Accounting for non-public franchisors’ pre-opening services: An overview
One of the most significant changes of Topic 606 relates to how a franchisor accounts for up-front or initial franchise fees. Under Topic 606, the license may need to be combined with other performance obligations that are associated with those fees. Changing the recognition period for upfront fees may directly impact regulatory requirements when filing the Franchisor’s Disclosure Document. (Read more in our previous overview of how the new revenue recognition standards impact franchisors.)
Earlier this year, the Financial Accounting Standards Board (FASB) released Accounting Standards Update (ASU) 2021-02, which offers a practical expedient for pre-opening services that franchisors that are not public business entities can use when applying Topic 606’s guidance on identifying performance obligations in contracts.
For non-public business franchisors that have adopted Topic 606, the ASU is effective for interim and annual periods beginning after Dec. 15, 2020, with early adoption permitted. For non-public business franchisors that have not yet adopted Topic 606, the transition provisions and effective dates in paragraph 606-10-65-1 should be applied, which has an effective date of annual reporting periods beginning after Dec. 15, 2019, and interim reporting periods within annual reporting periods beginning after Dec. 15, 2020.
PRACTICAL EXPEDIENT FOR PRE-OPENING SERVICES
The ASU allows a practical expedient to account for certain pre-opening services provided to a franchisee as distinct from the franchise license. These pre-opening services, as listed in the ASU, are:
- 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 regulations affecting the franchisee’s business
- Inspection, testing, and other quality control programs
In addition, under the ASU, the franchisor can make an accounting policy election to recognize the pre-opening services as a single performance obligation.
For example: A franchisor that is not a public business entity enters into a contract with a franchisee to grant a license to operate a restaurant. In this contract, the franchisor also agrees to provide assistance in selection of a site, training the franchisee’s personnel, and inspection, testing, and other quality control programs, as well as assistance in advertising. The franchisor determines that it is eligible to apply the practical expedient in the ASU and makes the accounting policy election available under the ASU, which is noted above. The franchisor determines that it has multiple performance obligations, which embody promises to provide a franchise license, those pre-opening services listed under the ASU, and advertising services. Therefore, the franchisor applies the practical expedient under ASU 2021-02 to the assistance in selection of a site, training the franchisee’s personnel, and inspection, testing, and other quality control programs, and makes an accounting policy election to account for these as a single performance obligation.
TRANSACTION AND STAND-ALONE SELLING PRICES
The ASU is intended to simplify certain aspects of franchisor identification of performance obligations; however, franchisors will still need to continue to apply the other aspects of Topic 606. This includes determining the stand-alone selling prices, allocating the transaction price of the contract among the identified performance obligations, and recognizing revenue.
The transaction price of the contract will be determined and allocated between the pre-opening services included in the ASU using the practical expedient and the remaining performance obligations. Generally, the transaction price is allocated at contract inception to performance obligations in proportion to their stand-alone selling prices (i.e., based on the relative stand-alone selling price of each distinct good or service). (Learn more in our resource “Detailing the Five-Step Framework for Revenue from Contracts with Customers (Topic 606),” available for download here.)
Topic 606-10-32-34 outlines suitable estimation methods that may be used when estimating stand-alone selling prices. These include:
- Adjusted market assessment approach
- Expected cost plus a margin approach
- Residual approach
The stand-alone selling prices of pre-opening services may be difficult for a franchisor to determine, particularly because franchisors do not typically sell these services on a stand-alone basis. The price at which a service is sold is typically the best observable evidence to utilize in allocating the transaction price to the performance obligations included in a contract. Franchisors may need to use multiple approaches in determining the stand-alone selling prices of performance obligations (including pre-opening services) to allocate the transaction price of the contract.
For example, a franchisor may utilize the “expected cost plus a margin” approach for training of the franchisee’s personnel if the franchisor utilizes a third-party vendor in an arms-length transaction to deliver the training; the franchisor could easily determine the expected cost of the training based on its contract with the third-party vendor, and then add its expected sell-through margin to that cost. On the other hand, for site selection services, a franchisor could utilize the “adjusted market assessment” approach because there are third parties that provide site selection services separately, and as a result, the franchisor could obtain market data on stand-alone selling prices for such services. The prices for these similar services could be considered an observable data point in the adjusted market assessment approach. The franchisor would then adjust those market prices to reflect its own cost and expected margin structure when estimating an appropriate stand-alone selling price.
Franchisors will need to use judgment when determining the stand-alone selling prices of the performance obligations included in a contract and how much should be allocated to the pre-opening services. Additional disclosures are also necessary if non-public franchisors elect the practical expedient and/or accounting policy election.
Contact a trusted advisor to discuss preparation for the new standard and how it may impact your business.
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