5 Steps of the New Model of Revenue Recognition for Franchisors
The new rules around revenue recognition are lengthy and complex. Here’s what you need to know.
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Like businesses in most industries, the new revenue recognition rules put forth by the Financial Accounting Standards Board (FASB) — and effective as of Jan. 1, 2018 for public companies and Jan. 1, 2019 for private companies — have specific and significant implications for franchisors. These rules require the attention of franchisors and their accountants and attorneys now and will continue to necessitate consideration in years to come. This summary describes how specific areas of revenue recognition will impact franchisors.
Within the new standards there are five steps outlined for revenue recognition.
Step 1: Identify the contract with a customer.
This step will typically be straightforward for franchisors because they have a written franchise agreement in place that specifies the parties, each party’s rights and obligations, and the payment terms. The agreement will also have “commercial substance,” meaning the cash flows of both parties are expected to change as a result of the contract. Franchisors must take the additional step of determining collectability based on its credit underwriting of the franchisee.
Step 2: Identify the performance obligations in the contract.
Franchisors must determine if the services — such as pre-opening activities, site selection and training — it provides to the franchisee at the onset of the franchise agreement can be identified as “distinct” from the intellectual property that the franchisee is licensing. This determination should be made based on professional judgment and industry best practices. (In many areas, including this one, privately held franchisors can look at the filings of publicly held franchisors to see how those businesses handled a determination.)
One potential indicator that a service is distinct is that it is broken out separately, with a separate fee in the franchise disclosure document (FDD) and franchise agreement. Another indicator is whether a service is optional or a required component of service. For example, if a franchisor offers site selection as an option and a franchisee could alternatively use an outside vendor for this service, then it is likely the service is distinct.
Franchisors should note that some services will be more difficult to label as distinct, such as training that is specific to the brand and its processes. In the case of training, if the education is available from a third party, such as a business class at a university, then that portion of the training may be distinct. Generally, to be classified as distinct, the service would have to have value to the franchisee regardless if they were a franchisee of the system or not.
Step 3: Determine the transaction price.
For franchisors, this step involves listing all the revenue streams — including those that will be received up front, and those that will be received over time — it will collect from the franchisee, including the initial franchise fee, royalties, renewal fees, transfer fees, relocation fees and so on. All revenue streams should be outlined in the franchise agreement.
Franchisors may also need to note significant financing components in arrangements in which the timing of payment is extended or significantly later than when the goods or services are provided, such as area development rights or master franchise rights. Additionally, non-cash services must be valued as part of the transaction price at the inception of the agreement.
Step 4: Allocate the prices to the performance obligations
For this step, franchisors must take each distinct good or service determined in step 2 and assign a transaction price at the inception of the agreement. One or more approved methods may be used to make these determinations, including the adjusted market assessment approach, the expected cost plus a margin approach, and the residual approach. The outcome for each item must be a stand-alone value, meaning the value at which the good or service could be sold on its own.
Step 5: Recognize revenue.
For franchisors to recognize revenue for a particular good or service, that good or service must be transferred to the franchisee, either at a point in time, or over time (over the period of the franchise contract). Royalties have a carve-out exception as sales-based royalties; therefore the franchisor continues to recognize them as the underlying sales occur, and accrues for royalties earned but not yet received.
Another concept covered within this step is principal versus agent transactions, such as in the case of an advertising or national marketing fund. If the franchisor controls how the funds are to be spent, the monies collected for these funds are recognized as revenue in a manner similar to royalties and expenses are recognized as incurred.
Areas of note
In addition to those described above, franchisors should note several other areas specifically impacted by the new revenue standards:
- Contract costs: Costs related to obtaining a contract, such as broker fees and commissions, should be capitalized and recognized over the period of the contract.
- Disclosures: Under the new standards there are considerably more disclosures required in the audited financial statements included in Item 21 of the FDD. These requirements are meant to provide insight into management’s judgments included in recognizing revenue.
- Initial franchise fees: Franchisors should consider describing distinct pre-opening services, such as site selection, design assistance, project management and employee training in their FDD.
- Renewal franchise fees: Franchisors will be far less likely to find distinct performance obligations connected with renewals of existing franchise agreements. The revenue from the renewal is expected to be recognized over the renewal term.
- Financial impact on other agreements: Franchisors need to consider the impact on other financial arrangements held by the company.
The new rules around revenue recognition are lengthy and complex, and require judgment calls on management’s part. Public companies have already been required to make some of these judgments and reveal them in their public filings. For private franchisor companies, the important thing is to begin thinking about the transition now. This process should start with franchisor companies and their accountants and attorneys. The judgment calls required by the new standards will not be easy, and the sooner franchisors and their accountants and attorneys begin tackling them, the better.