Our previous blog highlighted the changes franchisors need prepare for in light of the new revenue recognition changes. In addition to that, there are some procedural guidelines. Within the new standards, there are five steps outlined for revenue recognition:
Step 1: Identify the contract.
Franchisors typically have a written franchise agreement in place that specifies the parties, each party's rights and obligations, and the payment terms, so this step will likely be the easiest. Note that 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.
Franchisors must determine if the services it provides to franchisees at the onset of a franchise agreement-- things like pre-opening marketing activities, site selection, training, etc. -- 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. Again, get with your CPA for guidance.
Step 3: Determine the transaction price.
This step will involve listing all the revenue streams -- including those that will be received up front, and those that will be received over time -- the franchisor 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.
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 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.
A few more things to consider
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: The new standards contain 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.
This isn’t easy. The new rules around revenue recognition are lengthy and complex and require complex judgment calls. For private franchisor companies not having yet made the transition, the important thing is to begin working with us to take the necessary steps to compliance. The sooner we begin tackling the issues around the new standards, the better. Please reach out.