The Financial Accounting Standards Board (FASB), which sets U.S. GAAP standards, has clarified key language around its new revenue-recognition guidelines.
Until a November 29 meeting, there were widespread and fundamental misconceptions about FASB’s new revenue recognition standards, which take effect in 2018 for public companies and in 2019 for private companies.
There were a lot of changes (which you can read about here) but one of the trickiest was how initial franchise fee revenue was to be recognized. Instead of having access to the up-front franchise fee right away, audit firms initially concluded that the entire fee would have to be amortized over the period of the franchise agreement. So instead of being able to take those funds into income in year one, to be spent on site selection help, training, equipment or anything else, it looked as if most of the fee revenue would have been recognized over time, which wouldn’t have been consistent with how franchisors work in practice.
"Consequently, we were going to end up in a situation where those companies would have had to dip into their retained earnings to finance the current operations," described Lee Plave, partner at franchise-focused law firm Plave Koch PLC, ahead of the November 29 FASB meeting.
That might not have been a big deal for large franchisors, but for startups and young franchises, it sounded disastrous.
"If your McDonald’s or Hilton, that’s a thorny accounting issue, but for an emerging franchisor, that may be existential, and they may have to go to the bank to get funds to finance their business," said Plave.
It would also mean some ugly financial statements and valuations, making it harder and harder for young franchises to find growth partners or capital to get to the next phase.
Many accounting firms saw the new standard requiring a single performance obligation, i.e. the license and only the license. Plave said he and the IFA FASB task force thought that was wrong.
"So a franchisor that provides training site selection or other services that are distinct should be able to recognize the revenue associated with those services when they are rendered," said Plave.
He said in talks with the FASB, some board members agreed. Ahead of the November 29 meeting, its staff issued a FASB meeting handout:
One of the most prevalent questions from the franchising industry involves determining whether or not pre-opening activities constitute a distinct performance obligation. Under current GAAP, franchisors generally recognize the initial fee when the location opens and recognize the subsequent royalty stream over time. Because industry-specific GAAP exists, franchisors historically have not had to assess whether the pre-opening services are a separate deliverable. In making this determination under the new standard, the first step for the franchisor is to determine if the pre-opening activities contain any distinct services. If none of the pre-opening services are distinct, then the initial fee would be part of the transaction price for the combined performance obligation of the license and services and, thus, recognized over the entire license period.
During the meeting, things became substantially more clear.
"FASB Vice Chair James Kroeker, who took the lead on this, spoke about paragraph nine of the handout [concerning revenue recognition] and said, on the record—which is a big deal in FASB world, that there are distinct and separate performance obligations," said Plave.
While there were no changes to the new rules, the body clarified a clunky example that was originally included along with the guidelines. Kroeker specifically mentioned (on record) that separate performance obligations were appropriate for things like site guidance, equipment, and general business training.
"Many of the pre-opening services that are provided to new franchisees, and that are vital to having them start a new business can be a basis for separate performance obligations," said Plave, "so that the revenue can be recognized when those services are provided. That’s a big deal."
So for CFOs having recurring nightmares about how they’d address these issues, the FASB clarification will provide some welcome relief. Young franchised brands can especially rest easy.
Now there’s the matter of identifying those separate performance obligations and justifying the market value of each. But adhering to the new guidelines certainly got a lot easier because of this clarification.