Franchisors Beware: New Accounting Rules Will Significantly Impact Revenue Recognition, Creating Great Risk for Your Business Model
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.
February 13, 2017