Under recent guidance from the Financial Accounting Standards Board (FASB), franchisors can only recognize revenue from initial franchise fees in their financial statements after they perform services that are distinct from the franchise agreement. Otherwise, they must recognize the revenue over the term of the agreement. This change can have a significant effect on franchisors’ financial statements, particularly those that are in the start-up or growth phases.
When to Recognize Franchise Fee Revenue
When a franchise agreement is executed, franchisees typically pay an initial franchise fee for an intellectual property license. Under the license, they can create a business using the franchisor’s trademarks, operations and business systems, and more proprietary information when selling the franchisor’s products. Previously, franchisors often recognized the revenue from initial franchisee fees shortly after the agreement was signed and franchisors provided some initial services, such as setting up a site location and delivering training.
Under ASC 606, franchisors must determine whether some or all their pre-opening activities can be considered standalone products or services. If so, revenue can be recorded when those services are completed. Otherwise, revenue must be pro-rated over the license agreement period.
How to Apply the Standards
ASC 606 applies to all industries, eliminating transaction- and industry-specific rules for revenue recognition. Franchisors and other businesses should apply the following steps to determine when to recognize revenue in their financial statements:
- Step 1: Gather all contract(s) with a customer.
- Step 2: Determine each contract’s performance obligations.
- Step 3: Determine the price of each transaction.
- Step 4: Assign the transaction price to each of the performance obligations in the contract.
- Step 5: Recognize revenue related to a performance obligation when the obligation is complete.
Determining which service obligations are separate from the franchise license
Franchise license agreements typically contain multiple service obligations that cannot be considered separate from the agreement. For example, an introductory training that covers brand-specific information about business operations would likely not be considered separate from the license. This is because the franchisee cannot apply the training outside of the franchisor’s brand.
If the franchisor delivers training on general topics that can be used in any business, such as business management or vendor relationships, this performance obligation could be considered as separate from the franchise license. Franchisors can determine the value of this standalone training, and then recognize an equivalent dollar amount from the license fee as revenue once the training is completed. Therefore, it can be a complicated process to determine how and when to recognize revenue from licensing fees, and it varies from one franchisor to the next.
When the standards apply
After being deferred multiple times, ASC 606 standards apply to annual reporting periods beginning after December 15, 2019 and interim periods within annual periods beginning after December 15, 2020. The deferral is only available to private companies and nonprofit organizations, and it is not mandatory. Therefore, entities may choose to adopt the standard early.
The FASB creates the generally accepted accounting principles (GAAP), a set of accounting principles that companies should follow when compiling financial statements, reports, or audits. Companies are not bound to follow GAAP by law, but following these standards is critical to establishing credibility in an industry, obtaining funding, and going public.
FASB’s revenue recognition standards can be complicated. Franchisors will need to closely examine their initial franchise fees and related performance obligations to determine when they can recognize this revenue source. Contact a trusted Chugh CPAs, LLP accountant for help recognizing revenue.