Franchise Fees (Royalties)
The business concept of a royalty is a cut off the top. Basically, it is a share of the revenue (sales). This is customary in the entertainment and literature industries. Typical royalties range from 5 to 15% depending on the circumstances. In business, franchisors sell the right to use their logo, brand, processes and product by taking a cut of the sale.
There is an entire section on this website dedicated to the franchise industry.
Franchising exists in just about every industry out there. Many small businesses are franchise affiliated. This is most prevalent in the service sector. There are generally four major fee payments paid by the franchisee to the franchisor. They consist of the:
- Franchise Fee – The actual royalty paid to use the name.
- Franchise License – An upfront fee that is amortized over the life of the agreement.
- Marketing Fee – A percentage of revenue to promote the entire franchise network.
- Contractual – Annual licenses or requirements to maintain compliance with the franchise agreement.
The franchise fee is a true sharing of revenue. As an example, many of the Subway franchise agreements are 8% fee on sales. So when you pay the $5.99 for that sandwich, Subway’s share is 48 cents. This co-sharing of the sale is recorded in the revenue type of accounts. The interesting question is whether the 5.99 is split into two revenue accounts, one for the franchisor (48 cents) and another for the franchisee ($5.51) OR to use a contra account to offset the total sale of $5.99. Look at the two separate formats below:
. SUBWAY STORE # ZZZZ
. Sales Section for a Single Transaction
. Split Sale Contra Format
. – Franchisee $5.51 $5.99
. – Franchisor .48 -0-
. Subtotal Sales 5.99 5.99
. Franchisor Share (.48)
. Franchisee Sales $5.51 $5.51
The split sale method is more comprehensive for accounting purposes. The contra method is the widely accepted method. Its format is much simpler to use and to understand. It condenses into the following:
Franchisor Share (Royalty) (.48)
Franchisee Sales $5.51 *Adjusted Gross Sales
The book entry is as follows:
Date ID Ledger Description DR CR
Today 0309161131 Sales 1 Italian Sub $5.99
. 0309161131 Franchisor Share 8% to Subway $.48
. 0309161131 Royalties 8% to Subway .48
. 0309161131 Cash Cash Payment 5.99
. $6.47 $6.47
Over on the balance sheet in the current liabilities section sits a parent account called accrued expenses. A child account to accrued expenses used is called ‘Royalties Due’ to post the credit amount of the contra offset to the sale. Each month or week a debit is posted for the payment made to the franchisor.
Since cost of sales include traditional costs such as advertising and direct costs (materials, labor etc.), those franchise costs are customarily posted in this section with the offsetting amounts payable (credit) to accrued expenses. Another child account is used entitled ‘Franchise Costs Due’ or ‘Compliance’. Naturally the licensing fee is treated in a similar fashion as other amortized costs.
So why is it so important to post the franchise fee (royalty) to revenue?
Business licenses are effectively permission slips from the local government to conduct business within its boundaries. The most common price tag or tax involved is based on revenue. Rates range from 10 cents per $100 of revenue to as much as $1.70 per $100 of sales. Often counties or cities have a flat rate up to a certain threshold, then a percentage of revenue once that threshold is met. The following is an example of this business license tax formula.
Mark’s Dental Practice
Mark is a dentist in a small town whereby he collects around $425,000 per year in sales. The local government charges 44 cents per $100 of sales with a flat $50 fee for the first $100,000 of sales. How much is Mark’s annual business license tax?
. Tax Computation
Mark’s Annual Sales $425,000
First $100,0000 (1st Tier) 100,000 $50
2nd Tier Tax $.44/$100 3,250 Units 1,430
Total Tax $1,480
Typically the tax is paid at year end for the upcoming year and is based on prior year sales. In effect, you are estimating the sales for the upcoming year. So how is this tax accounted for related to bookkeeping?
There are two optional methods used to record revenue taxes. The first is simple and straight forward, debit expense under taxes and licenses and credit cash via the cash disbursements journal. This method is widely acceptable if the dollar amount involved is less than $250. If more than $250, then another method is more appropriate.
The second method is amortization of a prepaid expense. I have mentioned prepaid taxes several times throughout this bookkeeping series. The most common prepaid expenses are taxes, insurance and technology fees. Basically the business entity pays the providing vendor the dollar amount upfront for the upcoming year or quarter. Excellent examples include:
* Real Estate Property Insurance
* Real Estate Taxes
* Property Taxes
* Various types of insurance specifically professional and umbrella
* Custom Software Licenses
* Maintenance Contracts (Technology, Software and Legal)
The revenue tax (business license) fits this definition.
As with all prepaid items, the amount paid is posted to a child account of prepaid expenses. The most caution journal used is the general journal; whereby a debit is posted to the revenue tax sub-account under prepaid expenses (remember, prepaid expenses are a current asset group account). The corresponding credit is customarily cash.
As a function of recurring entries (explained in a future lesson) one-twelfth of the total amount is amortized each month to taxes and licenses, an expense account. Therefore the ledger for revenue taxes will have one debit for the initial annual fee and 12 credits depleting this value to zero at year end.
Now getting back to the original issue of the franchise fee (royalty) co-sharing of revenue. As stated in the royalty section above, royalties are a co-sharing of sales. In effect, that royalty percentage is the responsibility of the franchisor to pay the revenue tax. Franchise agreements are almost identical to partnership agreements. If there is no clause in the agreement passing the responsibility of the tax to the franchisee, then assigning the revenue tax portion to the franchisor is business appropriate. Afterall, it isn’t the small company’s revenue anyway.
Think of a typical Subway franchise with sales of $700,000 per year. An 8% royalty fee on this revenue equates to $56,000 and at .35% revenue tax; it saves the small business $196 per year.
Summary – Franchise and Revenue Taxes
Franchise fees are essentially a royalty or co-sharing of revenue. The contra method is the most widely accepted method to record a sales transaction related to franchise revenue. The amounts owed to the franchisor are recorded to a royalties due account accrued expenses (a current liability). For revenue taxes (business license) the tax is most often a prepaid item (a current asset). The value is amortized to expense over the year providing for greater accuracy with interim financial statements. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.