John Gordon - December 2019

Implications of the Wave of Complicated Accounting Changes 

by John A. Gordon, Principal and Founder, Pacific Management Consulting Group

I grew up as a general manager, area manager and then as a junior headquarters finance staffer in the late 1970s and early 1980s with two midwestern chain restaurant companies. We had a fully sorted unit, area and corporate P&L, a theoretical food cost system, a labor chart and a sophisticated POS system as early as 1979.  For some reason, the midwestern chains were very numbers and controls intense. From that point, the industry’s accounting and analytical culture has grown more complicated every few years.

Imagine how some restaurant numbers reader’s heads must be spinning now with some of the loaded on accounting developments of the last few years.

In the last decade, net income as the premiere profit measure has taken the backseat to EBITDA—earnings before interest, taxes, depreciation and amortization as a headline “profit like” measure. EBITDA is subtotal profit like measure--and it is true that store managers can’t control interest, taxes or depreciation. Store level EBITDA is a better value for management performance reviews for example. However, using only EBITDA in corporate level cash forecasting or M&A projections is very counterproductive—because so many real cash outlays are missed.

Since 2010, the US has been transitioning towards international GAAP<1> which will represent some significant changes to US GAAP. This has affected restaurants in several ways:

Recognition of franchisor new unit development  

In the past, the initial fee for area development territory contracts was recognized as revenue when the area development (AD) contract was signed. Not now.  Due to the guidance agreed upon by FASB in ASC 606<2>, this revenue is recognized over the span of the life of the AD contract.  This has the effect of “declumping” the initial financial effect of the big deal signings. In the future, it will take a longer period and more actual units opened to show the desired ramp ups of royalty revenue that all franchisors hope to show. <3>

Ad funds now posted to face of franchisor income statement  

Also, as a consequence of ASC 606, the franchise ad funds collected by the franchisor now appear on the franchisor income statement as revenue, and the offsetting ad fund outlays appear as expenses. This is a material change, as financial operations of many franchise ad funds previously were in a separate “trust” fund that could be in surplus or deficit.<4> Going forward, now those surplus or deficits will now affect franchisor corporate earnings.  Should a franchisor like Wendy’s desire to implement a new daypart, like breakfast, the ASC 606 effect means they must consider posting a big new expense or raise franchisee ad fund collections or reallocate funds from the existing marketing budget, which could be suboptimal.

Typically, restaurant franchisor ad fund outlays approximately balance over time, but this ASC means that management of ad funds could boost corporate earnings to make the all important year end number.  We analysts will have to watch Q4 carefully for swings.

Lease Accounting Changes Also Dramatic

The most complex changes have come in the area of lease accounting. Per ASC 842, larger firms starting in 2019 are required to bring all of their leases onto the balance sheet. Additionally, all of the leases and services agreements need to be reviewed to determine whether those are operating or finance leases. The placement of all the leases on the balance sheet is dramatic and almost certainly will affect loan covenants and the all important debt to EBITDA and fixed cost coverage ratios, among others. On the positive side, at the recent 2019 Restaurant Finance and Development Conference, the lenders I was with and listened to in panels were well aware of this change and were not panicked in any way.

Recommendations

Don’t assume that operations, supply chain, marketing and finance staff understand the effects of these accounting changes. Conduct an actual or electronic catch up “brown bag” lunch session with staff.   Their day to day decisions now will affect the P&L directly.

Inform your investors and lenders that leases now are on the balance sheet and will show up as debt and will throw off the ratios. In reality, nothing has changed with the business, but the accounting disclosure.

Note that some new expenses now posted to the income statement, such as operating leases, are only non cash expenses which were paid with CAPEX funds earlier.  As a result there is no real new expense, just a paper expense. Remind your investors of that point.

About the author:

John A. Gordon is a long time restaurant industry veteran, with operations, corporate staff and management consulting experience. His founded firm, Pacific Management Consulting Group (founded 2003) works restaurant operations, financial management and strategy engagements for clients. He specializes in earnings analysis, investment due diligence and franchisee-franchisor matters. He is always reachable at (858) 874-6626, or jgordon@pacificmanagementconsultinggroup.com.

<1>   Generally Accepted Accounting Principles

<2>  FASB is the US Financial Accounting Standards Board. ASC 606 is their directive regarding leases.

<3>   The industry feeds into Wall Street’s obsession with the number of units opened by reporting on that metric and sometimes little else in reporting franchise results. This is counterproductive for several reasons, which we will discuss in future discussion pieces. For now, new unit growth stats matter greatly.

<4>   And/or, were shown as a net value, or only contributions from the franchisor were shown.

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