Impacts of the New Revenue Recognition Rule (ASC 606)
The Financial Accounting Standards Board (FASB), which is responsible for determining generally accepted accounting principles (GAAP), made a change to its rules for when businesses can recognize revenue, summarized here:
|Current Rule: ASC 952-605||New Rule: ASC 606|
|Franchisors recognize initial franchise fees when (or shortly after) the franchisor has performed its material pre-opening and opening obligations to a new franchisee (typically, when the franchisee commences operations).||Depending on its operations and nature of the initial services a franchisor provides to its franchisees, the franchisor may have to defer recognition of some or all of the initial franchise fees. If deferred, the franchise fees would likely be recognized as revenue over a much longer period of time, e.g., the term of the franchise agreement.|
In essence, the rule change means that while you used to be able to recognize all of the initial fees that you collected by the time the franchisee opened for business, under the new rule, at least a portion of that initial fee will be spread out over the entire course of the franchise agreement – potentially 10 years.
For privately held companies, this rule change is effective for annual reporting periods after December 15, 2018, and interim periods within annual reporting periods beginning after December 15, 2019. Check with your auditor to find out what these deadlines mean for your fiscal year and circumstances.
How Will This Impact My Business?
From a cash perspective, this should have no impact on your business. You will continue to collect initial fees, pay bills, and operate as you always have.
But because this may postpone when you can recognize a portion of the initial fees for many years, it is likely to mean that some of the cash you collect during the year will not be reflected as revenue for the current year in your annual audit. It is likely to decrease the net income your audited financial statements show, compared to what would have been shown under the previous rules. This will impact the picture your audited financial statements paint for both franchisees and for state franchise examiners.
State franchise examiners are aware of this change, but they are still discussing how to deal with it. States which have very strict rules about when to impose a fee deferral requirement may find that franchisors who would not trigger the fee deferral requirements under the old rule now do trigger the fee deferral requirement under the new rule. They have not yet announced how they intend to approach those situations.
Experienced franchisee attorneys are also largely aware of this, but you can anticipate that during the sales process after the new standard is applied to your audit, if your audit shows a significant difference between one year’s audit and the next year’s audit, there may be questions about whether and how the company’s financial condition actually changed. This will require you to understand your new audited financial statements and to train your salespeople about how to answer questions about these documents in a way that is accurate and not misleading.
Will This Complicate My Audit?
This is a question best answered by your auditor. However, at a minimum, it will require more or different information from you than you are typically used to having to provide, as discussed more below. In order to keep things as organized and timely as possible, reach out to your auditor to understand when this will impact your company and what you can do to prepare.
How Do I Figure Out What Portion Of Initial Fees Will Be Recognized Later?
This is the million dollar question, which can only be answered by your work with your audit team. However, franchise attorneys and FASB representatives who worked on this issue together have recommended the following five-step process, which you will work through with your auditors:
Step 1: Identify and define the contract. This means look at your franchise agreement and any side agreements or other terms between you and the franchisee to identify your obligations.
Step 2: Identify the separate performance obligations in the contract. For example, separate performance obligations could include, for example:
- Site selection services
- Architectural drawing review
- Training regarding the general fundamentals of operating a restaurant
- Training regarding the brand-specific obligations of running a [Your Brand] Restaurant, such as preparation of specific recipes
- Grand Opening assistance
Step 3: Determine the transaction price. This is the amount of cash and non-cash consideration you are receiving from the franchisee, including financing and other factors.
Step 4: Allocate the transaction price to the separate performance obligations. Here you will work with your auditor to determine what portion of the value you are receiving should be apportioned to the various obligations you identified in Step 2.
Step 5: Recognize revenue when each performance obligation is satisfied. You will work with your auditor to determine when you can recognize revenue.
A key factor in this process is that if the benefit from a particular obligation is tied to the franchise agreement, the revenue must be recognized over time. Conversely, if the benefit is felt all at once, the revenue may be recognized at that time.
As a simple example, hypothetically you and your auditor might conclude that the franchisor’s assistance with purchasing generic kitchen equipment is not tied to the franchise agreement since that equipment could be used in any restaurant kitchen, not just in the kitchen of a [Your Brand] restaurant. Consequently, the transaction price allocated to that assistance might be recognized immediately. Conversely, a portion of training which explains how to specifically operate under [Your Brand’s] systems and methodologies is tied directly to the license of intellectual property and may need to be recognized over the duration of the franchise agreement.
Isn’t There A Shortcut?
Unfortunately, no. Compliance with these new standards will require going through the exercise outlined above. Companies cannot simply decide that everything gets recognized immediately, or everything gets recognized over the term of the agreement, without going through each step. For this reason, communicate with your audit team early to make sure they are looking at these issues and are helping you formulate a plan.
We want to make sure you are aware of a change to accounting rules which may impact your audit process and your tracking of various tasks within your system in the coming year. While we are outlining this change at a very high level, we are not accountants. Speak with your auditor about this information and its impact on your business to get a detailed understanding of how this change affects your business.