Why accountants are key for franchisees amid reforms

By Beth Wallace

The franchising industry is a major player in the Australian economy. It collectively employs more than half a million people and turned over about $135.2 billion in 2023, according to the Treasury’s Review of the Franchising Code of Conduct Final Report, released in February 2024.

Yet interest in the sector has waned. According to the report, the total number of franchisees declined by about 5.2 per cent between 2014 and 2023. This is in stark contrast to the broader Australian business population, the report notes, which grew by 28 per cent during the same period.

In addition to the economic hardships that all businesses face in the current market, the franchise sector must navigate a unique set of challenges, which may play a part in its recent downturn, says Peter Knight FCPA, business and franchise accountant at Franchise Accounting and Tax in Sydney.

“The costs to set up a new franchise have increased dramatically over the last couple of years, but we are seeing that many franchisors have not reviewed their pricing structure to reflect this.

“They are simply passing these increased costs on to franchisees, without looking to see if they can change their model to adapt to the ‘new normal’,” he explains.

Profitability has consequently decreased, Knight adds, making it harder for franchisees to achieve a strong return on investment.

Protections to drive growth

In August 2023, the Australian Government announced a review of the Franchising Code of Conduct. The Code is due to sunset on 1 April 2025. This is the latest in a long line of reviews, including the 2019 Parliamentary Joint Committee on Corporations and Financial Services’ Fairness in Franchising report.

Tabling the review to Parliament on 8 February 2024, Minister for Small Business Julie Collins MP said the review was “an opportunity for government to make sure the regulatory settings support the sustainability and growth of franchising into the future”.

Among the report’s 23 recommendations and 34 implementation suggestions, one in particular has the potential to revitalise growth, says Dr Michael Schaper, who chaired the independent review.

“There is a recommendation that a franchise agreement has to provide a reasonable opportunity for the franchisee to expect a return on investment, including provision for compensation in the event of early termination,” Schaper explains. “This already exists for new vehicle dealerships, but not other industries.” 

 

"There is a recommendation that a franchise agreement has to provide a reasonable opportunity for the franchisee to expect a return on investment, including provision for compensation in the event of early termination,” Schaper explains. “This already exists for new vehicle dealerships, but not other industries."

 

Such protections would likely encourage would-be franchisees to invest with more confidence, Schaper says. “If you know you have a legal right to get a decent return, it is going to make you feel a lot better about entering into the contract.”

In addition, the review recommends further consideration be given to the Australian Competition and Consumer Commission’s proposal to introduce a licencing system that would “provide a more robust compliance framework and reduce the harms that persist in franchising”.

Mirroring existing determinative schemes, such as the Telecommunications Industry Ombudsman and the Australian Financial Complaints Authority, a licence regime would allow a regulator to suspend, cancel and impose conditions on a franchisor’s ability to promote and sell franchises, and facilitate efficient and binding resolution of disputes.

This could potentially move disputes away from the court system, Schaper says, which would enable minor issues to be resolved quickly and at minimal cost in comparison with the current model.

“It might conceivably allow the regulating body to say certain franchisors are no longer allowed to trade,” Schaper adds. “We strike off doctors and lawyers who are found to be incompetent or unable to practice and, in some industries, you need a licence to operate, but you don’t with franchising.”

The role of goodwill

One of the foundational – and most controversial – issues raised about franchising relates to goodwill, the review has found.

The problem stems in large part from franchisees’ lack of awareness around what they are – and are not – entitled to at the end of their contract. While some believe they may have a right to payment for the “value added” they have delivered to a franchise system, more than 80 per cent of franchise agreements explicitly exclude franchisee goodwill.

Misunderstanding of the legal versus accounting concept of goodwill adds to the confusion, says Derek Sutherland, consulting principal at Keypoint Law.

Sutherland highlights the example of 38 Mercedes-Benz dealers who, in 2021, filed a claim in the Federal Court of Australia (AHG WA(2015) Pty Ltd v Mercedes-Benz Australia/Pacific Pty Ltd & Ors [2023]FCA 1022]) against the car manufacturer for an alleged loss of A$650 million in goodwill after they received notice of non-renewal of their dealer agreements. Though they were ultimately unsuccessful in their claim at trial, they have recently appealed that decision.

 

"The costs to set up a new franchise have increased dramatically over the last couple of years, but we are seeing that many franchisors have not reviewed their pricing structure to reflect this. They are simply passing these increased costs on to franchisees, without looking to see if they can change their model to adapt to the ‘new normal’."

 

“Justice Beach made it clear in the primary case that the claimants’ confused the accounting definition of goodwill with the legal definition of goodwill, and they are not the same,” Sutherland says.

Under a franchise agreement, Sutherland adds, goodwill in law is property because it is the legal right or privilege to conduct a business “in the same manner and by the same means that attracted custom to it” (Commissioner of Taxation (Cth) v Murry 193 CLR 605 (1998)). That right may arise from the franchise agreement.

In this scenario, goodwill is an asset of the business because it is a valuable right or privilege to use the other assets of the business to produce income.

“When the right to conduct the franchised business ends, by termination or expiration of the franchise agreement, then the goodwill also comes to an end,” Sutherland says.

Schaper adds that enhancements to education and advice delivered by government would be beneficial in this and many other aspects of franchising that tend to give rise to disputes and financial harm.

In addition to increasing existing requirements that franchisees seek professional advice before entering into a franchise agreement, the review recommends making the Franchise Disclosure Register (FDR) more user-friendly and creating a “one-stop-shop” website for franchising information, based on the Moneysmart model.

“Essentially, we think education is key,” Schaper says.

Client support

For Schaper, a key advantage of the independent review is that it has, for the first time, provided an accurate overview of the size and scale of the franchising sector in Australia.

For instance, of the 1712 franchisors currently operating, 665 have a turnover of less than A$10 million and fewer than 20 staff and 30 franchisees.

“That is important to think about, because we know small businesses have a very strong need for support and often turn to their accountants as a primary source of information,” Schaper says.

Knight says accountants play a critical role in educating franchise clients about their duties and obligations as business owners and directors. They can help clients to stay on top of compliance obligations, help them to access finance by providing up-to-date financial statements, budgets and cash flow forecasts, and be on hand to answer any questions.

Sutherland believes accountants acting for franchisees could better support their clients by helping them to understand the issues and concepts that affect the value of their business at the end of its term.

“There are specific items in a disclosure document that deal with goodwill and whether a franchisee is entitled to goodwill at end of term,” Sutherland says.

On the franchisor side, he adds, one of the key areas where clients might require assistance relates to marketing funds and how franchisors administer them – a common cause of conflict.

“Unfortunately, there is no audit guidance statement for marketing funds when there really should be,” Sutherland says.

“The Franchising Code imposes obligations on franchisors that are not just an accounting exercise. As a result, many audit reports are just not helpful to franchisees, because they relate to accounting standards rather than compliance with the Franchising Code.”

Accountants and registered company auditors could improve their performance concerning audit reports and ensuring franchisors comply with their Franchising Code obligations, he adds. For instance, disputes may arise about whether a marketing fund can be used to pay certain expenses.

“Franchisors often forget that the Franchising Code expressly prohibits marketing fund money being used other than for specified things andthat the provisions in the Franchising Code apply, despite the terms of the franchise agreement.”

Since launching in Taiwan in 2003, bubble tea brand Chatime has opened more than 2000 stores worldwide, including about 165 outlets (or “T-Breweries”) across Australia.

The Chatime Franchise Agreement is typically a five-year contract with an option to extend for another five years, during which time franchisees have access to support teams in business development, marketing, IT, finance, leasing, supply chain and project management.

According to Carlos Antonius, CEO of Chatime Group Australia and Chatime Global USA, the franchisor’s success can be attributed to a range of factors, including strong brand disciplines, product innovation, franchisee selection criteria, a multi-unit franchise focus and ongoing reviews of all datasets, including cost of entry.

In addition, he says the company undertakes ongoing reviews of franchisee profitability, which is formally updated every quarter.

“As a result of this, we have and continue to make changes to the variables we can influence such as cost of goods sold (COGS) and some services to help maintain a profitable operational model.”

Two areas where he believes franchisees could benefit from accounting support relate to pre-trade expenses and end-of-lease refurbishments.

“Franchisees get very absorbed in the value of the initial capital investment and either fail to consider or underestimate how much they need to set aside for pre-opening expenses and working capital,” he says. “A small delay in a project proceeding can result in extra wages to hold team members, or extra rent.”

Further along in the contract, Antonius recommends franchisees put aside a “sinking fund” or cash equivalent to their depreciation to cover a refurbishment at the end of lease and/or potentially their franchise term.

Especially in a bricks-and-mortar franchise, he says most retail landlords will require a refurbishment at lease renewal, which is a good opportunity for franchisees to “freshen up” their premises.

“There is evidence that this generally provides a top-line sales improvement,” he adds. “Often the best time for a franchisee to exit and maximise the value of their investment is just after the retail lease and refurbishment is complete, but they need to have reserves put aside to enable it to happen quickly.”