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  3. Franchisors Beware: New Accounting Rules Will Significantly Impact Revenue Recognition, Creating Great Risk for Your Business Model

14Feb 2017

Franchisors Beware: New Accounting Rules Will Significantly Impact Revenue Recognition, Creating Great Risk for Your Business Model

SRA Accounts Rules software & service support for law firms

In a little noticed change to the generally accepted accounting principles formally approved a year ago

this week, the Financial Accounting Standards Board and the International Accounting Standards Board

jointly issued ASC 606, Revenue from Contracts with Customers: Identifying Performance Obligations and

Licensing (Topic 606), also known as ASU 2104-9. ASC 606 provides new guidance for franchisors and

their auditors, requiring them to evaluate the services the franchisor provides for the initial franchise

fees and multi-unit development fees more carefully. This will affect how revenue can be recognized on

the audited financial statements disclosed in their franchise disclosure documents. This rule change will

become effective for audited financial statements issued after December 15, 2017 for publicly traded

companies and for audited financial statements issued after December 15, 2018 for all other franchisors.

The net effect of the new interpretation is that most franchisors will be required to recognize a

significant portion of the revenue generated from the payment of initial franchise fees and multi-unit

development fees over the life of the franchise agreement or the multi-unit development agreement,

rather than recognizing the revenue in the year in which the first franchised location opens for business.

For many franchisors, the revenue reduction could be quite dramatic. For example, if the term of the

franchise agreement is ten years, the first-year revenue from each franchise sale could be reduced by as

much as ninety percent. In the case of multi-unit development agreements, the franchisor will now be

required to recognize the development fee revenue as each location opens, rather than the day the first

franchised location opens under the terms of the multi-unit agreement.

This new interpretation of the revenue recognition rule will have several significant impacts on

franchisors. First, it will dramatically reduce the financial statement income that a franchisor will be able

to report from initial franchise sales in first year, while at the same time increasing short-term and long-

term future liabilities on the balance sheet. This could effectively reduce or eliminate the profitability of

most growing franchise systems that rely on franchise sales for a significant portion of their revenue

during any calendar year. This could potentially make such franchise systems less attractive to

prospective franchisees and current franchisees looking to expand.

In addition to the reduction in revenue, the resulting increases in short-term and long-term liabilities will

materially impact the franchisor’s balance sheet. In many cases, this could lead some registration states

to impose financial assurance requirements on more franchisors seeking franchise initial registration or

renewal. Depending upon the financial assurance option chosen by the franchisor, these requirements

can significantly increase operating costs or deprive emerging and high-growth franchisors of the

franchise fee payments they need to continue to grow and support the franchise system.

Finally, once a franchisor adopts this accounting approach, auditors will likely require that the franchisor

restate its financial statements for the prior two years. In many cases, these restated financial

statements will make the franchisor look financially weaker. This could open the door for franchisees

who are unhappy with their relationship to sue franchisors for rescission of their franchise agreements

under the theory that they were misled about the state of the franchisor’s financial position. This could

give any franchisee who purchased a franchise during the two-year period prior to the adoption of the

new accounting rule with a “get out of jail” free card merely based on the change to the accounting rule.

Most franchisors are now in the midst of their 2016 audits. However, it is not too early for franchisors

to begin discussions with their auditors and legal advisors regarding the implications of this rule in the

coming years. It is critical that franchisors seek the advice of accountants, attorneys and other advisors

who understand the interplay between this new interpretation and the way these new rules will play

out in the real world. By analyzing the way in which the revenue is defined and described in the

franchise agreement and the multi-unit agreement carefully, it may be possible to reduce the impact of

this new rule on the franchisor’s revenue. But franchisors cannot afford to ignore this development or

“kick the can down the road.” The new implementation deadlines are right around the corner.

By: William A. Hoppe, CPA

Kevin P. Hein, Esq.

Alexius, LLC

February 13, 2017

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