December 07, 2018 | Tips and Tools

Is Your Business Ready for FASB’s Revenue-Recognition Standards?

Privately held franchisors must begin adopting the Financial Accounting Standards Board’s (FASB) new revenue-recognition standards in their 2019 reporting period. In this post we review FASB’s latest guidance to help you prepare.

In late 2017, we advised you that FASB had clarified how its new standards for revenue recognition would impact initial franchise fees charged by franchisors. Specifically, FASB stated at the time that revenue from an initial franchise fee could be recognized as separate performance obligations—that is, as “distinct” goods or services—were performed. Without these distinct obligations, franchisors would likely need to recognize the initial franchise fee over the term of the franchise agreement as part of the payment for the license.

But questions remained, particularly in the context of pre-opening services provided by franchisors: what is a “distinct” service? And how much of the initial franchise fee may be allocated to distinct services and recognized as revenue as those services are performed? Following a non-decision-making meeting in November of 2018, FASB issued a Staff Paper in which it attempted to answer these questions.

According to the Staff Paper, services provided by a franchisor are “distinct” if they are not “highly interrelated” with the license granted by the franchisor. For example, an initial training could be distinct if the training “could be relevant to the operations of a similar business or businesses in general,” and site-selection services might be distinct if they aren’t “specific to the brand and could be provided by a third party.”

Once a franchisor determines that a service it provides under the franchise agreement is “distinct,” then it may allocate and recognize as income the portion of the initial franchise fee equal to the “standalone selling price” of the service. According to the Staff Paper, the selling price is “the price at which an entity would sell a promised good or service separately to a customer,” and it will either be “observable” or estimated. An “observable” price might be found in the franchise agreement itself. For example, if the franchise agreement provides that payment of the initial franchise fee includes initial training the first five employees, but $X per additional employee, then the “selling price” of the training might be 5 times $X, and that amount could be recognized as revenue once the training is performed.  An estimated selling price, on the other hand, might be calculated through a variety of mechanisms such as looking at the price third-parties charge for the same or similar service (after all, since the service at issue is “distinct,” evidence of third-party pricing should out there).

Franchisors should review their initial franchise fee, and particularly the amount of the fee, in the context of these guidelines (if, for example, the standalone selling price of all of the services a franchisor provides prior to opening exceeds the initial franchise fee, then it may recognize the entire initial franchise fee at the time the services are provided). Franchisors may also want to review their operations manual and initial training schedule for franchisees to differentiate operational training from brand training to further delineate them as “distinct” and to make it easier for the auditor to rationalize which portion of the initial fee may be taken into revenue at which time. However, it is important to balance the benefits of categorizing training as non-brand related training for accounting purposes with the benefits of categorizing it as brand-specific for purposes of enforcing trade secrets or avoiding joint employer liability. Therefore, franchisors should ensure their accounting and legal teams communicate when making these decisions.

We will continue to monitor developments in this area as the revenue-recognition rule is put into practice.

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