FIN 46R, like many accounting principles, is a matrix of decision points with major yes/no decisions based upon qualitative and quantitative sub-decisions.  A diagram of the FIN 46R matrix is presented below.

A.        First Hurdle – Business Scope Exclusion

1.         Is there a business?  As it relates to franchisors, the first decision point is whether or not the franchisee is a “business.”  This is called the “business scope exclusion.”  A business is deemed to be 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:

(a)        inputs – all of the material tangible and intangible assets, capital, and labor needed to make a product or provide a service;

(b)        processes – that is, the processes that are applied to those inputs (processes include business systems such as strategic management, operations management, and resource management); and

(c)        outputs – in a business, the resulting outputs are used to generate revenue by obtaining customers.

If the franchisee is not a “business” as defined in FIN 46R, then further FIN 46R analysis is required.  If the franchisee is a ”business,” the relationship of the franchisor and franchisee needs to be considered to confidently claim exclusion from FIN 46R.

2.         Is the business conducted for the franchisor or reliant upon the franchisor’s subordinated financial support?  If the franchisee is a “business,” the next questions require a review of the franchisee’s business structure.  A franchisor must consider the following questions:

(a)        Do substantially all of the franchisee’s activities involve, or are they conducted on behalf of, the franchisor and its related parties?

While an analysis is needed, most franchised businesses are unlikely to fall within the scope of this factor.  In private discussions, audit firms have advised us that this relationship will be deemed to exist when there is a “closed loop” system – such as one in which the franchisor controls the franchisee's  input and processes, or takes all or most all of the output created by the franchisee.  That situation is rare among franchise companies, where inputs may be available from a variety of acceptable sources and where output – in the form of products and services – is typically sold to third-party customers.  Dealerships and some distributorship arrangements could have difficulties with this requirement.  However, most franchise networks will not involve activity that will fall under this category.

(b)        Did the franchisor or its related parties provided more than 50 percent of the total equity, subordinated debt, and other forms of subordinated financial support measured at fair value?

These are the most likely trips over the first hurdle.  An analysis requires a look at:

Related Party Equity.  Direct or related party economic involvement in franchisees will trigger further analysis under FIN 46R.  For this purpose, related parties include franchisor management (and their family members), subsidiaries, sister companies, and parents.  If a related party owns a franchisee, the business will be subject to a FIN 46R evaluation.  Franchisors that enter into joint ventures to form franchisees need to consider whether their equity involvement will trip the consolidation hurdle.  An investment that gives the franchisor or a related party over 50 percent of the franchisee’s total capitalization will bring the franchise under the consolidation rules, as will material subordinated financial support.  While joint ventures are not commonplace in domestic franchise arrangements, they are frequently used as a vehicle in international franchise structures.  To the extent franchisors are not required to consolidate the results of their joint ventures under other aspects of GAAP, FIN 46R may require that the joint ventures be consolidated.

Subordinated Financial Support.  Subordinated financial support is any variable interest, meaning any pecuniary interest in an entity that varies with changes in the value of net assets of the entity (other than the variable interest), that will absorb some or all of the entity’s expected losses.  In other words, if a franchisor or a related party is actively involved in the business of a franchisee, has an investment in a franchise, or provides credit enhancement to a franchisee, it can expect to have to step into the FIN 46R evaluation.  Subordinated financial support may also include guarantees a franchisor gives on the franchisee’s behalf; the interpretation includes situations where the franchisor will absorb the franchisee’s losses through financing mechanisms such as subleasing real property or leasing equipment to the franchisee.

(c)        Is the franchisee’s activity primarily related to securitization, asset-backed financing, or single-lessee leasing arrangements?

This factor is unlikely to apply in a franchise setting.

If the answer is yes to any of these questions, even though the franchisee is a business, the business scope exclusion will not apply and the franchisor must proceed through the FIN 46R matrix.  If the answers are no, then the franchisor can wipe its brow, breathe a sigh of relief, and slash its outside accountants’ budget significantly – no further evaluation is necessary.

B.         Second Hurdle – VIE Interest

As illustrated in our diagram, at this hurdle all that has been determined is whether franchisees qualify for the business scope exclusion from FIN 46R.  Failing to so qualify is not the end of the consolidation-free world – just the start of a deeper analysis.  The next step is to determine whether the franchisee has sufficient total equity at risk to carry out its business without additional subordinated financial support.  If the answer is yes, the evaluation continues.  If the answer is no, then the franchisee is a consolidation candidate.

1.         Is there sufficient equity?  Total equity at risk includes equity that shares in profits and losses.  It excludes equity interests issued in exchange for subordinated interests in other entities (VIE swaps), amounts paid to the equity investor by the franchisee or others, or amounts financed for the equity investor by the franchisee or other persons involved in the franchisee.  If the total equity at risk is less than 10 percent of the franchisee’s total assets, the total equity at risk is deemed to be insufficient.  However, the inverse is not the case.  Rather, for a franchisee with total equity at risk that is greater than 10 percent of its total assets, the franchisor must first consider qualitative factors such as proven financial ability and comparability of equity invested to businesses having similar assets that do not require additional subordinated financial support.  Then, if the qualitative tests are not met, a quantitative test that measures total equity to estimated expected losses must be undertaken.

2.         Who makes decisions, absorbs losses, and realizes gains?  Assuming that the franchisee has cleared the equity sufficiency hurdle, the next evaluation is an analysis of control.  Who are the decision makers?  Who is obligated to absorb expected losses?  Who has the right to receive the expected residual returns?  If the answer to any of these questions is anyone other than the equity investor group, the franchisee is a consolidation candidate.

The FASB’s staff provided guidance via an FASB staff position paper, FSP FIN 46R‑3, issued at the same time as FIN 46:

The FASB staff believes it was not the Board’s expectation that all franchise arrangements would be variable interest entities.  Rather, the FASB staff believes it was the Board’s expectation that franchise arrangements with equity sufficient to absorb expected losses would normally be designed to provide the equity group (the franchisee) with key decision-making ability to enable it to have a significant impact on the success of the entity (the franchise).

FSP FIN 46R‑3 helped to clarify the question of just who is the decision maker.  This pronouncement acknowledged the arguments that IFA’s task force had advocated – which were that the decisions relevant to the consolidation question are those that affect day-to-day operations and fundamental matters such as hiring and firing employees and amount and character of capital.  The franchisee’s decision to sign a franchise agreement, and therefore adopt and adhere to business standards required by the franchisor designed to protect the assets of a franchisor and all of its franchisees, does not confer upon the franchisor the control needed to transform the franchisor into the “decision maker” and render the franchisee a VIE.  (However, FSP FIN 46R‑3 also notes that if, as a condition of providing financial support, a franchisor requires that it be given control over the organic decisions of the franchisee, then the franchisor might become the decision maker.)

Relief has also been provided in determining who absorbs what amount of expected losses and who is to receive anticipated residual returns.  Expected losses and residual returns are measured on the basis of changes in the fair value of net assets determined by quantifying probable expected cash flows from operations.  In other words, the analysis is based on variations from financial projections, not a measurement of actual results.  Expected losses can be attributed to equity owners, guarantors, lenders, and others who may suffer from a decline in the value of the net assets of the franchisee.  Thus, a franchisor who has no equity interest in a franchisee may be attributed expected losses if the franchisor has provided credit enhancement to the franchisee either alone as part of a group program (such as loan guarantees, lease guarantees, or subleases).  Fortunately, it is now clear that customary franchise and license fees payable to the franchisor are not included in the equation.

C.        Third Hurdle – Primary Beneficiary

Moving through the matrix, it has now been determined that the franchisee does not qualify for the business scope exclusion and that it is a variable interest entity because it either does not have sufficient equity by FASB standards or someone other than its equity owners has control over day-to-day and fundamental decisions, or shares in expected losses or residual returns.  This takes you to the final hurdle of the matrix.

1.         Who is the Primary Beneficiary?  So, because the franchisor has tripped over a hurdle or two, a franchisee is characterized as a VIE and is a consolidation candidate.  There is still one more matrix decision point to be considered – who is the “primary beneficiary?”  Every VIE has one (but only one) primary beneficiary.  The primary beneficiary 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.  Only the primary beneficiary is required to consolidate with the VIE.  The primary beneficiary can be an equity owner, a lender, a credit enhancer, or a contracting party, depending upon the determinations of expected losses, expected residual returns, and amounts at risk.  A de facto agent or two can tip the scales where the interests in the VIE are fractionalized.  Because many franchisors have subsidiary and sister companies involved with franchisees and often permit management and employees to invest or otherwise participate in franchisees, the potential for de facto agency combinations can be serious.

2.         Is there a de facto agent?  A de facto agent of a franchisor is a party that cannot finance its operations without subordinated financial support from the franchisor, e.g., a sister company to the franchisor or another franchisee of which the franchisor is the primary beneficiary.  It may also be any person that receives its interest in the franchisee as a contribution or loan from the franchisor, as well as an officer, employee, or director or equivalent of the franchisor.  A close service provider to the franchisor, such as a lawyer or accountant, also could be a de facto agent to the franchisor.  Finally, a de facto agency could apply if the franchisor can constrain another party’s ability to sell, transfer, or encumber that party’s interest in the franchisee.  However, FASB has made it clear that usual and customary franchise agreement transfer restrictions are not included in such determination.  The risk of de facto agency is the potential for combining loss absorption and residual return interests of minority parties to create a single de facto principal, the franchisor, who would be deemed the primary beneficiary.