Franchising has become a popular growth industry, with many businesses seeking to sell franchises as their primary income source and individuals seeking to buy franchises and become entrepreneurs. Prime accounting issues are how to recognize revenue on the individual sale of franchise territories and on the transactions that arise in connection with the continuing relationship between the franchisor and franchisee. This post provides revenue recognition rules and schema for franchise companies.
The American Institute of Certified Public Accountants (AICPA) published an industry accounting guide, Accounting for Franchise Fee Revenue, in 1973, from which the FASB extracted the principles it used to prepare FAS 45, having the same title.
Franchise operations are generally subject to the same accounting principles as other commercial enterprises. Special issues arise out of franchise agreements, however, which require the application of special accounting rules.
Revenue is recognized, with an appropriate provision for bad debts, when the franchisor has substantially performed all material services or conditions. Only when revenue is collected over an extended period of time and collectibility cannot be predicted in advance would the use of the cost recovery or installment methods of revenue recognition be appropriate.
Substantial performance means:
- The franchisor has no remaining obligation to either refund cash or forgive any unpaid balance due.
- Substantially all initial services required by the agreement have been performed.
- No material obligations or conditions remain.
Even if the contract does not require initial services, the pattern of performance by the franchisor in other franchise sales will impact the time period of revenue recognition. This can delay such recognition until either services are performed or it can be reasonably assured they will not be performed. The franchisee operations will be considered as started when such substantial performance has occurred.
If initial franchise fees are large compared to services rendered and continuing franchise fees are small compared to services to be rendered, then a portion of the initial fee is deferred in an amount sufficient to cover the costs of future services plus a reasonable profit, after considering the impact of the continuing franchise fee.
Example Of Initial Franchise Fee Revenue Recognition
Lie Dharma Oriental Cuisine sells a Quack’s Roast Duck franchise to Great Taste Restaurants. The franchise is renewable after two years. The initial franchise fee is $50,000, plus a fixed fee of $500 per month. In exchange, Lie Dharma provides staff training, vendor relations support, and site selection consulting. Each month thereafter, Lie Dharma provides $1,000 of free local advertising. Lie Dharma’s typical gross margin on franchise start-up sales is 25%.
Because the monthly fee does not cover the cost of monthly services provided, Lie Dharma defers a portion of the initial franchise fee and amortizes it over the two-year life of the franchise agreement, using the following calculation:
Cost of monthly services provided $1,000 × 24 months = $24,000
Divide: Markup to equal standard 25% gross margin = .75
= Estimated revenue required to offset monthly services provided = $32,000
Less: Monthly billing to franchise $500 × 24 months = $12,000
= Amount of initial franchise fee to be deferred = $20,000
Lie Dharma’s entry to record the franchise fee deferral follows:
[Debit]. Franchise fee revenue = 20,000
[Credit]. Unearned franchise fees (liability) = 20,000
Lie Dharma recognizes 1/24 of the unearned franchise fee liability during each month of the franchise period on a straight-line basis, which amounts to $833.33 per month.
Area Franchise Sales
Sometimes franchisors sell territories rather than individual locations. In this event, the franchisor may render services to the area independent of the number of individual franchises to be established. Under this circumstance, revenue recognition for the franchisor is the same as stated above. If, however, substantial services are performed by the franchisor for each individual franchise established, then revenue is recognized in proportion to the amount of mandatory service. The general rule is that when the franchisee has no right to receive a refund, all revenue is recognized. It may be necessary for revenue recognition purposes to treat a franchise agreement as a divisible contract and allocate revenue among existing and estimated locations. Future revisions to these estimates will require that remaining unrecognized revenue be recorded in proportion to remaining services expected to be performed.
Example Of Revenue Recognition For Area Franchise Sales
Lie Dharma Oriental Cuisine sells an area Quack’s Roast Duck franchise to Lou Investments for $40,000. Under the terms of this area franchise, Lie Dharma is solely obligated to provide site selection consulting services to every franchise that Lou opens during the next 12 months, after which Lou is not entitled to a refund. Lou estimates that it will open 12 outlets sporadically throughout the year. Lie Dharma estimates that it will cost $2,500 for each site selection, or $30,000 in total. Based on the initial
$40,000 franchise fee, Lie Dharma’s estimated gross margin is 25 percent.
Lou’s initial payment of $40,000 is recorded by Lie Dharma with the following entry:
[Debit]. Cash = 40,000
[Credit]. Unearned franchise fees (liability) = 40,000
After six months of preparation, Lou requests that four site selection surveys be completed. Lie Dharma completes the work at a cost of $10,000 and uses the following entry to record both the expenditure and related revenue:
[Debit]. Unearned franchise fees (liability) = 13,333
[Credit]. Franchise fee revenue = 13,333
[Debit]. Site survey expense 10,000
[Credit]. Accounts payable 10,000
By the end of the year, Lie Dharma has performed 10 site selection surveys at a cost of $25,000 and recognized revenue of $33,333, leaving $6,667 of unrecognized revenue. Since Lou is no longer entitled to a refund, Lie Dharma uses the following entry to recognize all remaining revenue, with no related expense:
[Debit]. Unearned franchise fees (liability) = 6,667
[Credit]. Franchise fee revenue = 6,667
Other Form Of Relationships
Franchisors may guarantee debt of the franchisee, continue to own a portion of the franchise, or control the franchisee’s operations. Revenue is not recognized until all services, conditions, and obligations have been performed.
In addition, the franchisor may have an option to reacquire the location. Accounting for initial revenue is to consider the probability of exercise of the option. If the expectation at the time of the agreement is that the option is likely to be exercised, the entire franchise fee is deferred and not recognized as income. Upon exercise, the deferral reduces the recorded investment of the franchisor.
An initial fee may cover both franchise rights and property rights, including equipment, signs, and inventory. A portion of the fee applicable to property rights is recognized to the extent of the fair value of these assets.
However, fees relating to different services rendered by franchisors are generally not allocated to these different services because segregating the amounts applicable to each service could not be performed objectively.
The rule of revenue recognition when all services are substantially performed is generally upheld. If objectively determinable separate fees are charged for separate services, then recognition of revenue can be determined and recorded for each service performed.
Franchisors may act as agents for the franchisee by issuing purchase orders to suppliers for inventory and equipment. These are not recorded as sales and purchases by the franchisor; instead, consistent with the agency relationship, receivables from the franchisee and payables to the supplier are reported on the balance sheet of the franchisor. There is, of course, no right of offset associated with these amounts, which are to be presented gross.
Continuing Franchise And Other Fees
Continuing franchise fees are recognized as revenue as the fees are earned. Related costs are expensed as incurred. Regardless of the purpose of the fees, revenue is recognized when the fee is earned and receivable.
The exception is when a portion of the fee is required to be segregated and used for a specific purpose, such as advertising. The franchisor defers this amount and records it as a liability. This liability is reduced by the cost of the services received.
Sometimes, the franchisee has a period of time in which bargain purchases of equipment or supplies are granted by the contract. If the bargain price is lower than other customers pay or denies a reasonable profit to the franchisor, a portion of the initial franchise fee is deferred and accounted for as an adjustment of the selling price when the franchisee makes the purchase. The deferred amount is either the difference in the selling price among customers and the bargain price, or an amount sufficient to provide a reasonable profit to the franchisor.
Costs – Direct and incremental costs related to franchise sales are deferred and recognized when revenue is recorded. However, deferred costs cannot exceed anticipated future revenue, net of additional expected costs. Indirect costs are expensed as incurred. These usually are regular and recurring costs that bear no relationship to sales.
Repossessed Franchises – If, for any reason, the franchisor refunds the franchise fee and obtains the location, previously recognized revenue is reversed in the period of repossession. If a repossession is made without a refund, there is no adjustment of revenue previously recognized. However, any estimated uncollectible amounts are to be provided for, and any remaining collected funds are recorded as revenue.
Business Combinations – Business combinations where the franchisor acquires the business of a franchisee are accounted for in accordance with the requirements of FAS
141, Business Combinations. No adjustment of prior revenue is made, since the financial statements are not retroactively consolidated in recording a business combination. Care must be taken to ensure that the purchase is not a repossession. If the transaction is deemed to be a repossession, it is accounted for as described in the preceding section.
Disclosure Of Franchising Revenue Recognition
There are several disclosures required for franchise fee transactions. They include:
- The types of significant commitments resulting from franchising arrangements, as well as franchisor services not yet performed
- The franchise sale price
- The amount of deferred revenue and costs
- The periods when fees become payable by the franchisee
- The amounts of revenue initially deferred due to collectibility uncertainties, but then recognized due to resolution of the uncertainties
- The number of franchises sold, purchased, and in operation during the period (which shall segregate the number of franchisor-owned outlets in operation from the number of franchisee-owned operations)
- Segregate the reporting of initial franchise fees from other franchise fee revenue, if they are significant
- Segregate the revenues and costs of franchisor-owned outlets from those of franchisees, when practicable
- If there is no reasonable basis for estimating the ability of the franchisor to collect franchise fees, the type of accounting method used to recognize franchise fee revenue (either the installment or cost recovery method) must be disclosed
- If initial franchise fee revenue is likely to decline because of market saturation, this issue should be disclosed
Franchise Definitions Of Terms
Area franchise. An agreement that transfers franchise rights within a geographical area, permitting the opening of a number of franchised outlets. The number of outlets, specific locations, and so forth are decisions usually made by the franchisee.
Bargain purchase. A transaction in which the franchisee is allowed to purchase equipment or supplies for a price that is significantly lower than their fair value.
Continuing franchise fee. Consideration for the continuing rights granted by the franchise agreement and for general or specific services during its term.
Franchise agreement. A written business agreement that meets the following principal criteria:
- The relationship between the franchisor and franchisee is contractual, and an agreement, confirming the rights and responsibilities of each party, is in force for a specified period.
- The continuing relationship has as its purpose the distribution of a product or service, or an entire business concept, within a particular market area.
- Both the franchisor and the franchisee contribute resources for establishing and maintaining the franchise. The franchisor’s contribution may be a trademark, a company reputation, products, procedures, labor, equipment, or a process. The franchisee usually contributes operating capital as well as the managerial and operational resources required for opening and continuing the franchised outlet.
- The franchise agreement outlines and describes the specific marketing practices to be followed, specifies the contribution of each party to the operation of the business, and sets forth certain operating procedures with which both parties agree to comply.
- The establishment of the franchised outlet creates a business entity that will, in most cases, require and support the full-time business activity of the franchisee.
- Both the franchisee and the franchisor have a common public identity. This identity is achieved most often through the use of common trade names or trademarks and is frequently reinforced through advertising programs designed to promote the recognition and acceptance of the common identity within the franchisee’s market area.
Franchisee. The party who has been granted business rights (the franchise) to operate the franchised business.
Franchisor. The party who grants business rights (the franchise) to the party (the franchisee) who will operate the franchised business.
Initial services. Common provision of a franchise agreement in which the franchisor usually will agree to provide a variety of services and advice to the franchisee, such as the following:
- Assistance in the selection of a site. The assistance may be based on experience with factors such as traffic patterns, residential configurations, and competition.
- Assistance in obtaining facilities, including related financing and architectural and engineering services. The facilities may be purchased or leased by the franchisee, and lease payments may be guaranteed by the franchisor.
- Assistance in advertising, either for the individual franchisee or as part of a general program
- Training of the franchisee’s personnel.
- Preparation and distribution of manuals and similar material concerning operations, administration, and recordkeeping.
- Bookkeeping and advisory services, including setting up the franchisee’s records and advising the franchisee about income taxes, real estate taxes, and other taxes, or about local regulations affecting the franchisee’s business.
- Inspection, testing, and other quality control programs.
Initial franchise fee. Consideration for establishing the franchise relationship and providing some agreed-upon initial services. Occasionally, the fee includes consideration for initially required equipment and inventory, but those items usually are the subject of separate consideration. The payment of an initial franchise fee or a continuing royalty fee is not a necessary criterion for an agreement to be considered a franchise agreement.