Days of Reckoning

As usual, March Madness took center stage for many universities in recent weeks. Yet this March, we in higher ed had an additional reason to focus on the National Collegiate Athletic Association. On March 31, the U.S. Supreme Court heard oral argument in NCAA v. Alston to decide whether college athletes may receive some forms of compensation for their efforts -- an increasingly vital issue of fairness and equality.

Throughout the argument, the justices expressed support for some kind of compensation for student athletes. Their repeated references to the billions of dollars in revenue, the sky-high coaching salaries and the bizarre nature of a market that depends upon free labor demonstrated that the justices are keenly attuned to the reality of college sports. Predicting the outcome from argument is always speculative at best. But the justices clearly signaled that the equities are on the side of the student athletes.

The justices did struggle with where to draw the line about any compensation. Experienced advocates will assure you, however, that a defense to a glaring injustice that depends on the difficulty of line drawing is the last line of defense.

The Supreme Court’s decision will command attention. Yet new state laws already authorize payment, and proposed federal legislation is moving in a similar direction. Regardless of the court’s ruling, compensation of student athletes is inevitable. The question is not if but when.

The spotlight will then shine on universities, which will have to do something they’ve never had or wanted to do: open up their books and give a truthful accounting of their athletics financials. It won’t be a pretty sight. Even in the best of times, most institutions run substantial deficits. More troubling, institutional leadership -- presidents, chancellors and trustees -- won’t be able to hide the questionable financial accounting practices that some now employ.

What do I mean by “questionable financial accounting practices”? What I discovered as chancellor of Vanderbilt University about other higher ed institutions is that some do two kinds of accounting: one for the university based on established accounting rules and another for athletics. Universities are assiduous about following the former in all formal reporting. But when it comes to their athletics numbers, practices diverge sharply. The NCAA tries to impose some structure, but its efforts are incomplete. And it keeps the report for each institution confidential, with only some public universities’ numbers available under state freedom of information laws. Not much transparency in a system that’s behind a firewall.

The revelation of certain accounting tricks that other universities practiced really stunned me when I was a chancellor. How could this happen, I wondered. I was grateful that my university hadn’t fallen to the temptation to employ these sleights of hand. Let me offer a survey of some of them.

Not charging the athletics department for the cost of its scholarships. This is one of the most common schemes. When a university gives scholarships to students, including athletes, it has the expense of paying for those scholarships. For example, if 200 athletes receive a $60,000 scholarship, the institution has an expense of $12 million.

Wouldn’t it be wonderful if those costs could vanish and the athletic department’s costs could go down by $12 million? Yes, and here’s how it’s done. Many people -- including those of influence, like some athletics boosters and board members -- don’t believe athletics scholarships truly cost that much. They insist that “adding this small number of students to classes is not that expensive.” Putting the argument in the language of economics, the claim is that those students add very little or no marginal cost -- that they are like the last few passengers who fill up an airplane on a flight that would have taken off anyway.

There are colossal and myriad problems with this view. The most basic flaw, apart from violating accounting rules, is that it is an exceedingly bad business practice. When any business takes in revenue, its positive margin comes from its ability to cover its fixed costs and then keep its marginal revenues above marginal cost.

It is no different at a university. On a university budget of $1 billion in revenue, about 80 percent, or $800 million, would cover fixed costs, and maybe another 10 percent, or $100 million, would cover variable costs. The remainder of the revenue -- $100 million -- is from the ability to price above marginal and variable cost. This is the positive margin universities need to pay for things like building construction, replacement and other capital needs, as well as any interest due. Nobody runs a great business charging below marginal cost or zero. It is the ability to price above marginal cost that allows an institution to have a positive margin.

Hiding the costs elsewhere. If we don’t charge the athletics department for those scholarships, then on what set of books do they land? I ask on “what set of books” because a university metaphorically is keeping two sets of books: one in the formal financial report and the other when it shows the athletics budget. And here’s how that’s done.

A university financial report must follow established accounting rules that scholarships are an expense (“contra revenue”). Thus, in a university financial report, accounting for scholarships is a two-step process: first, there is gross tuition, which means all charged tuition, and then there is the cost of scholarships. Subtracting the scholarships from gross tuition is net tuition, or money actually collected.

The scholarship costs for all students, including athletics scholarships, are found in that second number. Thus, the university is obliged to show such scholarship costs in the aggregate. But since athletics costs are not reported out separately, the athletics department often will show its numbers without those costs. As I said, two sets of books.

Now this is getting mysterious. This is an expense. Somebody has to pay. Who pays? The costs of those scholarships are shifted to the departments and schools in which the student athletes are enrolled. Academic budgets take the hit.

People often suggest establishing an endowment for the athletic scholarships to provide the revenue to offsets the cost. Never going to happen. Athletic directors and coaches with short time horizons are focused on facilities. They want big, shiny new stadiums and locker rooms to show off. It’s all part of the facilities arms race in college athletics. Raising dollars for scholarships in athletics is not a priority with some. I’ve even heard an athletic director say, “Why should I raise money for scholarships? The university will pay for them!”

Not charging overhead, plant and other costs to athletics. Besides not passing along the cost of scholarships, some universities use another, similar technique. They ask themselves, “Heck, if we don’t have to charge athletics for scholarships, why charge them for anything?”

Universities have the costs of overhead, or what is often called “G and A” -- general and administrative expenses -- for items like utilities, police and security, and so forth. They allocate such costs in various ways, with some institutions charging by actual usage, others charging on a flat tax basis and others doing something in between. Whatever the method chosen, all parts of the university should be charged under the same set of rules. But what if the athletics department has different rules and could just make overhead costs disappear?

Take an institution with $100 million in athletics revenue and $115 million in expenses. That deficit of $15 million is not welcome news, especially if leaders and boosters want to invest more in athletics. A great solution is to “turn athletics into a profit center.” If administrators remove $15 million in overhead and another $12 million in scholarships, athletics is left with a profit of $12 million.

This overhead ruse comes in particularly handy when it comes to building large new facilities. Every building on campus has operating expenses, including the costs of utilities and upkeep. To make new athletic facilities financially viable -- especially those that have no underlying ticket or other revenue -- a good trick is to “waive” such operating costs. The athletics building thus gets a free pass on what every academic facility has to pay. Nobody notices, because these athletic costs are shifted into the rates paid by academic facilities for utilities and upkeep. A secret well kept, and a fight with deans and faculty avoided.

Counting philanthropy bogusly. Universities want to fund very large capital investments without drawing the ire of a number of constituencies. Athletics projects may be very popular with some individuals, but others will wonder how they will be paid for and what trade-offs will be made. Faculty and staff, the former always and the latter increasingly, will want to know how these investments will affect them: their salaries, wages and benefits, as well as the facilities where they work together on research and teaching. Students and parents will wonder about rising tuition and the quality of the educational experience.

Every president or chancellor wants to say that “athletics fundraising paid for this!” It generally quiets down objections, although faculty members will wonder if the institution’s prioritization of capital gifts for athletics will diminish donations to academics. The costs of many of these projects can total in the $100 millions, and outside of a few universities, it is hard to cover the high debt levels through ticket sales and luxury suites. Being able to say, “We paid for it through fundraising” is the ultimate safe harbor.

One of the most pernicious spins is to falsely imply that “gifts to athletics paid for this facility.” For example, if a facility costs $100 million, and for the past decade, athletics has raised $200 million, you might hear someone say that “money has been given to athletics well above the cost to pay for this facility.” Notice the misdirection here. The person doesn’t say, “Money has been given for this facility.” When, in fact, was the money given? A year ago? Ten years ago? And for what purpose? To build a practice gym? A soccer field? Annual operations? And has the money already been spent? If so, that money is gone. Misleading and crafty! The PR department is not the audit arm, and it will want to put a helpful spin on things to hype results or get leadership off the hot seat.

Agents for Honest Accounting

This is all pretty grim, and it must pain some people to learn of the lack of courage and transparency of some of our leaders. But I’m not so cynical as to believe that change is hopeless. How can we go about fixing this? Who might be the best agent for change? Let’s review some options here and assess their likelihood.

• Governing boards. Good luck! Sadly, some athletic boosters and even trustees know that showing large subsidies to athletics, which must come from academic funds, higher tuition and fees is a tough sell. So they are looking for ways to boost the monies going to athletics without it “being shown” or “felt.” Other presidents and chancellors have told me about these issues at the board level. Fortunately, where I teach, the practice has been to have one set of accounting rules govern all schools and departments, including athletics.
• Presidents and chancellors. Top administrators can sometimes be advocates for the tricks I’ve described. Why? Perhaps because the trustees and leadership both embrace the scheme. Don’t expect the president or chancellor who has been complicit to suddenly say, “This is all misleading and inappropriate!”
• Athletic directors. No way! They love bragging about how they are performing. Redoing the accounting would weaken their position internally and undercut their carefully crafted “master of the universe” public image. It is also hard to defend multimillion-dollar athletic director contracts if people know the department is cratering financially.
• NCAA. LOL! It is on its last legs and trying to figure out how to compensate players (finally) without losing all of the monies it has made for itself. Survival, not sanity, is its goal.
• Faculty members. They can be good on these issues, yet do they know how to decode university financial statements? What’s more, their interest in this topic waxes and wanes. But faculty members can provide useful checks, especially if the university leadership is transparent and truthful.
• Journalists. Another LOL, at least for those in the sports media. They’re usually part of the “athletic-military-industrial” complex. They engage in cheerleading, or alternatively deifying or roasting coaches, and remain silent on important issues in college sports. Check your local sports pages and ask yourself how many stories they publish on the economics of athletics or whether college athletes should be paid -- as well as about the clear link between lack of compensation and issues of race and inequality.
• Knight Commission. This commission is a credible and influential voice on college athletics reform. It is a diverse group representing all of the key constituencies, and it openly and robustly debates the issues and recommends solutions. (Full disclosure: I was a member of this commission.) As the commission addresses compensation for college athletes, it will inevitably get into the true costs and revenues.
• Securities and Exchange Commission. Universities issue both tax-free and taxable debt to the public markets, yet it seems unlikely that the SEC will get engaged. That said, one should never say never. The PAC-12 conference’s flirtation with selling its media rights to private equity investors is yet another signal that money and profit maximization reign supreme. It’s not beyond the realm of possibility to think of some federal or state agency holding an inquiry into monetization of athletics revenue.
• Bond rating agencies. Presidents are in conversation with agencies -- Moody’s, S&P and Fitch -- that rate their debt, and those discussions can lead to pointed questions about areas of risk. It would not be far-fetched for such agencies to start asking about athletics budgets, and university leaders will have to be honest in response. If those agencies decide to probe on athletics finances, we could see a major shift in university behavior.
• Congress. Athletics has been called the front porch of the university, and a lot of ambitious and curious legislators around the nation walk by that front porch every day. Congress is increasingly focusing on college sports, and several proposed bills on paying student athletes have bipartisan support. One proposal allows royalty-sharing revenue paid to student athletes to be offset by the cost of scholarships. Congress may decide that if athletics departments don’t pay for scholarships, that offset would be disallowed. Uncovering the true numbers seems foundational to any congressional plan to compensate college athletes
• Litigation. Until Congress acts, and especially if the Supreme Court rules for student athletes, this is perhaps the best option for forcing change. Even a ruling for the NCAA may not foreclose future litigation. Moreover, a court ruling for the NCAA will only increase the likelihood of federal legislation that will spawn litigation. State laws already permit compensation, and litigation on these is inevitable. The NCAA has already threatened to challenge a new California law, arguing that such laws "burden interstate commerce" in college sports. Plainly, the NCAA misses the irony of insisting that student athletes must remain amateurs to sustain a multibillion-dollar industry in college sports. Discovery in our civil justice system is broad and appropriately deep on matters of significant relevancy.

Whatever the way into the numbers, student athletes will rightly claim that they produce much of the revenue and are entitled to get a true accounting of all of these hidden subsidies and tricks. A good model can be found in the collective bargaining agreements of the professional leagues. Indeed, during the recent oral argument, Justice Brett Kavanaugh referred to collective bargaining as an endgame solution. Importantly, these agreements give the players audit rights.

I’ll say it again: compensation is inevitable, however the Supreme Court rules. Indeed, the NCAA’s recent crabbed proposal -- now delayed -- to pay some compensation clearly jettisons their long-standing argument that the product called college sports would not exist if student athletes were compensated. Fair compensation for student athletes is coming. And with that, we will finally get an honest accounting. Stay tuned.