This report was originally published 10/28/09.

Readers of our research know that we have been bearish on the for-profit education sector for the past few quarters based on our concerns about growing fundamental headwinds, increasing regulatory scrutiny, and what we view as significant structural issues for a few operators in the sector. Outside of our analysis of COCO (17.3 ↓1.09%)’s bad-debt expense recognition, we have not spent too much time reviewing the accounting policies of the publicly traded for-profit postsecondary education providers up until now.

After the close today, APOL (63.13 ↓0.36%) reported 4Q09 results.  You can read the release here.  The quarterly results and management commentary about the outlook have become a sideshow to investor concerns about the company’s disclosure that the SEC has commenced an informal inquiry into the APOL’s revenue recognition policies.  The stock was down as much as 15% after hours and other publicly traded for-profit education providers, such as COCO and ESI (109.11 ↓0.35%) traded down as much as 8-10% in sympathy.  Clearly initial investor reaction has been to assume that any potential accounting issues at the industry leader could be an industry-wide problem.  The company does not have any specific information on what the SEC might be reviewing at this stage.  THIS IS PURE SPECULATION ON OUR PART, BUT WE THINK THE SEC COULD BE REVIEWING THE ACCOUNTING POLICIES RELATED TO STUDENTS THAT WITHDRAW.

Accounting for Student Withdrawals Is Not Necessarily Ratable With the Completion of Class Time

We want to reiterate that the forthcoming analysis and discussion is purely speculation on our part. We have no specific knowledge as to what the SEC’s informal inquiry into APOL’s revenue recognition relates.  However, the manner in which revenue is recognized for students that withdraw or dropout has long been an area of confusion and debate in the investment community in the for-profit education sector.

APOL’s Stated Revenue Recognition Policy

The following text is APOL’s stated revenue recognition policy from the company’s most recent 10-K filing with the SEC. It is not particularly specific on the issue of how revenues are calculated for a student that drops out (or when a student is determined to be withdrawn)

“Our educational programs, primarily composed of University of Phoenix programs, range in length from one-day seminars to degree programs lasting up to four years. Students in University of Phoenix degree programs generally enroll in a program of study encompassing a series of five- to nine-week courses taken consecutively over the length of the program. Generally, students are billed on a course-by-course basis when the student first attends a session, resulting in the recording of a receivable from the student and deferred revenue in the amount of the billing. University of Phoenix students generally fund their education through grants and/or loans under various Title IV programs, tuition assistance from their employers, or personal funds.“

A Case Study: ESI’s Revenue Recognition Policies for Students that Withdraw or Dropout

We thought it might be helpful to review ESI’s stated revenue recognition policies with regard to student withdrawals/dropouts in order to illuminate the complexities of current practices.  We want to make it clear that ESI is not subject to any SEC inquiry as far as we know. We are only using ESI in this case because the company provides more detailed revenue recognition disclosure in its SEC filings and makes its student handbooks publicly available.  Although we do not know this explicitly, we have always assumed that revenue recognition policies among operators in the space was fairly similar.

First let’s take a look at ESI’s discussion of its revenue recognition policies in its most recent 10-K filing.

“Tuition revenue is recorded on a straight-line basis over the length of the applicable course. If a student withdraws from an institute, the standards of most SAs that regulate our institutes, the ACICS and our own internal policy limit a student’s obligation for tuition and fees to the institute depending on when a student withdraws during an academic quarter. The terms of the Refund Policies vary by state, and the limitations imposed by the Refund Policies are generally based on the portion of the academic quarter that has elapsed at the time the student withdraws. Generally, the greater the portion of the academic quarter that has elapsed at the time the student withdraws, the greater the student’s obligation is to the institute for the tuition and fees related to that academic quarter. We record revenue net of any refunds that result from any applicable Refund Policy. On an individual student basis, tuition earned in excess of cash received is recorded as accounts receivable, and cash received in excess of tuition earned is recorded as deferred revenue.“

ESI provides a great deal more clarity on its accounting for student withdrawal/dropouts.  Let’s take a look at a few practical examples of how the actual tuition billing/revenue recognition works at three of ESI’s campuses located in different states.  To complicate matters, not every state has the same policies related to “billable tuition” based on how long a student is enrolled.  The first ITT Tech location we will evaluate is in Florida.  In the table below you can see the amount of tuition that a student will be billed depending on how long they stayed enrolled.  In short, any student that withdraws or drops out after the third calendar week of the quarter will still owe full tuition.

Source: ITT Educational Services, Inc.

Now let’s evaluate the tuition recognition policies for ITT Tech locations in the state of Arizona.  The tuition recognition policy for students that withdraw is slightly more nuanced. The state allows a different calculation of billable tuition based on whether or not it is the first quarter of a student’s enrollment.  The billable tuition/revenue recognition policyin that case is similar to that in the state of Florida:

Source: Company reports

When a student withdraws after completing the first quarter of an academic program the tuition billing/revenue recognition policy is different than for a student in their first quarter.  In general, we would characterize it as more aggressive.

Source: ITT Educational Services Inc.

Finally, let’s look at the revenue recognition/tuition billing policies for students attending an ITT Tech location in the company’s home state of Indiana.  The policies appear to be more favorable to students and closer to the schedule of earned tuition under Department of Education guidelines.

Source: ITT Educational Services, Inc.

Three states, three completely different ways to recognize revenue for students that withdraw.  Needless to say this is not a billing policy that favors students, nor does it appear to be particularly conservative. Remember, this is not necessarily dictated by ESI, but is allowed by the company’s accrediting body and each individual state.

Earned Tuition Under the Department of Education Guidelines – Why Bad-Debt Expense and Student Retention Rates Are Correlated

“Earned tuition” under Department of Education guidelines adds one more wrinkle to the complexity of revenue recognition for students that withdraw from an ITT Tech location.  “Earned tuition” represents the amount of Title IV funds that a school is allowed to collect.  If a student withdraws, the difference between the federal student loan disbursement and the amount of tuition “earned” must be refunded. Under Department of Education guidelines, tuition is earned ratably up until 60% of an academic period is completed after which the full amount of tuition is considered earned.  The difference in revenue recognition policy and earned tuition often is a source of bad-debt expense.

Let’s walk through a practical example.  A student enrolls at an ITT Tech location in Florida and drops out four weeks into the program.  For this example we will assume quarterly tuition is $5,000 (fairly close to reality) and it has been fully financed by federal financial aid.  Here are the accounting steps:

• Looking at the first table above, we know the school can bill and recognize $5,000 of tuition revenue because the student dropped out after three weeks of the program.
• The company has only “earned” 40% of the tuition according to Department of Education guidelines.  ESI will keep $2,000 of the federal loan and return $3,000.
• ESI will then book a receivable of $3,000 and create a reserve against that receivable

We are not certain that APOL’s revenue recognition policies are exactly the same as those of ESI.  We do know that other for-profit educational institutions have policies that are similar in spirit, if not explicitly to those of ESI.  Again these policies are dictated in large part by the accrediting agencies of each respective school and the state regulating bodies.  We would not characterize these tuition billing policies as favorable to students, but they were established with the concept that a greater portion of the education of any course occurs in the early stages.

In our view, there are three areas from a revenue recognition perspective that can be viewed as controverial in the for-profit education sector: what constitutes an enrollment and how withdrawals are determined, what constitutes a credit hour, and how revenue is recognized for withdrawals.  It appears many on the sell-side think that the SEC inquiry relates to the manner in which APOL determines when a student has withdrawn or dropped out.  The concept being that APOL could conceivably delay the determination of a dropout or withdrawal thereby recognizing more revenues.  We would argue that the accounting policies for a student once they have been determined to have withdrawn COULD be the focus the SEC.  This is very clearly an example where tuition recognition does not match services rendered ratably.  The revenue recognition policies have been in place a long time, so in theory this issue should have been vetted by the SEC.  At this stage it is pure speculation on our part, but we think it is important that investors understand the accounting policies surrounding student withdrawals.

APOL Backs Away from Lower Quality Students

The other major takeaway from APOL’s 4Q09 earnings conference call was the company’s explicit statements about renewing its focus on “responsible growth”.  Management stated that: “only students that have a reasonable chance to succeed will enroll in our universities.”  From a strategic perspective APOL has increasingly moved “downstream” from a socio-economic perspective over the past decade to sustain enrollment growth.  To put this in perspective, in FY01, the company generated 48% of its revenues from Title IV. This was due in large part to the huge amount of corporate tuition reimbursement the company received.  The company has enrolled younger students from lower socio-economic backgrounds into associate’s degree programs to sustain growth.  Now it appears the company is willing to curtail growth in order to ensure it is not enrolling students that are not capable of completing their degree programs or have a high drop-out rate. We can’t help but wonder if APOL is increasingly worried about the implications of 90/10 and the transition to a 3-year calculation of cohort default rate.  On its conference call management indicated that the University of Phoenix’s cohort default rate for FY08 will likely be above 10% on the current 2-year calculation basis. Remember, on a 3-year basis that could convert to a 20%+ cohort default rate.

We think APOL’s decision has serious ramifications for companies like COCO, ESI and WPO (447.74↓1.27%) that enroll the type of students that APOL will increasingly shy away from.  On a positive note, one could make the argument that students that cannot enroll at Axia/University of Phoenix can now attend Everest, ITT Tech, or Kaplan.  However, if the industry leader suggests that outcomes for these students are not favorable, should anyone in the space continue to enroll these types of students?  We think the transition to a 3-year cohort default rate calculation and increased regulatory scrutiny related to recruiting practices could be the catalysts that could force changes to enrollment practices industry-wide and lead to lower structural growth for companies such as COCO, ESI, and WPO.

As always, please act accordingly…