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New financial reporting calls for smart communication

RFP
“Consistency and transparency!” in financial reporting was the rallying cry behind changes to not-for-profit and higher education reporting in the 1990s. Institutions adapted to those changes, some of which were controversial — e.g., recording pledges and tracking gifts, grants and endowment earnings through temporarily restricted revenues. The current standard does not mandate a specific operating measure; over time a practical but inconsistent measure of “operations” materialized. Now, 20 years later, an enhanced financial reporting model will emerge that defines a new operating measure. The new model will provide for comparability on results from operations among private colleges and universities, and will increase the comparability between private universities and public universities. But it will not lead to enhanced understanding of — i.e., transparency in — the cost of education. To achieve that level of insight, management will need to supplement financial reporting with a more robust management discussion and analysis (MD&A) of operations.
Institutions will have to do a better job of explaining how the education and student services they provide are funded, and in the process of doing so, strongly consider whether costs are sustainable.

The proposed model will require endowment earnings to be shown as non-operating revenue and quasi-endowment gifts as reductions of operating revenue. This will make it harder for many institutions to achieve a positive net income from operations. As a result, institutions will have to do a better job of explaining how the education and student services they provide are funded, and in the process of doing so, strongly consider whether costs are sustainable.

Measurement and presentation will change

Users of financial statements in the past decade have called for simplification of financial reporting and disclosures. The proposal of the Financial Accounting Standards Board (FASB) is a somewhat simpler model, although there is still an abundance of complexity. New terminology is introduced to define the measures of operations: “Operating excess before transfers” and “Operating excess after transfers.” The presentation of revenues is modified by requiring a new “Transfer of revenue” line to move gifts and endowment earnings from the non-operating to the operating category. The proposal also eliminates one of the classes of net assets by combining permanent and temporary restricted net assets into one category.

As for clarifying operating excess, the model proposes defining operating revenue based on two dimensions — mission and availability. On this basis, all legally available mission-related revenue and support would be presented as gross revenue in the statement of activities. Proceeds from investment activities (i.e., endowment earnings) would not be included in the operating measure unless the organization’s primary mission was to generate a return on investments. Funds designated by the governing body for use in future periods would be shown as reductions from gross revenues. Funds previously unavailable but available for use in the current period, either by board action or the endowment spending rate, would be added to revenue through the transfer category. This presentation forms the basis for the measures of operations.

For the majority of private universities, a portion of endowment earnings has been included as operating revenue based on a board-approved spending rate. Typically, the rating agencies have calculated operating ratios based on their standard ratio (5%) of endowment earnings treated as operating revenues, regardless of the institution’s specific spending rate. Treating a portion of endowment earnings as operating revenue resulted in most private universities presenting an operating surplus, because the endowment earnings covered a large portion of the institutions’ financial aid and scholarships — the tuition discount. As noted above, this will have the effect of weakening the operating margins of institutions that rely heavily on endowment earnings to cover tuition discounts and endowed chairs.

On the plus side, eliminating investment earnings from operating revenue creates comparability between private and public universities. The endowment earnings treatment would become the same as that of public institutions under the Governmental Accounting Standards Board (GASB). In this way, the model will make it possible for private universities to show the comparison of their results against those of public universities.

On the plus side, eliminating investment earnings from operating revenue creates comparability between private and public universities.The model is in the proposal stage with an official Exposure Draft to be released for public comment in April 2015. FASB was also the force behind the changes to the reporting model in the 1990s. FASB has been discussing the proposed model during the past year with the AICPA expert panel and the National Association of College and University Business Officers (NACUBO).

These changes create an opportunity to refresh how financial performance is communicated. Going forward, the CFO and the provost can supplement the financial statement presentation with an insightful MD&A that lays out the cost of education, cost of student services and auxiliary activities, use of operating and non-operating funds to cover these costs, and performance metrics of revenue and expense per student.

Internally, a private university will need to reconsider its measurement of operating performance. One of the standard measures of financial stability is the ability to cover expenses with tuition — how can a university scale operations so that net tuition revenue covers 100% of its education, academic and student support activities? Another standard measure is the net operating income of auxiliary services, fundraising activities and related health care entities, and the amount of operating subsidy required by research activities and public/community service. These operating measures should be considered when determining the presentation of operating expenses. FASB’s proposal requires expenses to be presented by both functional and natural classifications, but it allows either format to be used in the statement of activities. The other format would be presented in a separate financial statement or in the notes to the financial statements.

These changes create an opportunity to refresh how financial performance is communicated.Currently, the major operating performance differences among institutions are the amount of endowment earnings consumed in operations, the profitability of auxiliary and noncore activities, the success of fundraising campaigns, and the ability to designate operating surpluses to cover future years’ budget deficits and strategic investments in programs and facilities. An institution’s spending policy and the applicability of the policy to quasi-endowment funds can have a significant impact on financial strength and flexibility. So, too, the ability to garner significant philanthropic gifts. The past two years have seen record-breaking fundraising results for many universities. While many of the new multimillion-dollar gifts are for capital investments in new initiatives, the ability to raise this amount of interest-free capital significantly affects the institution’s financial flexibility. A revised reporting model that redefines the operating excess presents an opportunity to explain the sources of revenues in a manner that enhances the consumers’ understanding of the breadth and complexity of educational institutions. The benefit is deeper knowledge of how the instructional mission is funded, the scope of services provided to the community, the costs of maintaining a campus, the costs of investing in technology and equipment, and the cost of supporting student success inside and outside of the classroom.

A revised reporting model that redefines the operating excess presents an opportunity to explain the sources of revenues in a manner that enhances the consumers’ understanding of the breadth and complexity of educational institutions.Capitalize on the opportunity to tell the whole story

While many educational institutions include an MD&A in their published annual reports, this is usually a CFO’s perspective on revenue growth, expense control, investment performance and capital plan initiatives. To truly convey the institution’s financial strength, revenue opportunities and cost drivers, the academic enterprise needs to supplement this financial view by offering perspective on course offerings, student achievement, faculty development, facilities usage and operations of the academic departments. While the CFO can state the tuition discount rate and trends relative to prior years and to budget, the provost can explain how enrollment management is affecting class size, preparedness of students, and the competitive position of the schools and academic units. Most readers of college financial statements do not know what student services or academic or institutional support services are. Many can’t differentiate student services from auxiliary services, or institutional support from overhead costs. The activities and outcomes of these areas can be explained in the MD&A. If regulatory mandates are driving up institutional support costs, this is the opportunity to explain, and to describe steps to streamline administrative and reporting functions. Communicating the difference between operating revenue and infusions of nonprofit capital in the financial statements and the MD&A can help consumers, funders and regulators better understand the revenue sources needed to sustain the institution and enhance the educational mission.

There’s one more rallying cry, and it comes from consumers. In response to “Cost and value!” smart organizations will capitalize on the change in model format to communicate a more consistent, transparent and simple story about costs, price and value.

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