Accounting for Franchises (#265)
/In this podcast episode, we discuss the accounting for franchises. Key points are noted below.
Overview of Franchising
A franchise is a privilege granted to a third party to market a product or service, usually under a trademarked name. The franchisor is the party that grants business rights related to a franchise to the franchisee, which is the party that commits to operate the franchised entity. In return, the franchisee pays a fee to the franchisor, which is usually based on a percentage of the sales generated by the franchisee.
There may be a single unit arrangement with a franchisee, where the franchisee becomes the hands-on manager of a franchise that covers a specific geographic region. The agreement may be for a specific period of time, such as ten years. If the franchisee wants to renew at the end of the current contract period, it will need to pay a renewal fee. Or, there may be an area development franchising arrangement, where the franchisee gets the right to develop a certain number of units within a specific territory, such as a county or a state. This entity then enters into a separate arrangement with the franchisor for each unit constructed within that territory.
A variation on the concept is the master franchising agreement, where the franchisor grants the master franchisee the right to sub-franchise to an additional level of franchisees. A master franchising agreement tends to cover a larger region than you normally see for an area development franchise.
There are several ways to build a franchise operation. One approach is for the franchisor to provide the franchisee with a turnkey solution, where the franchisor finds a location, builds it out, stocks it with inventory, and then hands everything over to the franchisee. In return, the franchisee pays quite a large up-front fee to the franchisor. A variation is for the franchisor to also operate the unit for a period of time, and then hand it over to the franchisee, just to make sure that everything is running properly.
Yet another approach is for the franchisee to be directly involved in the development process, with the oversight of the franchisor. This approach increases the risk of failure, since the location of the unit is untested. A final possibility is for a pre-existing, independent business to enter into a franchisee relationship, where it agrees to operate under the logo of the franchisor. In this last case, the franchisee already knows that the selected location will succeed, since it’s already been in operation for some time.
Business Development Expenditures
So, as you might expect, these arrangements can trigger some accounting issues. First up is what the franchisor is supposed to do with its business development expenditures. It might spend millions developing its franchise concept. Even though these expenditures might lead to lots of franchising revenue somewhere down the road, they’re still considered to be research and development costs, and those costs are charged to expense as incurred.
Facility Construction
Next, let’s assume that the franchisor is constructing facilities on behalf of its franchisees, with the franchisees paying advances as the work proceeds. In addition, the franchisor may charge the franchisee a fee to manage the construction process. The franchisor records these incoming payments in a development fund liability account, which the construction billings are then charged against.
Franchise Fee
After that, there’s the accounting for the continuing franchise fee, which is based on a percentage of the franchisee’s sales. When the franchisor incurs expenses related to these continuing fees, it should charge them to expense as incurred. These expenses include pretty much every operating cost of the business, such as general, selling, and administrative expenses.
Cooperative Advertising Fund
A franchisor might require its franchisees to pay into a cooperative advertising fund, which it then uses to advertise on behalf of the franchisees. Advertising funds are usually collected first and then paid out; this means that the funds collected are initially a liability of the franchisor. In the reverse situation, where the franchisor first pays for the advertising and then collects the money from franchisees, the franchisor might charge interest on the funds that it’s already expended.
Franchise Buy-Back
So, what if a franchisor buys a franchise back from a franchisee? The accounting for it depends on the intent of the franchisee. If the intent is to close it, the franchisor apportions the purchase price among the acquired assets and liabilities and writes off any residual amount. But if the intent is to keep running the business, the same approach applies, except that any residual amount is now allocated to the goodwill intangible asset, because now the transaction is treated as a business combination. Which leaves us with a third possibility, which is that the franchisor intends to turn around and sell the operation to a new franchisee. In this case, reacquired assets are classified as held for sale, which allows the franchisor to hold the assets without depreciating them; the assets are then included in the cost of the eventual sale to a new franchisee.
Franchisee Accounting
Now let’s look at things from the perspective of the franchisee. When a franchisee pays an initial franchise fee to the franchisor, the payment can be considered an intangible asset. The franchisee can recognize this payout as an asset; if so, it should amortize the amount over its estimated useful life, which is probably the term of the franchise agreement. The asset should be tested for impairment at least once a year, so if its carrying amount is greater than its fair value, the franchisee has to take a write down. The judgment of what constitutes fair value is based on things like changes in revenues or expenses, regulatory changes, litigation, or maybe the loss of key personnel.
And what if the franchisee decides to pay a renewal fee when the initial franchise period expires? In that case, the fee is again treated as an intangible asset and amortized over the life of the new agreement.
It’s possible that a franchisee may sell out to a replacement franchisee, which usually calls for the payment of a transfer fee to the franchisor. The outgoing franchisee can account for this fee as a cost of selling the business, so it’s deducted from the gross proceeds of the sale.