Analysis of McDonald's Accounting Choices

Accounting Choices

In studying MCD’s financial statements and accompanying notes, we identified three key areas where values reported may have departed from those that are more factually correct. These three primary areas were 1) carrying amount of debt, 2) operating lease arrangements, and 3) a sizable transaction known within MCD as LATAM. The source notes and analysis are presented in Exhibit 6. We begin by addressing the issue of debt not being carried at fair value on the balance sheet. A specific note to the MCD statements indicates that the fair value of the Company’s debt is estimated to be $11.3 billion, however the debt is only being carried at $10.6 billion on the balance sheet. Current accounting rules make this treatment of debt acceptable, and the size of the discrepancy is a mere $0.7 billion, hardly breaking the threshold of material in the context of MCD’s operations. So while we do not recommend an adjustment to the balance sheet for this issue, it is something an analyst may want to keep in mind when assessing debt covenants, ratios, and interest coverage.

Next, we address the issue of off-balance sheet financing via operating leases. MCD operates in the restaurant industry, and as expected requires the use of vast amounts of real estate. Assumedly for cash flow and financial statement presentation purposes, the company leases the majority of its restaurant space. The sheer size of MCD’s future minimum lease payments (upwards of $10 billion) suggests that aggressive accounting tactics may be at play here. An astute analyst must consider the impact that this future liability will have on MCD’s operations. Presented in Exhibit 7 is the conversion of operating leases into capital leases. The exhibit reveals that if today’s leases were included on the balance sheet, MCD’s long-term debt would be boosted a hefty $8.212 billion, or about 27% of total assets. Because this is the nature of the restaurant industry, and most of MCD’s competitors use this same leasing strategy, we have decided not to include this amount in our financial statements for purposes of valuation and forecasting.

The third major presentation issue we identified involves a 2007 transaction that MCD engaged, referred to as “LATAM.” This acronym is short for the Latin America business of fast-food restaurants that MCD owned at the time. The Company decided to sell its ownership of those restaurants under an agreement that would provide MCD substantial royalty payments in the future. For accounting reasons, the organization recorded an impairment charge against 2007 net income in the amount of $1.6 billion. This one-time charge will be offset in future years by earnings from this agreement. For this reason, a savvy analyst may wish to exclude the charge from 2007 operating results, as the transaction caused net income to fall from $4.0 billion to $2.4 billion. The charge seriously throws off 2007 results and disrupts the steady growth pattern that MCD had displayed to that point. We have decided not to consider the event in our prospective analysis, but we are aware that some portion of future income is associated with this expense, and the expense that was reported in 2007 may be a stretch of the truth. Based on this analysis of these three factors, it appears that MCD understates liabilities, underreports income, and understates expenses and assets (operating vs. capital leases). As a whole, MCD’s accounting choices seem generally aggressive.