to the reporting standards of the Government Accounting Standards Board (GASB). Unlike the FASB that suggests the change in unrestricted net assets as an operating measure, the GASB’s guidance for the operating income measure focuses upon the classification scheme used to report cash flow activities. The difference in guidance between the two standard setters creates difficulties in comparing private and public institutions of higher education (Engstrom and Esmond-Kiger 1997, Fischer 1997). This issue is of concern to industry groups, such as the National Association of College and University Business Officers (NACUBO) and the American Council on Education (ACE), as well as bond rating agencies (e.g., Moody’s 1999a). The National Postsecondary Education Cooperative (NPEC) has also expressed interest in having a standardized operating measure (NPEC 2000). Unfortunately, the participants at a recent forum could only agree that arriving at a standard measure will take more time, effort and dialogue (Goldstein 2002).
Potential Impact on Decision Makers
In theory, there are three major user groups for U.S. private college and university financial statements. The first group includes the institutions themselves and their associations (ACE, NACUBO, accreditation agencies, etc.). These users are interested in making peer group and other inter-institutional comparisons. The second major user group is comprised of entities that make lending and other resource-related decisions based on a nonprofit’s financial condition. This group includes the U.S. Department of Education (DOE), bond rating agencies, foundations, and other major donors. Finally,
participants are frustrated with “inconsistent and inadequate classification of non- operating revenues and expenses, particularly for gift support and investment return” (p. 1).
We analyzed the decision tools used by bond rating agencies (Moody’s 1999b, Standard and Poor’s 2001, Fitch 2001) and the DOE (see Appendix A).^3 Several key ratios rely upon operating revenues and/or operating expenses as inputs, so the definitions of these items will affect the ratios. Our analysis of the ratios currently being used by the rating agencies indicates that the rating agencies do not use the change in unrestricted net assets as an operating measure The adjustments that these market participants make to the numbers reported under GAAP provide “user group” evidence as to how an operating income measure might be calculated. Unfortunately, there is considerable variation in both the ratios considered important by each rating agency and the specifics of how they compute comparable ratios. Thus definitions of operating revenue and operating expense cannot be derived from an examination of bond rating procedures alone.
Since 1998, the DOE has been using a composite index based on three ratios to assess financial responsibility. This evaluation is very important in higher education since Congress has legislated that the Secretary of Education scrutinize the financial condition of institutions of higher education to determine whether they should continue to receive funding for student financial aid under Title IV Higher Education Act (HEA) programs (Pub. L. 94-482). Unrestricted revenues and total expenses are denominators in two of the three ratios. All three bond rating agencies use one or more of the DOE ratios (or variations) in their evaluations. 5 Standard and Poor’s generally specifies operating
expenses or operating revenues rather than the total figures in their ratios. Moody’s ratios rely on total expenses with no mention of adjustments for nonoperating items, but they exclude from unrestricted revenues any 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 nonoperating purposes. In other words, the three bond rating agencies use or compute “operating” figures in evaluating the financial statements of colleges and universities. However, each agency computes operating revenues or operating income differently.
Prior Research
Recent research has examined the implementation of FASB Statement No. 117 by college and universities. The results suggest that understandability and decision usefulness have been limited by the diversity of allowable practice. Fischer et al. (2002) reported that the majority (69 percent) of fiscal year 1997 financial statements of 61 private institutions made a voluntary distinction between operating and nonoperating income in the statement of activities. They found that some institutions reported all investment income as operating revenue, while others allocate investment income in accordance with their endowment income spending policy. That is, reinvested investment income was displayed as nonoperating revenue, while the income authorized by the endowment spending policy for programmatic activities was reported as operating revenue. Fischer et al. (2002) also found that, unlike net revenues over expenses, the change in unrestricted net assets (the measure suggested by the FASB as an operating
in 2000. Specifically, we examine the following research questions:
- What are the characteristics of schools that choose to display operating and nonoperating revenue and expense on the statement of activities?
- Are particular audit firms associated with the presentation of anonoperating section on the statement of activities?
- Which revenue and expense items do schools classify as operating or nonoperating?
- Do financial statement disclosures facilitate the computation of alternate definitions of operating revenues and expenses? The annual reports were obtained in conjunction with a survey of the 1,100 four- year, degree-granting private colleges and universities in the United States to collect information regarding financial statement display. Of the 293 survey respondents, only 71 percent (207) provided their annual report.^6 The data reported here was derived from a content analysis of the 207 audited financial statements received. The content analysis instrument was created and tested to collect data relevant to the research questions as well as financial statement amounts, format and disclosures from the annual reports. Numerous items reported as operating revenue and operating expense and items reported in a separate “other” or “nonoperating” section were coded by entering the dollar amounts.
The quality of coding was enhanced by the use of internal controls to tie detail amounts to financial statement totals and by having the original coding checked by a second member of the research team. While every effort was made to insure the accuracy of data collected from the financial statements including verification of each other’s work, errors are possible particularly when the financial statements were in less user- friendly formats and when disclosures were inadequate. The sample size represents only
about 19 percent of the population of private U.S. four-year institutions of higher education and it is possible that those who chose not to respond to a study concerned with operating measures could be systematically different.
RESEARCH FINDINGS
Who Reports An Operating Measure?
While half or less of survey respondents (Weis 1999, Fischer and Gordon 2002) reported that their institutions present an operating measure in the statement of activities, Table 1 shows that 59 percent of our sample report some type of operating measure. As shown in Table 1, institutions that report an operating measure tend to be significantly larger than those that do not on most dimensions, ranging from total assets to enrollment. We found that 80 percent (24 of the 30) institutions classified as research and doctoral universities presented an operating measure. In contrast, approximately half of the comprehensive masters and baccalaureate schools reported an operating measure, and specialized schools were the least likely (39 percent) to report an operating measure. Institutions with an operating measure also charged higher tuition per student and were less tuition-dependent.
Table 2, Panel A shows that colleges and universities that use the major (Big Five) accounting firms more often include an operating measure in their statements of activity. Nearly 64 percent of schools with a Big Five auditor presented an operating measure. The institutions audited by smaller CPA firms were significantly less likely to report an operating measure (Chi-square 12.915, 1 d.f., p=.0003). Panel B of Table 2
spending formulas was 5.3 percent. As discussed earlier, Moody’s Investor Services excludes from operating revenue any investment income in excess of 4.5 percent of the beginning balance in cash and investments. For schools in our study that split investment income between operating and nonoperating, the percentage of investment-related revenue classified as operating was 6.36 percent of the beginning balance in cash and investments.^7 Any reported endowment spending percentage would presumably apply only to investments designated as true or quasi-endowments. Income, gains and losses on other investments held by the institution might be handled differently. This additional investment income probably explains why the actual spending percentage exceeds the average reported endowment spending formula.
Contributions and bequests. Only 4 schools in our study classified all contributions as nonoperating. Most (70 of 74) of the schools that reported contributions in a nonoperating section also reported contributions among operating revenues. For these 70 institutions, the average proportion of contribution classified as nonoperating was 58 percent of total contributions. The criteria used to determine whether a contribution was operating or nonoperating in nature was rarely evident although permanently-restricted gifts were almost always reported in the nonoperating section. However, unrestricted contributions were split between operating and nonoperating by 44 of the 70 institutions that displayed contributions in both the operating and nonoperating sections. For these 44 schools, 26.3 percent of total unrestricted contributions were, on average, classified as nonoperating.
Some bond rating agencies estimate operating income by removing the portion of
net assets released from restrictions related to capital additions. These are contributions received in an earlier period that are being transferred from temporarily restricted to unrestricted net assets because the donors’ restrictions have been satisfied. Disclosure regarding the lifting of temporary restrictions was less than adequate (Table 3, Panel B). Over half of the sample provided only a total figure on the statement of activities, and another 16 percent reported only the minimum required disclosure of time versus program restrictions (FASB 1993b). As a result, we could compute this common adjustment for only 56 annual reports (27 percent of the sample).
When the institutions provided details as to the nature of temporary restrictions at both the beginning and the end of the year, the amount of the adjustment can be estimated as the decrease in net assets restricted for capital acquisitions. Detailed ending balances for at least the current year were reported by only 84 percent of the schools. Estimates based on end-of-year balances were not necessarily accurate. We found that -- for the 56 schools that did provide a detailed breakdown of net assets released from restrictions -- the amount rarely equaled the change between the beginning and ending balances. In fact, net assets released for capital acquisitions often existed even when the ending temporarily restricted net asset balances with that restriction increased during the year.
Other gains and losses. The educational institutions did not follow a consistent practice in reporting the gains or losses associated with split interest agreements and payments to annuitants.^8 Some organizations reported these items as operating, while others reflected them as nonoperating. In some cases, information in the statement of cash flows was the only hint that such amounts were included in the financial statements
guidelines, if enacted, may help standardize the presentation of this item.
SUMMARY AND CONCLUSION The U.S. system of higher education has many characteristics other than size that make it unique in a broader international context. Nearly 3.5 million students attend some 1,700 private institutions of higher education in the United States. There is considerable latitude in the design of curricula, particularly for undergraduate programs. Private colleges often capitalize on this latitude to provide their vision of a liberal education. The diversity of the sector is treasured and protected by a number of national associations that look after the interests of and publicize the virtues of their member schools (Geiger 1986, 161). These schools compete with the public sector for students, strive to remain independent even while courting public support, and struggle to maintain diverse streams of revenue from students, alumni, and investments. Almost all of them periodically borrow money in the capital markets.
Consistent with the diversity of the sector, the flexibility in FASB Statement No. 117 was intended to let not-for-profit organizations make distinctions that they believe will provide more meaningful information for the users of their financial statements (¶66- 68). This study focused on one aspect of the permissible diversity in practice: operating performance measures on the statement of activities. Our findings indicate that only 60 percent of private colleges and universities report a separate operating measure. These schools tended to be the larger research institutions audited by a Big Five audit firm. Among the schools that chose to display operating income and operating revenue we found wide differences in definition and computation.
The inclusion of tuition, room and board and similar income earned in direct exchange for services provided do not appear to be controversial: all institutions in our sample reported these items as operating revenue. Revenues from auxiliary enterprises like dormitories were almost always separately stated and included in operating revenue, and the related auxiliary expenses were separately reported among operating expenses. Most other expenses were also reported in the operating section and in accordance with current accounting standards (with the occasional exception of interest expense and depreciation).
The treatment of contributions and investment income, gains or losses was another story. These were the two items most frequently excluded from operating revenue by a majority of the schools that made a distinction between operating and other income. Since almost all institutions have these two sources of revenue, improved standardization would be very helpful to financial statement user groups. The treatment of gains and losses related to split-interest agreements is another fairly common item accounted for in a variety of ways by the schools in our sample. Determining the proper treatment of just these three items would go a long way toward enhancing the comparability of the financial statements of private 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 nonoperating revenues and expenses. Goldstein (2002) reported that a variety of constituents agreed on the need for a standard definition of operating income. This was confirmed by a survey of college and university business
classification of items such as interest paid and investment income received is very different from that required on a FASB statement of cash flows (SFAS No. 95, 1987). Additional guidance from both standard setters could reduce the existing difficulties involved in comparing private and public institutions of higher education.
The variations found in the financial statements we examined have the potential to influence decision makers who rely on financial data. Our analysis of decision tools used by bond rating agencies and the U.S. Department of Education (DOE) suggests that several key ratios would be affected by the choices institutions make as to what should be included or excluded from operating revenues and operating expenses.
Future research is needed to determine whether different measures of operation would have a significant impact on key ratios. While variations in practice clearly exist, do they matter? We do not know whether the differences between the total changes in net assets and the total changes in unrestricted net assets or various alternative measures of operation are large enough to affect the decisions made by financial statement users.
REFERENCES
American Institute of Certified Public Accountants, AICPA (2001), Proposed Statement of Position – Accounting for Certain Costs and Activities Related to Property, Plant and Equipment. (Exposure Draft 6/29/01) (New York).
Avery, S. A. (2001), Nonprofit Financial Management Guidelines, www.saverycpa.com. Chabotar, K. J. (1989), ‘Financial Ratio Analysis Comes to Nonprofits’, Journal of Higher Education , Vol. 60, No. 2, pp. 188-209. Dickmeyer, N. and K. S. Hughes (1980), Financial Self-Assessment: A Workbook for College, National Association of College and University Business Officers (NACUBO) (Washington DC). DiSalvio, P. (1989), ‘Ratio Analysis in Higher Education: Caveat Emptor’, Journal of Education Finance. Vol. 14, pp. 500-512. Engstrom, J. H. (1988), Information Needs of College and University Financial Decision Makers, Research Report, Government Accounting Standards Board (Norwalk, CT).
Engstrom, J. H., and C. Esmond-Kiger (1997), ‘Different formats, same user needs: A comparison of the FASB and GASB college and university financial reporting models’, Accounting Horizons, Vol. 11, No. 3, pp. 16-34.
Financial Accounting Standards Board, FASB (1987), Statement of Financial Accounting Standards (SFAS) No. 95 – Statement of Cash Flows , FASB (Norwalk, CT). _______ (1993a), Statement of Financial Accounting Standards (SFAS) No. 116 - Accounting for Contributions Received and Made , FASB (Norwalk, CT). _______ (1993b), Statement of Financial Accounting Standards (SFAS) No. 117 - Financial Statements of Not-for-Profit Organizations , FASB (Norwalk, CT).
