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Income Wreck-ognition: Part IV

Need some more background? Check out Income Wreck-ognition: Part I and Part II. and Part III: Survey

Maximizing Income Recognition with Your Outside Auditors

The adoption of the new income recognition standards will affect most franchisors as they pursue their 2019 audit in time to issue their FDD in 2020. The effort to maximize income recognition is not an all-or-nothing game. Based on our experience, auditors are all over the place in how they approach the issue and what they permit a franchisor to recognize. Some of the disparity results from the specific facts and circumstances of each franchisor. However, there also appears to be a lot of confusion as to the standard, and some fear on the part of auditors, causing them to take the most conservative position. But not recognizing income when you should is just as misleading as recognizing income when you should not.

Generally, an auditor should recognize that portion of the initial franchise fee upon the provision of any distinct goods or services. A good or service is distinct if the franchisee can benefit from the good or service on its own and it is separately identifiable from other promises in the franchise agreement. Usually, a franchise agreement requires a franchisor to provide: (i) site selection assistance; (ii) construction management or other real estate services; and (iii) training. Take a critical eye to these obligations, and determine: (i) whether the franchisee can benefit from all or part of these obligations apart from the trademark license; and (ii) what the value to the franchisee may be.

Take, for example, site selection obligations. If your site selection criteria are separate and usable apart from the trademark license – such as traffic count and visibility – such obligation would seem distinct, as the franchisee could use the location for any retail business. If you provide lease review or negotiation, or visit sites to provide services which have a value on the open market, then you have an argument that the fair market value of these services should be recognized when the unit opens.

If any portion of the initial fee is paid to a bona fide third party for site selection, lease negotiation, construction management, real estate or to any third-party training company, and those services have a calculable value on the open market, there is good argument that they should be recognized in the year incurred. If your own internal employees perform the same services, then you should provide your auditors with evidence of the cost of comparable services.

If you provide other real estate services, or incur fees from third-party landlords or brokers in connection with the ultimate site and the site is relatively ordinary – that is, it doesn’t have an ice cream cone roof or other specially-branded roof or design, like Pizza Hut did in the 1970s – like an inline or freestanding unit in a strip mall, you have a better argument for recognition. Because the site is useable for operating another retail or restaurant business, it is not related itself to the trademark license. The more generic the space and demographics, the better the argument for recognition.

Regarding the training component of the initial fee, much time is likely dedicated to the particular operation of the franchise business, in a specifically prescribed manner in strict compliance with the operations manual. But each element of training needs to be broken down and analyzed. If your training includes education on commercially available equipment, like restaurant or gym equipment, or a POS system or bookkeeping software, that portion of the training is likely useable apart from the trademark license and could be recognized.

With respect to multi-unit franchisees and area developers, intellectually, you should only recognize a percentage of these fees on the first unit, when it opens for business, because the training would have less or no value for the second and successive units. However, if you provide training to a new dedicated designated manager or other personnel who must attend and complete initial training for each outlet developed, the initial training arguably has the same value for the second and successive units and the percentage of the initial franchise fee dedicated for the initial training could be recognized upfront.

You shouldn’t have to break down the initial franchise fee into these components, but rather should be able to establish to your auditor the time spent and benefit conferred on the franchisee, and assist in determining the fair market value of these services. If all or a portion of your training is offered to third parties or independents for a “tuition,” or in connection with equipment sales to competitors or independents, then the cost of such training as part of the initial fee should be recognized upon opening.