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Franchisor Accounting: A Focus on Consolidation and Revenue Recognition Standards

Julie Wynstra

Marietta College

INTRODUCTIONA franchise is an agreement between two entities, the

franchisor and the franchisee, that gives the right to use

certain trademarks, marketing strategies, products, and

other items owned by the franchisor to the franchisee.2

The franchisee usually pays an initial fee to start the

franchise and then pays royalty fees. These fees cover

the cost of continued use of the franchise brands and

ongoing services provided by the franchisor. Common

franchises include restaurants, hotels, convenience

stores/gas stations, retail stores, and many different

services such as cleaning and vehicle repair. The

current and proposed standards of consolidation and

revenue recognition in the Accounting Standards

Codification are addressed, including an analysis of any

trade-offs between the qualitative characteristics of the

financial statements.

WHY CONSOLIDATION AND REVENUE RECOGNITION ARE ISSUES

REVENUE RECOGNITION STANDARDS

Franchises are a major factor of the businesses in this

country, and they are rapidly increasing in size and

output.

ANALYSIS AND SUMMARY

LITERATURE CITED

CONSOLIDATION STANDARDS

Over 750,000 businesses

Employing over eight million people

3% of total GDP

Possibility of improved earnings quality with IFRS: increase in small positive earnings and earnings persistence

1951: ARB 51 defined a Variable Interest Entity (VIE) as an entity in which a company has 50% or more controlling interest,

meaning ownership of the investee voting stock. VIE’s are subject to consolidation by the controlling company.7

2003: FIN 46R was issued by FASB in order to address and interpret ARB 51. This revision further characterized the “controlling

interest” in a VIE by stating that if a company was significantly impacted by the profits and losses of an entity, it was the primary

beneficiary and required consolidation of the VIE. VIE’s were also characterized as having insignificant investment risk because they are

“thinly capitalized” with little to no key decision-making abilities. Key decision-making abilities are those that would significantly impact

the economic performance of the entity.7

2009: FAS 167 required further analysis of whether the company has substantial control over key business processes that would “significantly impact”

the VIE’s economic performance.4 If the company had key decision-making abilities within the entity, it was a VIE and subject to consolidation. FASB

issue a new system of standards called the Accounting Standards Codification (ASC). ASC transferred FAS 167 to ASC 810-10, which is an overall

discussion of consolidation standards and determination of VIE’s. ASC 952-810-55-2 grants the franchisor scope exceptions to rights included in the

franchise agreement designed to protect the brands and trademarks of the franchisor. These can include, but are not limited to, the right to approve

locations and operation days/hours, products sold and inventory purchased, and suppliers of the franchisee.

Conclusion: Most franchisors do not consolidate franchisees. Most annual reports do not even mention consolidation. Of the 10 annual

reports I read, only two mentioned consolidation of franchisees in a short note. McDonald’s Corporation, for example, stated in their 2010

Annual Report: “The Company has concluded that consolidation of any such entity [including franchisees] is not appropriate for the

periods presented.”5

Current Revenue Recognition Standards for

Franchisors

Franchisors may recognize revenue from franchisees when services are substantially performed or goods are transferred

(ASC 952-605-25-1).

Initial Services Revenue: Franchisors may recognize revenue when services are virtually completed as stated in franchise

agreement( ASC 952-605-25-2).

Continued Services Revenue: Revenue from continued services must be recognized as a bundle unless the services are

separately estimable and/or specifically designated. Bundled services can only be recognized when the majority of all services have been performed (ASC 952-605-25-11 and ASC 952-605-25-

13).

Continued Product Sales: If a product is sold to franchisees at a bargain, then a portion of the cost can be deferred until the

product is sold. The portion to be deferred is usually the difference between the fair value and the bargain price, but the franchisor

can defer any cost in excess of the bargain price in order to make a decent profit (ASC 952-605-25-15).

Proposed Revenue Recognition Standards by

FASB and IFRS

In the proposed model, there are five distinct steps to determine criteria for when and how to recognize revenue. The revenue

recognition standards are essentially the same, however, the new model focuses on an asset and liability approach instead of an earnings process. This is consistent with FASB’s and IASB’s

frameworks’ approach.8

The five steps in the proposed modle are summarized below:

1: Identify the contract with the customer.

2: Identify the separate and bundled performance obligations.

3: Determine the transaction price.

4: Allocate the transaction price to performance obligations.

5: Recognize revenue when or as the obligation is satisfied.6

Step 2 focuses on determining single or bundled obligations. Obligations that are “highly interrelated” or “significantly modified” for the customer can be bundled together. Obligations that are regularly

sold separately or have stand-alone benefits can be recognized separately.6

Step 5 focuses on when revenue is recognized. Specifically for franchisors, it must be taken into account when the initial franchise agreement is created. The initial franchise license and any initial

services provided are combined into one obligation. Revenue from initial obligations are recognized “over time as the combined

obligation is satisfied.” 6

Enhancing Characteristics: Comparability and Understandability

Fundamental Characteristics: Relevance and Faithful Representation

The proposed revenue recognition standards focus on the

balance sheet approach instead of the earnings process

model. Even though it is generally accepted by the

profession, there is a possibility for relevance and faithful

representation to be minimized and comparability and

understandability to become key qualitative elements of the

financial statements.

1. “2012 Franchise Economic Outlook Fact Sheet.” IHS Global Insights for: International Franchise Organization. (2012): n. pag. Web. 20 Mar 2012.

2. Beshel, Barbara. “An Introduction to Franchising.” IFA Educational Foundation. (2010): n.pag. 20 Mar 2012. 3. “CON 8.” Financial Accounting Standards Board. (2010): n. pag. Web. 10 Apr. 2012.4. “FAS 167.” Financial Accounting Standards Board. (2009): n.pag. Web. 22 Mar 2012. 5. McDonalds Corporation. “2010 Annual Report.” 30. Web. 20 Mar 2012.6. Olsen, Lori, Weirich, Thomas R. “New Revenue Recognition Model.” Journal of Corporate Accounting and Finance. (2010): 55-61. Print.7. Reinstein, Alan, Gerald H. Lander and Steven Danese. “Consolidation of Variable Interest Entities: Applying the provision of FIN 46(R).”

CPA Journal (2006): 28-34. Print. 8. Ryerson III, Frank E. “Major changes proposed to GAAP for revenue recognition.” Journal of Finance and Accountancy. (2010): 1-9.

Print.9. Sun, Jerry, Cahan, Steven, David Emanuel. “How would the mandatory adoption of IFRS affect the earnings quality of US firms?”

Accounting Horizions. 25.4 (2011): 837-860. Print.

(1,9)

Franchisees are, in essence, a customer of the franchisors,

and as long as franchisors are careful to keep franchisees

at arm’s length, then consolidation will not become

necessary. I see no trade-offs concerning consolidation in

franchisor accounting because it is not an important issue.

Only two out of ten annual reports even included a

paragraph about consolidation.

To summarize, franchises are rapidly increasing in size and

output making it important to financial statement users,

creditors, and others how franchisors account for their

franchise agreements. Consolidation is not a major issue for

franchisors, but revenue recognition can be complex. In any

case, with franchise agreements becoming more and more

popular, it will be interesting to follow what direction FASB

and IASB take in the consolidation of standards.