When is a Franchise Fee Considered Income?

Finance

Franchisors should not rely on their “professionals” to put together the proper documents. A strong franchisor is one that “minds his or her own business.”  

By Aaron Chaitovsky         

Tough economic times are upon us. No news there. Finding the right franchisees, uncovering financing alternatives, evaluating fixed and variable costs, and reassessing expansion plans are but a few of the concerns plaguing the franchising world. Although these items may be foremost on the minds of franchise executives now, there are still some fundamental issues that must be dealt with regardless of the state of the economy. Over the past eight years, numerous high-profile companies have admitted to accounting problems with regard to the improper recognition of income, such as Enron, Cendant, Computer Associates and many others that made headlines due to the company’s’ admissions of overstating income during a time when the economy appeared stronger than it is now. The impact of these “misstatements” resulted in litigation, fines and for some, jail time. The consequences of prematurely recognizing income earned or the “overstatement” of sales or income, however, is not reserved just for those well-known public companies. Every franchisor must deal with its own financial statement presentation and really understand what their financial statements represent. Not having a full understanding of your statement can very easily be seen as “misleading” your franchisees and prospects, thus potentially ending up in a litigious situation.   

According to Craig Tractenberg, partner at the law firm of Nixon Peabody LLP, “After Enron, regulators now require transparency in financial representations, and litigators scrutinize financial statements for misleading information. A financial statement may not have been materially misleading, but when the franchisee is dissatisfied with franchisor support, improper accounting taints the entire relationship. If the financial statement is opaque or misleading, the franchisee may convincingly argue that other aspects of the franchise relationship were concealed or not properly performed. Relatively minor accounting infractions can take on magnified importance and can support concerted actions by franchisees for redress.”    

Franchisors who rely on other professionals such as accounting and consulting firms for their accounting and financial needs must understand what their financial statements say about their businesses. This includes financial statements and disclosures. The accounting firm performing the audit of your books and records is doing just that, auditing your books and records. The accountants will also obtain a representation letter from management. You must understand what you are representing to the auditors, as well as what your financial statements say about your business. Specifically, understanding what your financial statements say about income recognition is critical in this analysis.   

Let’s take a step back and focus on exactly what “revenue recognition” represents before we understand the requirements set forth by the Financial Accounting Standards Board specifically for the franchising industry. The term “revenue recognition” for financial statement purposes describes the specific conditions under which transactions are recognized as revenue in your financial statements. Generally, revenue is recognized only when specific critical events have occurred and the amount of revenue is measurable. One key condition is that revenue should only be included in the company’s profit and loss statement when the amount has been determined to be realizable.   

The FASB, standard setters for U.S. companies, has established guidelines as to the how revenues should be recognized. For the franchising world, the FASB issued the Statement of Financial Accounting Standards No. 45, Accounting for Franchise Fee Revenue, which establishes the specialized accounting and reporting standards for franchisors. The underlying principle of the standard requires that “franchise fee revenue from individual and area franchise sales be recognized only when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisors.” The guide also indicates that there is an underlying presumption that the earliest point at which substantial performance occurs coincides with commencement of operations by the franchisee unless it can be demonstrated that substantial performance of all obligations has occurred before that time. The statement encompasses revenue recognition treatment for continuing franchise fees, continuing product sales, agency sales, repossessed franchise, franchise costs, commingled revenue and relationships between a franchisee and franchisor. Although there may be some gray areas as to what actually constitutes “substantial performance,” one thing is quite clear. The fact that a franchise fee is non-refundable does not in itself create revenue recognition. The following is a general synopsis of the revenue recognition guidelines as described in FASB 45. Franchisors are urged to refer to the actual pronouncement for the specifics as they may apply to their particular businesses.      

Individual Franchise Fees 

Franchise fee revenue is recognized when all material services or conditions relating to the sale have been substantially performed. The FASB defines substantial performance using all of the following three criteria:   

1. The franchisor has no remaining obligation or intent to refund any cash received or forgive unpaid notes.

2. Substantially all of the initial services of the franchisor have been performed, if initial services are not required by the franchise agreement, but a practice of voluntarily rendering initial services exists because of business or regulatory circumstances, substantial performance will not be assumed until either the services have been substantially performed or there is reasonable assurance that the services will not be performed.   

For example, if a franchise agreement is silent as to the training of franchisee personnel or assistance in site selection, and these components are ordinarily performed by franchisors in the applicable industry, these items may be deemed as initial services for purposes of revenue recognition even though there is no contractual obligation.      

3. No other material conditions or obligations related to the determination of substantial performance exist. For example, if a franchisee pays a $100,000 franchise fee plus a $100 a month continuing fee to cover the franchisor’s obligation of providing back office accounting and billing support, a portion of the initial fee, the $100,000, may have to be deferred and amortized over the life of the franchise. Recognizing the $100,000 franchise fee once the franchisee commences operations could be deemed to be inappropriate revenue recognition.     

A common pitfall: In situations where the initial franchise fee is very large and the continuing fees are small in relation to the ongoing services provided by the franchisor such that the continuing fees do not cover the ongoing costs incurred by the franchisor for such services, a portion of the initial franchise fee would need to be deferred to cover estimated cost in excess of fees collected and provide a reasonable profit on those continuing fees.      

Area Franchise Sales 

The accounting guidelines for area development franchise sales are based on the same principals as individual franchise sales except that the assessment of when a franchisor has satisfied “substantial performance” depends on the nature of the franchise agreement. “If the franchisor’s substantial obligations depend on the number of individual franchises established within the area, area franchise fees shall be recognized in proportion to the initial mandatory services provided. Revenue that may have to be refunded because future services are not performed shall not be recognized by the franchisor until the franchisee has no right to receive a refund.”   

As an example, a franchisor sells a territory for $500,000 with a franchisee obligation to open 10 outlets within five years within that territory. Each outlet will require extensive training on the part on the franchisor. Since the franchisor will incur substantial costs relating to each outlet, the initial fee collected may have to be treated as divisible and revenue would be recognized in proportion to the outlets for which required services have been substantially performed.   

A Common Pitfall: Under certain circumstances, the sale of an area franchise may fall under the category of a “Sale with Multiple Deliverables” in which case, the entire area franchise fee may have to be deferred until all performance requirements of the franchisor, are fulfilled. Source: Emerging Issues Task Force Issue 00-21.     

Relationship Between Franchisor and Franchisee 

When a franchise agreement gives the franchisor the right or option to purchase the franchisee’s business, the likelihood of the franchisor purchasing the business must be considered in accounting for the initial franchise fee. If at the time of the initial franchise sale, an option was given to the franchisor to repurchase the unit, and an understanding exists that the option will be exercised or it is probable that the franchisor will exercise the option, the initial franchise fee must be deferred and, when exercised, will reduce the franchisor’s investment in the business.   

A Common Pitfall: Under circumstances where franchisors buy back franchised outlets that are in financial difficulty as a matter of management policy to preserve the reputation and goodwill of the franchise system, consideration will have to be given to the likelihood of the franchisor’s repurchase of the unit at the time of the initial sale. Keep in mind, most litigation has the benefit of hindsight.     

Franchising Costs 

All of the direct (incremental) costs related to the deferred franchise revenue are ordinarily deferred until the related revenue is recognized. Generally, this applies only to those direct costs relating specifically to the revenue which has been deferred. All indirect costs of a regular recurring nature must be expensed as incurred.   

A Common Pitfall: When deferring direct incremental costs related to deferred revenue, care must be taken not to defer costs in excess of anticipated revenue less estimated additional related costs.   

For example, a franchisor sells a franchise for $25,000 and pays a sales commission of $15,000 to the franchise sales broker for the sale. If the franchise is not opened and operating for 10 months and it has been determined that the franchisor has not completed substantial performance of its obligation until the unit is operating, then the $25,000 franchise fee revenue along with the $15,000 sales commission cost will be deferred until the unit opens. However, if an additional commission of $15,000 will be incurred for the broker’s assistance in physically opening the outlet, since the total costs related to this franchise fee exceed the fee received, only a portion of the commission costs may   be deferred and the rest must be recognized as expense when incurred.   

Many factors go into the production of the franchise disclosure document and related agreements. Attorneys, accountants, consultants must work together with the franchisor to ensure that the final product represents an accurate and transparent depiction of what a prospective franchisee is to expect in addition to setting the guidelines as to how revenue will be recognized by the franchisor, considering the complexities of revenue recognition standards. Franchisors should not rely on their “professionals” to put together the proper documents. A strong franchisor is one that “minds his or her own business.”    

Aaron Chaitovsky, CPA, is a partner and the chairman of franchise services at the accounting firm of Citrin Cooperman & Company, LLP. He can be reached at 212-697-1000 or  achaitovsky@citrincooperman.com.

Advertisement