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Understanding the impact of ASC 606 on franchising and franchise brokers

| Jul 12, 2021 | Franchise Law

Franchise accounting is an area with many nuances. As times change, so do the regulations and guidelines that franchise accountants follow.

Over the last several years, ASC 606 has been going through several stages of implementation in the franchise world. For public entities, the guideline went into effect in 2017; nonpublic entities needed to start following the guidance or fiscal years beginning after 2018.

While the 700-page rule applies to revenue recognition in all contracts with customers, it also has specific impacts on franchising. Here’s what you should know about the new rule and how it affects the recognition of franchise fees.

The IFA’s 5 step model

During their annual conference in 2018, the International Franchise Association put together a presentation to support franchisors in understanding how ASC 606 would impact future franchise sales. The IFA identified the core principle and went on to break the guideline into a five-step process.

Core principle

The intent behind ASC 606 is to give concrete guidance for when franchisors should recognize the revenue from their initial franchise fees.

Under this guidance, revenue should show the transfer of goods or services to customers. The amount of the revenue from the transaction should reflect the consideration the franchisor expects to be entitled to in exchange for the goods or services they provide.

Getting started

While it seems obvious, it is essential to identify the contract in question and the key clauses that could apply to this particular legislation.

Next, it is essential to look at the performance obligations and what they mean to the franchisor and the customer. These obligations contain specific promises that:

  • Benefit the franchisee with a good or service that is readily available
  • Transfers the good or service in a way that is distinct from other promises in the contract

Taking the time to recognize the distinguishing features of each performance obligation will be an essential part of fulfilling the guideline, both when looking at the price of the transaction and when determining when to recognize revenue.

While some obligations like intellectual property rights may be tied to other similar responsibilities, there may also be promises that should be separate from the others. Therefore, the franchisor should consider obligations, such as:

  • Location considerations and support
  • Discounts
  • Operations expenses, like equipment
  • Training and personnel support
  • Identifying the distinct promises in the contract which will be essential to the final steps in the IFA’s proposed process for applying ASC 606.
  • Applying costs to promises

Once you establish the promises in the franchise agreement and the price of the transaction, you will need to allocate the transaction price to the specific promises from the previous step. As you consider how to proceed with allocating the transaction price, keep in mind that you should evaluate the price each good or service would be as if it was part of a separate transaction.

Recognizing revenue

Rather than recognizing revenue as one amount assigned to the complete contract, the core principle that goes with ASC 606 allows franchise brokers to recognize revenue as promises are delivered. Depending on the nature of the promise, the revenue could be spread out over time or recognized at once.

For example, promises that continue through the life of the contract, like intellectual property licenses or royalties, are something the customer uses for the entirety of the agreement. On the other hand, one-time promises, like site selection, happen at one specific time.

The introduction of a practical expedient

Trying to break down all the elements of the franchise fee can be cumbersome. To make step two of ASC 606 simpler for private-company franchisors to apply, the Financial Accounting Standards Board (FASB) added an amendment that includes a practical expedient.

While the spirit of ASC 606 will still be an essential part of the revenue recognition process for franchisors, the practical expedient allows franchisors to treat certain preopening services as separate from the license. The amendment allows the inclusion of services, such as:

  • Site selection services
  • Training franchisee’s personnel
  • Inspections and other quality control

Currently, franchisors do not need to apply the practical expedient, but if they choose to utilize it, they must disclose that they are using the practical expedient.

While the amendment makes the second step of ASC 606 simpler, the rest of the guidance still applies.

Impact on franchise brokers

Franchise brokers count on being paid by the franchisor from the initial franchise fee that a candidate of theirs has paid.  If the franchisor cannot recognize the full fee, are they still going to pay the broker the full amount of the broker’s fee that is owed or will they pay it over a period of time in which the franchisor is able to recognize the fee from an accounting perspective?  The answer is that the broker typically still gets paid the full fee earned, but the franchisor may not have the ability to recognize that full amount.

One of the challenges that comes with ASC 606 is that revenue recognition will happen over time. This means that a franchise broker looking to secure income from the placement may not be paid the full amount until each year of the contract.

Eventually, professionals in related industries will adapt to the new guideline. They will likely develop ways to support the change in revenue recognition.

Being prepared

Understanding how to apply ASC 606 will also be essential when it comes time for an audit. Regardless of whether you have had audits in the past, it will be critical to demonstrate compliance. It may also be beneficial to contact potential auditors in advance to discuss expectations, so you are ready.

Keep in mind, as you look towards your own implementation of ASC 606, you may find it beneficial to make changes to your contracts and other documents. For example, rather than your past documents where you needed to find distinct promises and assign a portion of the transaction price, future agreements could have a more strategic approach.

The advantage of ASC 606

The prior model made it challenging for customers and other entities to determine what costs were associated with certain goods and services in the franchise agreement. While this often is not an issue with contracts with a smooth process, when there are conflicts or requested changes, having a clear understanding of the promises, their costs and when the franchisor recognized the revenue could be beneficial.

Rather than spending time debating costs and promises when there is an issue, following the guidance of ASC 606 can support an understanding of the value assigned to specific promises and when franchisors should recognize the revenue.

Getting the right support

ASC 606 is a long and complex guideline for franchises. Therefore, it is vital to get help from experienced professionals who understand the rules. When you have the proper support to implement regulations, like ASC 606, you can avoid some of the costly mistakes that can come from a misunderstanding and the expectations behind it.