Sonic 2012 Annual Report Download - page 28

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Management's Discussion and Analysis of Financial Condition and Results of Operations
Our estimates are based on the best available information at the time that we prepare the provision, including legislative
and judicial developments. We generally file our annual income tax returns several months after our fiscal year end. Income
tax returns are subject to audit by federal, state and local governments, typically several years after the returns are filed.
These returns could be subject to material adjustments or differing interpretations of the tax laws. Adjustments to these
estimates or returns can result in significant variability in the tax rate from period to period.
Leases. We lease the land and buildings for certain Company Drive-Ins from third parties. Rent expense for operating
leases is recognized on a straight-line basis over the expected lease term, including cancelable option periods when it is
deemed to be reasonably assured that we would incur an economic penalty for not exercising the options. Judgment is
required to determine options expected to be exercised. Within the terms of some of our leases, there are rent holidays and/or
escalations in payments over the base lease term, as well as renewal periods. The effects of the rent holidays and escalations
are reflected in rent expense on a straight-line basis over the expected lease term, including cancelable option periods when
appropriate. The lease term commences on the date when we have the right to control the use of lease property, which can
occur before rent payments are due under the terms of the lease. Contingent rent is generally based on sales levels and is
accrued at the point in time we determine that it is probable that such sales levels will be achieved.
Accounts and Notes Receivable. We charge interest on past due accounts receivable and recognize income as it is
collected. Interest accrues on notes receivable based on the contractual terms of the respective note. We monitor all accounts
and notes receivable for delinquency and provide for estimated losses for specific receivables that are not likely to be collected.
We assess credit risk for accounts and notes receivable of specific franchisees based on payment history, current payment
patterns, the health of the franchisee’s business, and an assessment of the franchisee’s ability to pay outstanding balances.
In addition to allowances for bad debt for specific franchisee receivables, a general provision for bad debt is estimated for
accounts receivable based on historical trends. Account balances generally are charged against the allowance when we believe
it is probable that the receivable will not be recovered and legal remedies have been exhausted. We continually review our
allowance for doubtful accounts.
Quantitative and Qualitative Disclosures About Market Risk
Sonic’s use of debt directly exposes the company to interest rate risk. Fixed rate debt, where the interest rate is fixed
over the life of the instrument, exposes the company to changes in market interest rates reflected in the fair value of the debt
and to the risk that the company may need to refinance maturing debt with new debt at a higher rate. Sonic is also exposed
to market risk from changes in commodity prices. The company does not utilize financial instruments for trading purposes.
Sonic manages its debt portfolio to achieve an overall desired position of fixed and floating rates.
Interest Rate Risk. Our exposure to interest rate risk at August 31, 2012 was primarily based on the 2011 Fixed Rate
Notes with an effective rate of 5.4%, before amortization of debt-related costs. At August 31, 2012, the fair value of the 2011
Fixed Rate Notes was estimated at $510.8 million versus a carrying value of $482.0 million, including accrued interest. To
derive the fair value, management used market information available for public debt transactions for companies with ratings
that are similar to our ratings and information gathered from brokers who trade in our notes. Management believes this fair
value is a reasonable estimate. Should interest rates and/or credit spreads increase or decrease by one percentage point,
the estimated fair value of the 2011 Fixed Rate Notes would decrease or increase by approximately $24 million, respectively.
The fair value estimate required significant assumptions by management.
Commodity Price Risk. The company and its franchisees purchase certain commodities such as beef, potatoes, chicken
and dairy products. These commodities are generally purchased based upon market prices established with vendors. These
purchase arrangements may contain contractual features that limit the price paid by establishing price floors or caps; however,
we generally do not make any long-term commitments to purchase any minimum quantities under these arrangements other
than as disclosed above under “Contractual Obligations and Commitments.” We also do not use financial instruments to
hedge commodity prices because these purchase arrangements help control the ultimate cost.
This market risk discussion contains forward-looking statements. Actual results may differ materially from this discussion
based upon general market conditions and changes in financial markets.