In addition to royalties, most franchisors will collect amounts from franchisees for brand marketing and advertising. Typically, these are set as a percentage of sales for each franchisee. The franchisor has control over the collection and the spending of the advertising funds, which should be used for the overall promotion of the restaurant brand that benefits all franchisees.
Usually, your Franchise Disclosure Document (FDD) will outline exactly what the advertising funds are to be used for. It will also provide information to franchisees on the rights they have to request information related to the administration of the advertising fund, in particular, how amounts are being spent. It is important that you ensure sufficient accounting for the advertising funds in order to provide this reporting to franchisees upon request.
Sometimes, a separate entity is created simply for the tracking of the advertising fund collections and expenditures. This entity will be consolidated with the franchisor for financial reporting. You could also consider using a separate fund or department within your accounting software for this tracking that would allow you to prepare a separate profit and loss statement for the advertising fund.
As it relates to the advertising funds, you will want to make sure that you have adequate internal controls for approving the proper classification of expenses as an obligation of the advertising fund. In addition, if internal employee salaries and benefits are charged to the fund, be sure that adequate time and record keeping is maintained to support the hours dedicated to administering the advertising fund and the nature of any specific advertising and marketing services that are being provided by your internal employees on behalf of the advertising fund. As advertising fund collections are not to be used to cover general operating costs of the franchisor, you will want to make sure that you have adequately tracked internal employee time on the front end in order to alleviate any questions that might arise during a franchisee-requested audit of the advertising fund. Good practice would be to share financial information of the advertising fund with your franchisees to increase transparency.
For your financial statements, starting with the adoption of the new revenue recognition standard (effective in 2019 for most companies), advertising fund collections and expenditures are shown on a gross basis on your income statement. Prior to adoption of the new revenue recognition standard, as it was considered that the franchisor acted as an agent in the administration of the advertising fund, these amounts were usually not included within the income statement but rather a liability was carried on the balance sheet for any advertising fund collections in excess of fund expenses. The new revenue recognition standard looks at the definition of control.
As you are able to direct how and when the advertising funds are spent, advertising fund collections are included in revenue when earned and expenses are included in your operating expenses as incurred. This means that your net income will be impacted by the level of advertising fund collections and expenses in each period. In periods where you collect more advertising funds than is spent on advertising fund activities, your net income for the period will increase. Contrary, when advertising fund expenses exceed collections for a period, this will result in a negative impact to your net income.
Whether you are just getting into franchising your restaurant concept or are an established franchisor, it is always important to understand your responsibilities related to your franchise’s advertising fund. Making sure that you are adequately administering the fund and advertising funds are being spent on allowable costs will help keep you out of any hot water with your franchisees.
Contact your Henry+Horne tax professional for more details.
Jonathan Poppel, CPA