Income Wreck-ognition

Income Wreck-ognition

We are just around the corner from the deadline to comply with the new income recognition rules, which will likely “loot” much of the capitalization of an emerging franchisor.  The restatement will likely have the effect of driving many rapidly growing franchisors’ capital into the negative — jeopardizing (un-impounded) state registrations and impairing franchisee diligence.

Here’s what up

tarting with the 2019 audit (for privately held companies), all initial fees which are related to the trademark license must be amortized over the term of the franchise agreement.  Only that portion of the initial fee unrelated to the trademark license may be recognized upon opening of the franchise unit — like the cost of training related to learning QuickBooks, or getting a third-party certification or training (which has value outside the franchise).  Just how much of the initial fee is recognizable upfront is determined by your accountant.  In our experience, between 0 and 30% of the initial fee will be recognizable upon opening, with the balance amortized over the term of the franchise agreement.

To illustrate the issue, consider that last year, under the applicable rules, you could recognize the entire initial fee upon opening of the franchise unit — so if your initial fee was $40,000, $40,000 would hit your P&L as income.  Today, many franchisors may only be able to recognize 10% of the initial fee, or $4,000, with the remaining $36,000 booked to a liability on the Balance Sheet.  It’s as if you have to borrow $36,000 to open a unit to recognize $4,000.  There are few emerging franchisors who can withstand a 90% reduction in income recognition.

Making matters worse, the applicable rules require franchises to apply the new income recognition rule retroactively for 3 years, so that franchisors will have to restate income for the past 3 years, and unrecognize income improperly recognized in prior years. This change will increase liabilities on paper and erode equity. Any erosion in financial performance  will no doubt impair franchisors’ ability to become registered in the registration states.

The largest impact will be felt by the brands which were thinly capitalized and which grew quickly over the past 3 years.  If you sold no new franchises, the impact will likely be modest.

Capitalization Requirements:

As a preliminary matter, all financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles (“GAAP”), and audited in accordance with United States Generally Accepted Auditing Standards (“GAAS”), unless you are a start-up franchisor eligible to phase the disclosure of audited financial statements.

Although we cannot be certain what examiners may focus on in any particular instance, we know from prior experience that they consider a variety of factors in determining whether a franchisor is sufficiently well capitalized, including: (a) a positive overall net worth (excess of total assets over total liabilities); (b) a positive current ratio (excess of cash and other current assets over liabilities due within the year) plus sufficient working capital to cover projected openings; (c) the presence of fixed assets; and (d) income.

Generally, the net worth aspect of financial review is satisfied if you have a positive net worth, regardless of the amount (with the exception of Washington and Illinois, which have policies requiring all applicants to have a net worth of $100,000 or more).

In addition, in our experience, the current ratio must be positive and you must have sufficient working capital to support your franchising activities in the coming fiscal year. Examiners generally use the following formula to determine how much working capital is necessary for a franchisor to obtain a registration without an impound condition:

Cash and cash equivalents must at least equal:

Current Liabilities

+(Cost to Establish Franchisee X Number of Projected Openings During Coming Fiscal Year)

+(Cost to Establish Franchisee X Number of Franchisees Signed but not yet Open As of Year End)

Examiners may request additional capital if the applicant experienced a net loss or consecutive net losses during its prior fiscal year ends.

A list of other factors examiners have considered when reviewing financials include:

  1. The auditor’s opinion letter (i.e. were any qualifications placed on the audit opinion letter itself, or were any going concern issues raised?);
  2. Negative or inconsistent information in the notes to the financial statements;
  3. The proportion of tangible and intangible assets;
  4. The amount and maturities of debts;
  5. The debt/equity ratio;
  6. The amount of equity;
  7. The earnings history;
  8. The proportion of receivables compared to other assets; and
  9. The quality of the receivables themselves (e.g. financial statements reflect receivables that will not be collected, including bad debts, a debt discharge in bankruptcy, or the failure to allow for aged receivables).

Change in Treatment of Initial Franchise Fees in 2019 for Private Companies

The treatment of initial franchise fees changed this year for private companies (the change already took effect in 2018 for public companies).  Under the prior standard, initial franchise fees are “recognized, with an appropriate provision for estimated uncollectible amounts, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor.”  In most cases, as described above, this means that franchisors recognize the initial franchise fee once its pre-opening obligations are complete and upon opening of the franchised unit.

In Topic 606 of Accounting Standards Update No. 2014-09, the Financial Accounting Standards Board (“FASB”) has issued new standards that address the recognition of revenue in licensing contracts.  Because a trademark license is a core component of a franchise agreement, these standards will be applied to the recognition of initial franchise fees. Accounting firms have interpreted the new standard to presumptively require the initial franchise fees to be recognized over the course of the term of the franchise agreement, as opposed to recognizing the full fee at the time of opening.  As a result, franchisors will suffer from reduced assets and greater liabilities, resulting in a lower net worth on their balance sheet.  Franchisors that show a negative net worth in their audited financials often face impound conditions in certain franchise registration states, as well as additional questions from franchisee prospects regarding the strength of the system.

FASB recognizes that the new standard was not intended to create a presumption of amortization of initial franchise fees or to create a “default” amortization position.  FASB acknowledges that there can be multiple performance obligations in regards to revenue recognition of initial franchise fees that may permit a franchisor to recognize the initial fee or a portion thereof upon opening.  Auditors are not to merely spread recognition of the initial franchise fee over the term of the franchise agreement, but rather need to engage in an analysis of performance obligations and allocate that part of the transaction price to those performance obligations and recognize revenue at the time of performance.  While the analysis will differ for each franchisor and franchise arrangement, most franchisors provide training, site selection and other valuable products and services to franchisees at or prior to opening, which may mean in many instances that the initial franchise fee should can still be recognized as revenue at opening of the unit as has historically been the case.  Aside from the text of the accounting standard itself, FASB has issue some examples to guide franchisors and their accountants as to revenue recognition.

We recommend that you speak with your accountant to ensure that you put yourself in the best position to recognize revenue as early as possible.  We’re available to assist you and answer any questions you may have.

Do not hesitate to contact one of the attorneys at FisherZucker to discuss your particular situation.