New Guidance on How Long-Term Debt is Treated in Financial Responsibility Scores

The Department of Education published a Dear Colleague Letter (DCL) that provides guidance for how long-term debt (LTD) is treated in financial responsibility composite score calculations. While the guidance provides clarifications to existing processes, it does not significantly alter the treatment of LTD in calculating the composite score. 

This publication supersedes prior guidance released in 2020 that followed the 2019 regulatory changes.

Background. An institution’s financial responsibility composite score is a critical test the Department uses to determine an institution’s financial health, though NAICU has long-documented concerns with its use, as constructed. The composite score is comprised of three roughly equally weighted ratios: Primary Reserve, Equity, and Net Income. (More information can be found in the Code of Federal Regulations.)

Between 2003 and 2019, an institution’s composite score calculation allowed all LTD to be included in the Primary Reserve Ratio up to the total amount of an institution’s property, plant, and equipment (PP&E). The original KPMG report that formed the Department’s financial responsibility regulations recommended removing both net PP&E and LTD from the Primary Reserve Ratio, so the 2003 guidance was a positive allowance that allowed schools to avoid being penalized from the formula for investing in their physical property. (More of the Department’s reasoning can be found on page 49873-4 of the Federal Register.)

The 2020 changes. In 2020, new guidance went into effect that changed how LTD would be treated in the formula. The Department grandfathered in all LTD reported before July 1, 2020, as “pre-implementation,” and treated it the same way as always but required any new LTD to meet new requirements to be reported as “post-implementation.” Additionally, if any “pre-implementation” debt was refinanced and resulted in proceeds of even a dollar more, the entire amount of debt would no longer be considered “pre-implementation” and would be treated as new LTD.

The core issue. The 2020 changes created a problem for institutions. During the low-interest rate environment of the pandemic, institutions that held “pre-implementation” LTD saw an opportunity to refinance their bond debt to save money on their debt service. In doing so, many institutions received more in proceeds than the “pre-implementation” total on their financial statements, which resulted in their old debt being converted to new debt and carrying a heavier weight on their composite score – at times, causing them to fail entirely.

The new guidance. The new DCL provides significant clarifications to existing processes but changed relatively little of the treatment of LTD in the composite score calculation. However, it does provide a specific scenario for institutions that have or would like to refinance their existing pre-implementation LTD and associate it with the same pre-implementation PP&E. For an institution seeking to refinance its PP&E-restricted bonds, here is the Department’s guidance:

Option B – Bond Refinancing (Original and Refinancing Bond Restricted to PP&E):

If the refinancing bond indebtedness resulted in proceeds, then the bond can qualify as post-implementation long-term debt subject to the limitation of the associated PP&E, if the following conditions apply:

• The original debt must be a bond, and both the refinancing bond and original bond must each have a restriction that it can only be used for PP&E.
• If there are cash proceeds obtained from the refinancing bond, the Statement of Financial Position or the Balance Sheet must have a restricted cash account and a clear audit trail/note in the audited financial statements that records the following information:
  • total amount of the refinancing bond(s) and date of refinancing bond indebtedness;
  • total amount used to pay off the original bond(s);
  • the identification of the specific PP&E purchases made with the original bond and their book value as of the time of the refinancing;
  • the identification of the specific PP&E purchased with the refinancing bond(s) (purchased with refinancing proceeds); the ending book value of PP&E purchased with the original bond and the refinancing bond (less any depreciation or disposals) reflected in the financial statements; and
  • details of the refinancing and PP&E acquisition transactions in the restricted cash account during the fiscal year.

Any refinancing bonds with proceeds in financial statements submitted after July 1, 2020, can only qualify as post-implementation PP&E and post-implementation long-term debt. The PP&E originally purchased with the original bonds under this option would move to post-implementation PP&E. Both the PP&E and refinancing bonds must follow the post-implementation regulations.

The scenario also includes additional reporting requirements from the institution to the Department, which will be published at a future date.

For years, NAICU has worked with member institutions and the National Association of College and University Business Officers (NACUBO) to bring more clarity to this process and demonstrate the impact of the Department’s deficient FRS system on institutions. For example, last April, NAICU partnered with NACUBO on a research effort to assess how the 2020 changes to the long-term debt calculations were affecting institutions’ composite scores. That effort helped convince the Department to make at least some change to its initial guidance.

For more information, please contact:
Justin Monk