We’re going to play a word association game. When you...
In a move to standardize accounting practices further than is already being done by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), the organizations’ latest ASC 606 implementation date came and went just before Christmas last year and is now on the minds of franchisors nationally and abroad.
What is ASC 606?
It’s a joint revenue project called “Revenue from Contracts with Customers” and is a rule that revolves around exactly that. Revenue is an important number to users of financial statements in assessing an entity’s financial performance and position. The goal for ASC 606 is to standardize the way companies, including franchisors, recognize any revenue from contracts.
For example, when a franchisor sells a franchise to a candidate, there is an initial franchise fee that is typically recognized at the time the franchise location is opened or when training is complete if it is a home-based business. This is the amount of money that goes on a balance sheet under the Franchise Development column and drives goals for the sales team while supporting the bottom line of the business. Under ASC 606, instead of the franchisor recognizing the full amount when the unit opens, the new rule dictates it be recognized over the length of the contract term.
This is a big adjustment.
For example, let’s say the initial franchise fee for Brand X is $30,000 for a 10-year term. Instead of the company recognizing $30,000 upon the opening of the unit, the new rule dictates it be amortized throughout the term of the agreement. In this case, over 10 years which means the franchisor would recognize $3,000 per year for 10 years. The math is simple and unfortunately can be detrimental to Brand X’s bottom line. Let’s say Brand X sells 10 units in one month; instead of recognizing $300,000 for that month, they will only recognize $30,000. The effect of this rule on the value of the company at any given time can be monumental.
How will franchisors weather the storm that is ASC 606?
The adoption of ASC 606 has changed how franchisors recognize the initial franchise fee. While this will have no impact on cash, as those funds can be used immediately upon collection, this will have a major impact on balance sheets and what the company’s net worth will look like at the end of each year. It will also affect the statement of income because less revenues are being recognized.
The recommendation is that you follow a five-step process in determining how income is recognized from the initial franchise fee. Note that royalties are not affected by this rule change.
- Note the contract most affected for most will be the Franchise Agreement.
- Determine what the separate performance obligations (SPOs) are. For example, SPOs could be training or site selection that were included in the initial franchise fee. You must determine where the SPOs are distinct, meaning they could be allocated as a portion of the initial franchise fee, to be recognized when the services have been completed.
- Determine the total amount collected by the initial franchise fee.
- Attribute the value of each SPO. For example, if a 2-week training program is offered, what would that program cost separately? This is the cost that needs to be recognized when the training is completed. In the case of site selection, figure what the value of that service would be at the conclusion of the service (when the site has been selected).
- Decide which revenues contributed to each SPO and recognize them.
Let’s go back to our $30,000 example above.
If it is determined that the initial training is valued at $10,000, and site selection services are valued at $5,000, then $15,000 of the original $30,000 can be recognized when all pre-opening obligations have been satisfied, i.e. the franchise opens. Then, the remaining $15,000 will be amortized over ten years.
It is certainly possible there will be a sufficient dollar amount of SPOs to cover the entire initial franchise fee by the time the franchise opens for business. Franchisors should speak to their auditors to clarify what SPOs reasonably qualify.
The implementation of ASC 606 doesn’t have to be as grim or complicated as it sounds. With collaboration between the franchisor, auditor, and franchise attorney, the topic of revenue recognition will be challenging but not impossible to weather.
The full text of ASC 606 can be found at FASB Accounting Standards Codification.