April 21, 2020 update: To provide accounting relief and clarity during the COVID-19 crisis, the FASB published an exposure draft with proposals to delay the effective dates for Revenue Recognition (Topic 606). Find more information here.
Franchisors, it’s not too late to start assessing and evaluating the impact of a new accounting guidance. ASU 2014-09, “Revenue from Contracts with Customers” (ASC 606), provides new guidance for recognizing revenue for contracts with customers.
The guidance under ASC 606 is effective for public entities with annual reporting periods beginning after December 15, 2017. For non-public entities, it is effective one year later, for years beginning after December 15, 2018.
Background of Franchise Agreements
Franchise agreements include a laundry list of deliverables that are provided to franchisees. Those deliverables can include functions at the start of the contract, such as lease negotiations, assistance with location selection, hiring, training staff, and tenant improvements. The agreement typically includes the ability to use the brand name, ongoing advertising, menu support, as well as purchasing of goods.
The franchisee normally pays an upfront fee as well as royalties over the franchise agreement based on a percentage of sales. Historically, the recognition of revenues was simple – upon completing the deliverables to start the contract (which usually coincides with the restaurant/hotel opening), the initial franchise fee was recognized as revenue. The royalty was recognized when sales took place.
What Will Change Under ASC 606?
Under ASC 606, franchisors can only recognize the initial franchise fee if any of the upfront activities performed are distinct services within the context of the franchise agreement. Essentially, the franchisor needs to determine if any of the goods or services have stand-alone value.
Certain delivered items are part of the brand and cannot be separated, while other items could be considered distinct. For example, if the franchisee purchases furniture from the franchisor and the furniture is a key part of the brand (i.e., the same at every location) it is likely part of the overall franchise agreement.
However, if the furniture is different at each location and could easily be purchased from a third party, it may be considered distinct. The franchisor should consider each promised good and service to determine whether any portion of the initial franchise fee may be allocated to it, allowing recognition of that portion of revenue at the time that the good or service is delivered.
As the public company implementation has already occurred, there are numerous example disclosures related to the implementation. Following are two case studies.
Case Study 1: Hotel Franchisor
For our franchised hotels, we have a performance obligation to provide franchisees and operators a license to our hotel system intellectual property for use of certain of our brand names. As compensation for such services, we are typically entitled to initial application fees and ongoing royalty fees.
Our ongoing royalty fees represent variable consideration, as the transaction price is based on a percentage of certain revenues of the hotels, as defined in each contract. We recognize royalty fees on a monthly basis over the term of the agreement as those amounts become payable.
Initial application and relicensing fees are fixed consideration payable upon submission of a franchise application or renewal and are recognized on a straight-line basis over the initial or renewal term of the franchise agreements.
Case Study 2: Restaurant Franchisor
On January 1, 2018, the Company adopted ASU No. 2014-09 “Revenue Recognition (Topic 606), Revenue from Contracts with Customers” using the full retrospective transition method.
Under ASU No. 2014-09, revenue is recognized in an amount that reflects the consideration an entity expects to receive for the transfer of goods and services. The standard also requires additional disclosures about the nature, timing and uncertainty of revenue and cash flows arising from contracts with customers.
Under the new standard, the Company recognizes gift card breakage proportional to redemptions, which are highest in the Company’s first fiscal quarter. Previously, under the remote method, the majority of breakage revenue was recorded in the Company’s fourth fiscal quarter, corresponding with the timing of the original gift card sale.
Advertising fees charged to franchisees, which were previously recorded as a reduction to other restaurant operating expenses, are recognized as franchise revenue. In addition, initial franchise and renewal fees are recognized over the term of the franchise agreements. As part of the adoption of ASU No. 2014-09, the Company applied the practical expedient to use the portfolio approach to assess contracts and performance obligations. In connection with adoption of ASU No. 2014-09, a cumulative effect adjustment of $33.1 million, net of tax, was recorded as a credit to the ending balance of accumulated deficit as of December 27, 2015.
Regarding franchise fees, initial franchise and renewal fees are recognized over the term of the franchise agreement and renewal period, respectively. The weighted average remaining term of franchise agreements and renewal periods was approximately 15 years as of April 1, 2018.
Take Action Now
If you have not yet already done so, now is the time to begin assessing and evaluating the impact ASC 606 may have on your business. While the magnitude of changes to a franchisor’s current revenue recognition practices will vary, almost all franchisors will see changes upon adoption of the new guidance. In addition to the topics covered here, franchisors need to consider the impact of ASC 606 on gift card revenue as well as advertising or brand fee revenue.
Contact your Clark Nuber professional or Christie Streit for more information about revenue recognition for franchisors.
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Originally published October 2018.