In September 2019, the Department of Education finalized the regulations related to borrower defenses to repayment, pre-dispute arbitration agreements, internal dispute processes and guaranty fees. Included in this regulation, the Department clarified the treatment of the new accounting standards brought about by FASB ASU 2016-02, ASC 842 (Leases) and how it will impact the composite score calculation. The Department also updated the treatment of long-term debt in the composite score calculation.
FASB ASU 2016-02, ASC 842 (Leases)
- The implementation date for the new lease accounting standard for public companies becomes effective for fiscal years beginning after December 15, 2018.
- The implementation date for private companies has been delayed to fiscal years beginning after December 15, 2020.
The new lease standards require institutions to record a right to use asset and a lease liability for most operating leases. The right to use asset will increase an institution’s total assets which will negatively affect the equity reserve factor within the composite score calculation; this factor is based on the ratio of modified equity over total assets.
Given the impact of the new standard on the composite score, the Department considered various transitionary steps to minimize the immediacy of the negative ramifications for financial responsibility. The Department ultimately settled on a compromise by applying the new FASB standard to all leases an institution has entered into on or after December 15, 2018 (post-implementation leases) and all leases an institution has entered into prior to December 15, 2018 as they would have been treated prior to the new FASB requirements. The Department did this to treat all institutions (public and private) fairly. The Department also clarified that any options exercised after December 15, 2018 for pre-implementation leases would be accounted for as post-implementation leases in the composite score.
The Department’s clarification on the treatment of the new lease standard doesn’t address the negative impact from the new standard on the composite score, but it, along with FASB’s recent delay for the implementation for private companies provides institutions the time and opportunity to start building its equity reserve now before they see the impact on their 2021 audits.
The other planning opportunity for the future is to consider moving away from longer operating leases and explore shorter leases. While any operating lease over a year will require the recording of a right to use asset, shorter leases come with smaller right to use assets and a smaller impact on the equity reserve factor. However, there is a trade-off in that lessening the ratio impact comes at the cost of opening up what tends to be an institution’s major expense to more market volatility.
The Primary Reserve Factor portion of the composite score calculation is based on the ratio of adjusted equity divided by the total expenses for the year. One of the adjustments to arrive at adjusted equity involves subtracting net property (fixed asset – plant, property and equipment less accumulated depreciation). However, under the current rules, long-term debt was allowed to be added back to equity to offset the amount of property that was subtracted.
With the new regulations, the Department wants to minimize manipulation of the composite score and is requiring long-term debt be specifically used to fund plant, property and equipment for it to be added back to adjusted equity in the Primary Reserve Factor.
This is a minor change that can have a significant impact on an Institution’s composite score calculation in that debt obtained for general purposes.
The Department is applying a similar transitionary approach to implementation. Existing debt obtained prior to the implementation date (Department has not yet finalized the implementation date, but it will be effective for all audits submitted after 7/1/2020) will continue to reduce net property in the primary reserve factor. However, the Department will use the lesser of (1) the PP&E as of the last audit prior to the implementation date minus depreciation/amortization or other reductions, or (2) the qualified debt obtained for long-term purposes minus any payments or other reductions, as the amount of debt. Any refinancing or renegotiated debt cannot increase the amount of debt associated with previously purchased PP&E.
This further complicates what was already a complicated area. Institutions should continue to focus on using long-term debt to finance capital projects to minimize the impact on the composite score. It will be important to make a focused effort to directly link the debt acquired with the capital projects when making purchases. Institutions will no longer be able to manipulate the composite score by drawing down on a long-term line of credit at year end.
The Department’s clarifications may have a direct impact on your institution. Make sure your school is complying with this update and talk through your specific situation with a Title IV audit expert.