GAAP is the four-letter acronym for Generally Accepted Accounting Principles….most non-accountants have other four-letter words they might use to describe it. Most entrepreneurs and business owners I talk to rightfully comment they don’t care about GAAP because it doesn’t apply to their business. Unfortunately, franchisors are not in that category.
Most franchisors think of themselves as small business owners at first. Most can attest that it takes a large number of franchisees to reach a 7-figure top line. If that is the case, then why do these businesses get caught up in GAAP? The answer is the Franchise Disclosure Document (“FDD”). This document is required for franchisors to sell to prospective franchisees. One of the requirements of the FDD is that you must include audited financial statements. Because of this, most franchisors are required to care about GAAP (we won’t get into the exceptions).
In May 2014, the Financial Accounting Standards Board released new rules on how revenue should be recognized in the financial statements according to GAAP. Because my industry moves fast (sarcasm intended), these rules became effective for most franchisors in 2019. These new rules significantly affect franchisors when it comes to accounting for franchise fees, area development fees, and gift card revenue.
For most companies, these next few months will be the period when they wrap up their 2019 books and get them ready to be audited. That means it will be the first time most of these companies have to deal with these new rules. Most companies will need to rely on a financial professional above their bookkeeper in order to handle this new standard.
Franchise Fees
While some franchisors don’t necessarily have to deal with the area developer fees or gift card revenues, almost all of them have franchisee fee revenue.
Under the previous guidance, recognizing revenue from franchisee fees was very straight forward. Franchise fees were often recognized at a point in time shortly after entering into the franchise agreement, typically after certain initial obligations were completed. This meant that these revenues were often able to be recognized close to the time the franchise agreement was entered into.
Under the new guidance, revenue is now recognized as a distinct series of performance obligations and essentially is a license that allows the franchisee to use the franchisor’s intellectual property. Intellectual property may include pre-opening services, marketing services, and use of the franchisor’s systems. Accordingly, license agreements typically include multiple support services that equate to multiple performance obligations. Certain upfront pre-opening activities may be determined to be distinct performance obligations separately from the license agreement if the fair value of those services is determinable. There are methods described in the literature of how this can be done, however, for many small franchisors, it may not be practical (or necessary).
Given the highly interdependent nature of the license agreement, related use of intellectual property and other factors, many franchisors are recording all franchise fee revenues over the expected life of the franchise agreement. The series of distinct service obligations may be considered a single performance obligation.
Area Developer Fees
In Area Development agreements (also called Master Franchises), an area developer franchisee typically purchases the rights to develop and own an exclusive area development territory and then sells portions of this territory to new sub-franchisees. Area development agents (also called master franchisees) then often split the roles and responsibilities as well as the franchise fees and ongoing royalties with the franchisor.
A development right has no value without the ability to operate under a franchise agreement. Area development agreements would most likely not be considered a separate performance obligation. Amounts paid to obtain the area development rights and amounts paid for franchise rights would be recognized over the life of the expected benefit (or the life of the underlying franchise agreement). In practice, some companies (especially newer, less experienced franchisors) might opt to use the initial life of the franchise agreement as a basis for the expected life over which to record the revenues, on a straight-line basis.
Expected life an either of the scenarios discussed can be complicated. In determining the expected life, franchisors would have to consider the frequency of renewals and whether fees paid to renew the license agreement after the initial term are substantive.
Why Does This All Matter?
That is a great question….for starters, it matters because franchisors are required to report their financial statements in accordance with GAAP.
A second reason might be for investment. A growing franchisor might get to the point they are wanting or require outside investment for their business. It is important that financial statements can be articulated to potential investors. If the owner of the franchise can’t do that, then they should have someone on hand that can.
It is possible to carve up the franchise agreement and recognized revenue on certain distinct services. This would be important if a franchisor has specific services they provide at a great cost and want to match up revenue with those expenses. If certain services can be distinguished as having value separate from the franchise agreement and those services’ fair value is estimable, revenue can be recorded as those services are completed. Let’s put that in plain English….
Let’s say a franchisor provides construction management services to both franchisees and on a standalone basis to other independent (but like) businesses. That revenue may potentially be about to be carved out of the franchise agreement and recognized when completed, rather than being amortized over the life of the agreement.
Don’t Forget About Gift Card Revenue
Some franchisees have systems and rules in place where they collect or have rights to certain gift card revenue. The new guidance lays out three methods to recognized revenue from redeemed and unredeemed gift cards. It is not important at this time that franchisors have a deep understanding of these methods. However, it is important to know that if a franchisor has gift card sales, there are specific rules they must follow in recognizing revenue.
So Where To Go From Here
Congratulations, if you are reading this you made it through approximately 1,000 words on how to recognize revenue. You are practically an accountant now!
I always tell my franchising clients that it is not important they know the rules. It is important, however, that they know there are specific rules that exist around these fees. I highly recommend bringing in a financial professional to help them with these rules. For the cost it takes to hire someone, a franchisor often can get valuable input in other areas of their business and save money in audit fees.
Krieger Analytics works with franchisors to help them with their profits and grow through accounting, finance, and bookkeeping. I am a great partner to work with for franchisors because like them, I am a franchisor. I am not the perfect match for all franchisors so I have honest conversations upfront to see if I am are a good match for you. Contact us now for a call to learn more about us and have a conversation about your business.