Franchise accounting guide ASC 842 for franchise leases: what goes in the liability, and what stays expense?

What goes into the lease liability?

• Fixed payments, including fixed escalations and payments that are fixed in substance^[1].
• Payments that depend on an index or rate, such as CPI, measured using the index at the commencement date; later changes in the index are expensed as they occur, not remeasured into the liability^[2].
• Payments for renewal periods the tenant is reasonably certain to exercise, and a purchase option or termination penalty on the same test.
• Amounts probable of being owed under a residual value guarantee — rare in a store lease.

What stays out?

Variable payments that do not depend on an index or rate: percentage rent on sales, and CAM, real estate tax and insurance charges that pass through the landlord’s actual costs. They are expensed in the period the obligation is incurred^[3]. That keeps the balance sheet stable when sales swing, but it moves a real cost into the P&L as it happens — a store near its breakpoint needs the percentage rent accrued monthly, see how percentage rent works.

CAM that the lease fixes — a stated monthly amount, not a reconciled share of costs — is a fixed payment. If you elect the practical expedient not to separate lease and non-lease components, fixed CAM goes into the liability with the rent.

Which discount rate should a private franchisee use?

The rate implicit in the lease if it is readily determinable — it rarely is for a store lease. Otherwise the incremental borrowing rate: what the tenant would pay to borrow, on a secured basis, over a similar term. Companies that are not public business entities may instead elect a risk-free rate, and since ASU 2021-09 may make that election by class of underlying asset — real estate, say — rather than for every lease they have^[4]. A risk-free rate is lower, which makes the liability larger; that trade is a choice to make deliberately, with your lender’s covenants in view.

A worked example: a ten-year store lease

A ten-year lease starts at $8,000 a month, paid in advance, escalating 3% each lease year. There are no renewals the tenant is reasonably certain to take. The incremental borrowing rate is 6%.

Total fixed rent over 120 months          1,100,532.48
Present value at 6% (payments in advance)    818,210.44   ← lease liability and ROU asset
                                                            (before initial direct costs,
                                                             incentives and prepaid rent)
Operating lease: single straight-line cost
  1,100,532.48 ÷ 120 months =                  9,171.10 a month

End of year 1
  Interest accreted on the liability            47,287.51
  Lease liability                              769,497.95

For an operating lease the P&L shows one straight-line cost of $9,171.10 a month, above the $8,000 cash rent in the early years and below it later; the difference moves the right-of-use asset. For a finance lease the same liability would produce interest plus amortisation instead, front-loaded.

Which leases can stay off the balance sheet?

Leases with a term of twelve months or less and no purchase option the tenant is reasonably certain to exercise, if you elect the short-term exemption for that class of asset. A store lease almost never qualifies; a month-to-month storage unit or a short equipment rental might. A lease that has been signed but not yet commenced is disclosed, not recognised, until the tenant has the right to use the space.

What is different about franchise leases?

• The owner is often the landlord. A property company leases the building to the operating company under common control. Private companies may use the written terms of such an arrangement to decide whether a lease exists and how to account for it, without assessing whether those terms are legally enforceable^[5].
• The franchisor may be on the lease. Some brands sublease to the franchisee or hold a collateral assignment. A sublease is still a lease to the franchisee; the head lease’s terms matter only as far as they flow through.
• Percentage rent is common. It stays out of the liability, and the breakpoint moves with base rent.
• Many locations, one policy. The discount-rate election, the component expedient and the short-term exemption are policies — apply them the same way across every entity, or the group’s numbers stop being comparable.