In a typical contract between a restaurant franchisor and franchisee, the franchisor grants the franchisee the right to operate a restaurant using the brand name, concept, logo, food and operating system. The franchisor also typically performs several functions at the beginning of the contract, such as assistance with site selection and training of employees. During the course of the agreement, the franchisor will also undertake activities to improve the performance of the brand, such as advertising, testing new menu items and refreshing marketing materials. The franchisee will typically pay an initial franchise fee up front and royalties over the period of time during which the restaurant operates. The royalties are usually based on a percentage of the restaurant’s sales.
Revenue recognition used to be very simple for franchisors. Upon evidence of completion of all initial obligations (training, site selection, etc.), the franchisor would recognize the revenue from the initial franchise fee. Generally, the opening of the store was the best indication that these obligations had been satisfied. The royalty, of course, was recognized as the restaurant’s sales took place over the period the restaurant‘s operation.
On May 28, 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (ASC 606), which provided new guidance for recognizing revenue for contracts with customers and is poised to change the way franchisors recognize their revenue.
ASC 606 indicates that the franchise right is a distinct performance obligation that transfers over time, and therefore any portion of the initial franchise fee that is allocated to the franchise right should be recognized over the course of the contract term.
In order to determine how much of the initial franchise fee to allocate to the franchise right, the franchisee must determine whether any of the upfront activities performed are distinct within the context of the contract and thus represent separate performance obligations. To be considered distinct, a promised good or service must be distinct within the context of the contract, which essentially means that it has standalone value from the viewpoint of the customer. Some obligations present in the contract, such as ongoing brand enhancement, are clearly not separable from the overall franchise right. Others, such as restaurant equipment that is purchased from the franchisor as part of the transaction, clearly are distinct, but not all are so obvious.
For example, it might be argued that selecting a site or training employees is integral to the successful operation of the franchise. On the other hand, the site selection activities might not be specific to the brand, and thus might be considered distinct from the franchise rights. The franchisor will need to carefully consider each promised good and service to determine whether any portion of the initial franchise fee may be allocated to it, thus resulting in recognition of that portion at the time that the good or service is delivered, usually upon opening of the restaurant.
Because ASC 606 requires the revenue associated with a franchise right to be recognized over time, the recognition of royalty income remains unchanged. Royalties are still recognized as the restaurant completes sales over the term of the agreement.
Let’s look at a fairly simple example. A franchisee purchases the right to operate a restaurant for 10 years from a franchisor for a price of $35,000. In addition, the franchisor buys an oven—a type that could also be easily purchased from a third-party vendor—from the franchisor for $20,000. The agreement stipulates a 4 percent royalty is be paid on the store’s sales. Because the franchisee already operates other franchised locations, no upfront site selection, training or other set-up activities are necessary. Thus the franchisor concludes that the agreement includes only two performance obligations, the franchise right and the oven.
Assuming that the oven and franchise agreement are sold at their stand-alone prices, the franchisor would recognize the revenue from the sale of the oven upon delivery. The franchise fee itself would be recognized over the life of the agreement. The royalties would be recognized as the sales take place over the 10-year term of the agreement. Despite the relative simplicity of this example, it is critical to understand the nuances of the updated revenue recognition standards. These changes may significantly impact the amount of franchise fee recognized and could also affect loan covenants or capital requirements for a franchisor.
ASC 606 is effective for public entities with annual reporting periods beginning after December 15, 2017 (fiscal year 2018). For non-public entities, the standard is effective for annual reporting periods beginning after December 15, 2018 (fiscal year 2019). Both public and non-public entities may elect to apply this guidance earlier, however, only for the annual reporting period beginning after December 15, 2016 (fiscal year 2017).
Be sure to keep up with the Restaurant Practice’s latest thoughts by subscribing to our blog on the Selections homepage here and following us on Twitter at @BDORestaurant. For timely information on transitioning to ASC 606 and applying it to your organization, visit BDO’s Revenue Recognition Resource Center here.
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