Franchisor Revenue Recognition Simplified

Lee Plave
Plave Koch PLC

 and

Aaron Chaitovsky, CPA
Citrin Cooperman

On January 28, 2021, the Financial Accounting Standards Board (FASB) issued its long-awaited “practical expedient,” which will truly help privately-held franchisors tackle the relatively new revenue recognition requirements of US GAAP.

Franchisors have been waiting for this development for quite some time, and the FASB delivered after almost four years of discussion and efforts on the part of the IFA Task Force, which worked closely with the FASB and its staff, to address this issue in a constructive manner.

Here are the highlights:

FASB’s revenue recognition standard (technically called “ASC 606”) will still apply … but privately-held franchisors can elect to adopt a “practical  expedient.”

ASC 606 applies a five-part model for how companies should recognize revenue:

      1. Identify the Contract – Determine all of the relevant contracts (e.g., the franchise agreement plus any separate agreements, such as an equipment agreement, a supply agreement, a training agreement, etc.)
      2. Identify the performance obligation in the contract – Determine each of the separate performance obligations under the contracts (what the franchisor is providing in conjunction with the agreements). Consider the portions of the separate performance obligations that are brand-specific and non-brand-specific. Non–brand specific performance obligations related to franchisee training, for example, would include the portion of training that could be of value to a franchisee if they were operating an independent business not using the trademarks (for this purpose, assume the confidentiality and non-competition clauses are not considered). The portion of the services that cannot be used without also using the trademarks are considered brand-specific. As an example, training related to soft skills or general business operations may be non-brand-specific training. Other examples could include site selection and equipment layout and design.
      3. Determine and allocate the transaction price – The first step here is to establish how much the franchisee pays up front in initial fees, including any multi-unit fees, development fees under all of the contracts,* and the standalone value (to the franchisee) of the separate performance obligations. Valuation of these items can be determined on the basis of the franchisee’s replacement cost (e.g., a market assessment of what the franchisee would have to pay to obtain the same services elsewhere), the costs that the franchisor incurred plus a reasonable margin, or any another method that can reasonably assess the value to the franchisee of an individual performance obligation. It is important to note that there are some instances in which royalties might be also included in the calculation of initial fees, if the royalties are pre-determinable and not percentage-based, or if the royalties are not earned by the franchisor as the franchisee operates its business.
      4. Allocate the transaction price to the performance obligations in the contract – This process starts with the total transaction price and then applies the transaction price to the respective performance obligations by applying a reasonable value to each of the separate performance obligations delivered. As part of this exercise, the franchisor must apportion the transaction price to both the brand-specific and non- brand-specific portions of each separate performance obligation.
      5. Recognize the revenue when the entity satisfies the performance obligation – For example, the revenue attributable to the not-brand-specific portions of the performance obligation can be recognized immediately when the service or the goods are delivered to the franchisee. The remainder of the of the revenue (that is, the “transaction price” determined as explained in step #3, above), if any, would be so closely tied to the use of the trademarks that that revenue would be recognized on the same timescale as the trademark license itself is used (e.g., ratably across the x-year term of the franchise agreement).

Many of the steps listed above are quite subjective and, therefore, it became costly for franchisors to develop their five-part analysis and the support for each conclusion. For this reason, the practical expedient brings clarity.

PRACTICAL EXPEDIENT: THE PRACTICAL APPROACH

The January 2021 practical expedient can simplify a portion of the five-step process for many franchisors.

A privately-held franchisor can now elect to adopt the practical expedient and recognize revenue in the following manner (in addition to some other technical recording and reporting requirements):

  1. The franchisor can deem all of its pre-opening obligations as one single performance obligation, which vastly simplifies step #2, above. One proviso is that the franchisor must have listed these obligations in the relevant agreements
    • The FASB, in the language of the expedient, listed six categories of pre- opening obligations that a privately-held franchisor can now consider as one singular performance obligation:
      • Assistance in the selection of a site;
      • Assistance in obtaining facilities and preparing the facilities for their intended use, including related financing, architectural, and engineering services, and lease negotiation;
      • Training of the franchisee’s personnel or the franchisee;
      • Preparation and distribution of manuals and similar material concerning operations, administration, and record keeping;
      • Bookkeeping, information technology, and advisory services, including setting up the franchisee’s records and advising the franchisee about income, real estate, and other taxes or about regulations affecting the franchisee’s business; and
      • Inspection, testing, and other quality control programs
    • For any other pre-opening obligations provided by the franchisor that are not listed above, the franchisor would have to apply the original five-step analysis.
  2. The practical expedient specifically eliminates the need to allocate the pre-opening value as between the brand-specific not-brand-specific portions of the performance obligations, which simplifies step #2 above. This should make the analysis simpler to apply and diminish subjectivity, while creating more comparability among brands that adopt the expedient. Note, however, that a good bit of subjectivity will remain because each franchisor will determine for itself the value of the performance obligations (steps 3 and 4, above) using the methodology that it determines is reasonable.

There is still time this year to adopt the practical expedient, but franchisors can also choose to apply the practical expedient starting with FY21 and then must apply it on a retrospective basis for previous FYs.

The practical expedient is not available to “public business entities” – which are publicly- traded entities and subsidiaries that are included in a publicly-traded entity’s SEC filings.

*****

The January 2021 “practical expedient” represents a considerable achievement for the franchise sector. The practical expedient is a helpful supplement to revenue recognition standards that apply not just to franchisors, but to all sectors in the U.S. economy. In fact, the new U.S. revenue recognition standards are much more in line with similar standards that apply in other countries, with one method applying across all industries.

We were proud to play a role as members of the small IFA FASB task force. Our group began its work in 2017 when we met with the SEC’s Chief Accountant, FASB’s professional staff, and FASB Board Members – as well as technical presentations to the FASB and in meetings with Congressional staff, discussions with state examiners, the FTC, and in joint presentations with FASB Board Members and its staff of professionals.

We also salute the work done by the IFA’s professional staff as well as the FASB Board and its professional staff. The FASB Board and its staff appreciated the significance of the issue and the impact that would fall upon privately-held franchisors. This is the second time that we were able to prevail upon FASB to consider and align an accounting standard that inadvertently ensnared franchising, so as to avert substantial damage to the franchise sector – the first being the FASB’s 2003 revision of post-Enron accounting changes originally known as FIN46, which were reissued as FIN46R.

There are technical details as to how a company should go about meeting the requirements of the revenue recognition rules, which go well beyond the scope of this summary. We are pleased to answer questions if they arise.