By George Wilson
In this series of posts we are exploring examples of COVID-19’s impact on Form 10-Q disclosures for the first quarter of 2020. This third post draws examples from McDonald’s Form 10-Q for their first quarter ended March 31, 2020.
In our earlier examples we saw two different approaches:
Starbucks, who put all COVID-19 disclosures in a single footnote, and
Alphabet, who included disclosures in individual notes.
McDonald’s has included disclosures in individual notes as Alphabet did. McDonald’s disclosed several interesting issues, including that they did not yet have an interim indicator for impairment of long-lived assets and goodwill and lease concession disclosures from the perspective of a lessor.
As a preliminary thought, in case you have not looked at McDonald’s Form 10-K recently, you might want to review the communications focused approach McDonald’s has taken this year. As GE and Intel did earlier, McDonald’s has revamped its 10-K to focus on communication.
You can find McDonald’s first quarter Form 10-Q here. In this report, here is how McDonald’s addressed revenue recognition relating to lease concessions in their financial statements. You will see that the overall revenue recognition note actually cross references to the lease footnote:
The Company's revenues consist of sales by Company-operated restaurants and fees from restaurants operated by franchisees, developmental licensees and affiliates. Revenues from conventional franchised restaurants include rent and royalties based on a percent of sales with minimum rent payments, and initial fees. Revenues from restaurants licensed to developmental licensees and affiliates include a royalty based on a percent of sales, and generally include initial fees. The Company’s Other revenues are comprised of fees paid by franchisees to recover a portion of costs incurred by the Company for various technology platforms, revenues from brand licensing arrangements to market and sell consumer packaged goods using the McDonald’s brand, and third party revenues for the Dynamic Yield business.
Sales by Company-operated restaurants are recognized on a cash basis at the time of the underlying sale and are presented net of sales tax and other sales- related taxes. Royalty revenues are based on a percent of sales and recognized at the time the underlying sales occur. Rental income includes both minimum rent payments, which are recognized straight-line over the franchise term (with the exception of rent concessions as a result of COVID-19 – refer to the Leasing policy update on page 10), and variable rent payments based on a percent of sales, which are recognized at the time the underlying sales occur. Initial fees are recognized as the Company satisfies the performance obligation over the franchise term, which is generally 20 years.
The Company provides goods or services related to various technology platforms to certain franchisees that are distinct from the franchise agreement because they do not require integration with other goods or services we provide. The Company has determined that it is the principal in these arrangements. Accordingly, the related revenue is presented on a gross basis on the Condensed Consolidated Statement of Income. These revenues are recognized as the goods or services are transferred to the franchisee, and related expenses are recognized as incurred. Brand licensing arrangement revenues are based on a percent of sales and are recognized at the time the underlying sales occur. Dynamic Yield third party revenues are generated from providing software as a service solutions to customers and are recognized over the applicable subscription period as the service is performed.
The leasing footnote in the financial statements addresses concessions McDonald’s has made as a lessor along with a discussion of the FASB’s Q&A document addressing such concessions:
The FASB has issued additional guidance for how companies may account for COVID-19 related rent concessions in the form of FASB staff and Board members’ remarks at the April 8, 2020 public meeting and the FASB Staff Q&A issued on April 10, 2020.
The Company has elected the practical expedient to account for COVID-19 related rent concessions as if they were part of the enforceable rights and obligations of the parties under the existing lease contract. This has been elected for the Company’s entire lessee and lessor portfolio for any rent deferrals or rent abatements. For the lessee portfolio, the Company has elected not to remeasure the lease liability and right-of-use asset if a rent deferral or a rent abatement is granted.
For the first quarter 2020, the Company deferred collection of approximately $300 million of rental income on revenue that was recognized in the first quarter. Rental income includes both minimum rent payments and variable rent payments based on a percent of sales. The extent of the deferrals differ in length by market, but the deferrals primarily impact cash collection in the second quarter of 2020, a large portion of which is expected to be collected in the third and fourth quarters of 2020.
Refer to the Cash Flow and Liquidity section on page 24 of this Form 10-Q for additional information on deferred collections of rental income as well as royalties.
This is McDonald’s footnote disclosure about impairment:
Long-lived assets and Goodwill
Long-lived assets and Goodwill are typically reviewed for impairment annually in the fourth quarter and whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable or if an indicator of impairment exists. The Company has continued to monitor the significant global economic uncertainty as a result of COVID-19 to assess the outlook for restaurant operations and the impact that any disruption may have on the Company's business and overall financial performance.
As a result of the Company's analysis, and in consideration of the totality of events and circumstances, including the potential impact of COVID-19 related disruptions on the Company’s operating results, there were no indicators of impairment during the first quarter of 2020.
McDonald’s addressed the uncertainty created by COVID-19 on its use of CECL:
Financial Instruments - Credit Losses
In June 2016, the FASB issued guidance codified in Accounting Standards Codification Topic 326, "Financial Instruments – Credit Losses: Measurements of Credit Losses on Financial Instruments". The standard replaces the incurred loss impairment methodology in prior GAAP with a methodology that instead reflects a current estimate of all expected credit losses on financial assets, including receivables. The guidance requires that an entity measure and recognize expected credit losses at the time the asset is recorded, while considering a broader range of information to estimate credit losses including macroeconomic conditions that correlate with historical loss experience, delinquency trends and aging behavior of receivables, among others. The Company has adopted this guidance effective January 1, 2020, prospectively, and the adoption and application of this standard did not have a material impact to the consolidated financial statements during the first quarter. The Company will continue to actively monitor the impact of the COVID-19 pandemic on expected losses.
McDonald’s addressed COVID-19’s impact in a number of sections in its MD&A. Here are some of the more important sections from MD&A:
From the MD&A Overview:
The Company requires franchisees to meet rigorous standards and generally does not work with passive investors. The business relationship with franchisees is designed to facilitate consistency and high quality at all McDonald’s restaurants. Conventional franchisees contribute to the Company’s revenue, primarily through the payment of rent and royalties based upon a percent of sales, with specified minimum rent payments, along with initial fees paid upon the opening of a new restaurant or grant of a new franchise. The Company's heavily franchised business model is designed to generate stable and predictable revenue, which is largely a function of franchisee sales, and resulting cash flow streams. As most revenues are based on a percent of sales, the Company expects the ongoing temporary restaurant closures, limited operations and dramatic changes in consumer behavior, as a result of COVID-19, will continue to have a significant negative impact on revenues.
This was a separate section after the Overview:
COVID-19 Impact and Strategic Direction
Driven by our Velocity Growth Plan (the "Plan") the Company delivered strong global comparable sales and results in 2019 and for the two months ended February 2020. The outbreak of COVID-19 and the resulting operational impact brought on by several related factors, including restaurant closures, limited operations and dramatic changes in consumer behavior, led to a marked decline in sales during the second half of March.
While the COVID-19 pandemic has significantly disrupted the operations of McDonald’s business in every market in which we operate, the Company has taken several steps focused on the safety and well being of restaurant crew, franchisees, employees, and customers. In addition, the Company is:
- Working with franchisees around the world in order to evaluate operational feasibility and support financial liquidity during this period of uncertainty.
- Utilizing our high Drive-Thru penetration as a critical asset during the COVID-19 pandemic, and this order channel continues to enable us to serve customers during this challenging time.
- Applying learnings from our Experience of the Future deployment over the last several years, when we shut down and reopened restaurants, which should prove invaluable as we emerge from the crisis.
- Collaborating closely with suppliers on contingency planning for continuous supply.
While the Company cannot predict the duration or scope of the COVID-19 pandemic, it has negatively impacted the business and our financial results, condition and outlook. By remaining focused on our people and our business, the Company will continue to take actions that are designed to put the System in a position to succeed when the pandemic subsides. This includes the Company's investments in technology and new capabilities through the following initiatives:
- We now offer delivery in over 25,000 restaurants across the global system, and our delivery business has become more relevant than ever during the crisis. Despite the challenging business environment, we have continued to meet customers’ expectations, and in many markets delivery sales per day are up significantly versus pre-COVID-19 figures. Additionally, we are sharing innovative best practices across our markets, including the use of contactless delivery, to adapt to changing customer behaviors. We continue to see great runway ahead of us to drive awareness and trial of delivery, and are focusing on efforts to encourage frequency and retention in 2020 and beyond.
- The investments the Company has made over the past several years with our emerging digital customer experience platform, including mobile order and pay and the acquisitions of Dynamic Yield and Apprente, remain a priority for our business. Dynamic Yield has been implemented via outdoor digital menu boards across the U.S. and Australia, offering customers a more customized experience, while Apprente, the conversational interface technology, is expected to provide more efficient and accurate ordering in the drive-thru in the future. These digital investments enable us to give customers more choice and flexibility in how they order, pay, and receive their food during this unprecedented time and will remain important in serving customers as we think about our business beyond this crisis.
Looking ahead, the Company understands that these unprecedented times will bring about fundamental changes to the way our business operates. While the Plan has been instrumental in our performance over the past few years, our strategy may need to evolve in the aftermath of the COVID-19 pandemic. As such, the Company will rely on its ability to adapt and adjust to changing conditions to ensure we emerge from the crisis in a position of competitive strength.
McDonald’s addressed financing issues related to COVID-19 in this MD&A section:
Financing and Market Risk
Debt obligations at March 31, 2020 totaled $39.2 billion, compared with $34.2 billion at December 31, 2019. The net increase in 2020 was primarily due to net long-term debt issuances with a principal amount of $5.5 billion, which were used to bolster our cash position in anticipation of the adverse macroeconomic and business conditions associated with COVID-19.
As always, your thoughts and comments are welcome!