Financial Responsibility: How to Stay in Compliance

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Financial ResponsibilityHow to Stay in
Compliance

• Presenter Joe Knutte
• For Regions VII VIII
• Private Career Schools
• Colleges Jan 28-30

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What was your composite score at 12-31-07?
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Financial Responsibility Focus

• Financial Responsibility as defined by NACCAS
  and DOE
• Computing the Composite Score
• Beating the Composite Score

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Financial Responsibility as defined by NACCAS

• From Standard VII Financial Practices and
  Management of NACCASs National Standards
  (Criteria 2 only)
•  
• Two options
•   
• 1. Meet ALL THREE financial measurements
•  
• A. Acid Ratio of 11 or greater
• B. Positive Tangible Net Worth
• C. Profit in current year or in two of the most
  recent three accounting
• years
•  
• 2. 1.5 or greater on the Composite Score

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Composite Score

• History
• A. Established under the Higher Education Act
  (HEA) of 1992
• B. Developed by KPMG
• Definition
• The Department of Educations rating system
  which combines different measures of fundamental
  elements of financial health to yield a single
  measure of a schools overall financial health.
• Broken down, it serves to answer two fundamental
  questions
• Is the institution clearly financially healthy or
  not as of the reporting date?
• Did the institution live within its means during
  the year?
• Comprised of Three Ratios
• 1. Primary Reserve Ratio measures a schools
  viability and liquidity.
• 2. Equity Ratio measures a schools capital
  resources and its ability to borrow.
• 3. Net Income Ratio measures a schools
  profitability.
•  

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Computing the Ratios

• For proprietary institutions (34 CFR 668.172
  Financial Ratios)
• Definitions (Appendix A to Subpart L of Part
  668Ratio Methodology for Proprietary
  Institutions)
•  
• Adjusted Equity (total owners
  equity)-(intangible assets)-(unsecured related
  party receivables)-(net property, plant and
  equipment) (post-employment and retirement
  liabilities)(all debt obtained for long-term
  purposes)
•  
• Total Expenses excludes income tax, discontinued
  operations, extraordinary losses, or change in
  accounting principle
• Modified Equity (total owners
  equity)-(intangible assets)-(unsecured related
  party receivables)

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Calculating the Strength Factors, Weighted Score
and Composite Score

• Strength Factor
• A. Primary Reserve Strength Factor Score 20 x
  Primary Reserve Ratio
• B. Equity Reserve Strength Factor 6 x Equity
  Reserve Ratio
• C. Net Income Strength Factor 1 (33.3 x Net
  Income Ratio)
•  
• Weighted Score
• A. Primary Reserve Weighted Score Primary
  Reserve Strength Factor x 30
• B. Equity Reserve Weighted Score Equity
  Reserve Factor x 40
• C. Net Income Weighted Score Net Income
  Strength Factor x 30
•  
• Composite Score
• Sum of all three weighted scores and then round
  the composite score to one digit after the
  decimal point to determine the final score.
•  
• Scoring System
• A. 1.5 to 3.0 School is considered financially
  responsible without further oversight.
• B. 1.0 to 1.4 In the Zone. The school is
  considered financially responsible but additional
  oversight is required.
• C. -1.0 to 0.9 School is not considered
  financially responsible.

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Example The Sample School
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(No Transcript)
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Example TheSample School Income Statement Year
Ended December 31, 2007
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Compute the Composite Score

• From the Balance Sheet at 12-31-07
• A. Stockholders' Equity
• B. Intangible Assets, Net
• C. Related Party Receivables
• D. Property, Plant and Equipment, Net  
• E. Retirement Liabilities    
• F. Long-Term Debt  
• G. Total Assets  
• From the Income Statement for the year ended
  12-31-07  
• 1. YTD Total Expenses    

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Complete the Worksheet forThe Sample School

• Pull out the following numbers in order to
  compute the Composite Score
•   
• From the Balance Sheet at 12-31-07
•   
• A. Stockholders' Equity
  174,981
•  
• B. Intangible Assets, Net
  22,500
•  
• C. Related Party Receivables
  25,000
•  
• D. Property, Plant and Equipment, Net
  706,000
•  
• E. Retirement Liabilities
  -
•   
• F. Long-Term Debt 360,750
•   
• G. Total Assets 1,323,943
•  
•   

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COMPOSITE SCORE CALCULATION
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COMPOSITE SCORE CALCULATION(Contd)
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Ways to Improve Composite Score Before Year End

• 1. Take out more long-term debt
• A. Improves the acid ratio as cash goes up by
  the whole amount of the loan, but only the
  current portion of the loan (the amount payable
  in the first twelve months) goes into current
  liabilities.
• B. Helps the Composite Score on the Primary
  Reserve Ratio to the extent of net fixed assets.
• 2. Defer one-time (non-recurring) costs until the
  next fiscal year
• A. Such purchases as new equipment, new
  furniture, holiday parties, entertainment.
• 3. Owners compensation
• A. If taking salary (paychecks) consider
  shifting later checks until the next fiscal year.
• B. Consider taking money out via distributions
  instead of salary at year end. This will
  increase your net income as distributions are not
  expenses.
•  
• 4. Present accounts receivable and deferred
  tuition on the net method
• A. Currently an acceptable form of presentation
  of these accounts by the DOE.
• B. Helps the Equity Ratio on the Composite
  Score.
•  
• 5. Convert related party loans to equity
• A. Increases stockholders/members equity which
  drives both positive tangible net worth on the
  ratio test and also affects the Primary Reserve
  Ratio and Equity Ratio on the Composite Score.
•  
• 6 Infusion of Capital

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Actions to take

•  
• 1.      Take out more long-term debt
•   Owner able to get 200,000 of additional
  long-term financing.
•   
• 2.      Defer one- time costs until the following
  year
•   None found.
•  
• 3.      Owners compensation
•   None taken.
•  
• 4.      Present accounts receivable and deferred
  tuition on the net method
•    Reduces both balances by 427,511
•  
• 5.      Convert related party loans to equity
•    95,000 Due from Shareholder converted to
  Equity
•   
• 6.      Infuse more capital
•    Salon pays back 25,000 of money borrowed

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ExampleTheSample SchoolRevised Balance
Sheet December 31, 2007
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REVISED COMPOSITE SCORE CALCULATION
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REVISED COMPOSITE SCORE CALCULATION
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Maximizing Your Ratios

• Primary Reserve Ratio
•  
• Adjusted Equity needs to be 15 of year to date
  Total Expenses to arrive at the maximum possible
  score of 0.9.
•  
•  
• Equity Ratio
•  
• Modified Equity needs to be 50 of Modified
  Assets to arrive at the maximum possible score of
  1.2.
•  
•  
• Net Income Ratio
•  
• Net income before taxes needs to be 6 of Total
  Revenues to arrive at the maximum possible score
  of 0.9.

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What is Better 1.5 or 3.0?

• The Department of Education does not
  differentiate between 1.5 and 3.0. If you score
  1.5 or greater, you are considered financially
  responsible.
• A 3.0 means you are maximizing your Net Income
  Ratio. Depending upon your corporate structure,
  this could result in increased corporate taxes.
• Once you become accredited and Title IV eligible,
  the Composite Score will become a permanent
  fixture in managing your school.

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Planning for Continued Success

• 1. Maintain your books on the accrual basis in
  accordance with GAAP.
•  
• 2. Make sure you are performing monthly closes
  of your books of account.
•   
• 3. Compute your Composite Score on a monthly or
  quarterly basis.
•   
• 4. Build up your Stockholders Equity -- The
  first two ratios of the Composite Score
  calculation are predicated on the amount of
  capital retained in the school.
•   
• 5. Plan for your year end. There are always
  steps that can be taken before year end to beat
  the Composite Score.

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•  
• Joseph D. Knutte, CPA
• Partner
•  
• Knutte Associates, P.C.
• 7900 South Cass Avenue, Suite 210
• Darien, Illinois 60561
•  
• Phone [phone]
• Fax [phone]
•  
• Email josephk_at_knutte.com