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Franchisors, Are You Ready for New Revenue Guidance?

ASC 606, Revenue from Contracts with Customers, is here and has completely replaced all revenue guidance under US Generally Accepted Accounting Principles. While there may not be extreme differences, there are differences, and depending upon the complexity of your business and contracts this could be more impactful than you may realize. This is a comprehensive revenue recognition model that will impact all companies, including franchisors. It is not industry specific however, there are industry specific considerations. Since the disclosure requirements are new, implementation will require dedicated time and effort to evaluate the revenue streams and disclosures and will therefore, impact financial reporting even if the amounts are not significantly affected. Franchise agreements, Franchise Disclosure Document, internal controls over systems and processes, covenants and contracts will be an integral part of your evaluation to adopt the new revenue guidance. If you have not already done so, the time is now to implement ASC 606.

Nonpublic entities are required to apply the new standard for annual reporting periods beginning on or after December 15, 2018, including interim periods therein. Public entities are required to adopt ASC 606 in reporting period beginning after December 15, 2017, including interim periods therein. Therefore, franchisors that are privately-held companies must adopt the new standard in the 2019 calendar year. The new standard is retrospective, meaning it requires restatement of prior years or a cumulative catch-up.

Careful consideration should be given to how this will impact your business and revenue recognition.

Does this apply to me?

Under Federal Franchise Rule, franchise disclosure documents (FDD) are required prior to the offer or sale of any franchise. Audited financial statements must be included in the filing of this document for the past 3 fiscal years. All financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles. If your company annually discloses a FDD, and complies with the Federal Franchise Rule, then this applies to you!

Revenue recognition under legacy guidance (superceded):

Revenue is now recognized when risks and rewards are transferred, with an emphasis on when a change in control occurs. Revenue streams for a franchisor typically include initial franchise fees and royalties over the course of a franchise agreement that are based on a percentage of sales. The franchisor would recognize revenue upon completing each deliverable. For example, the initial franchise fee could be recognized as revenue when the franchisee opened for business. Royalties were recognized when the sales took place.

ASC 606, The 5 Step Model:

The fundamental principle of the new five-step recognition process is to recognize revenue such that it depicts the consideration which the company expects to be entitled to in exchange for the transfer of promised goods or services to its customers. The key to this five-step process is that the steps are to be achieved consecutively, or else proceeding to the next step will not be possible.

Step 1: Identify the contract
Step 2: Identify the separate performance obligations
Step 3: Determine the transaction price
Step 4: Allocate the transaction price to the separate performance obligations in step 2
Step 5: Recognize when (or as) the contractor satisfies as performance obligation.

How will these steps affect franchisors?

Step 2 requires the greatest amount of critical thinking. Franchisors must identify each separate performance obligation. It can not be assumed that all services promised under a franchise agreement count as one performance obligation.
The franchise contract is essentially a license that allows the franchisee to use the franchisor’s intellectual property. Generally, activities to support the brand are considered a single performance obligation. For example, transfer of the franchise license. However, the franchisor MUST assess each promise in the FDD and franchise agreement to determine where they are distinct. For example, consider all the promises to a franchisee that are included in a franchise agreement; selecting a site, providing financing, training employees, obtaining equipment, establishing suppliers, etc. Determining if an item is distinct, involves an understanding of the rules surrounding this.

Step 4 includes allocating the transaction price between performance obligations. The most important item to consider is that the allocation is based on the relative ‘standalone selling prices’ of each identified performance obligation. Stand- alone selling price is the price a company would sell a promised good or service separately to a customer.
This is particularly important to franchisors when allocating initial franchise fees. It will not be uncommon for a majority of the transaction price to be allocated to the performance obligation that includes the franchise rights, license of intellectual property, as well as any other distinct performance obligations identified in the contract, on a relative stand-alone selling price basis. If there is bundling of pricing in your arrangement, this step may reveal an allocation to the various performance obligations that may differ from previous guidance.

Advertising fund: Some franchise agreements require franchisees to remit a percentage of gross sales to an advertising fund. The advertising fund dollars are then spent on advertising for the company as a whole. Previously, advertising fees charged to the franchisee were recorded on a net basis against advertising costs on the franchisor’s income statement. Topic 606 takes a different approach. Because the franchisor controls advertising expenditures and the promise to provide advertising is not distinct from the franchise right, itself, brand fund fees should have a gross presentation for advertising fund income and related marketing expenses on the income statement.

How could this affect my business?:

If you are a franchisor that has not reached royalty self-sufficiency and you are relying on recognizing initial franchise fees as your primary source of revenue, your impact could be substantial. ASC 606 will require that you “smooth out” your initial franchise fee revenue over the term of the contract. For example, if you collect initial franchise fees of $30,000 from a 10-year franchise agreement, you will report $3,000 of revenue a year for 10 years. While this will not impact cash flow, the new reporting standard may affect your net income presentation, negatively. This will also have an effect on bank covenant calculations as your bottom line will be impacted.

The bottom line:

Under the new standard, revenue is recognized as/when a franchisor satisfies each performance obligation. This could be over the term of the franchise agreement for initial franchise license fees, on a straight-line basis. Or, at a point in time if the services have standalone value and are considered distinct and separate from the other performance obligations. Royalty fees will be recognized as revenue when subsequent sale or usage occurs and the performance obligation has been satisfied.

While this may not seem too different than previous practices, applying each step could prove challenging and produce different outcomes when reviewing franchise agreements. At a minimum, all entities will be subject to more disclosure requirements. However, this will also vary and requires management’s judgement.

Adoption of this new standard will require time and effort. Don’t delay in implementing the new revenue recognition standard. Some steps you should be taking now:

  1. Develop an understanding of ASC 606, as soon as possible.
  2. Perform a deeper dive. Identify and evaluate the impact of ASC 606 for your business along department lines: accounting, finance, technology, legal, tax, financial covenants and internal controls. Specifically, select a few representative franchise agreements, and evaluate them using the new revenue recognition model to identify areas for a further analysis.
  3. Monitor industry-specific transition guides and resources.
  4. Select a transition method, and plan for how you will retrospectively adopt ASC 606.
  5. Establish an implementation plan, including a timeline, education sessions for your operations and finance staff that impact the way you do business, identify third-party resources that you may need to assist you, and possibly a transition committee to oversee conversion. While conversion may not result in significant changes to you, documenting the conversion and the decisions is imperative and as your external advisors, we will be able to review this with you to assist in addressing any audit and tax compliance impact.
  6. Educate financial statement users and stakeholders about the changes ASC 606 will have on your financial statements. Be proactive and discuss with any lenders the effect this will have on financial covenants. The lenders are accustomed to working with clients on accounting and financial reporting changes that impact covenants, however, having discussions in advance of year end will provide for a smooth transition.

Author: Dominique Walsh, CPA | dwalsh@withum.com

For questions or more information on this topic, contact a member of Withum’s Franchise Group by filling out the form below.

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