Accounting Change Is More Dramatic Than Most
Ok, maybe the rule change isn't as dramatic as the Warner Bros. movie "The Accountant," starring Ben Affleck, but franchisors should still take note.
A new accounting rule will change when franchisors can recognize revenue from initial franchise fees—stretching it out for the life of a development agreement rather than when the first location opens—and could mean a big hit to income statements.
So warns Kevin Hein, a franchise attorney at Alexius in Denver. “For many franchisors, the revenue reduction could be quite dramatic,” he writes in a recent blog post calling the change “a great risk for your business model.”
For example, if the term of the franchise agreement is 10 years, “the first-year revenue from each franchise sale could be reduced by as much as ninety percent. In the case of multi-unit development agreements, the franchisor will now be required to recognize the development fee revenue as each location opens, rather than the day the first franchised location opens,” he explains.
So what, you say? (proving you’re not an accountant; if you’re an accountant you already know about this and are dealing with it.) First, it will dramatically reduce the financial statement income that a franchisor can report, while at the same time increasing short-term and long-term future liabilities on the balance sheet.
“This could effectively reduce or eliminate the profitability of most growing franchise systems that rely on franchise sales for a significant portion of their revenue during any calendar year,” Hein writes. In turn, the shakier-looking finances could turn off prospective franchisees, and perhaps prompt some states to impose financial assurance requirements on more franchisors—a costly proposition.
“And, you’re going to get a lot of unhappy franchisees who will say this is a get out of jail free card,” allowing them to get out of their contracts because the franchisor’s financial health is restated, he adds in an interview.
“We’re trying to get the word out to our clients, because if they had a year where they didn’t have as many franchise sales they should adopt this rule now,” he says. The rule change will become effective for audited financial statements issued after December 15, 2017, for publicly traded companies, and after December 15, 2018, for all other franchisors.
“It is not too early for franchisors to begin discussions with their auditors and legal advisers regarding the implications of this rule in the coming years,” he writes. The rule, known as ASC 606, was issued a year ago February by the Financial Accounting Standards Board and the International Standards Board.