On December 9, 2020, the Financial Accounting Standards Board (FASB) approved a “practical expedient” for private franchisors. The practical expedient aims to reduce the cost and complexity of applying FASB’s new ASC 606 revenue recognition standards to initial franchise fees for franchisors that are not public companies by allowing a franchisor that is not a public company to essentially recognize revenue from the initial franchise fee immediately by taking into account certain pre-opening services provided to the franchisee as a single performance obligation.
Historically, franchisors have been allowed to immediately recognize initial franchise fees earned from incoming franchisees when all material services or conditions relating to the sale have been substantially performed or satisfied. For newer franchisors, or “developing brands,” the recognition of this income can be critical to the financial stability of a franchisor beginning to grow their system.
In 2019, private companies were required to comply with FASB’s new ASC 606 revenue recognition standards, requiring franchisors to amortize their initial fees over the life of the franchise term. For example, if a franchisor received $20,000 from a new franchisee who had signed a 10-year franchise agreement, the franchisor would have to amortize the fee over the 10-year term, providing the brand with only $2,000 in recognized revenue per year. In April 2020, FASB delayed the ASC 606 implementation for a year.
The economic effect ASC 606 would have on developing brands is serious, especially on the franchisor’s financial statements. As many are aware, franchisors that show a negative or insufficient net worth in their audited financials are often subject to escrow or other fee deferral requirements imposed by state franchise examiners in certain franchise registration states, as well as additional questions from franchisee prospects regarding the strength of their system. A lower net worth could also jeopardize net worth exemptions that a mature franchisor may have historically claimed. Further, according to FRANData, a franchise research firm, 930 franchise brands will be at serious risk of bankruptcy or closure within the first 3 years of the new revenue recognition standards going into effect…if relief isn’t provided.
Recognizing the problem this would create for franchisors, FASB recently voted to finalize the proposed practical expedient related to franchisors. The proposed guidance allows a franchisor, that is not a public company, to recognize revenue from the initial franchise fee immediately by taking into account certain pre-opening services provided to the franchisee as a single performance obligation. Under the proposed guidance, the predefined list of pre-opening services includes:
- Assistance in the selection of a site
- Assistance in obtaining facilities and preparing the facilities for their intended use, including related financing, architectural, and engineering services, and lease negotiation
- Training of the franchisee’s personnel or the franchisee
- Preparation and distribution of manuals and similar material concerning operations, administration, and record keeping
- Bookkeeping, information technology, and advisory services, including setting up the franchisee’s records and advising the franchisee about income, real estate, and other taxes or about local regulations affecting the franchisee’s business
- Inspection, testing, and other quality control programs
Although we are still waiting for FASB to issue final standards, the approval to finalize the proposed practical expedient is a win for franchisors. With renewal season approaching, franchisors should keep this in mind when reviewing pre-opening services and discuss the effect of the practical expedient with their accountant and franchise lawyer.