4May 2006 • The Franchise Lawyer

Revenue Recognition Rules for Franchise FeesBy Gerald C. Wells

The past few yearshave seen a

number of companieswith accountingproblems stemmingfrom improperlyrecognized revenue.These companieshave includedAmerica Online,

BoardVision, Cendant, Lucent,Legato, Microstrategy, Sunbeam andXerox. The failure to correctly applyrevenue recognition rules and stan-dards can result in seriousconsequences for a company, includingSEC audits and fines, shareholdersuits, the destruction of brand value,and the erosion of stock price. Toavoid these serious consequences, fran-chisors and franchisees need to besavvy about the concept of revenuerecognition and know the basic rules.

The phrase “revenue recognition”describes the point at which incomemay be included in a company’s profitand loss account. The fundamentalprinciple of revenue recognition is thatrevenue should not be recognizeduntil the revenue is realized or realiz-able and earned by the company. Toensure that this fundamental principleis followed, revenue recognition stan-dards or guidelines have beenpromulgated by the Securities andExchange Commission (“SEC”),Financial Accounting Standards Board,the Accounting Standards ExecutiveCommittee and the Emerging IssuesTask Force. The SEC, in particular,has prepared staff accounting bulletinson the application of general account-ing principles to revenue recognition.

In industries where expensive,custom products or solutions are deliv-ered in multiple parts over anextended period, the sales teams, attor-neys and accountants typically workhand-in-hand to structure the transac-tion and draft an agreement tomaximize early revenue recognition.As a general rule, most companiesprefer deferred revenue over norevenue. However, most companiesalso prefer to recognize revenue assoon as possible.

In the franchising world, FinancialAccounting Standards BoardStatement No. 45, Accounting forFranchise Fee Revenue (1981)(“Statement 45”) establishes standardsfor franchise fee revenue obtainedthrough a franchise agreement. Theremainder of this article focuses onStatement 45.

Single Unit Franchise Sale

For a single unit franchise sale,Statement 45 provides that revenueshould ordinarily be recognized when all material services or conditions relatedto the sale have been substantiallyperformed or satisfied by the franchisor.In Statement 45, “substantial perfor-mance” is defined as the point at which(a) the franchisor has no remainingobligation or intent — by agreement,trade practice or law — to refund anycash received or forgive any unpaid noteor receivable, (b) substantially all of theinitial services of the franchisor requiredunder the agreement have beenperformed, and (c) no other materialconditions or obligations related to thedetermination of substantial performanceexist. The commencement of operationsby the franchisee is presumed to be theearliest point at which substantial perfor-mance has occurred unless the franchisorcan demonstrate that substantial perfor-mance of all obligations has occurredbefore that time. When consideringwhether substantial performance hasoccurred, the franchisor must considerdiscretionary services and voluntaryservices that are provided by custom todetermine if all services have beensubstantially performed.

Some franchisors allocate each partof the initial franchise fee to a specificright granted by the franchisor andservice or product provided by thefranchisor. This may be desirable forfranchisors that (i) charge a large initialfranchise fee, (ii) provide tangibleproperty as part of the initial franchisefee, or (iii) grant franchises that take along time to become operational.When the initial franchise fee coverstangible property, such as equipment,inventory and signs, the portion of theinitial franchise fee attributable to the

tangible property (based on the fairmarket value) may be recognized at atime unrelated to the performance ofthe initial services.

But usually, all services are viewed asinterrelated, to such an extent that thecost attributable to each service cannotbe separated objectively. Unless a fran-chisor has evidence available of theactual cost attributable for individualservices, the initial fee should not beallocated as a means of recognizing anypart of the fee before all of the serviceshave been substantially performed.The additional documentation andstructuring and accounting workrequired to facilitate early revenuerecognition for single unit franchisesales does not ordinarily justify thisapproach. As discussed below,however, the additional documentationand structuring and accounting workmerits consideration when collectinglarge fees for area development rightsand master license rights.

Area Development and Master

License Sales

For sales of area development rightsand master license rights, Statement 45applies the same principle of recogniz-ing revenue discussed above: revenueshould ordinarily be recognized whenall material services or conditions relat-ing to the sale have been substantiallyperformed or satisfied. But considera-tion must also be given to whether theobligations depend significantly on thenumber of units to be established. Ifthe franchisor’s obligations dependsignificantly on the number of units tobe established, Statement 45 providesthat it is usually necessary to regard theagreement as a divisible contract andestimate the number of units involvedso that revenue can be recognized inproportion to the number of units forwhich the required services have beensubstantially performed. In estimatingthe number of units involved, consider-ation must be given to any maximumor minimum number of units providedfor in the agreement.

When a franchisor is receiving a largefee for area development rights ormaster license rights and the agreement

Gerald C. Wells

5 May 2006 • The Franchise Lawyer

is for a long period, it is important toconsider the franchisor’s revenuerecognition goals. Revenue recogni-tion should not always dictate how theagreement and transaction are struc-tured, but it should be considered.The franchisor’s training obligations,approval process, assistance obligationsand the amount and timing forpayment of additional unit franchisefees are some of the things that impactrevenue recognition in these situations.How the agreement is structured couldmean the difference between recogniz-ing all or most of the initial fee in thefirst year of a thirty year agreement orrecognizing 1/30th of the initial feeeach year over a thirty year period.

Area Representative Sales

The SEC has found that Statement45 does not apply to relationshipswhere an area representative does nothave the right to open, directly or indi-rectly, one or more franchises. Wherethe area representative is not authorizedto enter into franchise agreements fornew units, the area representative is nota party to franchise agreements for newunits and the franchisor retains soleapproval over franchisees for new unitspresented by the area representative,the area representative should betreated like an exclusive sales agent in aterritory. Because performance of anexclusive sales agent occurs over time,the SEC has determined that initialfranchise fees collected from an arearepresentative should be recognizedover the term of the area representa-tive’s agreement.

Refund Rights and Option to

Purchase Franchisee’s Business

Any refund right or practice will alsoimpact revenue recognition. Revenuecannot be recognized until there is noremaining obligation or intent (byagreement, trade practice or law) torefund the fees. Franchisors thatinclude refund rights in their agree-ments or have such practices shouldunderstand that this will impact thetiming of revenue recognition.Additionally, if a franchisor retains theright to purchase the franchisee’s busi-ness, the likelihood of the franchisoracquiring the business should beconsidered in accounting for the initialfee. If, when the right is given, thereis an understanding that the right willbe exercised or it is likely that the fran-chisor will acquire the business, theinitial franchise fee must be deferredand, when the right is exercised, thedeferred fee will reduce the fran-chisor’s investment in the business.Both Boston Chicken, Inc. andEinstein Noah Bagel Corp. were thesubject of class action claims byinvestors who alleged, among otherthings, that these companies improp-erly recognized revenue from areadevelopers where the companies hadrights, and the future intent, to exer-cise options to acquire the areadevelopers’ businesses.

Continuing Fees

In structuring franchise relationships,it is also important to consider contin-uing services in relation to continuingfees that will be collected. There are

times when initial franchise fees arelarge and continuing fees are small (ornot required) in relation to futureservices. These include situationswhere a franchisor (i) only requires aninitial franchise fee and does notimpose a royalty or (ii) collects theentire or majority of the initial fran-chise fee in advance for units that willbe developed under area developmentor master license rights. If it is likelythat the continuing fee will not coverthe cost of the continuing services anda reasonable profit on the continuingservices, a portion of the initial fran-chise fee should be deferred andamortized over the life of the franchise.For example, if a franchisor offerscontinuing services to franchisees butthe franchisor does not collect a royaltyand operates a system where revenue isderived by products purchased by fran-chisees from an affiliate of thefranchisor, the franchisor may need todefer and amortize the initial franchisefee over the life of the franchises.

Conclusion

When structuring and documentingfranchise relationships, the sales teams,attorneys and accountants should worktogether to find the right structurethat meets the operational, legal andrevenue requirements of the franchisor.This collaborative approach alsoinsures accurate revenue reporting thatis grounded in the legal agreement.

Gerald C. Wells is a partner at SmithGambrell & Russell in Atlanta,Georgia.

The Fine Art of Franchise Law

Mark your calendars! The Forumwill present the 29th Annual

Forum on Franchising in Boston,Massachusetts on October 11-13,2006. The Forum on Franchising willbe held this year at the Westin CopleySquare, a hotel centrally located in theheart of Boston and providing easyaccess to many of Boston’s notewor-thy attractions.

This year’s Forum will blend severalnovel program concepts with programsthat will elucidate traditional franchiseissues from a new perspective. TheWednesday Intensives will include a

negotiation workshop to be presentedin conjunction with the HarvardProgram on Negotiation. The Forumwill present, for the first time, a work-shop on the psychology of thefranchise relationship featuring GregNathan, an Australian consultant,psychologist, and former franchisorand franchisee. The program will alsoinclude workshops on understandingand using financial statements; plan-ning for disasters and coping withthem when they hit; and embracingdiversity in franchise systems – manag-ing associated legal risks.

Boston provides a wonderful venuefor social interaction among Forumparticipants. The Thursday nightreception will be held at the Museumof Fine Arts, and the Friday nightreception and dinner will be held atthe Kennedy Library. Both venues arevery attractive and offer exciting andfascinating exhibits.

Be sure to watch for the meetingbrochure! We look forward to seeingyou there.

Jack Dunham and Andy Scott2006 Program Co-chairs