A multi-unit franchisee is a retail or restaurant operator with a contract that sets its costs. The franchise agreement fixes royalty and advertising rates, development schedules and renewal conditions, and each store sits on a lease with its own economics. The audit is a store-by-store exercise in two questions: are the fees owed to the franchisor fully recorded, and are the leases and store assets carried at amounts the store can support.
Accounting framework
Revenue. Store sales are recognized at the point of sale, with gift cards and loyalty handled as contract liabilities. When the franchisor runs brand programs such as national gift cards and loyalty, funds settle between the parties. Read how funds flow and whether the franchisee is a principal or an agent. See revenue recognition audit procedures.
Fees to the franchisor. Royalties and advertising contributions are a percentage of sales under most agreements and are expensed as sales occur, so completeness is a recomputation. Initial franchise fees and development fees paid to the franchisor are assets that relate to the right to operate. Test the amortization period against the agreement term and any renewal rights, and read the agreement for conditions that could shorten it.
Leases. Under ASC 842, each store lease is a right-of-use (ROU) asset and a lease liability. A change in lease term triggers remeasurement of the liability, with the adjustment recorded against the ROU asset (ASC 842-20-35). Lease modifications, extensions and early terminations in a store base drive remeasurement. See ASC 842 lease accounting and private company elections and lease modifications.
Impairment. ROU assets and store-level fixed assets are tested under ASC 360 when events suggest the carrying amount may not be recoverable. An asset group is the lowest level at which identifiable cash flows are largely independent, which for a franchisee is the individual store in most cases. Subleasing a space for less than the head lease cost is an indicator. After an impairment, the written-down ROU asset is amortized, so lease cost shifts from a single straight-line charge to amortization plus interest on the liability. A decision to terminate early or abandon the space is a signal to test for impairment before remeasuring the lease, and leasehold improvements should have their lives shortened to the revised lease term. See impairment for private companies.
Risk areas
- Royalty and ad fund accruals. The percentage, the sales base and the timing can differ across agreements, including older stores on legacy terms.
- Underperforming stores. The impairment trigger decision is judgmental and sits with management.
- Closures and relocations. A closed store leaves a lease liability, an ROU asset, leasehold improvements and a landlord dispute.
- Development obligations. Failure to open on schedule can trigger penalties or loss of territory.
- Debt covenants. Lenders to franchisees often test fixed charge coverage that impairment and lease changes affect.
- Franchisor approvals. Remodel requirements, transfers and renewals create cash calls that management must plan for. See going concern where liquidity is thin.
Typical audit procedures
Fees. For each agreement, obtain the royalty and advertising terms and recompute expense for a sample of stores and months from point-of-sale sales. Agree to franchisor statements, and test the period after year-end for unrecorded fees. Confirm the balance with the franchisor and read for disputes or audit findings by the franchisor.
Leases. Obtain a lease schedule by store. Agree term, rent, escalations and options to the leases and amendments, and test the discount rate, the lease term conclusion and any modification. Recompute a sample of ROU assets and liabilities. For stores where the term changed in the year, test the remeasurement entry.
Impairment. Obtain store-level profit and loss statements with the cash flows used in management's analysis. Evaluate the triggers: sustained losses, a decision to close, sublease below cost, a loss of the franchise. For stores tested, test the undiscounted cash flows for reasonableness against history, trend and the agreement's remaining term, and recompute any fair value measure.
Closures. List all closed stores. For each, test the date of closure, the status of the lease (terminated, subleased or continuing), any termination fee, abandonment of improvements and the franchisor's consent. Confirm the unexpired lease obligation with the landlord where one exists.
Franchise agreement. Read renewals, transfer rights, territory protection and default provisions. Obtain a franchisor confirmation of agreements in good standing.
Worked example (illustrative numbers)
A franchisee operates 20 stores with a royalty of 5 percent and an advertising contribution of 4 percent of sales. Annual sales are $30,000,000, so fees should be $2,700,000 ($1,500,000 royalty plus $1,200,000 advertising). The books show $2,610,000. The $90,000 gap is traced to two older stores whose agreements carry a 6 percent royalty and one store where advertising was billed on net rather than gross sales. After correcting for the higher rates and the sales base, the books are short by $90,000 and the auditor proposes an accrual.
One store has a lease ROU asset of $400,000 and fixtures of $250,000, a carrying amount of $650,000. Losses have continued for two years and the owner plans to close the store at the next lease option date. Undiscounted cash flows over the remaining term are estimated at $480,000, which is below the carrying amount, so the store fails recoverability. Fair value is $300,000, and the impairment loss is $350,000, allocated to the assets of the group.
PBC items
- Franchise agreements, amendments and development schedules
- Franchisor royalty and advertising statements
- Store-level sales, profit and loss and cash flow forecasts
- Lease schedule, leases and amendments, and landlord correspondence
- Impairment analyses, with trigger assessment
- List of closed or relocated stores, termination agreements and sublease contracts
- Lender covenant calculations and compliance certificates
Red flags
- Royalty expense that does not move with sales
- Stores with multi-year losses and no impairment analysis
- Closed stores still showing ROU assets at lease commencement values
- Lease modifications recorded without remeasurement
- Unreconciled differences with the franchisor
- Covenant calculations that exclude impairment charges without an agreement permitting it
Sources
- FASB ASC 842-20-35 and ASC 360-10, Leases and Property, Plant, and Equipment (impairment of long-lived assets)
- Crowe, Lease modifications and other reductions: accounting impacts
- Cornell Law School Legal Information Institute, 16 CFR 436.5, Disclosure items (Items 5 and 6, initial and other fees)
- PwC Viewpoint, Revenue from contracts with customers: unexercised rights (gift card and loyalty liabilities)
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures
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