In franchising, revenue recognition refers to how and when a franchisor records income from franchise-related activities. Traditionally, this depended on the initial franchise fee, but modern accounting standards require a more nuanced approach that recognises revenue as performance obligations are met. Franchisors must identify distinct goods or services within the franchise agreement (e.g., the licence to use the brand, training, ongoing support) and recognise revenue as each of these is delivered to the franchisee. This often means revenue must be recognised over time, rather than up front.

Below, we’ll explain the different types of franchise fees, how to recognise revenue from each, how to apply the five-step revenue recognition model to franchises, and best practices for franchise revenue recognition.

What’s in this article?

• Types of franchise fees and how to recognise them
  
• How to apply ASC 606 to franchise revenue
  
• Challenges in franchise revenue recognition
  
• Best practices for accurate revenue recognition
  

Types of franchise fees and how to recognize them

Franchise fees can include ongoing royalties, advertising fees, and sales of goods or services. According to accounting standards such as Accounting Standards Codification (ASC) 606, each of these fee types is subject to different criteria and timings for revenue recognition. Here’s are the different types of franchise fees and how to recognise them:

• Initial franchise fees: Franchisees pay initial franchise fees up front. These fees generally cover the right to operate under the franchisor’s brand and system. The franchisor recognises revenue from these fees over time as they fulfil obligations like training, support, or territorial exclusivity.

• Ongoing royalties: A franchisee typically pays royalties based on a percentage of their sales, and the franchisor recognises their royalties as revenue as the sales occur. These are considered distinct, performance-based obligations, and the timing of revenue recognition aligns with the franchisee’s sales reporting periods.

• Advertising fees: Franchisors often collect advertising fees from franchisees to fund marketing and promotional activities. They recognise these fees as revenue when the advertising services are provided or incurred. If the franchisor manages these funds collectively for the benefit of the franchise network and the fees are not meant for a distinct service, the franchisor recognises the funds as part of the initial franchise fee.

• Sales of goods or services: When franchisors sell products, equipment, or services to franchisees, revenue recognition occurs when control of these goods or services transfers to the franchisee. This usually happens at the point of delivery or when contractual terms are met, depending on the agreement.

How to apply ASC 606 to franchise revenue

ASC 606 provides franchisors with a framework to ensure their financial reporting reflects the true economic activity and value exchange between them and their franchisees. Here’s how to apply this standard to franchise revenue.

Step 1: Identify the contract with a customer

First, identify the contract between the franchisor and the franchisee. In franchising, this typically means the franchise agreement, which outlines the terms, obligations, and rights of both parties. The contract must have clear terms, be approved by both parties, and establish the likelihood of collecting payments in exchange for the goods or services provided.

Step 2: Identify performance obligations in the contract

Next, the franchisor needs to define the distinct performance obligations in the agreement. These are specific, separate promises to deliver goods or services. Common obligations include granting the right to use the brand, initial training, territory protection, and ongoing support services. The franchisor must assess each obligation to determine if it is distinct and should be treated separately in terms of revenue recognition.

Step 3: Determine the transaction price

The transaction price is the total amount the franchisor expects to receive. This includes fixed amounts (e.g., up-front franchise fees) and variable amounts (e.g., royalties based on sales). The franchisor must estimate variable considerations carefully, using either the “expected value” method (considering a range of possible outcomes) or the “most likely amount” method (considering the most likely outcome). The franchisor must recognise revenue only to the extent that it is probable a substantial reversal won’t occur in the future.

Step 4: Allocate the transaction price to performance obligations

Once the performance obligations are identified, the franchisor must allocate the transaction price across them based on their stand-alone selling prices. This allocation determines how much revenue is associated with each obligation and ensures revenue is recognised in a way that reflects the delivery of goods or services to the franchisee.

Step 5: Recognise revenue when (or as) performance obligations are satisfied

Revenue recognition occurs when (or as) the franchisor satisfies a performance obligation. For obligations satisfied over time, such as ongoing support and training, the franchisor recognises revenue over that same time period. For obligations satisfied at a point in time, such as product sales and one-time services, the franchisor recognises revenue when control transfers to the franchisee.

Challenges in franchise revenue recognition

Revenue recognition in franchising can be complex due to the structure of franchise agreements and the variety of revenue streams involved. Here are some challenges that franchisors often face with revenue recognition.

Bundled services

Franchisors often bundle multiple services (e.g., initial training, site selection, marketing support) into the franchise fee. Determining how to separate these services for revenue recognition can be challenging. Franchisors might need to give each service a stand-alone selling price and must recognise revenue as each service is performed. This necessitates careful tracking and estimation.

• Example: A fast-food franchise incorrectly recognised the entire franchise fee when a new location opened. Part of the fee covered ongoing training and support, which should have been recognised over the time period the services were provided. This led to a substantial restatement of previously reported profits.
  

Variable consideration

Royalties based on a percentage of the franchisee’s sales are a form of variable consideration that can fluctuate. Predicting these fluctuations for revenue recognition purposes can complicate financial forecasting. Franchisors must also decide whether to recognise revenue based on expected sales, which can lead to adjustments in future periods if actual sales differ from estimates.

• Example: A fitness franchise faced a legal dispute over how royalties were calculated and recognised. The franchisor recognised royalties based on projected annual sales of new franchise units, but actual sales were much lower. This resulted in litigation with franchisees who felt misled about the viability and profitability of their franchises.
  

Rebates and incentives

Some franchisors offer franchisees rebates or incentives like reduced royalties in their early months of operation. Accounting for these incentives requires adjusting the transaction price and can impact the timing of revenue recognition, especially if the incentives are contingent on future events.

• Example: A retail franchise offered initial inventory rebates to franchisees but failed to properly account for these rebates as reductions in revenue. This oversight led to an overstatement of revenue in financial statements, which was found during an audit and required corrective action under ASC 606.
  

Best practices for accurate revenue recognition

Revenue recognition can be a challenging process to master, but there are some best practices that can make the process go more smoothly. Here’s a rundown.

Create a franchise-specific revenue recognition plan

Develop a dedicated playbook that addresses how ASC 606 applies to your specific franchise model. Include concrete examples for different types of franchise fees, royalties, marketing fund contributions, and product sales. Customise the plan to show how unique aspects of your business – such as regional variations in agreements and special incentives – impact when and how revenue is recognised.

Segment revenue by franchisee maturity

Consider that new franchisees might require different levels of support and have different earning patterns from those of established ones. Revenue recognition can shift based on the franchisee’s business stage (i.e., whether it’s their first year or their 10th in operation). For example, franchisors might recognise initial fees for new franchisees over a longer period due to the need for more intensive support and training, while more experienced franchisees might transition to different structures that could impact ongoing fee recognition. Create segmented reporting categories that reflect these differences and adjust revenue recognition practices accordingly.

Build a cross-functional revenue task force

Rather than leaving revenue recognition solely to the accounting department, form a cross-functional team that includes franchise development, operations, and legal. This task force can regularly review and refine how revenue is recognised, especially when new types of services or products are introduced. By including different perspectives, you can catch potential misalignments early and prevent new initiatives from inadvertently complicating revenue recognition.

Develop what-if scenarios for revenue recognition

Franchise agreements are not static. They evolve with renewals, add-ons, and modifications. Build what-if scenario models to understand how changes to agreements (e.g., adding new services, extending terms) would impact revenue recognition so you can prepare for different situations and maintain agile revenue recognition practices. For example, consider how adding a new digital marketing service that’s billed differently could change when and how you recognise the associated fees.

Localise revenue recognition practices as needed

Franchise operations might vary by region or country, each of which can present different expectations, legal environments, and market conditions. Design your revenue recognition practices to reflect these differences where it makes sense to. For instance, if franchisees in one country receive more support services due to local regulations or market entry tactics, ensure your revenue recognition practices reflect this added layer of service rather than applying a one-size-fits-all model.

Use franchisee feedback for better estimates of variable consideration

Actively engage with franchisees to understand their projections, challenges, and growth plans. Their feedback can provide more accurate, real-time insight into what to expect and help you refine your models and stay realistic about revenue variability. Regular check-ins or surveys can serve as a feedback loop to adjust your revenue forecasts accordingly.

Clarify the fine print on marketing funds

Marketing fees collected from franchisees can be a grey area. If your franchise agreement specifies that these fees are to be pooled and used for system-wide marketing, clearly define and track usage. Whether these fees count as revenue or liabilities can depend on how the funds are managed and spent. If the fees are revenue, recognise them as the marketing activities are performed; otherwise, manage them as a separate fund to avoid confusion or misreporting.

Create quick reference guides for field teams

Field operations teams often play an important role in day-to-day relationships with franchisees and might shape agreements or modifications that impact revenue recognition. Provide these teams with quick reference guides on how changes to franchise agreements or terms might impact financial reporting. This will help them understand the downstream effects of their decisions on accounting.

Align internal incentives with accurate revenue reporting

If internal incentives (such as bonuses for franchise sales teams or regional managers) are tied to revenue, ensure these incentives don’t inadvertently encourage practices that could lead to aggressive or premature revenue recognition. Align incentives with sustainable growth and accurate reporting, not just short-term gains. A balanced approach encourages responsible behaviour that supports long-term franchise relationships and compliance.