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Providing effective financing ideas to franchise companies is a goal of this column. A key element in obtaining financing is strong, clear and concise financial statements. Recently, certain accounting issues have surfaced which have an affect on the multi-unit retail and franchising world. While these issues have emerged in the public sector, they do have very important ramifications for the private sector.
One accounting issue revolves around the correct financial treatment of real estate leases. Recently a number of public restaurant companies decided to restate their financial statements based on a reconsideration of the treatment of real estate leases and depreciable assets associated with these leases. This issue was highlighted in a recent Wall Street Journal article by Steven D. Jones and Richard Gibson, (both highly respected journalists), who addressed the specific financial implications associated with the leased restaurants owned by CKE Restaurant Group, Jack In The Box, Brinker International, Ruby Tuesday and Darden Restaurants.
There are two specific components to this accounting issue and the way companies have calculated associated lease expenses: (1) The first component is whether the actual lease expense is based on a primary term (which is the base term) or the base plus option terms of the lease. In some cases, companies were reporting lease expenses based on the base term of the lease and did not include options. (2) The second element relates to depreciable assets associated with these leases. Some companies were taking the position that these assets should be depreciated over the base lease term plus the option periods. The bottom line is that if these treatments are inconsistent, the result is an understatement of the total cost of the lease and understatement of depreciation, thus, increasing earnings and not decreasing assets on the balance sheet. This treatment came into question and necessitated the restatement of earnings by these restaurant companies.
This lease issue is a result of certain accounting rule changes made in accordance with Statements of Financial Accounting Standards No. 13 and clarified by various technical bulletins. This sounds complicated but the point is there has been a continued effort by the accounting profession to make sure leases are treated in such a way as to properly reflect the appropriate economic obligation. In taking these obligations as a whole, the accounting firms involved with the companies that restated their financials determined that the terms used in depreciating or amortizing assets on leased real estate needed to match the rent expenses. In summary, the accounting rules require consistency. As a result CKE, Jack In The Box, Brinker International, Darden Restaurants and Ruby Tuesday have restated their earnings per share based on these accounting changes.
What does this mean to private companies? Public companies are governed by the Sarbanes-Oxley compliance and a number of other securities laws that do not apply to private companies. Financial statements and reporting rules are governed by GAAP (Generally Accepted Accounting Principles), and GAAP should be applied whether the company is public or private.
It would be nice if the lease expense issue was the only current difference between the public and private company’s financial reporting, but there are others. For example, another area is the issue of stock options. Stock options now offset earnings for public companies; they do not offset earnings in private companies. There is still an economic cost to a private company so some considerations should be given to reporting an expense and/or liability for stock options and phantom ownership. 2
Another financial issue relates to EBITDA (earnings before interest, taxes, depreciation and amortization) reporting. Franchise companies are normally judged on their EBITDA. While this does a wonderful job of approximating cash flow, it does not truly reflect economics, particularly issues such as required capital expenditures, the true cost of leases that may need to be capitalized, and the cost of appropriate reserves (which all franchise companies need). There are normal, re-occurring expenditures that need to be reflected as to the true economic cost to the company and may be a true offset to EBITDA. EBITDA is a good test of current cash flow, but it does not necessarily reflect the current financial cost in a long-term context for a company.
In some cases, tax planning takes precedence over accounting rules for private companies. Some companies ignore GAAP and defer only to the tax treatment for financials. Lending institutions are reluctant to consider financials prepared on a tax basis. The clear approach needs to be GAAP reporting, with appropriate reserves and disclosure of capital expenditures to come up with the economic cash flow of the company.
In light of the above, one thing we are seeing is that private companies are using independent advisors as much as public companies to develop “best practices” for corporate policies, accounting procedures and financial/accounting reporting. “Best practices” is a way to apply the rules of the Sarbanes-Oxley compliance and other securities rules to private companies. The key is to apply appropriate accounting principles in an attempt to quantify the company’s true economic value and cash flow.
In summary, the private sector can learn a great deal from the public sector. Private companies should apply the same accounting rules public companies use for leases, employee incentives, appropriate reserves and depreciation. The key is to provide the lender, investors, owners and the franchise community with a true picture of the economic value of franchise and multi-unit retail companies.
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