Significant Changes Coming to Revenue Recognition for Franchisors

Franchisors face significant changes in revenue recognition with the looming implementation of Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). This update is currently effective for public entities, but becomes effective for non-public companies for years beginning after December 15, 2018.

The new standard is intended to improve comparability across industries and between companies reporting under U.S. GAAP and International Financial Reporting Standards. It does this by eliminating much of the industry-specific guidance and establishing the following core principle: “an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The five steps to the new revenue recognition model include the following:

  • Identify the contract with the customer
  • Identify the performance obligations in the contract
  • Determine the transaction price
  • Allocate the transaction price to the performance obligations
  • Recognize revenue when (or as) each performance obligation is satisfied

Under ASU 2014-09 initial franchise fees, advertising fund contributions and costs incurred to obtain a contract are all affected.

Initial franchise fees

Under “Legacy GAAP” (ASC 952), the initial franchise fee was typically recognized after the franchisor performed substantially all of the initial services required under the franchise agreement. This often coincided with the beginning of the franchisee’s operations. The new standard first requires the franchisor to evaluate the franchise agreement, identifying any additional performance obligations beyond the license of the franchisor’s intellectual property, such as goods or services. If the license of intellectual property is not distinct from the additional goods or services promised in the franchise agreement, the entire fee should be accounted for as a single performance obligation; if separate performance obligations are identified, the initial franchise fee and these services may be accounted for separately. However, in many cases, the license of intellectual property is highly dependent upon the other services included in the franchise agreement, such as training, manuals, etc., and is therefore, unlikely to qualify for recognition as a separate performance obligation. For example, the grant of a license to operate a restaurant brand is of little use to a franchisee without appropriate training on how to execute the business model. Under ASU 2014-09, a franchise agreement is considered to be a license of symbolic intellectual property and is recognized over a period of time, such as the term of the franchise agreement. Consequently, for most franchisors, a significant portion of the initial franchisee is likely to be deferred and recognized over time.

Sales-based royalties

Most franchise agreements provide the franchisor with a specified royalty payment in consideration for the franchise right, typically based on a percentage of the franchisee’s sales. ASU 2014-09 generally requires variable consideration to be estimated at the inception of the contract; however, a specific exception is provided related to sales-based royalties, which allows them to be recognized when the subsequent sales occur. Consequently, the recognition of sales-based royalties will typically remain consistent with Legacy GAAP.

Advertising fund revenue

It is common for franchise agreements to require that franchisees contribute to an advertising fund, with the franchisor spending the money on national or regional advertising aimed at advancing the brand. Under Legacy GAAP such contributions were often viewed as being collected for a specific purpose and accounted for as an agency transaction, effectively reducing the advertising expenditures reported by the franchisor. In most cases under ASU 2014-09, the advertising fees will be viewed as interrelated with the franchisor’s ongoing support for the license and considered a portion of the overall transaction price paid for the rights granted to the franchisee. Therefore, advertising fund receipts will be recognized as revenue when received.

Cost incurred to obtain a contract

Franchisors often incur certain costs in conjunction with obtaining a new contract, which could include fees paid to brokers or commissions. Under Legacy GAAP, these costs have been expensed as incurred. The new standard requires incremental direct costs incurred to obtain a contract that are expected to be recovered over the period of the contract to be capitalized. The contract cost asset will typically be amortized over the life of the franchise agreement.

Implementation

The new standard provides two alternatives for implementation:

  • Full Retrospective Method – requires restatement of all prior periods presented, with the cumulative effective of the change being recognized as of the beginning of the first reporting period presented.
  • Modified Retrospective Method – allows the reporting entity to apply the guidance to contracts as of the implementation date and prospectively, with the cumulative effect being recognized as of the beginning of the reporting period in which the new standard is implemented. If comparative financial statements are prepared, this approach affects the comparability between reporting periods.

Reporting entities will need to consider which approach is appropriate given their circumstances and the needs of their financial statement users. Given the volume of data and significant changes involved, the implementation likely to be costly for franchisors, including time spent gathering data, analyzing contracts and potential modifications to systems and processes. From a practical standpoint, the implementation is likely to reduce most franchisors’ net worth, potentially affecting bank covenants and requiring registration in certain states where the reporting entity was previously exempt. As a result of the reduction in equity, certain states may require initial franchise fees to be held in escrow, adversely affecting cash flow. Franchisors need to evaluate their existing contract language and determine whether there are specific performance obligations that can be separated from the “symbolic license” granted to franchises to use the brand.

We anticipate that a significant investment of time and resources will be required to implement ASU 2014-09 and are advising reporting entities to begin the process as soon as possible. Your CSH advisors are well versed in the new standard and available to assist with your implementation.

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