Franchise accounting: An in-depth guide

The franchise model comes with unique financial challenges.

There are royalties and fees to consider, and there is something of a disconnect between the franchisor and franchisee that doesn’t occur in regular business models.

A proper understanding of these dynamics will help you stay on top of financial processes and maintain transparency.

Both franchisor and franchisee can benefit in this way.

Let’s explore what makes franchise accounting different from other multi-entity corporate structures.

Here’s what we’ll cover:

How does the franchise model work?

A franchise model is a business strategy where a company (the franchisor) grants individuals or groups (the franchisees) the rights to operate a business under its brand, using its established business model, products, and services.

Well-known examples of franchise businesses are Nando’s, Steers, Debonairs Pizza, Cash Converters, PostNet, Planet Fitness, and Servest.

The franchise model involves various fees and obligations that support both parties in maintaining a successful business relationship.

Here’s a quick run through the main components:

Initial franchise fee

Franchisees typically pay a one-time payment to the franchisor, securing their right to operate the business.

This includes the right to use the franchisor’s brand name, access to the business model, initial training, and setup of the franchise location.

The value of the fee varies widely depending on the brand, industry, and market potential.

Franchise royalties

Royalty fees are regular payments made by the franchisee to help cover the franchisor’s ongoing support, such as marketing, brand development, and system-wide innovations.

They finance efforts to maintain and grow the brand, which ultimately benefits the franchisees using it.

Royalties are usually a percentage of the franchise’s gross sales or, in some cases, a flat fee.  

Territorial rights

Restricting the franchisee to a specific area prevents oversaturation of the market as the presence of one outlet too close to another could reduce profitability for both.

In other words, it protects each franchisee from direct competition by the same brand.

Brand standards and guidelines

Franchisors enforce specific rules and guidelines that franchisees must follow to maintain brand consistency and quality.

This will typically include branding standards such as logo usage, store design, and marketing materials, as well as rules on product quality, customer service protocols, and cleanliness.

What is franchise accounting?

Franchise accounting refers to the process of managing financial transactions and records of a franchise business.

The definition is straightforward enough, but accounting for franchise operations means dealing with a range of unique revenue streams, like initial franchise fees, ongoing royalties, and advertising contributions from franchisees.

As you can imagine, this significantly impacts the accounting processes.

For example, revenue tied to the franchise agreements needs to be recognised, and shared costs between the franchisor and franchisees need to be allocated.

Another important aspect of franchise accounting is that part of your financial data becomes decentralised, which adds a layer of complexity.

There will be multiple franchise locations—each with their own incomes and outgoing—to consider when tracking and consolidating financial data.

Accounting standards include specific rules for the franchise model, particularly around reporting franchise-related revenue and expenses.

So, if you’re involved in franchise accounting, you’ll need to take a different approach to comply with standards like GAAP or IFRS.

It also means you may need accounting software tailored to franchise operations.

Consider a solution that integrates seamlessly with the different accounting methods or platforms used by the various businesses in the franchise.

What are the main franchisor accounting challenges?

As the franchisor, you bear the brunt of the added accounting complexity.

Let’s break down the main challenges:

Revenue recognition

The challenge here is mainly one of timing.

You have to administrate payments from multiple external sources, including initial franchise fees, ongoing royalties, and other revenue streams.

This increases the risk of errors and delays when tracking and recording entries.

Compliance with financial reporting standards

Standards like GAAP or IFRS have specific guidelines for reporting franchise-related revenues and expenses.

There may also be tax implications that differ from traditional models.

Expense allocation

As a franchisor, you will need to allocate costs accurately between franchise development, training, and marketing support.

You must also distinguish between shared costs and those specific to you and your franchisee.

Missteps here can lead to financial inaccuracies and strained relationships with your partners.

Disputes

You’ll want to make sure you have clear contracts and effective dispute resolution mechanisms to prevent discrepancies over things like royalty calculations and cost-sharing.

Benefits of the franchise model

Don’t let the complexity put you off.

The model has a strong foothold in the business landscape, which can only mean that both franchisors and franchisees find it appealing.

Let’s quickly go through some of the reasons why:

Benefits for the franchisor

1. Rapid expansion

Each new franchisee helps you expand quickly without the need for significant capital investment.

The franchisees take on the cost of setting up and operating new outlets. And if multiple franchisees launch simultaneously, the market penetration of your brand is greatly accelerated.

2. Increased revenue

You can quickly generate revenue through the initial franchise fees, ongoing royalty payments, and rapid sales growth.

The recurring fees provide a steady income stream that supports corporate growth, innovation, and marketing efforts.

3. Economies of scale

As your franchise network grows, you can leverage bulk purchasing and shared resources to cater for multiple franchisees, getting more of your money.

Bulk ordering will also help you negotiate better terms with suppliers, reducing marketing expenses.

4. Franchisee’s local knowledge

Your brand offering often needs to be adapted to satisfy regional preferences and cultural nuances.

Franchisees automatically take care of that, bringing valuable local knowledge and community connections that would otherwise take you years to accumulate.

5. Reduced operational burden

The franchisee can manage operational tasks such as hiring staff, training their teams, and managing inventory.

Meanwhile, you’re freed up to focus on strategic initiatives, such as brand development, research and development, and supporting the overall network.

6. Risk mitigation

Because franchisees invest their own capital in opening and running their locations, you are less exposed to the financial risks associated with each new outlet.

Additionally, this model distributes business risk across the network, making your overall operation less vulnerable. 

Benefits for the franchisee

1. Proven business model

As a franchisee, you’ll have instant access to a tested and proven business model, reducing the uncertainty and trial-and-error that often accompanies new ventures.

This established framework includes everything from operational processes to customer service protocols.

2. Brand recognition

You can leverage the franchise’s existing brand reputation and customer base from day one.

This instant brand recognition provides a competitive advantage and a faster path to profitability.

3. Training and support

Franchisors typically provide training in areas like operations, product knowledge, and customer service.

Sometimes this is complemented with ongoing support in marketing, technology, and business development. 

4. Easier financing

Lenders are often more willing to provide financing to franchisees due to the reduced risk associated with a proven business model and established brand.

Your franchisor may also have prior relationships with financial institutions, saving you the trouble of negotiating favourable loan terms.

Why franchise accounting isn’t the same as managing subsidiaries

Franchise accounting is just one example of multi-entity accounting, which can include models like parent-subsidiary relationships, Joint Ventures (JVs), and branches or divisions within a group.

Within that list, the JV model is the one closest to the franchise model, as both involve contractual relationships between two independent parties.

But even then, there are some major differences:

Profit vs. revenue Sharing

In the JV model, partners divide profits (or losses) based on their ownership stake.

In the franchise model, each party measures the direct value of the relationship in terms of revenue, which for the franchisor includes fees and royalties from the franchisee.

Risk distribution

JV partners share risk in proportion to their respective share of the venture. But in a franchise, the franchisee typically takes most of the operational risk, with the franchisor focusing on brand support and system-wide growth.

In the case of subsidiaries, branches and divisions, these are all “internal” entities.

As such, the parent can dictate the financial practices each unit must follow (something a franchisor can’t do with a franchise partner).

Also, there may be transactions between these internal entities and the parent company, or between sister entities.

The parent has to make sure money entering the organisation is not counted every time it is transferred internally.

Finally, each of these internal entities can rely on the parent company’s accounting and financial management systems.

Franchise partners don’t have that benefit, and must manage compliance and reporting on their own.

The importance of software for franchise accounting

You can streamline accounting for franchise business operations with software that automates processes and generates consistent financial reporting across multiple locations.

A good solution will help you manage royalties and fees, tracking and processing the periodic payments from each franchisee.

These solutions are primarily of benefit to franchisors and owners of the entire operation.

But they can also be invaluable tools in bookkeeping for franchisees, helping simplify and automate financial processes.

Choosing the franchise model is a leap of faith for franchisors and franchisees alike.

But managing the financial side of your business accurately and transparently is significantly easier with dynamic franchise accounting software.

Consider financial solutions that integrate easily with other systems, like your CRM and inventory management software.

That way, you’ll ensure seamless data flow across your operations, giving you real-time insights and enhancing decision-making processes.

Final thoughts

Franchise accounting is a unique and relatively complex subset of multi-entity accounting.

The distinguishing feature compared to the standard corporate model is that it involves interactions with a partner outside of your organisation.

It comes with specific financial challenges and requirements, such as royalties and franchise-based regulations.

However, it’s a well-established business model that can be mutually beneficial for franchisors and franchisees.

Both parties can take advantage of specialised tools and expert guidance to help ensure smooth business operations and profitable outcomes.