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.

Concerns with McDonald's 2009 Financial Statement Notes

Certain Assets Not Measured at Fair Value

The issue here is that MCD’s carrying amount of debt (on B/S) is less than the fair value of its debt obligations. Although correctly classified in accordance with fair value accounting, for analysis purposes it might be a good idea to include the $0.7 billion difference in long-term debt on the B/S.

The effect of including this in the B/S would be adding $0.7 billion to long-term debt and subtracting the same amount from Equity.

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Leasing Arrangements

Of course the operating lease issue is self-explanatory. You can see that MCD’s total minimum lease payments are quite substantial, and could be included in a ratio analysis as both long-term debt and a corresponding LT asset.

The exact effect of converting all Operating Leases into Capital Leases would be to add $8.212 billion to long-term liabilities and the same amount to long-term assets. See attached. Spreadsheet. The fact that this amount is so large (almost 30% of total assets) might suggest that MCD using aggressive accounting methods.

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Impairment and Other Charges

This note discusses an impairment charge to 2007s operating results. The company incurred a substantial pretax impairment charge of $1.7 billion due to the sale of its “Latam” licenses. The company sold its licenses in exchange for a 5% royalty each year for 20 years on Latam’s (Latin America) earnings. The company is recognizing a large impairment charge in one year to offset revenue that it will recognize for the next 20 years. This charge clearly disrupts the results for 2007 and might want to be considered during analysis.

The effect of this LATAM transaction would be to add $1.681 billion back to operating income for 2007. The net effect would be to add $1.32 earnings per share back for 2007. This one-time impairment charge seriously throws off the company’s earnings for 2007, and without the charge one would see much more stable earnings growth for MCD over the past 5 years.