Income Wreck-ognition: Here’s What You Should Know
The deadline to comply with the new income recognition rules is upon us, which will likely “loot” much of the capitalization of an emerging franchisor. The restatement will likely have the effect of driving many rapidly growing franchisors’ capital into the negative — jeopardizing (un-impounded) state registrations and impairing franchisee diligence.
HERE’S WHAT’S UP
Starting with the 2019 audit (for privately held companies), all initial fees which are related to the trademark license must be amortized over the term of the franchise agreement. Only that portion of the initial fee unrelated to the trademark license may be recognized upon opening of the franchise unit — like the cost of training related to learning QuickBooks, or getting a third-party certification or training (which has value outside the franchise). Just how much of the initial fee is recognizable upfront is determined by your accountant. In our experience, between 0 and 30% of the initial fee will be recognizable upon opening, with the balance amortized over the term of the franchise agreement.
To illustrate the issue, consider that last year, under the applicable rules, you could recognize the entire initial fee upon opening of the franchise unit — so if your initial fee was $40,000, $40,000 would hit your P&L as income. Today, many franchisors may only be able to recognize 10% of the initial fee, or $4,000, with the remaining $36,000 booked to a liability on the Balance Sheet. It’s as if you have to borrow $36,000 to open a unit to recognize $4,000. There are few emerging franchisors who can withstand a 90% reduction in income recognition.
Making matters worse, the applicable rules require franchises to apply the new income recognition rule retroactively for 3 years, so that franchisors will have to restate income for the past 3 years, and unrecognize income improperly recognized in prior years. This change will increase liabilities on paper and erode equity. Any erosion in financial performance will no doubt impair franchisors’ ability to become registered in the registration states.
The largest impact will be felt by the brands which were thinly capitalized and which grew quickly over the past 3 years. If you sold no new franchises, the impact will likely be modest.
These changes may cause successful and active franchisors to be put in the red based on an accounting rule, which, alone, doesn’t accurately depict the quality of the franchisor, or the economic opportunity represented by the franchise.
HOW WILL THIS AFFECT MY STATE REGISTRATIONS?
Although we cannot be certain what examiners may focus on in any particular instance, we know from prior experience that they consider a variety of factors in determining whether a franchisor is sufficiently well capitalized, including: (a) a positive overall net worth (excess of total assets over total liabilities); (b) a positive current ratio (excess of cash and other current assets over liabilities due within the year) plus sufficient working capital to cover projected openings; (c) the presence of fixed assets; and (d) income.
Generally, the net worth aspect of financial review is satisfied if you have a positive net worth, regardless of the amount (with the exception of Washington and Illinois, which have policies requiring all applicants to have a net worth of $100,000 or more).
In addition, in our experience, the current ratio must be positive and you must have sufficient working capital to support your franchising activities in the coming fiscal year. Examiners generally use the following formula to determine how much working capital is necessary for a franchisor to obtain a registration without an impound condition:
Cash and cash equivalents must at least equal: (Current Liabilities) + (Cost to Establish Franchisee * Number of Projected Openings During Coming Fiscal Year) + (Cost to Establish Franchisee * Number of Franchisees Signed but not yet Open As of Year End)
Examiners may request additional capital if the applicant experienced a net loss or consecutive net losses during its prior fiscal year ends.
A list of other factors examiners have considered when reviewing financials include:
- The auditor’s opinion letter (i.e. were any qualifications placed on the audit opinion letter itself, or were any going concern issues raised?);
- Negative or inconsistent information in the notes to the financial statements;
- The proportion of tangible and intangible assets;
- The amount and maturities of debts;
- The debt/equity ratio;
- The amount of equity;
- The earnings history;
- The proportion of receivables compared to other assets; and
- The quality of the receivables themselves (e.g. financial statements reflect receivables that will not be collected, including bad debts, a debt discharge in bankruptcy, or the failure to allow for aged receivables).
WHAT CAN I DO ABOUT IT?
The adoption of the new income recognition standards will affect most franchisors as they pursue their 2019 audit in time to issue their FDD in 2020. The effort to maximize income recognition is not an all-or-nothing game. Based on our experience, auditors are all over the place in how they approach the issue and what they permit a franchisor to recognize. Some of the disparity results from the specific facts and circumstances of each franchisor. However, there also appears to be a lot of confusion as to the standard, and some fear on the part of auditors, causing them to take the most conservative position. But not recognizing income when you should is just as misleading as recognizing income when you should not.
Some large auditing firms have determined that, as a matter of audit policy, they will require 100% of the initial fee to be amortized. Most auditing firms will work with the franchisor to determine what portion of its initial franchise fee relates to obligations which arise independent of the trademark license, and is therefore able to be recognized upon completing specific pre-opening performance obligations – at least, that is supposed to occur.
While auditors will make each analysis on a case-by-case basis, an auditor should generally recognize that portion of the initial franchise fee upon the provision of any distinct goods or services. A good or service is distinct if the franchisee can benefit from the good or service on its own and it is separately identifiable from other promises in the franchise agreement. Usually, a franchise agreement requires a franchisor to provide: (i) site selection assistance; (ii) construction management or other real estate services; and (iii) training. Take a critical eye to these obligations, and determine: (i) whether the franchisee can benefit from all or part of these obligations apart from the trademark license; and (ii) what the value to the franchisee may be.
Take, for example, site selection obligations. If your site selection criteria are separate and usable apart from the trademark license – such as traffic count and visibility – such obligation would seem distinct, as the franchisee could use the location for any retail business. If you provide lease review or negotiation, or visit sites to provide services which have a value on the open market, then you have an argument that the fair market value of these services should be recognized when the unit opens.
If any portion of the initial fee is paid to a bona fide third party for site selection, lease negotiation, construction management, real estate or to any third-party training company, and those services have a calculable value on the open market, there is good argument that they should be recognized in the year incurred. If your own internal employees perform the same services, then you should provide your auditors with evidence of the cost of comparable services. If you provide other real estate services, or incur fees from third-party landlords or brokers in connection with the ultimate site and the site is relatively ordinary – that is, it doesn’t have an ice cream cone roof – like an inline or freestanding unit in a strip mall, you have a better argument for recognition. Because the site is useable for operating another retail or restaurant business, it is not related itself to the trademark license. The more generic the space and demographics, the better the argument for recognition.
Regarding the training component of the initial fee, much time is likely dedicated to the particular operation of the franchise business, in a specifically prescribed manner in strict compliance with the operations manual. But each element of training needs to be broken down and analyzed. If your training includes education on commercially available equipment, like restaurant or gym equipment, or a POS system or bookkeeping software, that portion of the training is likely useable apart from the trademark license and could be recognized.
You shouldn’t have to break down the initial franchise fee into these components, but rather should be able to establish to your auditor the time spent and benefit conferred on the franchisee, and assist in determining the fair market value of these services. If all or a portion of your training is offered to third parties or independents for a “tuition,” or in connection with equipment sales to competitors or independents, then the cost of such training as part of the initial fee should be recognized upon opening.
We recommend that you speak with your accountant to ensure that you put yourself in the best position to recognize revenue as early as possible. We’re available to assist you and answer any questions you may have. Do not hesitate to contact one of the attorneys at FisherZucker to discuss your particular situation.