FIN 46R Featured

7:00pm EDT November 25, 2008

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