Revenue recognition is changing for franchisors
Published March 22, 2018
On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (ASC 606), which will change the way franchisors recognize revenue.
Under the old revenue recognition standards, a franchisor would recognize the entire franchise fee upon completion of all the initial obligations outlined in the contract. The best evidence of this was usually the opening of the franchised location.
Under ASC 606, a franchisor must carefully separate all performance obligations present under its franchise agreements. For many franchisors, examples of such performance obligations may include site selection, training of employees, specialized equipment, unique software or apps, and finally the right to operate the franchise itself. These obligations need to be separated and recognized as each are delivered to the franchisee. The right to operate the franchise itself is recognized over the term of the franchise agreement.
Here is an example. A franchisee purchases the right to operate a retail store for 20 years from a franchisor for a price of $25,000. The agreement stipulates that a four percent royalty is to be paid on the store’s sales. The agreement also calls for the store’s operating manager to be trained at the corporate office.
The contract has two separate deliverables, the right to operate and use the franchise brand, and the training of the manager.
The new standard requires the break out of performance obligations by their relative fair values. Assume that when a manager is trained for an existing location or for an expanding franchise group, the manager training fee is $5,000. The value of the training can be assumed to be $5,000 and the value of the use of the franchise brand is therefore $20,000.
Under the new standard, the franchisor would recognize $5,000 upon the completion of the manager’s training. The remaining $20,000, which is for the right to operate the franchise, would be recognized over the 20-year term of the agreement, or $1,000 per year.
The recognition of royalty income remains unchanged. Royalties are still recognized as the store recognizes sales as there are no separate deliverable components related to the royalty income.
ASC 606 is effective for public entities with annual reporting periods beginning after December 15, 2017. For non-public entities, the standard is effective for annual reporting periods beginning after December 15, 2018. Both public and non-public entities may elect to apply this guidance earlier.