This section is reprinted with permission from the Ratio Analysis in Higher Education, Second Edition, prepared by individuals associated with KPMG Peat Marwick, L. F. Rothschild, Unterberg, Towbin, and John Minter Associates, Inc.
First-time readers of college and university financial statements frequently are confused by what they see. This confusion results from the style of accounting and reporting that these institutions employ. The reader who wants to understand why the ratios described in this publication are useful needs to have some understanding of the special terms and concepts used by the reporting institutions. The purpose of this chapter is to help readers understand and appreciate why the resources of these institutions are classified the way they are, and how the basic financial statements tell their story. The reader who has an understanding of these concepts can better use and understand the ratios.
Fund accounting is the specialized type of accounting used by colleges and universities. It arose in response to the special limitations placed on significant amounts of the monies provided to these institutions by donors, grantors, and other resource providers. A knowledge of the types of limitations usually found and how they are reflected in the institution's financial statements will greatly facilitate the use of ratio analysis.
Chart 1, Resource Classification Chart, at the end of this section, represents graphically the questions that an institution's accountant must be able to answer in order to classify new resources properly.
At the top center of the chart is the starting point ("New Resources") for money entering the institution. The first question (indicated by A) is, Does the institution receive the resources as owner or as agent? If the institution receives resources that belong to another party and is acting simply as a custodian, paying agent, or bank, then the monies are classified as agency funds. Such funds play no part in meeting directly the institution's operating or capital outlay requirements. For analytical purposes, therefore, they are to be ignored.
The bulk of all funds received are owned by the college or university, so the next question (indicated by B) to be answered is, Are the assets received restricted or unrestricted? This distinction is at the heart of the need for fund accounting and is the cause of much complexity and confusion.
Restricted funds are assets that are provided to the university subject to legally binding limitations on their use. These limitations are imposed by the donor, grantor, or other fund provider outside the institution that receives the resources. An institution that accepts such assets must abide by the externally imposed restrictions. Even if events make impractical or impossible the use of restricted assets for the purpose originally specified, the institution cannot deviate from the legal restrictions by itself. Relief can be obtained only through the application of appropriate legal procedures.
There are several points to keep in mind about restrictions. First, a legally binding restriction usually must be evidenced in writing. Second, the language used to describe the restriction must be clearly restrictive and not merely indicative of a wish or desire. Finally, since the limitation imposed by legally binding restrictions cannot be removed casually by the recipient of the funds, the restrictions should be fully documented.
If a legally binding restriction exists, the next question (indicated by C) will be used to classify the amount as being expendable either for operations (e.g., departmental salaries, travel, scholarships) or for plant. Examples of the plant classification are amounts restricted for acquisition of land, buildings, equipment, and repayment of debt incurred to finance such assets already owned by the institution.
If the assets are expendable, the specific nature of the restriction (indicated by D) will be used to classify the amount as being expendable either for operations (e.g., departmental salaries, travel, scholarships) or for plant. Examples of the plant classification are amounts restricted for acquisition of land, buildings, equipment, and repayment of debt incurred to finance such assets already owned by the institution.
Assuming that the restriction calls for keeping the assets intact, there are three general classes of such nonexpendable assets (indicated by E).
The first class includes all amounts that are to be invested, with the income to be used for institutional purposes. If the donated assets (principal) are to be retained for investment purposes forever, such amounts are classified as endowment funds. If the nonexpendable character is to terminate at some future date or on the occurrence of a projected event, the donated principal is classified as term endowment. The income from investment of both endowment and term endowment assets may be restricted to a particular purpose or may be unrestricted. The stream of assets arising from the investment income would have to go through the same question-and-answer process in order to be properly classified.
Another type of nonexpendable restriction arises with assets limited to making loans to students, faculty, and staff. These loan funds are to be held intact for the purpose of making loans. The making of a loan
does not constitute an expenditure of cash but rather is treated as a conversion from one type of asset (cash) to another type -- loans receivable. When the loans are collected by the institution, the cash is used to make new loans.
The last category of nonexpendable funds comprises amounts contributed to an institution to be invested by it, but with the stipulation that an amount be paid to someone outside the institution for a term of years or for life. If the payment is a fixed amount, contributed assets are classified as annuity funds. Such payments may be greater or less than the income generated by the investments of annuity funds. If the payment by the institution is limited generally to the income from the investments, the contributed assets are classified as life income funds. Annuity and life income funds both ultimately become usable for institutional purposes, at which time they become reclassified in accordance with the terms of the original donation.
When there is no legally binding restriction, the assets received by an institution are considered to be unrestricted (see left-hand column on chart). Reading down the terms connected to Unrestricted on the Resource Classification Chart, one sees that all unrestricted assets received are, by their nature, fully expendable. Furthermore, all unrestricted expendable assets coming into the institution are first considered to be available for operating purposes.
The use of unrestricted assets for operating purposes usually is designated by the governing board through its approval of the operating budget. The board may, at its discretion, designate some of the unrestricted expendable assets for the financing of the physical plant. It may also decide to set aside some unrestricted expendable funds for long-term investment, to function, in other words, like an endowment fund. Assets so designated are called quasi-endowment funds, meaning that they are similar to, but not the same as, endowment funds because the governing board retains the power to reallocate them to other uses, such as operations or plant.
No legal proceedings, courts, or attorneys general are involved in redesigning the use of unrestricted assets. The income from the investment of these board-designated quasi-endowment funds is always legally unrestricted. The remaining designated the governing board may make of unrestricted assets is for loans to students, faculty, and staff.
Two other classifications of resources are shown on the chart. The first is the designation of restricted expendable operating assets for long-term investment. The income from these investments is automatically limited to the operating purposes to which the invested assets are restricted. The governing board can, at any time, redesignate these invested funds for expenditure for their original purpose. These invested assets are thus also classified as quasi-endowment funds.
The last classification on the chart relates to the institution's physical plant. When expendable funds, both restricted and unrestricted, are spent to acquire physical plant, the cash and related accountability (fund balance) are eliminated from the institution's financial records pertaining to expendable assets. Simultaneously, a record of the cost of the plant assets acquired is established in another set of accounts set up to report the historical cost of plant assets still in use. These assets may be thought of as expended funds, or "sunk costs", to use the economist's term. There is seldom any concern with restrictions in this category of assets, since any limitation that may have been established initially is extinguished or complied with when the restricted cash is used to acquire or finance the physical plant asset to which the restricted donation is related. There are cases where secondary restrictions are imposed on cash arising from subsequent disposal of the physical asset, but such restrictions are so rare as to be insignificant for reporting and analytical purposes.
Another look at the chart will show the sets of horizontal dashed lines that delineate classifications that are the same or similar. These horizontal groupings correspond to the major categories of resources that are managed together because they serve similar purposes. Note, however, that within each horizontal group the distinction between restricted and unrestricted resources must be maintained. The distinction is represented on the chart by the vertical cashed line headed X, with unrestricted resources to the left and restricted resources to the right. This classification is fundamental to the stewardship responsibility of the governing board. It is also important in assessing the transferability of resources from one category to another.
For analytical purposes there is another distinction that is critically important -- namely, the expendability of the resources. This distinction is indicated on the chart by the vertical cashed line headed by the symbol Y. Note that all resource classification to the left of line Y are expendable, with some being restricted and some unrestricted. All resource classifications to the right of Y are not only restricted but are nonexpendable as well. As stated earlier, the investment in plant is an aggregation of historical costs representing expended resources.
This three-way grouping of resources -- expendable, nonexpendable, and investment in plant -- is used later as the basis for the balance sheet ratios.