BEST PRACTICES – FRANCHISORS MUST ADJUST TO NEW ACCOUNTING RULES

Following best practices, franchisors must adjust to new accounting rules, which take effect for reporting years beginning January 1, 2019 for most franchisors. Publicly traded franchisors were required to comply for reporting years beginning January 1, 2018.

The change has been on the horizon for many years and represents a change in GAAP (Generally Accepted Accounting Principles) to more closely align US GAAP with international GAAP. The new rules apply to all companies, not just franchisors.

The key issue affecting franchisors is what is referred to as “revenue recognition” rules. Historically, franchisors (and others) have recognized revenue for auditing, tax and other purposes, when it is received. The new rules require recognition at the point it is earned, the service is provided or the goods are delivered. The difference becomes most clear when analyzing how a franchisor can “recognize” an initial franchise fee. Historically, franchisors recognized such initial fees at or before the time the franchisee opened for business. Under the new rules, franchisors will be required to “recognize” such initial fees amortized over the term of the franchise agreement. Over a ten year franchise term, the Franchisor can now recognize only 10% of the initial fee each year.

There are similar issues relating to recognition of royalties, advertising fees and other fees. All revenues will be recognized at the time they are earned by providing or delivering the services or goods.

Understanding that there is a major change, franchisors should be working with their accountants and auditors to understand and prepare for the change. This change will, in many cases, require restating two years of financials in order to show the required comparisons. It may result in an apparent degradation of the financial condition of many franchisors and could result in a low or negative net worth. It will probably increase the likelihood of state franchise examiners imposing financial assurance conditions, including impounds, deferrals and bonds.

As with many changes, after a few cycles of dealing with the new revenue recognition rules, franchisors will find ways to show on their financial statements that they are healthy entities. Franchisees will also learn how to understand the new statements. Because all companies will be using the same rules, comparisons within an industry or otherwise between companies will be normalized. Meanwhile, every franchisor concerned about best practices should be immediately speaking with their accountant about this change as well as to an experienced franchisor lawyer.

The change has been on the horizon for many years and represents a change in GAAP (Generally Accepted Accounting Principles) to more closely align US GAAP with international GAAP. The new rules apply to all companies, not just franchisors.

The key issue affecting franchisors is what is referred to as “revenue recognition” rules. Historically, franchisors (and others) have recognized revenue for auditing, tax and other purposes, when it is received. The new rules require recognition at the point it is earned, the service is provided or the goods are delivered. The difference becomes most clear when analyzing how a franchisor can “recognize” an initial franchise fee. Historically, franchisors recognized such initial fees at or before the time the franchisee opened for business. Under the new rules, franchisors will be required to “recognize” such initial fees amortized over the term of the franchise agreement. Over a ten year franchise term, the Franchisor can now recognize only 10% of the initial fee each year.

There are similar issues relating to recognition of royalties, advertising fees and other fees. All revenues will be recognized at the time they are earned by providing or delivering the services or goods.

Understanding that there is a major change, franchisors should be working with their accountants and auditors to understand and prepare for the change. This change will, in many cases, require restating two years of financials in order to show the required comparisons. It may result in an apparent degradation of the financial condition of many franchisors and could result in a low or negative net worth. It will probably increase the likelihood of state franchise examiners imposing financial assurance conditions, including impounds, deferrals and bonds.

As with many changes, after a few cycles of dealing with the new revenue recognition rules, franchisors will find ways to show on their financial statements that they are healthy entities. Franchisees will also learn how to understand the new statements. Because all companies will be using the same rules, comparisons within an industry or otherwise between companies will be normalized. Meanwhile, every franchisor concerned about best practices should be immediately speaking with their accountant about this change as well as to an experienced franchisor lawyer.