FisherZucker partner Joe Dunn was part of the IFA taskforce charged with addressing how the new standard alters the way in which franchisors can recognize initial franchise fees in their audited financial statement. After much consultation with the SEC and the Financial Accounting Standards Board (FASB), which governs auditing standards in the United States, we’re pleased to say that we’ve obtained some helpful clarity and guidance.
Under the present standard, initial franchise fees are “recognized, with an appropriate provision for estimated uncollectible amounts, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor.” In most cases, this means that franchisors recognize the initial franchise fee once its pre-opening obligations are complete and upon opening of the franchised unit.
In Topic 606 of Accounting Standards Update No. 2014-09, FASB has issued new standards that address the recognition of revenue in licensing contracts. Because a trademark license is a core component of a franchise agreement, these standards will be applied to the recognition of initial franchise fees. Public companies must implement the new standards in 2018, while private companies have until 2019 (early adoption is allowed starting in 2017).
Most accounting firms had interpreted the new standard to presumptively require the initial franchise fees to be recognized over the course of the term of the franchise agreement, as opposed to recognizing the full fee at the time of opening. Moreover, as the new standard is to be implemented retroactively, the calculation will need to be made for all years presented in the FDD or through an accumulative catch-up. As most franchise agreements have 10-year terms, this will require a lot of retroactive work, time and expense to allocate those initial franchise fees for each year of each franchise agreement.
FASB recognizes that the new standard was not intended to create a presumption of amortization of initial franchise fees or to create a “default” amortization position. FASB acknowledges that there can be multiple performance obligations in regards to revenue recognition of initial franchise fees as described in a handout distributed during its open board meeting held in Norwalk, Conn. on November 29, 2017.
Specifically, the handout states:
One of the most prevalent questions from the franchising industry involves determining whether or not pre-opening activities constitute a distinct performance obligation. Under current GAAP, franchisors generally recognize the initial fee when the location opens and recognize the subsequent royalty stream over time. Because industry-specific GAAP exists, franchisors historically have not had to assess whether the pre-opening services are a separate deliverable. In making this determination under the new standard, the first step for the franchisor is to determine if the pre-opening activities contain any distinct services. If none of the pre-opening services are distinct, then the initial fee would be part of the transaction price for the combined performance obligation of the license and services and, thus, recognized over the entire license period. If the franchisor determines that some or all of the pre-opening services are distinct, then it would allocate a portion of the transaction price to that performance obligation and recognize revenue when (or as) those services are performed.
The franchisor scenario illustrates the following key takeaways when implementing the revenue standard:
- Topic 606 does not include presumptions about how many performance obligations are in an arrangement.
- When assessing the standard, an entity should review the specific facts and circumstances of the arrangement and not over-generalize.
Thus, FASB has clarified that auditors are not to merely spread recognition of the initial franchise fee over the term of the franchise agreement, but rather need to engage in an analysis of performance obligations and allocate that part of the transaction price to those performance obligations and recognize revenue at the time of performance. While the analysis will differ for each franchisor and franchise arrangement, most franchisors provide training, site selection and other valuable products and services to franchisees at or prior to opening, which may mean in many instances that the initial franchise fee should can still be recognized as revenue at opening of the unit as has historically been the case.