´¬ücult for accountants to fully capture the risk-sharing complexities involved in these
types of relations. As a result, they provide an opportunity for analysts to add value by
clearly identifying how the partners share risks and rewards under the agreement, and
whether these events are portrayed in the ´¬ünancial statements.
Franchising is a popular organizational
EXAMPLE: FRANCHISE OPERATIONS.
form in the U.S., where franchise operations employ more than 8 million people and ac-
count for more than 30 percent of all retail sales. Franchise companies include Mc-
Donalds, Burger King, Kentucky Fried Chicken, Pizza Hut, Holiday Inn, Marriott, Avis,
Hertz, H&R Block, and 7 Eleven Stores.
A typical franchise arrangement works as follows. A franchisor sells the right to op-
erate a retail operation in a given location to a franchisee. The franchisee typically pays
an initial franchise fee to cover such services as management training, advertising and
promotion, site selection assistance, bookkeeping services, and construction supervi-
sion. Franchisees are also frequently required to purchase critical equipment and sup-
plies from the franchisor, and to pay annual fees that vary with franchise sales. Finally,
franchise agreements often provide the franchisor with the right to purchase pro´¬ütable
or unsuccessful franchise operations.
Franchising is viewed as an effective organizational form because it provides the
franchisee with some of the rights and incentives associated with ownership. Of course,
there are also potential problems arising from franchising. For example, franchisees can
underinvest in quality and free ride on the franchisorÔÇ™s reputation. Franchise arrange-
284 Entity Accounting Analysis
Entity Accounting Analysis
ments also make it cumbersome to coordinate corporate-wide changes in product offer-
ings and strategy. Finally, franchisees are often concerned that after they have invested
in establishing a market in a particular location, the franchisor will sell another (compet-
ing) franchise outlet in the same location.
The accounting entity question that arises for franchise arrangements is whether the
franchisor effectively has control over the franchisees and should therefore consolidate
their performance with its own. Several factors suggest that franchisors do have consid-
erable control over franchisees. First, as noted above, franchise contracts give franchisors
signi´¬ücant control over the franchiseeÔÇ™s business operations by requiring them to main-
tain certain quality standards and to acquire supplies from the franchisor. Second, many
franchisors have the right to acquire successful and also unsuccessful franchisees. Finally,
franchisors often provide signi´¬ücant ´¬ünancing to franchisees or guarantee their debt.
Given the considerable control exercised by franchisors over franchisees, some have
argued in favor of considering franchise operations as a system, rather than as indepen-
dent franchisor and franchisee entities. Consolidated reports for a franchise system
would provide information on the overall pro´¬ütability of the business concept. This type
of information could be very valuable to investors, particularly if franchisors do not op-
erate any established franchise outlets. However, consolidation fails to provide informa-
tion on that portion of the rewards of the franchise system that go to the franchisor.
Successful franchisors, after all, are likely to capitalize on their brand name by writing
franchise contracts that ensure that they, rather than the franchisees, earn most of the
rents from the system. This potentially creates a challenge for ´¬ünancial reporting, since
if the franchisor demands too much of the franchisee, it is likely to fail and have to be
acquired by the franchisor.
Because of the limitations of considering franchise operations as a system, fran-
chisors typically do not consolidate franchisees. Under SFAS 45, franchisors are required
to defer recognizing revenues from initial franchise fees until all services have been per-
formed. These services could include the guarantee of debt or the control of the franchi-
seeÔÇ™s operations. However, these rules do not require franchisors to provide key data on
the performance of their franchisees. This information is likely to be critical to help in-
vestors evaluate whether the concept is successful and whether the franchisor has been
too demanding in its contractual relations with franchisees. As a result, there is consid-
erable scope for ´¬ünancial analysis of franchise operations.
EXAMPLE: MANAGEMENT CONTROL OF A RELATED PARTY. Some compa-
nies have business relations with other companies that are owned by management. For
example, on November 17, 1997, Zaitun Bhd, a Malaysian personal care products com-
pany, proposed acquiring a piece of land for RM36 million from Benua Rezeki Sdn Bhd.
Benua Rezeki Sdn Bhd was partially owned by two of the directors of Zaitun (Datuk
Mohd Kamal Mohd Eusuff and Aisha Mohd Eusuff). On December 31, 1997, Zaitun put
down a deposit on the land for RM18 million, which was 50 percent of the total amount.
For the public owners of Zaitun, this type of transaction raised questions about
Entity Accounting Analysis
8-9 Part 2 Business Analysis and Valuation Tools
whether the proposed price for the land was a fair market price, or whether Zaitun
overpaid for the land, permitting the Zaitun directors to bene´¬üt at the expense of the
companyÔÇ™s external owners. In subsequent developments (on April 15, 1998), Zaitun
canceled the sale agreement and agreed to refund the deposit.
In the case of related-party transactions, external shareholders do not have any con-
trol over the related party. Consequently, there is no justi´¬ücation for aggregating the per-
formance of the two parties. The challenge for shareholders is to understand
managementÔÇ™s incentives in these types of transactions. This can be assessed by compar-
ing managementÔÇ™s stake in the related party and in the company it is managing. If man-
agement owns more in the related party than it owns in the company it manages, there
are potential con´¬‚icts of interest. Shareholders are then interested in understanding the
magnitude of the related-party transactions and their pro´¬ütability for the related party
versus the company. Not surprisingly, almost all countries require companies to make
disclosures of related-party transactions to ensure that shareholders have full informa-
tion on any potential management con´¬‚icts of interest. It is interesting to note that on
September 26, 1998, the Malaysian Securities Commission reprimanded Zaitun for fail-
ing to disclose the related-party land sale.
Key Analysis Questions
Complex business relations between companies can make it dif´¬ücult to measure
whether one ´¬ürm has control over another. Financial analysts can add value by un-
derstanding the details of these types of relations and their potential ´¬ünancial im-
plications. The following questions are likely to be useful for this purpose:
ÔÇó Does a firm have complex and/or unusual relations with other firms, such as
those discussed above for franchising and R&D limited partnerships? If so,
what is the primary purpose of these relations? Is it for risk management, for
raising capital, for keeping core assets and commitments off the balance
sheet, or for managing earnings?
ÔÇó Does it make sense to consolidate the performance of related entities that
have complex business relations? If not, what other information is needed
and available to fully understand the financial implications of the relations?
ÔÇó How is the company using the business relation to manage risk? If it has an
option to acquire another company, how is it exercising that option? Is it
exercising it in a way that is consistent with its stated purpose?
ÔÇó Does the company have any related party transactions? If so, who are the re-
lated parties? What governance mechanisms protect the rights of external
stockholders? Is there any evidence that resources are being siphoned out of
the company in related party transactions at the expense of external stock-
286 Entity Accounting Analysis
Entity Accounting Analysis
Challenge Three: Defining and Measuring
Core Business UnitsÔÇ™ Performance
For ´¬ürms in diverse businesses, consolidated information provides investors with a good
overview of the performance of the entire entity. However, investors are also likely to be
interested in understanding how the separate business units are performing. Consequent-
ly, diversi´¬üed companies provide disaggregated data on the performance of their major
business segments in the ´¬ünancial statement footnotes.
Segment reporting generates a number of measurement challenges. First, there are
many different ways of de´¬üning business segments, making it dif´¬ücult to compare per-
formance of supposedly similar segments across ´¬ürms or even over time for the same
´¬ürm. Second, analysis is particularly challenging for ´¬ürms with ´¬ünancial services
segments whose business models are very different from those of the other operating
segments. Finally, if there are transactions between business segments involving inter-
company transfer prices, it can be dif´¬ücult to evaluate the performance of individual
EXAMPLE: DEFINING BUSINESS SEGMENTS. Managers have traditionally been
able to exercise considerable judgment in deciding how to de´¬üne business units for seg-
ment reporting. A number of factors affect how business segments are organized. They
can be structured to create operating and management synergies between units with
overlapping development, production, or distribution processes. For example, in its
1998 annual report, Eastman Kodak disclosed separate information for four segments
that were primarily de´¬üned by the imaging needs of the companyÔÇ™s main customer
groups: Consumer Imaging, Kodak Professional, Health Imaging, and Other Imaging.
The Consumer Imaging segment produced ´¬ülm, paper, chemicals, cameras, photo-
processing equipment, and photoprocessing services for consumers. The Kodak Profes-
sional segment catered to professional customers. The Health Imaging segment
manufactured medical ´¬ülm and processing equipment. Finally, the Other Imaging seg-
ment was a catch-all for KodakÔÇ™s many other imaging businesses, including motion pic-
ture ´¬ülm, copiers, micro´¬ülm equipment, printers, scanners, and other business
Segment de´¬ünitions can also re´¬‚ect managementÔÇ™s desire to conceal information that
it regards as sensitive. For example, prior to 1998, Merck & Co. Inc. operated two pri-
mary businesses, Merck Pharmaceutical and Merck-Medco Managed Care, but avoided
reporting any segment data on the two. Merck Pharmaceutical discovered, developed,
manufactured, and marketed prescription drugs for treating human disorders, whereas
Merck-Medco generated revenues from ´¬ülling and managing prescriptions and health
management programs. MerckÔÇ™s management was concerned that reporting segment
data for these two businesses would make its pricing strategies more transparent to cus-
tomers, potentially reducing the ´¬ürmÔÇ™s future bargaining power in its negotiations with
medical providers. However, in 1998 it was required to report segment data for the two
businesses to satisfy new FASB rules on segment disclosures.
Entity Accounting Analysis
8-11 Part 2 Business Analysis and Valuation Tools
Finally, segment de´¬ünitions can be used by management as a way of concealing from
investors the poor performance in one or more business units. For example, management
may be particularly sensitive about poor performance of a recent acquisition and may
elect to combine it with a strong performer for segment reporting purposes.
In 1998 the FASB attempted to reduce the degree of management judgment in the def-
inition of reporting segments. SFAS 131 de´¬üned segments for ´¬ünancial reporting using
a ÔÇťmanagementÔÇŁ approach. Under this approach, ´¬ürms were required to report segment
data for signi´¬ücant business units whose ÔÇťseparate ´¬ünancial information is . . . regularly
reviewed by the chief operating decision makers in deciding how to allocate resources
and in assessing performance.ÔÇŁ 2 A significant segment is one whose assets, revenues, or
profits comprise at least 10 percent of consolidated assets, revenues, or profits. The stan-
dard requires companies to disclose revenues, profits, and assets for core segments.
The overall impact of the FASB standard on segment disclosures has yet to be ana-
lyzed. However, it has had an effect on reporting by some companies. For example, as
noted above, Merck expanded its segment disclosures to report data for both Merck
Pharmaceutical and Merck-Medco Managed Care. In addition, prior to 1998, IBM only
reported revenues for its business segments. Some analysts speculated that this decision
was made to avoid disclosing large losses in the personal computing segment. In 1998
IBM adopted SFAS 131 and began reporting operating pro´¬üt data for all its segments. The
results showed that the company had a sizable loss in 1998 in its Personal Systems seg-
ment (a pretax loss of $1.0 billion on revenues of $12.8 billion).
EXAMPLE: FINANCE COMPANIES. Another challenge in analyzing segment data
arises for companies with leasing, real estate, ´¬ünancing, or insurance subsidiaries. The
economic model for these companies is quite different from those for retail, manufac-
turing, or other service companies. Many ´¬ürms with ´¬ünance subsidiaries argue that con-
solidation of such ÔÇťnonhomogeneousÔÇŁ operations distorts the parentÔÇ™s key ratios,
particularly leverage, working capital ratios, and gross margins. For example, consider
the impact of IBMÔÇ™s ´¬ünance subsidiary on its performance. In 1998 the ´¬ünance subsid-
iary had assets of $40.1 billion versus $46 billion for the parent, and pretax pro´¬üt mar-
gins of 32 percent versus 11 percent for the company as a whole. It also had signi´¬ücantly
higher leverage than the parent company. These factors made it dif´¬ücult to compare the
performance of IBM with that of other computer companies that had no such ´¬ünance
Prior to SFAS 94, many U.S. companies elected to account for ´¬ünance subsidiaries
using the equity method rather than full consolidation. Frequently, a summary income
statement and balance sheet for the ´¬ünance subsidiary were also disclosed. SFAS 94
stopped this practice and required that ´¬ünance companies be consolidated. Companies
that provided separate ´¬ünancial statements for ´¬ünance subsidiaries were required to con-
tinue this practice.
The question of whether to use consolidated or segment information to best evaluate
´¬ürms with ´¬ünance subsidiaries is a complex one. Many companies with ´¬ünance subsid-
iaries provide additional disclosure to help analysts benchmark core segments with the
288 Entity Accounting Analysis
Entity Accounting Analysis
performance of companies that operate as stand-alone entities.3 However, this approach
ignores any interactions that occur between operating and ´¬ünance segments. For exam-
ple, some companies use ´¬ünance subsidiaries to provide low-cost ´¬ünancing to their cus-
tomers, affecting pricing and selling strategies for the other segments. Comparing
segment performance data for these ´¬ürms to that of other ´¬ürms in the same industries is
likely to uncover this strategy. It is then important to analyze consolidated data to under-
stand the performance of the entire portfolio of services provided to customers.
The ´¬ünal challenge for segment
EXAMPLE: INTERSEGMENT TRANSACTIONS.
reporting comes from intersegment transactions, such as intersegment sales and alloca-
tion of common costs across segments. SFAS 131 requires companies to use the same
transfer prices and cost allocations for segment reporting that are used internally. How-
ever, this permits management to have considerable control over the reported perfor-
mance of both segments. For example, by setting a relatively high transfer price,
management can enhance the reported performance of the selling segment at the ex-
pense of the buying one.
Many factors can in´¬‚uence managersÔÇ™ transfer pricing decisions. These include facil-
itating the ef´¬ücient allocation of resources within the enterprise, motivating segment
management, optimizing taxes, and affecting reported ´¬ünancial performance. It is there-
fore dif´¬ücult to know how to interpret segment performance when there are high levels
of intersegment sales. Is one segment outperforming its industry peers because of the
´¬ürmÔÇ™s transfer pricing policy? If so, what are managementÔÇ™s motives for such a policy?
Similarly, the allocation of common costs can give rise to dif´¬üculty in interpreting