ASC 606, Revenue from Contracts with Customers, was released by the FASB in May of 2014. It was effective for public companies in 2018 and was effective for most private companies in 2019, however, the FASB is still dealing with some of the accounting and reporting issues that arose when they initially issued their exposure drafts for the new standard, all the way back in 2012. In today’s post, we’ll look at how the FASB has resolved one such issue: how private company franchisors determine the amount and timing of revenue recognition for initial franchise fees. Let’s dive into the details of this issue and how the FASB resolved this issue by introducing both a practical expedient and an accounting policy election in ASU 2021-02, Franchisors – Revenue from Contracts with Customers (ASC 952-606).
A brief history lesson
To set the stage before we dive into the amendments, let’s remind ourselves what we’re talking about: upfront fees received by franchisors to help perform pre-opening activities for the franchisees. These pre-opening activities include things like:
- Assisting with or approving site selection
- Providing access to the franchisor’s operating manual
- Training for a limited number of the franchisee’s employees
- Other on-site pre-opening assistance from franchisor personnel.
For these services, franchisors commonly charge a nonrefundable upfront fee for each new franchise location. Of course, this fee is in addition to the ongoing sales-based royalties received over the term of the franchise agreement.
The question here is: How does the franchisor account for this upfront fee under ASC 606? Is it a separate performance obligation…or multiple separate performance obligations? Is it part of the franchise rate? When does the franchisor recognize revenue?
Before we dive into the amendments of the new ASU, let’s look at the prior accounting treatment – both under ASC 605 and under ASC 606.
ASC 605 (aka the OLD Rev Rec standard)
Under the guidance in ASC 952-605 (the old guidance), the upfront franchise fee is recognized as revenue when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor. What does this mean in practice? Revenue related to these fees would usually be recognized when the location commenced operations.
ASC 606 (aka the NEW Rev Rec standard…but before ASU 2021-02 is effective)
Under the guidance in ASC 952-606 (the NEW guidance), upfront payments are part of the consideration received for the contract with the franchisee in Step 1 of the new revenue recognition model. To figure out when and how much revenue to recognize, the franchisor must continue to step 2, which is to look at each of the pre-opening activities performed by the franchisor to determine if each represents a performance obligation as defined in ASC 606. If so, the franchisor will continue to steps 3 and 4 to allocate the transaction price to those performance obligations and ultimately to step 5 where it will determine whether to recognize revenue associated with each of those performance obligations over time or at a point in time.
The issue at hand
So, what’s the big deal? Can’t private company franchisors just apply ASC 606 like all other entities? Well, yes…but it’s complicated.
Even as the exposure drafts for ASC 606 were being released by the FASB, private company franchisors were starting to raise the alarm that this requirement of analyzing the upfront fee may be more complicated that it is worth, especially for franchisors that are start-ups or that have a small number of franchise units, because this would make it difficult to determine a relative selling price for each of the performance obligations identified. The FASB issued ASU 2021-02 to reduce the cost and complexity of applying ASC 606 to pre-opening services for franchisors that are not public business entities by providing a practical expedient for applying ASC 606 to preopening services.
The solution: ASU 2021-02
In response to private franchisors concerns, the FASB issued ASU 2021-02 in January 2012. This ASU applies ONLY to private company franchisors – so, all you public franchisors hoping to find relief, I’m sorry to say that you will not find any in this ASU! You’ll have to continue to apply ASC 606 and evaluate the initial fee and the services provided to determine if you have any performance obligations as defined in step 2 of ASC 606.
For private company franchisors, this ASU provides relief by introducing both a practical expedient and an accounting policy election for preparers to utilize. Let’s look at each, starting with the practical expedient.
The practical expedient permits franchisors that are not public business entities to account for pre-opening services provided to a franchisee as distinct from the franchise license if the services are consistent with those included in a predefined list within the guidance. This means no step 2 analysis required – the franchisor can simply assume that these services are distinct from the franchise license. Being able to skip that analysis can save preparers a lot of time…and cost!
So, what pre-opening services qualify? Let’s see which services the FASB included on its list:
- 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, and 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 setting up the franchisee’s records and advising the franchisee about income, real estate, and other taxes or about regulations affecting the franchisee’s business
- Inspection, testing, and other quality control programs.
The next natural question becomes: is this one performance obligation? Or are the services separate performance obligations? The answer depends on whether the private company franchisor elects the accounting policy election described below.
Accounting policy election
Now that the private franchisor has adopted the practical expedient to assume that the pre-opening services are distinct from the franchise license, the private company franchisor has one last decision to make: whether to adopt the accounting policy election offered in ASU 2021-02. This accounting policy election allows the private company franchisor to account for the pre-opening services as a single performance obligation. If the entity does not elect to apply the accounting policy election, then it must determine whether the pre-opening services are distinct from one another and potentially have multiple performance obligations!
As you can see, the combination of the practical expedient and the accounting policy election can provide some serious relief when it comes to evaluating performance obligations under step 2 of ASC 606.
If you’re interested in learning more about this ASU (including examples, adoption, effective dates, and more) or other ASUs effective for companies in 2021 and beyond, be sure to talk to the team at GAAP Dynamics today about our 2021 U.S. GAAP Update! For more information on applying ASC 606, check out our Revenue Recognition course collection on the Revolution!
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