Franchisors face unique challenges when applying Accounting Standards Codification (ASC) 606 Revenue from Contracts with Customers. Contract modifications, sales-based royalties, and licenses of intellectual property are common challenges. This article explains these challenges and how the Five-Step Method in ASC 606 addresses them.
Step 1: Identify the Contract
Modifications in a franchise contract are common, including renewals of the franchise agreement, transfers of the franchise to a different franchisee, the addition of locations in an area development agreement (ADA), and the early termination of a contract. All of these represent contract modifications because they include either a change in the scope or a change in the price of the contract.
If the contract modification increases the scope and price of the contract, and the price is increased by an amount that reflects the standalone selling prices of any additional goods or services, the contract modification should be accounted for as a separate contract. If the change in price does not reflect the standalone selling prices of the additional goods or services, but the goods and services are distinct, the modification should be accounted for as a termination of the existing contract and the creation of a new contract. If the additional goods and services are not distinct, the modification should be accounted for as part of the existing contract. (See Contract Modifications Part I – Separate Contracts for more information.)
Creative Learning Corporation (2019 10-K): Transfer Fees and Contract Termination Creating a Contract Modifications
Creative Learning Corporation is a franchisor of educational programs for children. In its 10-K for the fiscal year ended September 2019, the company discussed how it accounts for transfer fees.
“The Company collects transfer fees when contracts are transferred between parties and accounts for the transfer as a contract modification under ASC 606. Because the transfer does not increase the scope of the contract or promise any additional goods or services and there are no new distinct services that will be provided after the transfer the Company considers the transfer fee part of the existing contract. Transfer fees, then, are recorded as deferred revenue at inception and recognized on a straight-line basis over the remaining contract term.”
Since there are no new distinct goods or services, the transfer fees are included in the existing contract in accordance with ASC 606-10-25-13(b).
Creative Learning Corporation also discussed how it accounts for contract terminations.
“When contracts are terminated due to default, or in conjunction with an early termination agreement, the Company accounts for the early termination as a contract modification under ASC 606. Because the termination eliminates any future performance obligations of the Company any deferred revenue associated with the terminated contract is recognized into revenue at the time of termination, along with any early termination fees, in the initial franchise fee line on the Company’s Statement of Operations.” (2019 10K)
Since the termination goods and services are distinct from the goods and services transferred before the termination, Creative Learning Corporation accounts for the modification in accordance with ASC 606-10-25-13(a).
Step 2: Identify Performance Obligations
Initial Franchise Fee
A performance obligation is a promise to transfer a distinct good or service to the customer. There are many goods and services that a franchisor may transfer to the franchisee in return for the initial franchise fee, such as site selection, employee training, the franchise right, advertising, and equipment. However, not all of these promised goods and services will be distinct from each other. A good or service is distinct if the customer can benefit from it separately from other goods or services which the franchisor is transferring. For example, many goods or services might be highly interrelated with the franchise right itself, i.e., the goods or services would provide no benefit to the franchisee without the franchise right. (See our article Distinct Goods or Services in ASC 606 for more information.)
If a good or service is not distinct, then it should be combined with other goods or services until that bundle is distinct. This is done so that the revenue on franchisors’ income statements will reflect when the customer benefits from the good or service. If the franchisee cannot receive benefit from the franchisor’s operation manual without the franchise right, then revenue should be recognized when both are received by the franchisee.
Area Development Agreements
Many franchisors will have Area Development Agreements (ADAs), where the franchisor may grant that the franchisee can build within the specified location and have no other franchisees build within that specified location. In ADA contracts, the right of exclusivity would most likely be bundled with the franchise right.
In its 10-K for the fiscal year ended September 2019, Planet Fitness, Inc. explained that its ADA agreement is not distinct from its franchise license.
“The Company’s primary performance obligation under the franchise license is granting certain rights to use the Company’s intellectual property, and all other services the Company provides under the ADA and franchise agreement are highly interrelated, not distinct within the contract, and therefore accounted for under ASC 606 as a single performance obligation, which is satisfied by granting certain rights to use our intellectual property over the term of each franchise agreement.” (2019 10-K)
Step 3: Determine the Transaction Price
Most franchisors receive some consideration in the form of sales-based royalties. Although sales-based royalties are variable by definition, they are not accounted for according to the variable consideration guidance in ASC 606. That is to say, when determining the transaction price, the franchisor does not need to estimate the amount of royalties to which it expects to be entitled because sales-based royalties for intellectual property (e.g., franchise license) cannot be recognized as revenue until the sale or usage has occurred. More on this will be described as part of Steps 4 and 5.
If the franchisee is paying rent to the franchisor, these payments should not be accounted for under ASC 606. Instead, the franchisor should look to ASC 842, Leases. Note that there are many complexities associated with lease agreements that contain non-lease goods and services that would normally be accounted for under ASC 606. Significant judgment is required when applying these two standards in franchise situations.
Principal vs. Agent Relationships
The relationships a franchisor has with its franchisee can qualify as a principal/agent relationship in some situations where there is a third party involved in the transaction. This can happen with advertising, technology, equipment, or other types of transactions. If the franchisor has control of the good or service directly before it is transferred to the franchisee, it can account for the revenue at its gross amount. However, if the franchisor does not have control of the good or service directly before it is transferred to the franchisee, it will need to account for the revenue it receives from the franchisees net to what it pays to the third party. In some situations, the franchisees may pay the third party directly. (See our article Principal/Agent Considerations in ASC 606 for more information.)
Planet Fitness, Inc. explained how it accounts for selling a third-party distributer’s equipment.
“The Company sells and delivers equipment purchased from third-party equipment manufacturers to U.S. based franchisee-owned stores. Revenue is recognized upon transfer of control of ordered items, generally upon delivery to the customer, which is when the customer obtains physical possession of the goods, legal title is transferred, the customer has all risks and rewards of ownership and an obligation to pay for the goods is created. Franchisees are charged for all freight costs incurred for the delivery of equipment. Freight revenue is recorded within equipment revenue and freight costs are recorded within cost of revenue. The Company recognizes revenue on a gross basis in these transactions as management has determined the Company to be the principal in these transactions. Management determined the Company to be the principal in the transaction because the Company controls the equipment prior to delivery to the final customer as evidenced by its pricing discretion over the goods, inventory transfer of title and risk of loss while the inventory is in transit, and having the primary responsibility to fulfill the customer order and direct the third-party vendor.” (2019 10K)
Because Planet Fitness, Inc. determined it had control of the equipment before the equipment was transferred to the franchisees, the company accounted for the revenue on a gross basis in accordance with ASC 606-10-55-37 through 55-37B.
Step 4: Allocate the Transaction Price
As mentioned before, sales-based royalties included in franchise license agreements are excluded from the original transaction price. However, if there are some performance obligations that will be satisfied up front (distinct from the license of IP), the franchisor uses only the up-front fees to allocate to those initial performance obligations. More will be discussed in Step 5 about when royalties can be recognized.
Step 5: Recognize Revenue
The Franchise Right
The revenue allocated to the franchise right should be recognized over time. Although simple to implement, it is difficult to understand because under previous guidance, revenue would typically be recognized up front for franchise rights. Under ASC 606, this right is considered a license for symbolic intellectual property. It is the brand of the franchisor. This brand continues to grow and gain popularity over time. If you handed over the brand to your franchisee, and subsequently closed down every other location, that brand would not have much value to the franchisee. However, because the franchisor continues to maintain the brand by opening other locations and providing quality goods or services to the end customer nation- or world-wide, the franchisee realizes benefits by seeing customers come in to partake of a brand they know. Because the franchisor continues to provide benefit by maintaining the value of the franchise right over the term, the revenue allocated to the franchise right should be recognized over time.
McDonald’s Corporation explained the differences for franchisors between ASC 606 and ASC 605, including an explanation of the negative impact on revenue.
“Effective January 1, 2018, the Company adopted the guidance issued in Accounting Standards Codification 606, ‘Revenue Recognition – Revenue from Contracts with Customers.’ This standard changed the way initial fees from franchisees for new restaurant openings and new franchise terms are recognized. Under the new guidance, initial franchise fees are being recognized evenly over the franchise term rather than immediately upon receipt. Revenues for 2018 reflected a negative impact of approximately $42 million as a result of this new guidance.” (2018 10K)
Creative Learning Company explained in its 2019 10-K how revenue from initial franchise fees is recognized.
“Effective October 1, 2018 the Company began recognizing revenue under ASC 606. The Company considers initial franchise fees to be a part of the license of symbolic intellectual property (“IP”), therefore the performance obligation related to these fees is satisfied over time as the Company fulfills its promise to grant the customer rights to use, and benefit from, the Company’s IP, as well as support and maintain the IP. The initial franchise fee, then, is recorded as deferred revenue at inception and recognized on a straight-line basis over the contract term.” (2019 10K)
Sales-based royalties should be recognized only once the sales have occurred. This means that franchisors recognize sales-based royalties only in the period in which sales actually occur or the performance obligation is satisfied (whichever occurs later). This may necessitate estimation when sales figures for a particular period have not yet been reported by franchisees. (See Sales- and Usage-Based Royalties in ASC 606 for more information.)
Creative Learning Corporation explained how it accounts for sales- and usage-based royalties.
“In accordance with ASC 606-10-55-65, the Company has determined that the royalty fees, marketing fees, and technology fees are subject to a sales and usage-based royalties’ constraint on licenses of IP. Accordingly, these fees are recognized as revenue at the later of when the sales or usage occurs or the related performance obligation is satisfied.” (2019 10-K)
FASB Exposure Document: Pending Relief for Nonpublic Franchisors
In January, 2021, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2021-02, Franchisors—Revenue from Contracts with Customers (Subtopic 952-606). This subtopic would provide a practical expedient for nonpublic franchisors by which pre-opening services can be treated as distinct from the franchise license if elected. This practical expedient would reduce the cost and complexity of applying ASC 606 for nonpublic companies.
Franchisors face unique issues when applying the 5-step framework in ASC 606. These issues include accounting for sales-based royalties and initial franchise fees. Other issues will continue to arise, but this article serves as a reference point for your research into some of the focal issues encountered by franchisors.
- ASC 606-10
- KPMG: “Revenue for franchisors.” December 2017.
- International Franchise Association. “The New Revenue Recognition Rules: What is the Impact for Franchisors?” May 2018.