Delayed Revenue Recognition — A New Threat to Franchisor Financials

Delayed Revenue Recognition -- A New Threat to Franchisor Financials

A recent change in Federal Accounting Standards Board (“FASB”) guidelines threatens to alter the way in which franchisors can recognize initial franchise fees in their audited financial statements.Historically, franchisors have recognized the revenue from initial franchise fees as an asset upon the opening of the franchised unit, as accountants view the initial franchise fee as consideration for the franchisor completing its pre-opening obligations. Until opening, the initial franchise fee would show up on the franchisor’s audited balance sheet as a deferred liability, and for this reason FisherZucker has consistently warned clients against ending their fiscal year with a large number of sold but unopened units.

This practice has been promoted by the FASB, which previously stated in ASC 952 that initial franchisee fee revenue from an individual franchise sale “shall be recognized, with an appropriate provision for estimated uncollectible amounts, when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor.”  This rule was created decades ago to provide prospective franchisees with confirmation that the franchisor is financially stable and not surviving off its initial franchise fees.  Despite this settled practice that balances the aforementioned franchisee considerations with a franchisor’s reasonable desire to turn a balance sheet liability into an asset, the FASB has recently issued new standards that threaten to further delay the recognition of initial franchise fees, with hugely detrimental effects on a franchisor’s financials.

In sections 606-10-55-54 through 55-60 and sections 606-10-55-62 through 55-65B, the FASB has issued new standards that address the recognition of revenue in licensing contracts.  Because a trademark license is a core component of a franchise agreement, it appears that these standards will be applied to the recognition of initial franchise fees.  The FASB standards differentiate between whether a license transfers to a franchisee at a point in time or over a period of time, though it does not clearly state which category will apply to a franchise agreement.  However, if the franchise relationship is viewed as a license to use intellectual property over a period of time (which is supported by the fact that the franchisor is required to support and maintain the intellectual property, as well as the intellectual property often does not have standalone functionality), then auditors may require that initial franchise fees be recognized over the course of the initial term of the franchise agreement, as opposed to recognizing the full fee at the time of opening.

If this is the case, franchisors will suffer from reduced assets and greater liabilities, resulting in a lower net worth on their balance sheet.  Franchisors that show a negative net worth in their audited financials often face impound conditions in certain franchise registration states, as well as additional questions from franchisee prospects regarding the strength of the system.

Because these new rules won’t take effect for non-public companies until 2018,they haven’t been widely discussed in the franchise community. However, as noted above, the effect on a franchisor’s balance sheet will be substantial.  Additionally, the recognition of the initial franchise fee over time will be implemented retroactively so the calculation will need to be made for all years presented in the FDD.  Therefore, as we wrap up the 2016 calendar year (which is also the 2016 fiscal year for many businesses), it is crucial that franchisors meet with their accountants to discuss the possible application of these new standards and the resulting effect on their financial statements in future years.