Navigating Technical Accounting for Franchisors
Restaurant franchisors continue to navigate challenging issues and ever-changing rules in 2024. Five years have passed since private companies’ required adoption of Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, which, as subsequently amended, significantly changed how franchisors recognized revenue. As a result of ASC 606 and the 2021 Accounting Standards Update (ASU) 2021-02—Franchisors—Revenue from Contracts with Customers (Subtopic 952-606): Practical Expedient, many restaurant groups are now restructuring their franchise agreements in an effort to recognize more revenue upfront.
What Are the Key Impacts of ASC 606 and ASU 2021-02?
The most significant change to franchisors upon the adoption of ASC 606 was that franchise fees would be recognized over the term of the franchise agreement instead of when the location opened under previous guidance. This also required franchisors to analyze their franchise contracts and identify all of their performance obligations in the contract. More specifically, franchisors began analyzing pre-opening activities (such as site-selection assistance, access to the brand’s operating manual or training for employees) to identify whether the services provided in advance of the store opening were distinct from the franchise license and, therefore, could be considered separate performance obligations. For services that did meet the criteria of performance obligations, entities are then required to look at each performance obligation to determine standalone selling prices, allocation of consideration and timing of the revenue recognition. Many times, pre-opening activities were determined by the franchisors to not be distinct from the franchise license, and therefore required to be accounted for as deferred revenue on the balance sheet and recognized as revenue over the term of the franchise agreement.
Many franchisors voiced concerns about the cost and complexity of adopting ASC 606, and in 2021, the Financial Accounting Standards Board (FASB) released ASC 2021-02 to simplify the guidance about the identification of performance obligations for non-public franchisors. The ASU listed specific pre-opening services that could be accounted for as distinct performance obligations from the right to use the franchise license:
- Assistance in the selection of a site;
- Assistance in obtaining facilities and preparing the facilities for their intended use, including related financing, architectural and engineering services as well as lease negotiation;
- Training of the franchisee’s personnel or the franchisee;
- Preparation and distribution of manuals and similar material concerning operations, administration and record keeping;
- Bookkeeping, information technology and advisory services, including setup of the franchisee’s records and advising the franchisee about income, real estate and other taxes or about regulations affecting the franchisee’s business; and
- Inspection, testing and other quality control programs.
Upon the release of this ASU, certain brands initially did not adopt the practical expedient due to how burdensome it would be to determine the standalone selling prices and related allocation of the transaction price to the pre-opening activities. As such, they continued to recognize the full franchise fee over the term of the agreement. As time has passed, franchisors have started to analyze the pre-opening services and are amending franchisee agreements to more clearly break out the fees for training services, based on those fair values, and the fees for the license.
What Are the Challenges in Applying ASU 2021-02?
Almost every franchisor contract includes some pre-opening training services, and the training can be considered distinct from the franchise license according to ASU 2021-02. Companies should first consider whether the training services are specific to the franchisor’s IP and brand, and therefore bundled into the franchise right (i.e., not distinct). For example, training services (or hours) that are specific to a franchisor’s business model and standards are highly interrelated with the franchise brand and therefore must be bundled with the franchisee license. If there are distinct training services that are not highly interrelated with the franchise right and are material in the context of the contract, those services should be identified as a separate performance obligation. As a best practice, brands should consider creating a training calendar that clearly outlines time spent discussing specific brand business models versus generic training, as well as copies of the training materials used during the sessions. The fee identified for these combined training services must be allocated between the portion that pertains to intellectual property versus generic training of how to run a business.
For brands who are new to identifying pre-opening services and making adjustments to the language and fee structures in their franchisee contracts, they may be questioning exactly how to apply ASU 2021-02 to existing contracts if they previously had not considered their training services as distinct performance obligations. For existing franchisee contracts, should they retrospectively identify the district preopening services, allocate a portion of the initial franchise fee and restate retained earnings? Or can they adopt the ASU prospectively for all new franchisee contracts entered into and not revisit existing training services? In accordance with the revenue recognition standards related to modifications or changes to contracts, any new franchisee contracts (that are not modified) should be accounted for on a prospective basis, and existing franchisee contracts (that have not been formally amended) are not subsequently modified for these changes to the new agreements.
Windham Brannon Can Help Restaurant Franchises
For brands that consistently onboard new franchisees each year, a valuable practice would be to revisit their revenue recognition policies and thoroughly understand the pre-opening services they provide to their new franchisees. This will be essential to then determine any necessary formal changes to their written franchisee agreements. Windham Brannon’s Restaurant Practice is well-versed in helping organizations understand complex accounting rules for their franchise operations, including ASC 606 and ASU 2021-02. For questions or more information to help your franchise, contact your Windham Brannon advisor today, or reach out to Maggie Wise and Jeff Yelkovich.
