A franchisor sells a brand, a system and support. The cash arrives in a few forms: an initial franchise fee when the agreement is signed, royalties as franchisees sell, and contributions to an advertising fund. ASC 606 decides when each becomes revenue, and franchise disclosure rules mean many franchisors need audited statements every year. Firms that take on a franchisor need to know both.
How revenue is recognized
Initial franchise fees. Franchisors treat the initial fee as consideration for the franchise license, which is a right to use symbolic intellectual property, the brand. That obligation is satisfied over the term of the agreement, so the fee is deferred and recognized over the franchise term rather than at signing. Services the franchisor provides before the franchisee opens are a separate question. They can be distinct from the license or can be part of it, depending on the facts.
Pre-opening services and ASU 2021-02. For franchisors that are not public business entities, ASU 2021-02 provides a practical expedient. The franchisor can treat certain pre-opening services as distinct from the franchise license. The services covered include site selection, help obtaining and preparing facilities, training, preparing operations manuals, bookkeeping, IT and advisory support, and inspection, testing and quality control programs. The expedient is a policy election. A franchisor that elects it may account for the covered services as one performance obligation, and it must disclose the election and the policy. The standalone selling price question remains: the franchise fee is not automatically the value of the services. The codification reference is Subtopic ASC 952-606.
Sales-based royalties. Royalties promised in exchange for a license of intellectual property are recognized when the later of two events occurs: the franchisee's sale takes place, or the performance obligation to which the royalty relates is satisfied. This is the sales-based royalty exception in ASC 606-10-55, and it is not optional when the royalty is within scope. Royalties are recognized in the period of franchisee sales. A franchisor that books royalties only when franchisees report, weeks later, needs an estimate for sales that have occurred but not been reported.
Renewals and transfers. Renewal fees are treated as contract modifications. Transfer fees are folded into the existing contract and recognized over the remaining term when no new distinct services follow the transfer.
Advertising funds. Contributions are collected by the franchisor and spent on marketing. The accounting turns on whether the franchisor controls the advertising service (principal) or acts for the franchisees (agent). See gross versus net revenue for the analysis. Test the fund's terms, who directs spending, and whether unspent amounts are a liability.
Franchise disclosure and audited statements
A franchisor's disclosure document, the FDD, must include financial statements under 16 CFR 436.5(u) (Item 21). They are prepared under US GAAP and audited by an independent CPA under US generally accepted auditing standards. Balance sheets are presented for the two most recent fiscal year-ends, and statements of operations, equity and cash flows for the three most recent fiscal years. A start-up franchisor can phase in: an unaudited opening balance sheet in the first year of selling franchises, and an audited balance sheet as of the end of the first fiscal period in the second year. A parent that commits to post-sale obligations or guarantees the franchisor's obligations needs its own statements, or the franchisor may use the affiliate's statements where the affiliate absolutely and unconditionally guarantees performance. Item 5 (initial fees) and Item 6 (other fees) of the FDD should agree to the revenue streams you audit, so reading the current FDD belongs in planning.
Risk areas
- Deferred fee release. Revenue should follow the franchise term, not the opening date, and the term start has to be defined correctly.
- Pre-opening services. The allocation of the fee between services and license, and the timing of services.
- Royalty cutoff. Reporting lags, unreported sales and franchisee disputes.
- Collectibility. Royalty and fee receivables from franchisees that are struggling or closing.
- Advertising fund. Principal or agent, and fund deficits that the franchisor funds.
- Area development and master franchise agreements. Fees tied to a development schedule that may be amended.
- Terminations and refunds. Refund rights and conditions disclosed in FDD Item 5.
- Fee relief. Royalty deferrals and waivers granted in a downturn.
Typical audit procedures
Read each franchise agreement type and the FDD. For a sample of new agreements, agree the fee, term and opening date to the signed agreement and recompute the deferred revenue schedule (see deferred revenue schedule). Obtain the policy memo on pre-opening services and test whether the franchisor elected the practical expedient, whether the election is disclosed, and whether the allocation matches the contracts.
For royalties, obtain franchisee sales reports and the franchisor's royalty billing. Test completeness by comparing franchisee point-of-sale data or sales reports to billings for a sample of franchisees and months, including the period after year-end. Recompute any accrual for unreported sales. Confirm material receivables and review aging, credit terms and collections after year-end.
For the advertising fund, obtain the fund's budget and disbursements, agree contributions to billings, and read how the franchisor makes decisions. For revenue recognized on renewals, read each modification and test the deferral. Where fees were waived or deferred, inspect the amendments and the revenue effect. Search for contingent liabilities under the search for unrecorded liabilities.
Worked example (illustrative numbers)
A franchisor signs a ten-year agreement for a $50,000 initial fee. The franchisor does not elect the practical expedient and concludes the pre-opening services are not distinct from the license. The fee is recognized straight-line over ten years from the date the franchisee can use the brand, or $5,000 a year. If the agreement is signed on July 1 with the term starting on that date, the year of signing shows $2,500 of revenue and $47,500 of deferred revenue. If the franchisor does elect the expedient and the training and site selection services have a standalone selling price of $10,000, that amount is recognized as the services are performed and the remaining $40,000 is recognized over ten years, or $4,000 a year. Royalties of 5 percent on franchisee sales of $2,000,000 in a quarter are $100,000 and are recognized as those sales occur, with the unreported portion estimated at quarter-end.
PBC items
- Executed franchise agreements, amendments and the current FDD
- Franchise fee and deferred revenue schedule by franchisee
- Royalty reports, franchisee sales reports and billings
- Advertising fund agreements, budget and disbursements
- Franchisee receivable aging and collections after year-end
- Accounting policy memo covering pre-opening services and ASU 2021-02
- Listing of terminations, refunds and fee waivers
Red flags
- Initial fees recognized at signing for the whole amount
- Royalty revenue that is lagged by a quarter without an accrual
- Pre-opening services recognized earlier than they are performed
- Advertising fund balances in deficit and funded by the franchisor
- Rising franchisee closures with royalty receivables still carried at full value
- FDD financial statements that do not agree to the audited statements
Sources
- FASB ASC 606-10-55, Revenue from Contracts with Customers (licenses of intellectual property and sales-based royalties)
- FASB ASC 952-606, Franchisors, Revenue from Contracts with Customers (ASU 2021-02), as described in the BDO article below
- Cornell Law School Legal Information Institute, 16 CFR 436.5, Disclosure items
- BDO, Franchisor Revenue Recognition: New Practical Expedient
- RevenueHub (BYU School of Accountancy), ASC 606 for Franchisors
- AICPA, AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Part of CORAA University · Specialized engagements: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error