What does ASC 842 require a franchisee to record?
For each lease with a term over 12 months, the lessee records a lease liability equal to the present value of the remaining lease payments, and a right-of-use asset based on that liability adjusted for prepaid rent, initial direct costs and lease incentives. Leases of 12 months or less can be left off the balance sheet by election.
For a franchise group, that usually means store leases, and often equipment, vehicle and office leases too. Each lease belongs to the entity that signed it, so the schedule lives in that store's books and rolls up in consolidation.
Some franchisees lease or sublease their sites from the franchisor or its real estate affiliate. From the franchisee's side, that is still a lease and follows the same rules.
Are store leases operating or finance leases?
Most store leases are operating leases, because the franchisee does not take ownership, has no bargain purchase option, and does not use up most of the building's life or value. An operating lease produces a single straight-line lease cost. A finance lease splits cost into amortization and interest, which is higher in early years.
| Item | Operating lease | Finance lease |
|---|---|---|
| Balance sheet | Right-of-use asset and lease liability | Right-of-use asset and lease liability |
| Income statement | Single lease cost, straight-line over the term | Amortization of the asset plus interest on the liability |
| Expense pattern | Even each period | Front-loaded |
| Typical franchise examples | Store, office and most real estate leases | Some equipment and vehicle leases |
How do you set the lease term and discount rate?
The lease term is the noncancellable period plus renewal options the franchisee is reasonably certain to exercise. The discount rate is the rate implicit in the lease if readily determinable, otherwise the incremental borrowing rate. Private companies may elect a risk-free rate by class of underlying asset under ASU 2021-09.
Renewal options matter for franchisees because store leases often carry several five-year options. Consider the franchise agreement term, recent remodel spending and the store's performance when deciding whether an option is reasonably certain. Revisit the judgment when something significant changes.
A risk-free rate is simpler to source but produces a larger liability than a borrowing rate, because a lower rate discounts future payments less. Groups that care about balance sheet ratios in lender covenants often weigh that trade-off.
How are CAM, percentage rent and rent escalations treated?
Fixed payments and increases tied to an index such as CPI, measured at commencement, go into the lease liability. Fixed escalations are included as scheduled. Percentage rent and CAM, taxes or insurance billed on actual costs are variable payments outside the liability, expensed in the period they are incurred.
CAM is a nonlease component. A lessee can elect, by class of underlying asset, to combine lease and nonlease components and treat them as a single lease component. If you make that election, fixed CAM charges become part of the lease payments, while CAM billed on actual costs remains variable.
Percentage rent is common in restaurant and retail leases: once a store's sales pass a breakpoint, it pays a share of sales above it. Accrue it as the obligation is incurred, store by store, rather than waiting for the annual statement.
What makes ASC 842 hard with dozens of store leases?
The rules are the same for one lease or a hundred, but the volume is not. Each lease needs an abstract of its terms, a schedule, monthly entries in the right entity, and remeasurement whenever a term, option or payment changes. Missed amendments and renewals are the most common source of errors.
- Abstract every lease and amendment: dates, options, rent steps, CAM terms, percentage rent breakpoints.
- Keep one schedule per lease and post its entries to the entity that signed it.
- Track option notice dates on a calendar so a renewal decision is never missed.
- Remeasure when a lease is modified, extended or an option judgment changes.
- Reconcile the lease liability and right-of-use asset balances to the schedules at every close.