In addition to acquiring some physical goods, when a business enters into a franchise agreement it acquires franchise rights. While these rights are not tangible, they still have economic value that requires inclusion on a balance sheet. Franchise rights are an intangible asset, recorded on the long-term asset portion of the balance sheet. Amortize this asset over the term of the franchise contract.
American financial policy is defined by a set of rules known as Generally Accepted Accounting Principles, drafted by the Financial Accounting Standards Board. The Securities and Exchange Commission and American Institute of Certified Public Accountants recognize GAAP as authoritative, which means that that all audited statements comply with these standards.
A franchise is a contract where a distributor, or franchisee, gains the right to sell a well-known trademarked product from a franchisor. Common examples of franchises include fast food chains and clothing chain stores. These exclusive grants allow the franchisees to capitalize on the national or regional reputation of the product they sell, which presumably allows them to tap into an already developed customer base. This ability to tap into a pre-cultivated customer base is an intangible asset. An intangible asset is something that is not material, but still has economic value.
List the franchise rights on your balance sheet under long-term assets grouped with any other intangible assets you may have. List the value of the franchise rights at its fair value. The fair value of the franchise rights is equal to how much the franchisee paid in the initial contract to acquire the rights. The issue with defining this value is that generally the contract that generates the rights for the franchisee also transfers tangible assets as well. Because the overall cost of the contract needs to be divided amongst the individual tangible assets based on fair market value, the remainder is the value of the franchise rights.
Generally, the contract that grants the franchise is limited to a specific period. As a result, amortize the franchise rights assets over the term of the contract. Amortization reflects the depletion of intangible assets, and the asset’s value is decreased and converted to an expense used against the business’s income. Amortize the franchise rights in relation to the rate that the intangible assets are consumed. Absent any evidence revealing this consumption rate, amortize the franchise rights at a constant rate that allows them to be “used up” by the end of the underlying contract’s term. Calculate this rate by dividing the value of the assets by their useful life expressed in years. This will give you the annual amortization rate.
When drafting a franchise contract, consult with a licensed attorney in your area to ensure that the document conforms to the relevant laws. When preparing your financial statements as a franchisee or franchisor, consult with a certified public accountant. While every effort has been taken to ensure this article is complete and accurate, it is not intended to be taken as legal advice.