On May 28, 2014, the Financial Accounting Standards Board (FASB), the independent, private-sector, not-for-profit organization that establishes financial accounting and reporting standards for public and private companies and not-for-profit organizations that follow Generally Accepted Accounting Principles (GAAP), issued ASC Topic 606—Revenue from Contracts with Customers. Topic 606 changes the way franchisors recognize revenue related to advertising funds, upfront franchise fees, and gift card funds.
Under Topic 606, a franchisor must go through a five step process:
- Identify the contract
- Identify separate performance obligations
- Determine the transaction price
- Allocate the transaction price to performance obligations
- Recognize revenue as or when each performance obligation is satisfied
Depending on the terms of the franchise agreement, a franchisor must assess each of its performance obligations to determine whether or not they are distinct promises. A franchisor can no longer assume that all promises are part of the franchise license. Revenue must be recognized as or when a franchisor satisfies each performance obligation.
Most franchise agreements require franchisees to remit a percentage of gross sales into an advertising fund. The funds are then used to market the franchisor’s system as a whole or in a particular geographical region. Prior to Topic 606, if the advertising fees collected exceeded the expenses of advertising, the franchisor would report the unspent balance as a liability on its balance sheet. Conversely, if the advertising fees collected were less than the costs of advertising, the franchisor would report the expenditure as an advertising expense on its income statement.
Under Topic 606, a franchisor must carefully account for the timing of the collection of advertising funds and the timing of expenditures for advertisements. Now, if expenditures for advertising are not incurred evenly throughout the year, the timing of booking expenses may not match the timing of recognizing revenue as the advertising funds are paid from the franchisees to the franchisor. In addition, franchisors must now review their franchise agreements to confirm whether or not the franchise agreement requires it to spend excess advertising funds in the future, which will require the franchisor to book the excess funds as a liability. This is expected to increase revenues and expenses on a franchisor’s consolidated statement of earnings and will require new footnotes on financial statements.
INITIAL FRANCHISE FEES
Prior to Topic 606, franchisors would recognize revenue from their receipt of initial franchise fees and area development fees upon the opening of the franchised restaurant. Under Topic 606, a franchisor must now recognize the revenue related to initial franchise fees over the term of the related franchise agreement. Identifiable costs directly attributable to fulfilling the franchise agreement, such as the retention of a broker and franchisee training, should be deferred and recognized as the specific performance obligation is satisfied.
LOYALTY PROGRAMS AND GIFT CARDS
Loyalty points and rewards must now be considered a material right that should be accounted for as a separate performance obligation under the franchise agreement. Franchisors must defer a portion of the purchase price for a franchise to reflect the value of loyalty points earned.
Franchisors that issue prepaid gift cards must pay attention to new breakage reporting rules under Topic 606. Gift card revenue is recognized once a gift card is redeemed. Income recognized from gift cards that are never redeemed (typically 2 percent - 4 percent of all gift cards sold) is known as breakage income. Prior to Topic 606, breakage income could be (i) recognized when the probability of the redemption is remote, or (ii) pro-rated based on the redemption pattern of gift cards sold (the Redemption Method). Under Topic 606, franchisors are expected to use the Redemption Method. This will result in earlier recognition of breakage income and will require franchisors to more closely track and report gift card redemption patterns. The new breakage guidelines do not apply to gift cards that are subject to state escheatment laws.
Topic 606 became effective for public companies with fiscal years beginning after December 15, 2017. Topic 606 becomes effective for all other non-public companies for annual reporting periods beginning after Dec. 15, 2018, and interim periods within annual reporting periods beginning after Dec. 15, 2019. Early adoption is permitted.
Franchisors should be careful to follow Topic 606 guidelines and understand the impact of Topic 606 on their financial reporting requirements and specific performance obligations set forth in their franchise agreements.