On May 28, 2014, FASB introduced Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers, bringing comprehensive, industrywide changes to the way businesses recognize revenue and to reporting disclosures. Aimed at revising prior broad-based revenue standards open to interpretation within the industry, Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, converges standards to provide more uniform guidance. ASC 606 went into effect in 2018 for public entities and goes into effect in 2019 for substantially all other businesses.
The new accounting standard significantly affects franchisors in areas including the accounting for franchise fees and area development fees and the accounting for gift card revenues.
Franchise Fee Revenue
Under previous accounting guidance, franchise fees were often recognized at a point in time shortly after entering into the franchise agreement—typically after certain initial obligations were completed, such as site location assistance and training. This frequently meant companies recorded franchise income at the time, or close to when, the franchise agreement was entered into and when the store location opened for business.
Under ASC 606, the franchise contract is recognized as a distinct series of performance obligations and essentially is a license that allows the franchisee to use the franchisor’s intellectual property. Intellectual property may include pre-opening services, marketing services and use of the franchisor’s systems. Accordingly, the license agreements typically include multiple services and, therefore, multiple performance obligations. Certain upfront pre-opening activities may be determined to be distinct performance obligations separately from the license agreement if the fair value of those services is determinable. If so, they may be recorded after those services have been delivered.
Given the highly interdependent nature of the license agreement, related use of intellectual property and other factors, many companies are recording all franchise fee revenues over the expected life of the franchise agreement. In effect, the series of distinct service obligations may be considered a single performance obligation.
In addition, franchise agreements may provide for area development agreements, allowing the franchisee to build additional stores in specified geographic regions. Franchise agreements also can include site selection assistance, advertising programs and training related to the business or specific franchisor processes.
When applying the new revenue recognition guidance, entities should identify contracts with the franchisee and then identify all the performance obligations in the contract with the customer, as shown below:
In many circumstances, it is likely that performance under area development agreements and/or advertising agreements cannot be satisfied without possession of the franchise agreement itself and, therefore, would not be considered a separate performance obligation. In other words, a development right has no value without the ability to operate under the franchise agreement. In this case, area development agreements would not be considered a separate performance obligation. Amounts paid to obtain the area development rights and amounts paid for franchise rights would (after identifying appropriately separable performance obligations) be recognized over the life of the expected benefit. In practice, some companies (especially newer, less proven franchises) might opt to use the initial life of the franchise agreement as a basis for the expected life over which to record the revenues, on a straight-line basis. In determining the expected life, companies would have to consider frequency of renewals and whether fees paid to renew the license agreement after the initial term are substantive.
It is possible to carve out separate services and related revenues if those services have standalone value and are considered distinct and separate from other performance obligations. If certain services can be distinguished as having value separate from the franchise agreement and those services’ fair value is estimable, ASC 606 permits the revenues to be recorded when (or as) the related service is completed. For example, if a franchisor provides general site selection assistance and/or training for a franchisee that has value on a standalone basis, those revenues may potentially be recognized upon completion of the related service. Identifying services that can be separated from the franchise agreement should be determined on a case-by-case basis using relevant facts and will likely require significant judgment to determine the separate performance obligations.
In summary, recording franchise fee revenue requires significant judgment to determine all performance obligations, as well as whether there are standalone obligations that can be carved out of the franchise revenues and recorded as those separate obligations are performed. Management should carefully analyze the factors within their agreement to properly identify a distinct good or service and properly allocate the transaction price to distinct performance obligations. The revenues not recorded under distinct obligations would be recorded on a residual basis so the remaining revenues not allocated to distinct performance obligations completed would be spread over the expected life of the franchise arrangement.
Gift Card Revenue Recognition & Breakage
Prior to ASC 606, companies typically recognized gift card revenue after gift cards were redeemed and recognized income from unredeemed gift cards under three methods:
- Remote method – Income recognized when the redemption probability is determined to be remote
- Redemption pattern method – Income recognized pro rata based on the company’s historical analysis of redemption
- Released obligation method – Income is not recognized until the company is legally released of its obligation, typically at gift card expiration
In an effort to reduce diversity within industry practice and increase comparability between financial statements, FASB will require that companies use the redemption pattern method. Companies currently using the redemption pattern method for recording income are likely to see immaterial effects from the change. However, assuming that an entity does not expect to be entitled to a breakage amount, companies recording breakage income under the remote or released obligation methods will need to revise their accounting by recording breakage revenues in proportion to the pattern of rights exercised by the customer.
For more information or assistance with assessing the new standard’s effects on your business, reach out to your BKD trusted advisor or use the Contact Us form below.