Revenue recognition for private company franchisors will be changing drastically for fiscal 2019 and will require either a retrospective or modified retrospective application to prior years presented in your audited financial statements for FDD purposes. The main impact is affecting the recognition of the initial franchise fees and area development fees. Another impact is the accounting for advertising funds from a net basis to a gross basis. Here’s a breakdown of some of the changes under the new revenue recognition standard.
Old guidance v new guidance
Under current accounting standards, franchisors recognize revenue from initial franchise fees when they have substantially performed all the services required to earn the initial franchise fee. For most franchisors, this was traditionally upon opening of the franchise location. The new revenue recognition standard introduces new accounting rules for licensing of symbolic intellectual property (IP), which includes franchise rights. Under the new guidance, revenues from licensing of symbolic IP is recognized over time using a measure of progress that reflects the franchisor’s pattern of performance. In other words, over the term of the franchise agreement.
What this means is that previously recognized initial franchise fee and area developer fee revenue will be reversed and deferred on franchisor financial statements once the standard is in effect. While certain costs will be reversed and deferred as well to match the new recognition requirement for revenue, this is going to result in the reversal of previous profits of franchisors, which will also reduce the equity balances. This could have an impact to registrations in certain states to solicit new franchise sales.
Franchisors that are new concepts and haven’t been in operation for many years could be significantly impacted by this. These companies often spend a considerable amount to develop the company brand and market the franchise concept. Under the current standard, as the franchisor develops more franchisee locations, revenue would help offset the impact from these expenses on equity. Now, with franchise and area developer fee revenue being spread out over the term of the franchise agreement, it will take much longer to recover these expenses.
Get ready now
You should start preparing for the revenue recognition changes. You should discuss the upcoming changes with users of your financial statements and other interested parties so they can understand the impact. You will also have to modify the tracking schedules for deferred franchise fees and related costs so these amounts are amortized to revenue and expensed over time, rather than when a franchise location opens. In addition, you may need to accumulate additional information related to each franchise location to determine the adjustment that will be needed and to properly account for revenue and costs on a go forward basis once the standard takes effect in 2019.
While I’ve focused this blog on the significant change to franchise and area developer fees, there are other revenue items that will be impacted by the new revenue recognition standard. Download our revenue recognition e-Book to learn more! Check out the Franchisor Industry Guide and special topics section.
Jonathan Poppel, CPA