Thanks to the revised version of the
Financial Accounting Standards
Board’s (FASB) FIN 46, most franchisors can avoid consolidation with
franchisees and the related liability and
accounting complexities. However, it’s
important to be aware that there are still
interpretation concerns regarding the
application of FIN 46R.
Smart Business asked AnneMarie
Scully, CPA, senior audit manager for
Habif, Arogeti & Wynne LLP, to explain
why it is crucial for franchisors to understand the fine points of FIN 46R.
What is the story behind FIN 46R?
Formerly known as FASB Interpretation No. 46 (which interprets Accounting
Research Bulletin No. 51, Consolidated
Financial Statements), FIN 46 was
adopted in early 2003 to address special
purpose entities (SPEs), which had been
a pivotal factor in some corporate scandals, where these SPEs were being used
to hide losses from auditors and
investors. FIN 46 was FASB’s way of
applying broader accounting principles
to require companies to consolidate the
financial results of SPEs on their balance
sheets and into the operating and cash
flow statements of their sponsoring business enterprises.
Under the original release of FIN 46,
basic contractual relationships, including virtually all franchise arrangements,
were included under the umbrella of the
interpretation.
The ensuing burden and impact on
franchisors was enormous and posed a
threat to the franchise industry’s continued existence. FASB responded to the
concerns by issuing FIN 46R in
December 2004.
Does the interpretation eliminate the need
to consolidate?
Under the original FIN 46, franchisors
would have been required to prepare
consolidated financial statements that
include information about some of their
franchisees. The revised interpretation,
FIN 46R, exempts many entities from
these requirements. But there are still
‘grey areas’ regarding how much a franchisor must know about the financial
picture of its franchisees.
Many franchisors are involved to some
degree with their franchisees or have set
up, effectively, a ‘corporate store’ —
making loans to franchisees, providing
debt or lease guarantees, or subleasing to
franchisees. It’s important for franchisors to be alert to the decision points
along the way that might unintentionally
lead to consolidation.
What are the key aspects of a FIN 46R evaluation?
In order to be excluded from consolidation issues, a franchisor must be examined on three main points:
1) Business scope exclusion — Is there
a business? FIN 46R defines a business
as a self-sustaining, integrated set of
activities and assets conducted and managed for the purpose of providing a
return to investors. A business consists
of inputs, processes applied to those
inputs and outputs. If a franchisee is not
a business under the FIN 46R definition,
further analysis is warranted. If a franchisee is in fact a business, an assessment of the franchisor-franchisee relationship needs to be considered to be
certain the entity can be excluded from
FIN 46R. This examination requires a
deeper digging into the franshisee’s business structure.
2) Variable interest entity evaluation
(VIE) — Does the franchisee have sufficient total equity at risk to carry out its
business without additional subordinated financial support? If the equity at risk
is less than 10 percent of the franchisee’s
assets, the total equity at risk is deemed
insufficient. However, if the total equity
at risk is over 10 percent, the franchisor
needs to look at other qualitative factors.
3) Who is the primary beneficiary? This
is the party that absorbs a majority of a
VIE’s anticipated losses, recognizes a
majority of the entity’s residual returns
or does both.
While these evaluation points may eliminate consolidation worries for many
franchisors, there are still further interpretation concerns pertaining to FIN
46R.
How can we resolve these ‘gray areas’ of
interpretation?
It’s important for franchisors to plan in
advance and include the possibility of
consolidation in their franchise agreements. If the franchisor is going to guarantee the debt or the lease or provide
other financial support it might be worthwhile to add to the franchise the requirement to provide audited financial statements. This is certainly not an area to
tread into alone — count on using your
accountant to help you navigate these
waters to ensure that you don’t inadvertently take on the additional liability of a
franchisee entity.
ANNEMARIE SCULLY, CPA, is a senior audit manager with Habif, Arogeti & Wynne LLP. She has audit experience in various industries such as manufacturing, service and real estate. AnneMarie has worked with several publicly held companies and assisted them by
ensuring that their financial and filing responsibilities with the U.S. Securities and Exchange Commission were in full compliance with
all rules and regulations. She can be reached at (404) 814-4955 or [email protected].
