A Lesson in History: Where did Boston Chicken Go Wrong?

Boston Market is an extremely popular restaurant across the United States, and has only been around since the 1990s. It is currently owned by Sun Capital, and previously owned by McDonald's MCD. Boston Market was also at one point owned by a large-cap company called Boston Chicken. Boston Chicken Chicken was not a corrupt company, but ultimately played around with its financing activities a bit too much.

Unfortunately for many retail and Wall Street investors, the company was fairly vague in its SEC filings. Only the most diligent investors were able to crack down on the company and understand what it was doing. While modern companies are better about accounting clarity, it is always important for investors to thoroughly understand companies before long-term investing.

In this expose, we look at a few of Boston Chicken's accounting standards, and how some investors may have been able to prevent headaches and cash outflows if they paid more attention.

One glaring area of distortion regarding Boston Chicken's accounting methods revolves around its credit risk and allowance for loan losses. Boston Chicken acts like a financial institution in that it writes loans for both its franchisees and area developers in order to open new restaurants. The parent company was willing to loan as much as 80% of the starting capital required to open each restaurant.

While this practice isn't necessarily fraudulent, Boston Chicken never created an allowance for bad debts account to recognize the credit risk inherently involved with such practices. Especially considering that 3 area developers accounted for over 10% of total notes receivable each, allowance accounts should have definitely been implemented to conservatively recognize the fact that not all money will be received in the end. They also have the obligation to present to its shareholders the risks involved with its debt financing activities, which was obviously not done due to the absence of an allowance account for credit risk.

Moreover, Boston Chicken had the option to convert any amounts outstanding into equity, as long as 80% of any given loan's commitments were fulfilled, or in the event of certain default scenarios. Boston Chicken also implemented a conversion premium, which was approximately 17% over the per unit price of equity investments by the area developers/franchisees made concurrently with the loan agreements in the beginning of the venture.

This type of loan conversion deluded shareholders because Boston Chicken never actually had to report specific data regarding the borrowers' inability to pay back the loan or in the event of their default. Again, Boston Chicken should have presented the tangible losses incurred by its franchisees so that shareholders could track performance of the franchises owned by individuals and area developers.

Boston Chicken's current accounting standards have kept franchise losses from the public view. The debate concerns whether BC should recognize these losses since the franchises are nominally independent. However, with BC's large stake in these franchises with their debt financing, the parent company is able to manipulate their financial results to hide these losses and only recognize the royalty payments made by the franchises. Therefore, Boston Chicken's financial statements should include the losses incurred by their franchises since they have a significant stake in their ownership.

Boston Chicken has questionable accounting practices regarding their national and local advertising funds. All individual franchise agreements require the owners to pay 2% of net revenue toward a National Advertising Fund and 4% of net revenue toward a Local Advertising Fund.

However, the company does not separate the distinction between the two funds in the financial statements because they claim that they are only acting as “agents,” which is questionable since they own 80% of the franchisees. The heart of the issue is the fact that the funds have a $15.2 million deficit. Boston Chicken records that $10.2 million is paid up front in the form of due to affiliates and that the other $5 million they include as accounts receivable.

This is an issue because the $5 million is probable, and thus should not be included under the accounts receivable because it is still unknown how much, if any, will be paid to Boston Chicken.

Companies with distorted accounting standards are harder to find these days, as retail investors are forgetting to comb through 10-K documents and understand what happens behind the scenes. In as many words, companies may not be making money in the most direct way, as some investors may think. In the case with Boston Chicken, they acted more of a financial institution than a retail restauranteur. Investors should always understand exactly how businesses work before making investments.