Managerial accounting principles and practices

Dick and Mac McDonald opened their first restaurant in 1940 in San Bernadino, California. These men were among the first to introduce the concept of "fast food," and made dining fun for children. McDonald's went on to enjoy over 60 years of growth, which has only tapered in the last year due to a failure to expand successfully into places such as Bolivia. Despite these recent setbacks, it is notable that only the third world could thwart McDonald's is a testament to its brand name and its revenue model. There are currently over 28 thousand McDonald's Restaurants in over 120 countries. McDonald's global sales in 2000 were over 40 billion, and the company could boast 16 billion customers that year.

McDonald's success didn't occur in an incremental, measured fashion. The company only really took off in 1954 when a mixer salesman, Ray Kroc, discovered the operation and found a way to serialize the business format introduced in the original McDonalds. Although the issuance of licenses to sell products had been introduced by the Singer Sewing Machine Company over a hundred years prior to Ray Kroc's utilization of the model, it can be argued that his implementation of this formula was the most successful. As a franchise, however, McDonalds needed to employ much stricter accounting standards in order to convince potential franchisees to do business with the company. In this assignment I will review the differences between the accounting standards used prior to Kroc's involvement with those implemented after he partnered with the McDonalds brothers.

II. McDonald's Accounting Standards

A. 1940-1954, The Early Years

The franchising information available on the McDonald's web site notes "We franchise only to individuals, not to corporations, partnerships, or passive investors." Although these individuals are required to maintain strict records of their finances, these are mandated by the franchising agreement rather than GAAP. As a company that was wholly owned by two individuals, the accounting standards of the original McDonald's were limited to what would be pursuant to a normal partnership.

The original McDonalds drive-in hot dog stand was built just east of Pasadena, California with borrowed lumber, and was entirely self-financed. The McDonalds brothers, Dick and Mac, had arrived from New Hampshire and previously run a movie theater in Glendale, California that was rarely able to do more than break-even. Three years later they moved to a peculiarly octagon-shaped building at Fourteenth and E. Street in San Bernadino, California, then a sleepy working class exurb of Los Angeles. The brothers did not maintain books until after 1948, although their operation was by no means one that could be managed by these men alone; by 1948 they had come to employ 20 carhops.

Although as a general partnership they would have not been required to file as a taxable entity, both Dick and Mack would have been required to file their personal income statements noting the existence of the partnership and any income generated. A partnership is seen as a conduit for personal income similar to an individual proprietorship; the procedure governing these partnerships is to be found in subchapter K of the IRS code. General partners are required to fill out form 1065; those that live in California are additionally required to fill out state tax form 565.

The bellhops working for Dick and Mac MacDonald would have been required to fill out the all-too-familiar 1040 form after 1942. Although a withholding tax was introduced in the late 1930's, it only pertained to certain companies. The fist withholding tax to come into general use was implemented during the 2nd World War in 1942 and was referred to as the Victory Tax. For many Americans, this was the first experience that they had filing an income tax. Although the income tax had been introduced in 1913, it pertained exclusively to the wealthiest Americans. Four million Americans were income tax payers in 1939; by 1945 that number had risen to 43 million out of a total population of approximately 140 million people. Although the 1942 tax was initially only approved for two years, Congress enjoyed its new source of wartime revenue and faced the prospect of maintaining a permanent military presence in Germany and the North Atlantic. This tax has remained with us ever since.

A constant stream of revenue throughout the 1940's de-emphasized the need for Dick and Mac to implement formal bookkeeping procedures. This oversight proved costly. It was only in 1948, when the brothers were considering opening a diner, that they analyzed receipts that they'd kept for the last three years and discovered that the sale of hamburgers had accounted for a full 80% of sales volume. This didn't justify the thousands of dollars that the two had dedicated to maintaining their barbecue pit, which they had advertised heavily in flyers and over the radio. Nonetheless, the brothers were regularly pulling in 200 thousand dollars in revenue annually and were splitting 25 thousand dollars in profit.

Twenty five thousand dollars a year was a lot of money in the late forties, enough to buy the brothers a 25-room mansion. Perhaps more importantly, twenty-five thousand dollars was the cut-off for the high income tax bracket. During the Great Depression, President Roosevelt had implemented a 90% tax on all individual income earned in excess of twenty-five thousand dollars a year in the Wealth Tax Act of 1935. A subsequent wartime increase placed taxes on income above 25 thousand a year at 96%. Roosevelt, who had confiscated all privately owned American gold bullion and dined with Stalin at Yalta in the Crimean region of the Ukraine where the latter's "progressive" communist mandates had caused millions to starve, is thought by many to have harbored socialist sympathies: during the war he issued a decree that no one could make more than $25,000 after taxes. This was prudently overridden by congress.

Although these rates were eased during the Truman administration, it fell to the Kennedy administration to realize that if individuals had no incentive to earn their money, they'd do something else with their time, a policy that was expanded by the Reagan administration. Throughout the late 40's and early 50's, however, the MacDonald's partnership faced individual taxes of 70% should they report an individual income in excess of 25 thousand dollars. That the brothers took home 25 thousand each reflected the structural mandates of the existing tax code.

This re-investment came in 1948 due to the analysis of receipts that lead the brothers to completely re-vamp their operation. That fall, all of the carhops (who were thought to be slowing down business) were fired and McDonalds was re-invented as a counter operation where customers had to wait at a counter in order to receive their food. Not only did the smaller staff (employees still ran the counter) result in lower overhead, the brothers were able to streamline their operation by reducing the number of items on the menu from twenty-five to nine.

The McDonalds brothers decided to focus on their core proficiency: the production of hamburgers. In this they were a cost-leader, keeping the cost low so as to maximize volume. The pre-cooking weight of these hamburgers was reduced from 1/8 pound to 1/10 pound. The hamburger's cost was slashed from thirty cents to a mere fifteen cents. In simplifying their product, the McDonalds brothers were able to track volume and predict costs more effectively. Their menu was later increased by the addition of two items: French fries and milkshakes. Within six months, volume reached pre-conversion levels. Their product attracted working families with young children who were previously put off by the drive-thru's reputation as a hangout for teenagers. McDonalds made restaurant eating affordable to working people for the first time, which had previously taken most of their meals at home. This demographic continues to define the appeal of McDonalds in regions of the globe where restaurant eating is still a privilege only afforded the relatively wealthy.

Despite their initial success, the McDonald's brothers lacked the financial know-how to approach venture investors with their revenue model. Careful attention to the maintenance of financial records would not only have provided them with a viable pitch to provide investment bankers (who were not at that time a common fixture in the distant suburbs of Los Angeles) but would have allowed them to develop a more viable method for the development of the first franchise the brothers tried to sell: the Speedee Service System. For $1,000, the brothers would provide building plans, loan their counter-man Art Bender for a week, and provide franchisees with a basic description of their Speedee Service. Accountability was not encouraged; the thousand dollars was a one-time fee - the Speedee Service was a turnkey operation. It was left to Ray Kroc to re-invent the company in a way that would make it a successful franchise.

Kroc's Real Estate Company

According to John Love's McDonald's: Behind the Arches, Ray Kroc "never analyzed a business by its profit and loss statement, and he never took the time to understand his own company's balance sheet." Love also notes that this was before excessive government regulation increased the profile of accountants and financial managers, when salesmen like Kroc dominated the boardrooms of the nations corporations. At the time of Kroc's partnership with the McDonald's brothers, he was the sole proprietor of a company that sold the mixers that places like Big Boy, A&W and Dairy Queen used to make their milkshakes. By the time of Kroc's first encounter with Dick and Mac, he had been in the mixer-selling business for 15 years. Unsurprisingly, his income totaled 25 thousand a year. Unlike McDonald's, however, Kroc's business was a corporation, and it was he who incorporated McDonald's as a privately held corporation in 1955.

Incorporation allowed Kroc to grow the business; as a sole proprietor he would have had to pay taxes on all the revenues he generated, instead he was able to retain earnings. Initially these revenues were miniscule: in 1954 the franchising fee he charged was 950 dollars, which was raised to $1,500 in 1956. The 1.9% service fee McDonald's collected, its main source of revenue, was reduced to a miniscule 1.4% after the McDonald brothers were given their contractually agreed-to share of.5%. The franchising business attracted many new sole proprietors as franchisees, who averaged $200,000 in annual sales. Of this, a mere $2,800 was paid to McDonald's in service fees. McDonald's was responsible for the establishment of company standards, the maintenance of relationships with vendors, corporate advertising, and the training of new franchisees. These operating costs severely compromised the limitations imposed by its comparatively miniscule franchising cost and service fees. Kroc's unwillingness to franchise multiple units to companies that would own multiple units limited his ability to borrow the capital it would take to advertise to potential franchisees. Kroc was unwilling to sell his franchisees supplies as this was thought to be a conflict of interest, and he refused to take kickbacks from merchants that he deemed fit to provide the chain with its supplies.

The financial genius behind McDonald's was Harry J. Sonneborn, a former Tastee-Freez executive that Kroc hired in 1956. It fell to Sonneborn to develop a methodology whereby McDonald's could improve its revenue without unnecessarily burdening franchisees. Sonneborn came up with the ingenious idea of having McDonald's own the real estate used by its franchisees. McDonald's would establish a separate property owning company that would initially lease property from real estate investors that it convinced to build a McDonald's at a fixed rate, and sub-lease these restaurants to franchisees. It would eventually borrow money to build McDonald's restaurants. The company would then lease the property to McDonald's franchisees at a fixed rate. It was reasoned that most licensees lacked the thirty thousand dollars then needed to acquire neither a store site nor the forty thousand dollars needed to build the structure, nor the ability to borrow these sums. The real estate company was called Franchise Realty Corporation. Franchise Realty was able to recognize an immediate profit; due to the $7,500 security deposit it charged new franchisees. This was significantly more than franchisees were required to pay as an up-front franchising fee.

These companies would maintain separate books, and had separate personalities; whereas Kroc's original company always sought to provide its services as the lowest cost and generated a paltry profit, Franchise Realty was exclusively a moneymaking enterprise. Franchise Realty had ample incentive for the franchisees to generate a profit, because these profits were reflected in the leasing fees that constituted its remuneration. This fee was initially set at 5% but increased to 8.5% in 1970.

Sonneborn was relentless in his quest to borrow money for expansion. In 1958 when Sonneborn first started to search for real estate financing, McDonalds had a net worth of only 24 thousand. At that time, the franchise numbered only 38 restaurants but wished to add another 50 in 1958. By 1960, the chain had 228 restaurants in operation, and controlled the real estate in 172 of the sites. In order to achieve this, Sonneborn had to rely on investment capital to finance 10 or more restaurants at a time.

Unfortunately, the financial reporting integrity required of McDonald's by potential institutional investors was in excess of what was being practiced. According to Love, "In 1958, McDonald's balance sheet was strictly minor league material. Without a decent financial statement to show investors, Sonneborn's real estate strategy was a pipe dream." This prompted Sonneborn to implement new accounting standards that would make the company's financial statements and balance sheet look more presentable to investors. Sonneborne had already exaggerated some of the numbers associated with his Des Plaines operation, the first to be owned by Franchise Realty.

For expertise in re-imagining McDonald's financial records to attract capital, Sonneborn approached an accountant by the name of Richard J. Boylan, a veteran of the Internal Revenue Service. Boylan was an expert in real estate accounting. Sonneborn knew that in order to borrow the capital he needed, he had to present McDonalds as a real estate company rather than as a restaurant franchise, as franchises were seen as fly-by-night operations by many investors. In order to make the company look more profitable, Boylan decided to capitalize the real estate leases that McDonalds had contractually arranged with its franchisees. His reasoning relied on the fact that the IRS, when calculating estate taxes, would calculate the present value of future lease payments to the deceased. The company disclosed the nature of these capitalized leases in its balance sheet, as this practice had not been endorsed by the GAAP. It can be assumed that income reports that McDonald's generated for the IRS differed from those that were presented to potential creditors. By 1960, McDonald's calculated its total assets at 12.4 million, four times higher than in 1959. Most of this increase was itemized as "Unrealized Increment from Appraisal in Valuation of Assets." This represented $5.8 million dollars in capitalized leases. According to Sonneborn, "The bankers were bemused and befuddled by it because they had never seen it before, but it surely helped us get some loans."

McDonald's abandoned this inventive method of financial reporting in 1964 at the behest of Arthur Young and Company. At the time, McDonalds was readying itself for an initial public offering and was advised that Wall Street would not tolerate capitalized leases. As a result, $17.4 million in "assets" were removed from the balance sheet. By this point, McDonald's had traded equity to institutional investors for loans with which to expand its real estate holdings and purchase exclusive rights to the McDonald's name from the McDonald brothers.

Boylan also assisted McDonald's by helping them dress up their reported earnings. Revenues were lagging expenses in the late 50's due to the excessive costs of expansion that often exceeded 100% year to year. Although McDonald's total sales were in excess of 10 million in 1958, their net income was a paltry 12 thousand dollars, half the 24 thousand the company had generated in 1957. Again, Boylan decided to deviate from GAAP. This time, his innovation was to realize expenses relating to real estate development nine months later than a site was developed. Boylan also decided to amortize real estate loans over the twenty-five-year life of the franchise. By 1960, McDonald's was netting $109,000 a year, nearly 10 times the amount reported in 1958. Most of this growth was the result of Boylan's creative accounting.

C. A Review.

Although it is doubtful that McDonald's misreported its earnings to the IRS, one is lead to question the novel methodologies the company employed in the procurement of investment capital. It is quite commonplace among small firms looking to gain angel money to produce super-inflated projections of future revenue so that these investors are more likely to ignore the associated risks. However, the deliberate alteration of balance sheets along non-GAAP compatible lines is a practice forbidden to SEC-regulated companies. As a privately held corporation, McDonald's was not held to the same standards, although most institutional investors insist upon such reporting.

The best argument to McDonald's credit is that it, as a franchiser, realized its income from the sale of the limited use of its brand name. A brand name, as an intangible asset, doesn't appear on a balance sheet. As a company that had no real assets during its first several years of operation, McDonald's assets were negligible. When Sonneborn decided that the company should own real estate, this monopolized its revenue stream, leaving little money available for owner's equity.

III. A Case Study.

The biggest problem facing McDonalds today stem from the fact that its revenue model favors a growth environment. Although McDonalds realizes an income when heavy sales volumes are echoed in increased property rent and franchising fees, much of its money is derived from initial franchising costs. McDonalds runs a large training facility, Hamburger University, which is located on an extensive campus in suburban Chicago. This university, responsible for training new franchisees, represents a 40 million dollar initial investment in 1983 and innumerable fixed operating costs. With the slowing pace of franchise construction, this and other costs hurt the company's operating margin.

McDonald's has been falling prey to hard times within the past year. Since Jack Greenberg became the company's CEO in 1998, the share price of the world's largest restaurant chain has fallen a staggering 44%. McDonald's has been losing up-market customers to newly emerging chains such as Pr t a Manger, Panera's and Au Bon Pain. Theses high-quality fast restaurants are referred to by the food industry as "fast-casual" restaurants due to their combination of casual dining with the traditional fast pace of middle-market fast food restaurants.

Although McDonald's continues to gain market share from weaker traditional rivals such as Burger King and Jack in the box, the Economist reports its same-store sales to have fallen by 2.8% in America in the third quarter of 2002 and by 3% internationally. Part of the concern lies in that the fast-casual restaurants are siphoning away a key demographic of their customer base, who the Economist refers to as "Hoo-Foos" - Heavy Fast Food Users, otherwise known as young, single males. These men are being disproportionately hurt by unemployment and falling incomes. Many of them are unemployed and stuck at home, and have ceased to rely on McDonald's as an alternative to a brown bag lunch or the cafeteria food at their workplace.

McDonald's opened 2,000 new restaurants a year in its peak in 1996, but is planning to launch a mere 600 restaurants in 2003. Perhaps more ominously, McDonalds is closing 175 under-performing restaurants, leaving three countries and firing 600 workers. Although some analysts refuse to take McDonalds closure of all its restaurants in poverty-stricken Bolivia (just one) seriously, these moves to abandon new markets are ominous for a company that enjoys near-complete market saturation. It is estimated that a full 50% of the United States population lives within under two minutes of their nearest McDonald's restaurant. Although McDonald's maintains a presence on 121 countries, four fifths of its income is derived from four markets: America, Britain, Germany and France. These markets can be said to have experienced saturation.