Aside from the revenue recognition specific to initial franchise fees, there are many other forms of franchisor revenues to evaluate. When looking at other funds and fees paid by the franchisee to the franchisor, special considerations should be considered to determine the correct presentation and classification in the financial statements. A few of these fees commonly include items such as:
- Royalty fees
- Advertising, marketing, and brand fees
- Software, technology, equipment
- IT help desk
Management is required to apply the five-step revenue recognition process outlined by ASC 606 to each stream of revenue. There are a few overarching themes to consider when determining how to record these revenue streams, specifically related to the concept of royalty constraint and principal versus agent considerations.
Royalty constraint
- Typically, franchisors, depending on the language used in the franchise agreements, conclude that the performance obligation to provide royalty (or licensing services) and advertising services is not distinct from the franchise right and as such, should be recognized as a separate performance obligation.
- ASC 606 allows franchisors to recognize revenue that is sales or usage-based when the sale or usage occurs and the performance obligation is satisfied.
- As it relates to royalty fees or advertising, marketing, and brand fees, this typically means revenue is earned by the franchisor once the sale is made by the franchisee.
Principal versus agent considerations
Franchisors often collect fees from franchisees to cover fees they incur to run the business or sell products specific to running a franchised location to the franchisee. These fees need to be analyzed to ensure proper classification (gross vs. net) and presentation in the financial statements. This is dictated based on whether the franchisor is a principal or an agent in the transaction.
- If third-party involvement could possibly impact the delivery of goods or services to a franchisee, management must perform an analysis to determine if the franchisor is a principal or an agent.
- When a franchisor provides a good or service, they are likely the principal and should recognize the revenue on a gross basis.
- When the franchisor arranges the goods or services to be provided, but another party provides the good or service, they are likely the agent and should recognize the revenue on a net basis.
- Other factors to consider are control of the good or service, inventory risk, price discretion, and legal and physical control of title and control of the good or service.
- See below for examples of principal versus agent considerations:
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- Example 1 – A franchisor requires a franchisee to purchase a point of sale from them. The franchisor purchases the point of sale from the vendor, applies customizations, and then sells the point of sale to the franchisee. The franchisor is likely the principal as they control the inventory, set the price, and fulfill the purchase obligation for the franchisee, which would require the revenue to be recognized gross.
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- Example 2 – A franchisor requires a franchisee to purchase equipment from a predetermined vendor and requires the franchisee to directly interact with that vendor (i.e., the franchisor has no control of the inventory, no inventory at risk, no pricing discretion, no payment right or legal title to the assets) – this is not expected to have any impact on the financial statements as no revenue or expense related to this should pass through the franchisor.
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- Example 3 – A franchisor requires the franchisee to pay a set dollar per month to cover basic IT help desk services. These help desk services are fulfilled by the franchisor. The franchisor is likely the principal as they control the goods, set the prices, and fulfill the purchase obligation for the franchisee, which would require the revenue to be recognized grossly.
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- Example 4 – A franchisor requires 3% of franchisee sales to be paid monthly for advertising. The franchisor controls the advertising spending, including designing advertising programs, selecting vendors, and determining the timing of advertising programs; the franchisor is typically considered a principal and should recognize the revenue on a gross basis.
The above walks through a small subset of examples of possible fees required to be paid by the franchisor. It is important that management makes a complete list of all fees owed to the franchisor to ensure proper classification in the financial statements, as these amounts can have a very material impact on the statements.
If you have questions on any of the topics listed above, please contact your GBQ advisor.
