The Franchise Disclosure Document (FDD) generally requires three years of audited statements, which is included in Item 21 of the FDD. These financial statements are required to include financial statements in accordance with generally accepted accounting principles (GAAP). GAAP accounting has many impacts on franchisor financial statements, and today, we will cover revenue recognition specific to initial franchise fees.
A typical franchise agreement requires a franchisee to pay an initial franchise fee to the franchisor. This allows the franchisee to use the branded concept’s intellectual property during the period outlined in the agreement and typically also provides the franchisee with assistance with pre-opening activities, such as site selection, training materials, etc., as prescribed by the related franchise agreement. Recognition of this initial franchise fee is governed by Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), herein referred to as ASC 606.
ASC 606 requires management to perform a five-step analysis to ensure proper recognition of the initial franchise fee (or any revenue stream).
- Identify the contract with a customer
- The contract must meet several criteria to meet the definition of a contract, though typically includes both the franchise agreement and the FDD, as both of these documents contain information related to the obligations of the franchisor to the franchisee, payment term risk, timing or amounts of future cash flows.
- Identify the performance obligations
- The performance obligation represents a promise made by the franchisor to the franchisee. Management is required to assess the performance obligations and determine if the goods and services are distinct in order to determine how to apply the initial franchise fee to the various performance obligations. A typical franchise agreement may include a requirement that the franchisor perform various services or provide items necessary for the operation of the franchise, such as:
- Assistance with site selection
- Training and operating manuals
- Lists of known suppliers or access to proprietary food prep equipment
- Access to recipes
- The performance obligation represents a promise made by the franchisor to the franchisee. Management is required to assess the performance obligations and determine if the goods and services are distinct in order to determine how to apply the initial franchise fee to the various performance obligations. A typical franchise agreement may include a requirement that the franchisor perform various services or provide items necessary for the operation of the franchise, such as:
In most cases, the outcome of this step results in the determination that the performance obligations are not distinct and are highly interrelated, resulting in one performance obligation.
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- Private Company Alternative: Due to the complexity and costly nature of applying this step, the Financial Accounting Standard Board (FASB) issued a practical expedient for private companies that simplify this step. This guidance allows franchisors to easily assess performance obligations into two buckets – pre-opening services and ongoing support, which allows the franchisor to recognize a portion of revenue up front, with the remaining recognized over the franchise agreement term. See the previous article related to the practical expedient. A few key reminders when implementing the private company alternative:
- Guidance is clear around what constitutes “pre-opening services.”
- Track expenses related to these services, which likely include specific employee’s time. Some examples of this are as follows:
- if you have an employee train the franchisee’s personnel, track how many hours they spent training and what their salary/pay rate is;
- if you host a training session for one or multiple franchisees at a time, track the hard costs of the training event (cost incurred for the space, travel, food) as well as costs incurred for personnel (salaries/pay rates and the number of hours spent training).
- Franchisors can only account for pre-opening services as a single, current performance obligation if:
- it is probable that the continuing fees (like royalty fees) in the agreement would be sufficient to cover the franchisor’s continuing costs plus a reasonable profit and
- the pre-opening services fall within the list mentioned above.
- Private Company Alternative: Due to the complexity and costly nature of applying this step, the Financial Accounting Standard Board (FASB) issued a practical expedient for private companies that simplify this step. This guidance allows franchisors to easily assess performance obligations into two buckets – pre-opening services and ongoing support, which allows the franchisor to recognize a portion of revenue up front, with the remaining recognized over the franchise agreement term. See the previous article related to the practical expedient. A few key reminders when implementing the private company alternative:
- Determine the transaction price
- Franchise agreements typically include multiple payments, including but not limited to initial franchise fees (typically due upon signing of the franchise agreement) and other fees required at various other dates, such as royalty fees and advertising fees. The transaction price is typically the initial franchise fee and should not include any amounts related to sales or usage-based fees (i.e., royalty fees or advertising fees).
- Allocate the transaction price to the performance obligations
- The transaction price represents the consideration the franchisor is entitled to in exchange for transferring a good or service to the franchisee. As noted in step 2, we determined that the promises made to a franchisee typically result in one performance obligation. As such, the allocation of the transaction price to the performance obligation would simply be the value determined in step 3 or the initial franchise fee value.
- Recognize revenue as performance obligations are satisfied
- Revenue can be recognized as the performance obligation is satisfied (or the franchisor fulfills all promises). This typically starts on the date of store opening and is recognized over the remaining term of the franchise agreement on a straight-line basis.
In summary, management is required to document all steps noted above for all revenue streams. Typically, it is noted that franchise agreements constitute a single performance obligation, and the initial franchise fee is recognized on a straight-line basis over the term of the franchise agreement. If management elects the private company alternative, a portion of the franchise fee may be able to be recognized up front, with the remaining portion recognized on a straight-line basis over the term of the franchise agreement.
Management should also consider the costs of obtaining the contract. A general rule related to these expenses is any ongoing costs incurred or any cost that would require to be paid whether the contract is executed or not should be expensed as incurred. Whereas expenses that are only incurred when a franchise agreement is successfully executed should be deferred and recognized over the term of the franchise agreement. Common costs incurred during the execution of a franchise agreement include:
- Legal fees – may include costs to draft or update FDD and related franchise agreement, contract negotiations, etc.) – these should typically be expensed as incurred
- Travel-related expenses – may include meetings with the prospective franchisee, contract negotiations, etc. – these should typically be expensed as incurred
- Commissions or bonuses paid to internal sales teams or external brokers upon execution of or receipt of payment related to a new franchise agreement – these should typically be deferred and recognized over the term of the franchise agreement in alignment with the initial franchise fee revenue recognition.
If you have questions on any of the topics listed above, please get in touch with your GBQ advisor.
