Term Paper: Dick and Mac McDonald Opened

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[. . .] " 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… [END OF PREVIEW]

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