Can Franchise Rights Be Amortized?
When you order a cheeseburger at McDonald's or grab a chocolate-frosted doughnut at Dunkin' Donuts, the chance is good that you're dealing with a franchisee. Selling the rights to a successful business model, or franchising, has become popular over the last 50 years and today accounts for one-third of global retail sales. Franchise rights can cost a lot, but accounting rules allow small businesses to spread the cost of multiyear franchise agreements over time.
Franchising is essentially about not reinventing the wheel. When a company develops a successful business model, such as McDonald's fast-food restaurant, it can sell the rights to replicate its system. Under a franchising agreement, the franchisee pays the franchisor to use its brand name, marketing materials, store configuration, products, and other trade secrets and intellectual property. Franchising is usually allowed in locations where the franchisor isn't present, and the rights must be renewed after a number of years.
Under accounting rules, certain expenses can be capitalized -- or recorded as an asset on a company's balance sheet -- while others must be expensed immediately. The logic is that spending that results in future benefits over multiple years shouldn't be expensed right away. Examples would include buying a factory, upgrading equipment or acquiring multiyear franchise rights, the effects of which will be felt for years to come. In contrast, spending that only confers short-term benefits must be expensed at once, such as repairing equipment or paying salaries.
Capitalization is usually accompanied by amortization, or the gradual expensing of an asset over a number of years. The general approach is to estimate an asset's useful life and residual value and to select a cost allocation method. Thus, a factory might be deemed to last 10 years, a piece of equipment five years and a franchise agreement three years. Most companies use the straight-line amortization method to allocate the cost of a capitalized asset, spreading its cost evenly over the asset's useful life.
The same rules of capitalization and amortization apply to franchise rights. Since most franchise agreements span multiple years, they usually qualify for capitalization. Thus, a $100,000 payment to run a restaurant franchise for five years would be capitalized as a long-term asset. Using straight-line amortization, the franchisee would reduce its franchise rights asset on the balance sheet by $20,000 and record a corresponding $20,000 amortization expense on the income statement each year.