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The FASB's handout from a public meeting in 2017 regarding feedback from the franchising industry about the recognition of revenue for distinct services. The handout explains how franchisors can assess whether their pre-opening activities constitute distinct services and allocate a portion of the transaction price to those services. The document also covers the FASB's 606 revenue recognition standard and the determination of distinct goods or services. Common examples of distinct goods and services for franchisors include site selection, training, and equipment.
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International Franchise Association 51 st^ Annual Legal Symposium May 6-8, 2018 Washington, DC
I. Introduction One of the biggest fears connected with the introduction of the new revenue recognition rules^1 (“NRRR”) was that emerging franchisors would be forced to show a lower net worth on their balance sheets and as a result would be required by certain registration states to delay acceptance of initial franchise fee payments until the corresponding outlets were opened. Beyond the issue of cash flow, there was a fear that growth would be hindered because new prospects would be scared off when reviewing a revised balance sheet showing a franchisor with a lower net worth. More mature franchisors were concerned that a lower net worth would cause them to lose registration exemptions in certain states. This paper will give an overview of the NRRR and what is being done to address the fears and concerns of the industry. It will also describe the current lay of the land from the FASB^2 and the accounting industry, and what franchise attorneys can do to help their franchisor clients and their clients’ accountants going forward. The current picture and the current prospects are somewhat murky, and the dust has not settled on how the NRRR will affect the industry. The big four accounting firms^3 (the “Big 4”) have thus far taken a conservative approach and have generally advised their clients to recognize 100% of initial franchisee fees over the entire term of the franchise agreement.^4 The IFA has aggressively engaged with the FASB and others on this subject and has achieved tangible results, even if those results have not yet caused the Big 4 to change their guidance. The FASB received a report from its staff during a public meeting on November 29, 2017 regarding the feedback that the FASB staff had received from the franchising industry, and, while the FASB meeting was not a decision-making meeting, the FASB issued a handout^5 (the “Handout”) from the meeting stating that franchisors may assess whether any of their pre-opening activities constitute distinct services to the franchisee, and if the franchisors determine that there are indeed distinct services then they may allocate a portion of the overall transaction price^6 to those performance obligations and recognize revenue when (or as) those services are performed.^7 While (^1) Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) , The Financial Accounting Standards Board (“FASB”), adopted May 2014. (^2) The Financial Accounting Standards Board, a non-profit standards-setting body that establishes generally accepted accounting principles (“GAAP”) in the United States. (^3) Deloitte, PwC, EY and KPMG. (^4) See, e.g., Revenue for Franchisors , KPMG, July 2017, frv.kpmg.us/reference- library/2017/07/revenue-for-franchisors.html. (^5) Board Meeting Handout, Revenue Recognition Implementation , FASB, November 29,
(^6) The “transaction price” as used in the NRRR and by the FASB means all revenue received from the franchisee over the entire term of the franchise agreement, including the initial franchisee fee, royalties, advertising fund contributions and other fees from franchisor to franchisee (see Section II, Step 3, infra). (^7) Handout at 3- 4 (see Section III.A below).
e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer. In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession. 606 - 25 - 10 - 2 A contract is an agreement between two or more parties that creates enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a matter of law. Contracts can be written, oral, or implied by an entity’s customary business practices. The practices and processes for establishing contracts with customers vary across legal jurisdictions, industries, and entities. In addition, they may vary within an entity (for example, they may depend on the class of customer or the nature of the promised goods or services). An entity shall consider those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations. Franchisor application – For the franchisor this would seem rather straightforward. We have a franchise agreement that specifies, in writing, the parties, each party’s rights and obligations, and the payment terms. No one would doubt that a franchise agreement has commercial substance in that the cash flows of both parties are clearly expected to change as a result of the contract. The franchisor will have to determine the last step related to collectability based upon their credit underwriting of the franchisee. Step 2 - Identify the performance obligations in the contract 606 - 10 - 25 - 14 At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct. b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer. 606 - 10 - 25 - 15 A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met: a. Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 606- 10 - 25 - 27 : to be a performance obligation satisfied over time. b. In accordance with paragraphs 606- 10 - 25 - 31 through 25-32 : , the same method would be used to measure the entity’s progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer.
606 - 10 - 25 - 16 A contract with a customer generally explicitly states the goods or services that an entity promises to transfer to a customer. However, the promised goods and services identified in a contract with a customer may not be limited to the goods or services that are explicitly stated in that contract. This is because a contract with a customer also may include promises that are implied by an entity’s customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises create a reasonable expectation of the customer that the entity will transfer a good or service to the customer. 606 - 10 - 25 - 17 Promised goods or services do not include activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to a customer. For example, a services provider may need to perform various administrative tasks to set up a contract. The performance of those tasks does not transfer a service to the customer as the tasks are performed. Therefore, those setup activities are not promised goods or services in the contract with the customer. 606 - 10 - 25 - 19 Distinct Goods or Services - A good or service that is promised to a customer is distinct if both of the following criteria are met: a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct). b. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). 606 - 10 - 25 - 20 A customer can benefit from a good or service in accordance with paragraph 606- 10 - 25 - 19(a) : if the good or service could be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources. 606 - 10 - 25 - 21 In assessing whether an entity’s promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 606- 10 - 25 - 19(b), the objective is to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs.
In the circumstances of an area developer or a multi-unit agreement, exclusivity may be granted to your franchisee. That exclusivity is not considered a separate performance obligation but is part and parcel to the franchise right. Step 3 – Determining the transaction price 606 - 10 - 32 - 2 An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. 606 - 10 - 32 - 3 The nature, timing, and amount of consideration promised by a customer affect the estimate of the transaction price. When determining the transaction price, an entity shall consider the effects of all of the following: a. Variable consideration b. Constraining estimates of variable consideration c. The existence of a significant financing component in the contract d. Noncash consideration e. Consideration payable to a customer Franchisor application: The franchisor now needs to make a list of all the revenue streams it has coming into the company. These should be outlined in the franchise agreement. Just because a separate fee is charged for a service does not make it distinct (See Step 2). The transaction price is the amount of funds you will receive and some of these may be received as a onetime up-front fee and others may be received over time. An example of various revenue streams may be:
a. Adjusted market assessment approach—an entity could evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. That approach also might include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins. b. Expected cost plus a margin approach—an entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service. c. Residual approach—an entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. However, an entity may use a residual approach to estimate the standalone selling price of a good or service only if one of the following criteria is met:
amounts for the separately identified performance obligation, which may represent the stand-alone value, but you cannot presume that is the case. Observable data points are needed to determine the stand-alone value. This is a management estimate (that will need to auditable). As an example – a franchisor has in initial franchise fee of $50,000 and a 6% royalty. Separate performance obligations have been identified for the equipment, site selection and the franchise right. Based upon market data, the franchisor determines that site selection value is $10,000 and the equipment is valued at $60,000. The franchise should be able to sustain $500,000 of sales annually for the 10 years of the agreement. Royalty expectations would then be $200,000 over the contract. The franchisor could allocate the variable consideration to the franchise right and the up-front fee to the performance obligations for the equipment and site selection - Site selection – $10,000/$ 37 0,000 * $50,000 = $1, Equipment - $60,000/$ 37 0,000 * $50,000 = $ 8 , 108 Intellectual property - $300,000/$370,000 * $50,000 = $40, However, if the allocation would have resulted in the allocation to the site selection and equipment in excess of their value, then there would need to be an allocation to the franchise right resulting in a small amount of up-front recognition for the site selection and equipment and a large deferral to be recognized over the life of the contract. Step 5 – Recognize Revenue 606 - 10 - 25 - 23 An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. 606 - 10 - 25 - 24 For each performance obligation identified… an entity shall determine at contract inception whether it satisfies the performance obligation over time (in accordance with paragraphs 606 - 10 - 25 - 27 through 25-29) or satisfies the performance obligation at a point in time (in accordance with paragraph 606 - 10 - 25 - 30). If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time. 606 - 10 - 25 - 27 An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met: a. The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs. b. The entity’s performance creates or enhances an asset (for example, work in process) that the customer controls as the asset is created or enhanced.
royalties. There may be an exception to this if the marketing is very specific to a single franchisee. Generally, advertising costs are expensed as incurred. This is the applicable guidance going forward. This results in a presentation different than we’ve historically seen, such that revenues and expenses are not matched. There is a change in terminology used on the face of the financial statements as well. The title – deferred revenue – is now to be identified as contract liability. Below is a table that summarizes the old GAAP recognition vs. recognition under 606: *must determine if additional performance obligations exist at the inception of the contract Area Initial Franchise Fees
Royalties Area Developer Agreements Master Agreements Current U.S. GAAP When all material services are performed (gen. when unit opens) As earned (sometimes with a lag) Over time or units Up front or over time New Standard Over the term of the franchise agreement – if one performance obligation As earned (no lag allowed – must estimate) If finite number of units, as each franchise agreement is executed Over time assuming unlimited number of units
Contract costs Area Ad Fund Revenues Ad Fund Costs Renewal Fees Transfer Fees Current U.S. GAAP Gross vs. Net Recognize revenue to the extent of costs incurred Expensed as incurred (some netted revenue with expenses) When signed When signed New Standard Recognize revenue as earned (same as royalties) Expensed as incurred – gross presentation * Over new term of contract (assume Renewal fee is immaterial to the overall contract) over remaining term of contract (assume transfer fee is immaterial to the overall contract) Area Loyalty Programs Gift Cards Vendor Rebates Equipment / Product Sales Current U.S. GAAP Balance sheet only - net presentation Liability – revenue as used or net to franchisee Passed through to franchisee (net) or Ad Fund (net) When delivered – gross vs. net New Standard Defer at expected redemption rate – value of points probability Contract liability – revenue as earned; must include breakage Typically will reduce revenue (may adjust COGS) If in Franchisor control – then gross when delivered; otherwise net
Related to disclosures applicable to the performance obligations, an entity shall explain how the timing of satisfaction of its performance obligations relates to the typical timing of payment and the effect that those factors have on the contract asset and the contract liability balances. The explanation provided may use qualitative information. 606 - 10 - 50 - 12 An entity shall disclose information about its performance obligations in contracts with customers, including a description of all of the following: a. When the entity typically satisfies its performance obligations (for example, upon shipment, upon delivery, as services are rendered, or upon completion of service) including when performance obligations are satisfied in a bill-and-hold arrangement b. The significant payment terms (for example, when payment typically is due, whether the contract has a significant financing component, whether the consideration amount is variable, and whether the estimate of variable consideration is typically constrained c. The nature of the goods or services that the entity has promised to transfer, highlighting any performance obligations to arrange for another party to transfer goods or services (that is, if the entity is acting as an agent) d. Obligations for returns, refunds, and other similar obligations e. Types of warranties and related obligations. 606 - 10 - 50 - 13 An entity shall disclose the following information about its remaining performance obligations: a. The aggregate amount of the transaction price allocated to the performance obligations that are unsatisfied (or partially unsatisfied) as of the end of the reporting period b. An explanation of when the entity expects to recognize as revenue the amount disclosed in accordance with (previous) paragraph, which the entity shall disclose in either of the following ways:
606 - 10 - 50 - 20 An entity shall disclose information about the methods, inputs, and assumptions used for all of the following: a. Determining the transaction price, which includes, but is not limited to, estimating variable consideration, adjusting the consideration for the effects of the time value of money, and measuring noncash consideration. b. Assessing whether an estimate of variable consideration is constrained c. Allocating the transaction price, including estimating standalone selling prices of promised goods or services and allocating discounts and variable consideration to a specific part of the contract (if applicable) d. Measuring obligations for returns, refunds, and other similar obligations. Franchisor application: As you can see, there are considerably more disclosures required in the audited financial statements that will be included in Item 21 of your FDD. The spirit of these requirements is to provide insight into management’s judgments included in recognizing revenue. As franchisors and their accountants have done in the past, royalties should be recognized separately from initial franchise fees. If the franchisor determines there is more than one performance obligation, additional disclosures around that process will need to be made. Effective date and adoption The effective date for adopting this guidance was January 1, 2018 for public companies and January 1, 2019 for private companies (assuming calendar year end). There are 2 transition methods that the franchisor can select. The full retrospective approach allows the franchisor to push the adoption back to the earliest year presented. In other words, you would effectively restate your financial statements for all 3 years presented. The other option is to adopt on a modified basis, meaning you have an adjustment to your retained earnings on the date of adoption, January 1, 2018. If you use the modified approach, there are additional disclosures required to provide comparative information in the footnotes. Franchisor application: This is a dual edge decision for the franchisor. The FDD requires 3 years to be provided as part of the document. Providing comparative information for all 3 years simplifies the explanation that would be required to a prospective franchisee on the financial statements. However, the franchisor will be presenting different results for prior years. That could provide some exposure to the company or at least a lot of explanation. On the other hand, depending on the maturity of the franchise system, if the franchisor selects the modified approach, it will have numbers that on their face are not comparative but prior year’s results would not be impacted. The franchisor should have a discussion with its legal counsel and accountant as to these alternatives. III. Recent Developments from the FASB and Accounting Industry A. FASB Board Meeting Handout of November 29, 2017
As you can see, the FASB emphasizes that franchisors need to determine what pre- opening activities are distinct, and that the NRRR do not contain any presumptions in that regard. The difficulty is that, as we discuss above in Step 2 of Section II, making that determination is far from easy, and the determination can have an impact on other aspects of the franchisor’s business. That fact brings us back to, and also helps to explain, the conservative approach that has been taken thus far by the Big 4. B. Current Approach of the Big 4 to the NRRR While there has not (to the authors’ knowledge) been a full survey of annual reports of publicly-traded franchisor companies that have been audited by the Big 4 and how they plan to address recognition of initial franchise fees under the NRRR, anecdotal information supports the view that the Big 4 and the companies they audit have thus far taken a conservative approach. We look at four of the major, publicly traded restaurant franchisors below and what they and their Big 4 auditors have said in their public filings. Namely, we look at McDonald’s (audited by EY), Restaurant Brands International (parent of Burger King, Tim Hortons and Popeye’s, and audited by KPMG), Dine Brands (parent of Applebee’s and IHOP, and audited by EY), and Dominos (audited by PwC). McDonald’s, with guidance from EY, stated the following in its 10-K for the year ending December 31, 2017: In accordance with the new guidance, the initial franchise services are not distinct from the continuing rights or services offered during the term of the franchise agreement, and will therefore be treated as a single performance obligation. As such, beginning in January 2018, initial fees received will be recognized over the franchise term, which is generally 20 years.^8 There was no indication in the McDonald’s 10-K that it intends to assess what services are distinct, even though in Item 11 of its 2017 FDD it lists 4 separate “pre-opening obligations”.^9 Restaurant Brands International, with guidance from KPMG, stated the following in its 10- K for the year ending December 31, 2017: Under current accounting guidance, we recognize initial franchise fees when we have performed all material obligations and services, which generally occurs when the franchise restaurant opens. Under the new (^8) Form 10-K of McDonald’s Corporation , as filed with the U.S. Securities and Exchange Commission and dated February 23, 2018, page 37. (^9) Per copy of 2017 FDD downloaded from the Minnesota Commerce Department website.
guidance, we will defer the initial and renewal franchise fees and recognize revenue over the term of the related franchise agreement.^10 The company stated that it will defer initial and renewal franchise fees and recognize the revenue over the term of its franchise agreements for all of its three brands, despite the fact that the 2017 FDDs for all three brands list several pre-opening obligations under Item 11, including initial training.^11 Dine Brands is an interesting case study because their IHOP division earns a significant amount of its revenue from the sale of proprietary products to its franchisees, primarily pancake and waffle dry-mixes.^12 The company, with guidance from EY, states the following in its 10 - K for the year ending December 31, 2017: This new revenue guidance supersedes nearly all of the existing general revenue recognition guidance under U.S. GAAP as well as most industry- specific revenue recognition guidance, including guidance with respect to revenue recognition by franchisors. The Company believes the recognition of the majority of its revenues, including franchise royalty revenues, sales of IHOP pancake and waffle dry mix and retail sales at company-operated restaurants will not be affected by the new guidance. Additionally, lease rental revenues are not within the scope of the new guidance. The Company has determined the new revenue guidance will impact the timing of recognition of franchise and development fees. Under existing guidance, these fees are typically recognized upon the opening of restaurants. Under the new guidance, the Company has determined the fees will have to be deferred and recognized as revenue over the term of the individual franchise agreements. However, the effect of the required deferral of fees received in a given year will be mitigated by the recognition of revenue from fees retrospectively deferred from prior years. The Company presently expects to use the retrospective method of adoption when the new guidance is adopted in the first fiscal quarter of 2018. Upon adoption, the Company will recognize the deferral on its balance sheet of approximately $85 million in revenue from franchise and development fees and will reduce its receivables by approximately $7 million. As a result of adoption, the Company's accumulated deficit will increase by $60 million, net of deferred taxes of $32 million.^13 (^10) Form 10-K of Restaurant Brands International Inc. , as filed with the U.S. Securities and Exchange Commission and dated February 23, 2018, page 65. (^11) Per copies of 2017 FDDs for each brand downloaded from the Minnesota Commerce Department website. (^12) Form 10-K of Dine Brands Global, Inc. , as filed with the U.S. Securities and Exchange Commission and dated February 2 0 , 2018, page 8. (^13) Form 10-K of Dine Brands Global, Inc. , as filed with the U.S. Securities and Exchange Commission and dated February 2 0 , 2018, page 71.
