ACCOUNTING FOR INITIAL FRANCHISE FEE REVENUE: WHEN A JOURNAL ARTICLE IN 1970 CONSTITUTED GAAP IN THE EYES OF THE

SEC Stephen A. Zeff

ABSTRACT This article reports on an instance in 1969/70 when the leaders of the accounting profession orchestrated the drafting and publication of an article in the Journal of Accountancy, which was understood as having the force of an APB Opinion. INTRODUCTION From 1959 to 1973, the Accounting Principles Board (APB) issued 31 Opinions, and it was the usual practice of the accounting staff of the Securities and Exchange Commission (SEC) to require domestic registrants to comply with their terms. To the SEC, the APBs Opinions constituted the substantial authoritative support, which it said it sought in 1938 when it issued Accounting Series Release No. 4 (SEC, 1938). Yet in January 1970, a partner in non-Big Eight accounting firm published an article in the Journal of Accountancy (JofA) which the SEC treated as the equivalent of an APB Opinion, a rare instance in which an article published in a professional journal established generally accepted accounting principles in the view of the SEC, but without due process. It is the purpose of this article to explain the circumstances behind the writing of this article and to suggest the impact it had. The title of the article, which was published in the Accounting and Auditing Problems section of JofA, was Accounting for Initial Franchise Fee Revenue, and the author was Archibald E. MacKay, a partner in Main Lafrentz & Co., a major accounting firm based in New York City (MacKay, 1970a). Development of the MacKay article During the 1960s, franchising was a growth industry. In November 1969, The Wall Street Journal wrote, Franchising stocks have been among the markets hottest performers in recent months, and literally scores of new companies have gone public this year (Stabler, 1969). Evidently, most franchisors were recording their initial franchise fee as revenue even though they may have received only a small fraction of the cash from the franchisee and they had not yet rendered most of the services to be 1

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performed for franchisees. This practice came to be known as front-end loading of revenue or instant earnings (Kieso & Weygandt, 1974, pp. 773, 777). During the second half of 1969, Peat, Marwick, Mitchell & Co. was circulating a proposal within its firm which raised a concern about this aggressive accounting, saying that, in many instances, the stocks of franchising companies are selling for unreasonably high earnings multiples. The proposal recommended that franchisors should count the initial franchise fee as revenue only in proportion to substantial performance of the services they were obligated to render, and that, where appropriate, the franchisors should be required to record an adequate allowance for uncollectibles.1 The only APB pronouncement that had a bearing on the timing of revenue recognition in such cases was a paragraph in the omnibus Opinion No. 10, issued in 1966, which was a reaffirmation of a position adopted by the Institute in 1934: Profit is deemed to be realized when a sale in the ordinary course of business is effected, unless the circumstances are such that the collection of the sale price is not reasonably assured (Accounting Principles Board, 1966, para. 12).2 The Board added, it believes that revenues should ordinarily be accounted for at the time a transaction is completed, with appropriate provision for uncollectible accounts (para. 12), and it appended a footnote to say that when there is no reasonable basis for estimating the degree of collectibilityeither the installment method or the cost recovery method of accounting may be used. This passage would seem to allow franchisors to recognize the entirety of the initial franchise fee so long as they make an appropriate provision for uncollectible accounts. Yet a considerable number of franchisors and their auditors apparently had been interpreting this guidance rather loosely, by not providing for estimated uncollectibles, let alone using the installment or cost recovery method of revenue recognition. Peat, Marwicks advice on substantial performance reflected a well-accepted principle underlying accounting practice, but this earning side of revenue recognition had, for whatever reason,

For a report on the Peat, Marwick proposal, see Stabler (1969). For a subsequent expression of the firms concerns over franchisors accounting practices and of its recommendations for proper accounting, see Holton & Hoover (1971). This article was originally published in the Summer 1970 issue of World, the firms house organ. It is likely that this article mirrored the firms internally circulated proposal, because Holton was the firms leader, and perhaps also the professions leader, in tackling this issue. 2 This provision was a reaffirmation of an identical passage in Chapter 1A, paragraph 1, of Accounting Research Bulletin No. 43, issued in 1953, which in turn was a reaffirmation of an identical passage contained in a set of broad principles recommended by a blue-ribbon committee of the Institute in Audits of Corporate Accounts 1932-1934 (1934)and which were approved by the Institutes Council in 1934. It was obviously a long -standing tenet of proper accounting practice.

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not yet been etched in the authoritative literature, that is, in the Accounting Research Bulletins or APB Opinions. Only the issue of collectibility of the receivable had been accorded official sanction. Andrew Barr, the SEC Chief Accountant, was looking for substantial authoritative support which he could cite to require franchisors to delay this premature revenue recognition. Yet the APB was totally consumed at the time with developing an Opinion on accounting for business combinations and goodwill in a highly charged political environment and when the Board was sharply divided over how to treat poolings of interests accounting. Barr knew that the Board could not possibly take up the franchising issue in this climate. Furthermore, even if the Board could have taken it up, its due process would have put off the issuance of an Opinion for a year or more. Consequently, in the summer of 1969 he sought advice from the American Institute of Certified Public Accountants (AICPAs) Committee on Relations with the SEC and Stock Exchanges, chaired by Oscar S. Gellein, of Haskins & Sells (see Barr, 1970, p. 607; Briloff, 1972, p. 109). While it is not known what actual steps the Institute committee took, it is likely that it consulted with one or more members of the APB. At the time, Gellein was regularly attending APB meetings as an advisor to Board member Emmett S. Harrington, of his firm. The chairman of the Board was LeRoy Layton, senior partner of Main Lafrentz & Co., and, as it happened, Archibald MacKay, his partner, was then serving on the Institute committee. MacKay was apparently enlisted to coordinate the drafting of an article for immediate publication in the JofA, the object of which was to recommend a more conservative approach to revenue recognition by franchisors. The selection of a partner from a non-Big Eight firm to sign the article would have been less contentious than if the signatory had been a partner in one of the Big Eight firms. It seems probable that Leonard M. Savoie, the Institutes activist executive vice president and a former partner in Price Waterhouse & Co., was orchestrating this response by the accounting profession. In November 1969, he gave a speech which was widely reported in the press that was critical of franchisors aggressive accounting for the initial franchise fee. He contended that, If an adequate provision for uncollectible accounts is made, the franchise fee should be recognized as revenue on the accrual basis, that is, at the time the transaction is completed and the franchisor has substantially performed his obligations under the franchise agreement.[But] where collection of the sales price is not reasonably assured or there is no basis for estimating the degree of collectibility, the installment method or cost recovery method of accounting may be used. He issued a warning to the industry: If the practice of overstating income of franchising companies is not stopped immediately, the 3

[Accounting Principles] Board will have to issue detailed rules on accounting for franchisors (Savoie, 1969, pp. 18, 19).3 By early December, the drafting of the MacKay article had been completed. Leonard Savoie, who regularly attended APB meetings, announced at the Boards meeting on December 3, 1969 that An article on accounting and reporting for franchising companies will appear in the January 1970 Journal of Accountancy.4 It was reported later in December that The article was previewed by a number of accountants who presumably made comments and suggested revisions. According to several observers, the article is in fact a consensus of the accounting profession on how to resolve the franchise industrys current bookkeeping tangle. It will therefore probably be widely accepted (Whiteman, 1969, p. 732). The draft was also pre-cleared with the SECs Office of the Chief Accountant. A. Clarence Sampson, then the SECs Deputy Chief Accountant, recalls that he talked to MacKay about the draft.5 Arthur R. Wyatt, who accompanied Board member George R. Catlett, from Arthur Andersen & Co., to APB meetings during the 1960s, recalls that the Board really didnt do very much without talking to Andy Barr.6 Catlett himself recalls, we had to have their [the SECs] support or nothing would be enforceable.7 There were frequent references in the APBs minutes during the 1960s to consultations with Barr on projects in process.8 Indeed, the SEC said as follows in its 1969 Annual Report, under the heading of Accounting and Auditing Matters: In furtherance of the policy of cooperation between professional organizations and the Commission, the [APB] submits drafts of [its research] studies, opinions and statements to the Chief Accountant for review and comment prior to publication, and representatives of the Board confer with him on projects in progress or under consideration (35th Annual Report, 1969, p. 57). The MacKay article drew on the prescription in APB Opinion No. 10 that an allowance for uncollectibles should be provided, but when there is no basis for estimating the degree of collectibility of specific notes, there may be little choice other than to use either the installment method or the cost recovery method (MacKay, 1970a, p. 71). On the substantial performance or earning side of what MacKay called the executory initial franchise fee, he concluded that it does not appear that revenue
3 4

This speech was reported in Accounting Practices (1969) and Burck (1970, p. 121). Minutes of Meeting, December 3-6, 1969, Accounting Principles Board, p. 3. 5 Interview with Sampson on July 15, 2011. 6 Interview with Wyatt on July 14, 2011. 7 Interview with Catlett on July 15, 2011. 8 A candid discussion of the activist role played by the Commissions accounting staff in its relations with the APB may be found in: Report of the Study (1972, pp. 49-50).

should be recognized earlier than approximately the time the [franchised] unit has been completed and the franchisee has started operations (MacKay, 1970a, p. 70). McKay went on to discuss the treatment of unusual circumstances in franchisor-franchisee arrangements. In the lead-in to the article, it was stated that This article on franchise accounting is included in the Accounting and Auditing Problems department to give guidance to members who are faced with the problem of accounting for revenue from the sale of franchises. In preparing the article, the author, Archibald E. MacKay, has considered suggestions from several CPAs who have had broad experience in this field (p. 66).9 Lee J. Seidler, an accounting professor at New York University who wrote a newsletter, ERA Accounting Review, for the brokerage firm of Equity Research Associates, referred to this novel approach of publishing a journal article to change the course of accounting practice as a new, rather unorthodox, but apparently effective method. He commented as follows: The Journal of Accountancy normally confines itself to articles in favor of motherhood and against sin and the man-eating shark. Controversy rarely sees the light of its pages. The franchise article, however, presented an incisive analysis of the fundamental considerations in franchise accounting and concluded with prescriptions which were strongly at variance with present practices. A little investigation revealed that this article is not merely a departure in the publications usually bland editorial policy, but that for practical purposes it will have the effect of an APB Opinion. While the author of the article is given as Archibald MacKay, of Main Lafrentz & Co., it was essentially the product of a sub-committee of the Accounting Principles Board.Since the Accounting and Auditing Problems section of the Journal of Accountancy [in which the article appeared] has always had some quasi-official status, this would appear to endow this particular article with considerable authority. It also appears that several of the major accounting firms, working either independently or with the author(s) of the article, have evolved their own, very similar criteria for franchisors and intend to take a hard line from now on. Most important, ERA is informed that the Securities and Exchange Commission considers these criteria to be in agreement with its own views on the

Later in 1970, MacKay wrote an article, More Meaningful Reporting for Franchise Operations, in the 1970 edition of Viewpoint, the house organ of Main Lafrentz & Co. In the article, which drew on his JofA article, he pointed out how franchising had been used as a get rich quick operation, with inflated price-earnings multiples which had shrunk to lower levels in the 1969-70 bear market (MacKay, 1970b, pp. 2, 3). For a discussion of some of the financial problems of fast-food franchisors during the market shakeout, see Elliott (1969, pp. 5, 16, 18, 20, 29).

subject. The SEC will require earnings in the future (1970) to be reported in accordance with the guidelines developed in the article (Seidler, 1970, p. 2).10 There is, however, no mention in the APBs minutes of any formal role which the Board might have played in the development of MacKays article. That this episode, by which a journal article possesses the effect of an APB Opinion, was not unique was affirmed by LeRoy Layton in a speech given in October 1971: On two occasions, articles in the Journal of Accountancy have been reviewed in advance, again unofficially, by a majority of APB members and an understanding established that the SEC and the profession would follow the method or principles prescribed in the Journal article (Layton, 1971, p. 17). He gave no particulars. The subject treated in the other article and when it appeared is not known. In 1975, Donald J. Bevis, a retired partner in Touche Ross & Co. who was a member of the APB from 1965 to 1973, alluded to the Boards unconventional approach for dealing with franchise fee accounting when he wrote, because of the rapidly changing business and economic environment, it was necessary [for the Board] to put out fires, ignited in some cases by avant garde methods of front loading although a few flared up beyond the capacity of the fire department to handle in a satisfactory manner (Bevis, 1975, pp. 45-46). Impact of the MacKay article In his newsletter, Seidler singled out Career Academy, a client of Arthur Andersen & Co., as a franchisor that would, under the terms of MacKays article, need to abandon its practice of recognizing its initial franchisee fees as revenue in favor of recognizing only the amount of cash actually received from franchisees. Seidler estimated that this change would reduce its pre-tax profit for 1968 by about 48 percent (Seidler, 1969, p. 2). In February, it was reported in the press that the company instituted a retroactive change in its revenue recognition method which would halve the companys projections for 1969 earnings, and its stock price plunged. The company explained that this decision was intended to dispel the uncertainty over its earnings which began with Seidlers newsletter (Career Academy Ledger Change, 1970). Seidler later wrote that the accounting changes proposed in MacKays article were responsible for the downfall of Career Academy. (Seidler, 1973, p. 8).
10

Paul A. Pacter, who was then on the staff of Hurdman and Cranstoun, accompanied partner Charles B. Hellerson to APB meetings between 1969 and 1972. In a communication dated July 17, 2011, Pacter says that this interpretation accords with his own recollection of the episode.

A columnist for The New York Times affirmed shortly after the MacKay article was published that the SEC goes along with the change recommended in the article (Metz, 1970). In the Accountants Handbook, Henry R. Jaenicke wrote that MacKays recommendation to the effect that revenue be recognized when the franchisee begins operations was adopted by many franchisors (Jaenicke, 1981, vol. I, p. 11-34). In early 1973, the AICPA issued the first in a series of Industry Accounting Guides, entitled Accounting for Franchise Fee Revenue. The drafting committee was chaired by Archibald MacKay, and the recommendations in the Guide for the accounting for the initial franchise fee were patterned on those in his article, although the Guide was more expansive in its coverage. The drafting committee stated in the Preface, Following the publication of [the MacKay] article, practice began to change toward the proposals contained in the Journal of Accountancy article. This change was supported by the staff of the Securities and Exchange Commission by their frequently requiring such accounting in financial statements subsequently filed with that body. The mention of the SEC staffs enforcement of this recommended accounting was repeated later in the Guide so that readers would not lose sight of the authority behind it (Accounting for Franchise Fee Revenue, 1973, pp. iii, 8). The Guide pointed out that MacKays recommendation that the criterion of substantial performance was met when the franchisee begins operations was well received, because this point in time was easily determined and, for most franchisors, most of the services were rendered by then (p. 8). In March 1981, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 45, Accounting for Franchise Fee Revenue, in which it extracted the specialized accounting and reporting principles [from the Guide] without significant change (para. 2). Conclusion The accounting professions prompt reaction to the SEC Chief Accountants expressed concern over the lack of authoritative literature on this breaking issue illustrates how a journal article can substitute for an official pronouncement in filling this gap. The support of the SECs accounting staff when establishing generally accepted accounting principles was indispensable, and in the 1960s it was standard practice for the Accounting Principles Board to consult the SECs accounting staff when addressing accounting issues, as was reflected in the approval process for MacKays journal article on franchising (MacKay, 1970a).

Other avenues for the SECs accounting staff to make known its views on accounting principles subsequently became available. In January 1974, the AICPA, probably at the urging of SEC Chief Accountant John C. (Sandy) Burton, began holding an annual series of national conferences on current SEC developments, which provided a platform for SEC staff members to give their views on contemporary issues. In 1975, also under Burton, the SECs Office of the Chief Accountant (OCA) and Division of Corporation Finance began issuing Staff Accounting Bulletins, which were a vehicle for expressing the staffs views on accounting principles without a need for the Commission to issue an Accounting Series Release. And in 1984, when the Emerging Issues Task Force (EITF) was established by the Financial Accounting Standards Board, the OCA could deal more expeditiously with breaking issues. The SEC Chief Accountant attended as an observer at EITF meetings with the privilege of the floor, and he could play an influential role in shaping the consensus positions.

ACKNOWLEDGMENTS The author is grateful to those who commented on earlier drafts: J.T. Ball, Dennis Beresford, George Fritz, Ray Groves, Donald Hayes, Robert Herz, Daniel Jensen, Paul Pacter, Gary Previts, K. Ramesh, John Stewart, Bill Thomas, and Terry Warfield. What remains is entirely the responsibility of the author. REFERENCES Accounting for Franchise Fee Revenue. (1973). An AICPA Industry Accounting Guide. New York, NY: American Institute of Certified Public Accountants. Accounting practices of franchisers decried by CPA group official. (1969). The Wall Street Journal (November 19), 8. Accounting Principles Board. (1966). Omnibus Opinion 1966. Opinion No. 10. New York, NY: American Institute of Certified Public Accountants. Audits of Corporate Accounts 1932-1934. (1934). New York, NY: American Institute of Accountants. Barr, A. (1970). The SEC and the accounting profession. In: Written Contributions of Selected Accounting Practitioners Volume 3: Andrew Barr (pp. 600-610). Urbana, IL: Department of Accountancy, University of Illinois at Urbana-Champaign, 1980. Bevis, D. J. (1975). Eight years with the Accounting Principles Board: How it feels to be a gored ox. Touche Ross Tempo, 21 (1), 44-49. Briloff, A. J. (1972). Unaccountable Accounting. New York, NY: Harper & Row. 8

Burck, C. G. (1970). Franchisings troubled dream world. Fortune (March), 116-121, 148, 150, 152. Career Academy ledger change to halve estimate for 69 net; Stock sinks to low. (1970). The Wall Street Journal (February 2), 10. Committee on Accounting Procedure. (1953). Restatement and revision of Accounting Research Bulletins. Accounting Research Bulletin No. 43. New York, NY: American Institute of Accountants. Elliott, J. R., Jr. (1969). Chicken Delight? Some fast-food franchisers offer investors a wing and a prayer. Barrons National Business and Financial Weekly (September 29). Financial Accounting Standards Board. (1981). Accounting for franchise fee revenue. Statement of Financial Accounting Standards No. 45. Stamford, CT: Financial Accounting Standards Board. Holton, T. L., & Hoover, O. J. (1971). The accountants stand on franchise reporting, The New York Certified Public Accountant, 41(January), 49-56. Jaenicke, H. R. (1981). Revenue recognition. In: L. J. Seidler and D. R. Carmichael (Eds), Accountants Handbook (vol. I, chap. 11). New York, NY: John Wiley & Sons. Kieso, D. E., & Weygandt, J. J. (1974). Intermediate Accounting. New York, NY: John Wiley & Sons. Layton, L. (1971). A critical analysis of the present institutional framework for formulating financial reporting standards. In: A. Rappaport & L. Revsine (Eds), Corporate Financial Reporting: The Issues, the Objectives and Some New Proposals (pp. 1-19). Chicago, IL: Commerce Clearing House, Inc., 1972. MacKay, A. E. (1970a). Accounting for initial franchise fee revenue. The Journal of Accountancy, 129 (January), 66-72. MacKay, A. E. (1970b). More meaningful reporting for franchise operations. Viewpoint, 1970 edition, 25. Metz, R. (1970). Market place. The New York Times (January 28), 56. Report of the Study on Establishment of Accounting Principles (1972). Establishing Financial Accounting Standards. New York, NY: American Institute of Certified Public Accountants. Savoie, L. M. (1969). The business community and the public interest. Typescript of speech before the Atlanta Chapter of the Georgia Society of CPAs, Atlanta Society of Financial Analysts, Financial Executives Institute, National Association of Accountants, and Planning Executives Institute, Atlanta, Georgia (November 18). Securities and Exchange Commission. (1938). Administrative policy on financial statements. Accounting Series Release No. 4 (April 25). Seidler, L. J. (1970). Franchisor reported earnings to be reduced. ERA Accounting Review (January 15). 9

Seidler, L. J. (1973). Accounting Issues of Bear, Stearns & Co. (January). Stabler, C. N. (1969). Heard on the Street. The Wall Street Journal (November 11), 29. 35th Annual Report of the Securities and Exchange Commission, for the Fiscal Year Ended June 30th, 1969. (1969). Washington, DC: U. S. Government Printing Office. Whiteman, M. (1969). Major bookkeeping blow-up threatens franchise profits. Restaurant News, December 22. Reproduced in The Impact of Franchising on Small Business, Hearings before the Subcommittee on Urban and Rural Economic Development of the Select Committee on Small Business, United States Senate, Ninety-first Congress, Second Session, Part 2 (March 30 and April 24, 1970) (pp. 730-733). Washington, DC: U.S. Government Printing Office, 1970.

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