Analysis of the Impact of the FASB Rule Change

Based on analysis of the original proposed FASB revenue recognition rules, franchising as we know it would have been dramatically impacted:

  • 930 brands would have been at serious risk of bankruptcy or closure in the first three years of the rule going into effect. The associated 104,098 franchised small businesses would correspondingly have faced closure, causing approximately 1.1 million job losses.
  • The majority of the remaining 1800 brands that could handle the negative financial impact would have to curtail their growth significantly, thus shrinking the rate of new small business development and corresponding job creation. Potentially as many as 35,000 new small businesses would not open and 364,000 jobs not created annually.
  • Almost all of the 300+ start-up brands that begin to offer franchises each year would never get off the ground.

Here’s a simple example of how the addition of a new franchised unit under the original proposed rule would impact a franchisor’s financial health:

A franchisor signs up a franchisee who would be required to pay an initial franchisee fee of $36,000 (approximate industry average) for a 10-year agreement.  Under the proposed rule, in the first year of that franchisee’s unit operations, the franchisor would be allowed to only recognize revenue of $3,600, would pay taxes of $1,400 on that revenue, and incur significant pre-opening expenses related to recruitment, training, site selection etc.

In year two, the franchisor would recognize revenue from that franchisee initial franchise fees of another $3,600.  However, under tax law the franchisor can only defer revenue for one year so it would have to recognize the balance of the $36,000 initial franchisee fee.  The franchisor would need to draw cash from the business of approximately $13,000 to pay the second year tax liability. Because of the proposed FASB rule, it could only recognize two years of that initial franchise fee, or $7,200 but have paid taxes of approximately $13,000, thereby reducing net worth by the difference, or $7,200.

In other words, for each unit added, the franchisor would be reducing its equity by $7,200, only recovering that accounting impact over the following two years as $3,600 is recognized each year.  If enough units are added on an annual basis, less well capitalized franchisor total net worth could easily turn negative which, in turn could cause state regulatory agencies to require that the franchisor escrow the entire initial franchise fee of $36,000, thereby creating further cash flow pressures.  Most emerging brands do not have the reserve capital to withstand such an impact and it would clearly have slowed growth for almost all but the largest brands.

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