There are some big changes coming to the accounting department, and many companies have been slow to react. Under the Financial Accounting Standards Board’s new standard, dubbed Revenue from Contracts with Customers, there are a handful of new rules that will change things for restaurant franchisors especially.
The new accounting standard creates a universal standard instead of a patchwork of industry-specific guidance. Within that guidance, the standard splits licensing fees into two distinct categories, functional—which covers things like software—and symbolic, where franchising generally will fall, as the value isn’t in the tool, but in the brand support.
BDO National Assurance Partner Angela Newell co-authored an executive summary on the new standard and steps to approach it. She said falling under the symbolic license creates a major change in how initial franchise fees are recognized in financial statements.
"There was some industry guidance for franchisors that allowed them to recognized that upfront franchise fee when the related efforts were complete, which most people interpreted when the store opened," said Newell. "The news standard requires the revenue for the symbolic license to be recognized over the period of benefit from the licensee standpoint. Basically that’s going to be the term of the franchise agreement."
So instead of a $40,000 revenue bump with every franchisee grand opening, franchisors must now amortize that fee over 10, 15 or 20 years—however long the franchise term covers. For fast-growing brands that may alter the revenue line dramatically and investors may not understand what happened at first blush.
But there are ways around the standard for brands that still want to see revenue up front.
"The new guidance does have some language about identifying distinct performance obligations; what that really asks is, are you providing any services that are distinct or separate from the franchise right themselves," said Newell. "If recognizing some revenue up front is really important, they might consider renegotiating or restructuring franchise agreements such that they may take less up front but what they do take up front really only relates to the types of goods and services that can be separately identified."
In practice, a brand might look at real estate help as an opportunity for upfront recognition. Since quality real estate is not typically brand specific (e.g. many brands could work at the same location), fees associate with real estate guidance could be recognized as soon as the lease is signed.
Franchisors under a private-equity umbrella may especially be pushed to get as many of those tangential items recognized up front as firms look to keep GAAP revenue as high as possible for their ownership term. For others, it may amount to a lot of work with little payoff.
"The reality is that the upfront fees are not that much compared to the royalties that you get," said Newell.
Nick Bergamo, a senior manager Moss Adams in the restaurant space, said it just requires a little rethinking of that lump sum, breaking it down to individual services.
"You need to know how to bifurcate those services from the training and the franchise fee," said Bergamo. "Before, not a lot of people were doing those. So now there’s a lot of work to figure out if someone is paying me a $50,000 franchise fee, what goes into that and when do we recognize that."
Another quirk in the new rules will change how franchisors, franchisees and independent restaurant operations recognize breakage from loyalty and gift cards. Instead of waiting until the statute of limitations runs out, the new guidance requires companies to recognize breakage through the period of validity.
"It basically says if you sold $100 in gift cards and you think that 5% are never going to be redeemed, as the 95% gets redeemed, you recognize the breakage for the 5% that’s not redeemed," said Newell, nothing that it’s a tricky thing to do in practice. "On one hand, it’s positive because it allows you to get the breakage earlier in the process, on the other hand, it requires more recordkeeping. It’s not so hard to just recognize it all at once, but if you sort of spread it over based on the pattern of recognition as people are redeeming, that’s harder."
Another impactful change will be what footnotes are required under the new standard.
"The real work is in the footnotes," said Bergamo.
The new footnote requirements are in part due to the universal coverage of the new standard. To demonstrate the why and the how of results and recognitions, CFOs must essentially show their work in the footnotes.
"That’s one of the downsides of a principles-- standard, is that its all based on principle so there’s no bright line—it’s all facts and circumstances. This new standard will require more disclosures, not only about what the numbers but what the thought process was because it’s a principle based standard with judgment involved," said Newell. "It can be a big change, if you look at most financial statements in the restaurant space because the disclosures are minimal. Even for franchisors, it’s two or three sentences."
Newell said that’s one thing that many companies are glossing over as they prepare to adopt the new standard, but it’s a critical thing to think about early on in the process. Luckily companies have several months before the standard goes into effect, and private companies have an additional year to prepare (and learn from the public company efforts).
So far, however, companies have been slow to adopt the new standard that went into effect for public companies in January of 2018 and will in January of 2019 for private companies. In a recent survey from Ernst & Young, 14% of respondents said they hadn’t yet started doing anything, and 70% said they were not finished. Newell said that isn’t a huge issue, but those that wait too long may see some ugly surprises.
"They’ve got a bit of time. The challenge is really that if they want to revisit their negotiation process for their franchise rights, if they want to think about any changes they’d want to start doing that now," said Newell. "To the extent they have investors or banks that are tied to EBITDA or something else that includes revenues that will be impacted, they want to start having those conversations sooner rather than later so they aren’t caught with unexpected consequences