“The Enron Accounting Changes Are Going to Effect the Franchise Community”		«BACK
	by Dennis L. Monroe
	from November/December 2003 Franchise Times

FASB Interpretation 46

The first change deals with consolidation of variable interest entities. Simply stated, entities that have an economic effect on another entity are now required to be consolidated with that entity, even though the entities are legally separate. As many of you know, the franchise, multi-unit retail industry is proliferated by multi-entities: entities that may be joint ventures, captive finance companies or other creative structures to take advantage of different types of financing.

The FASB Interpretation 46 addresses a number of the various ownership structures. The rules are quite technical and not clearly defined, but the following are the two basic characteristics of a variable interest:

1. An entity that does not have the equity investment sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties (i.e. the equity investment at risk in less than the expected losses) is an entity that may be consolidated. This may draw thinly capitalized companies into the consolidation web. For purposes of FIN 46, an equity investment should equal at least 10 percent of the total assets of the entity or it will be considered insufficient.

2. An entity may be drawn in if the equity investors lack one or more of the following characteristics of a controlling financial interest: (i) the direct or indirect ability to make decisions about the activities of the entity through voting or similar rights; (ii) the obligation to absorb the unexpected losses of the entity, thereby making it possible for the entity to finance its activities (e.g., the investors are either guaranteed a return or are contractually protected from the expected losses); or (iii) the right to receive the expected residual return of the entity as compensation for the risk of absorbing the expected losses.

The establishment of either of the above two characteristics provides strong evidence of the existence of a variable interest which, in effect, means the entity is consolidated because there is no real equity base in the created entity. While these rules seem very technical, let’s give some examples of ways this may apply.

1. This may apply if one entity is guarantying the obligations of another, such as a franchisor agreeing to guaranty the loans of a franchisee. Or, this may apply where there is a guaranty of outside financing. In McDonald’s last annual SEC (10K) filing (even though they were not required to) their financials reflected their understanding of these new accounting rules.

2. Contracts to purchase or sell assets that are not at market value. Examples of this can be a put or call arrangement between a franchisor and franchisee or between franchisees.

3. Long-term leases that are not at market rates.

4. Subordinate debt instruments. Again, this type of financing vehicle may create consolidation problems.

5. Non-market rate service or supplier contracts.

If any of these types of characteristics exist or if the above list or similar arrangements exist, please consult your accountant prior to year end so proper planning and rules can be taken into account.

The effect these types of legal structures may have on available debt financing and equity investment for the franchise community is very crucial in terms of these extra consolidations.

The effective dates for FIN 46 are as follows: (i) for variable interests created after January 31, 2003 - immediately; (ii) for existing variable interests held by of public entities - the first interim period beginning after June 15, 2003; and (iii) for variable interests held by non-public entities - fiscal periods beginning after June 15, 2003.

FASB Statement 150

Now let’s turn our attention to an even more problematic accounting change: FASB Statement 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” As indicated in its title, FASB Statement 150 applies to certain instruments possessing characteristics of both debt and equity that have historically been treated as equity for balance sheet purposes. Now many of these financial instruments may be classified as debt instruments. Consequently, the equity section of the balance sheet will be reduced and the liability section will be increased.

Specifically, Statement 150 impacts the accounting for three types of financial instruments: (i) an instrument issued in the form of shares that the issuing company is required to buy back in exchange for cash or other assets (i.e. mandatory redeemable shares); (ii) an instrument, other than an outstanding share, that obligates the issuer to repurchase the equity shares of an issuer (e.g. written put options and forward purchase contracts); and (iii) certain obligations that can be settled through the issuance of a number of shares.

In the case of the redeemable share concept, if the obligation to redeem the shares is unconditional (e.g., a buy-sell agreement that is triggered by the death, disability or termination of the holder), the instrument must be recorded as a liability from the date of issuance. If, however, the obligation is conditional (e.g., a right of first refusal), the value received is recorded as equity until the condition comes to pass, at which time the instrument is treated as a liability.

Statement 150 is likely to impact franchise companies most significantly with respect to their financial covenants. Because most financing contains certain requirements and restrictions on debt to equity ratios of borrowers, the reclassification of equity as debt may cause the company to find itself in violation of the loan terms. As such, it is very important for franchise companies to make sure the terms contained in financing instruments represent a true reflection of the new guidelines set forth in Statement 150. If not, an entity may find itself in a default situation when its financial position has not changed.

The key regarding the issue of FASB Statement 150 is to review the various legal structures and positions of the company. A failure to review the structures may (i) result in a covenant default with the lenders; (ii) result in various control provisions that may be triggered if there are equity investors; and (iii) create an adverse financial condition of the company even though the company may be performing as planned.

The effective date for Statement 150 is as follows: (i) for agreements or financial instruments initiated or modified after May 31, 2003 - immediately; (ii) for existing financial instruments and agreements of public entities - the first interim period begins after June 15, 2003; and (iii) for existing agreement or financial instruments of non-public entities - fiscal periods beginning after December 15, 2003.

Summary

Through the issuance of these policy statements, the financing field for franchise companies has changed. Even though the rules have changed, do not worry. Many of these problems can be corrected, and we are hoping the lenders and investor groups look to the reality of the situation versus the pure accounting rules. Consulting a combination of your attorney and accountant is crucial in order to navigate through these tough issues.

Dennis L. Monroe is a partner and the chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation. Thanks to Jed D. Larkin, a senior associate at Krass Monroe, for all of his help on this article. The firm is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999. For previously published articles, and other Krass Monroe information, please refer to our Web site at www.krassmonroe.com