By Toby Leslie, CPA, Business Assurance & Advisory Services Partner
In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, which was incorporated into the existing codification under ASC 606. The current guidance on revenue recognition for franchisors is contained outside of the general revenue recognition guidance in ASC 952-605. However, when the transition occurs, ASC 606 will replace the current guidance in ASC 952-605. The Standard will result in some significant changes in certain aspects of revenue recognized by franchisors. Provided below is an example of a typical franchisor arrangement and how the accounting is to be recognized under the current guidance and the new standard.
- Upon signing of a franchise agreement on July 1 of Year One, the franchisee was obligated to pay $25,000. The fee is nonrefundable upon signing. In exchange for the fee, the franchisor must provide training at their facilities. The term of the franchise agreement is 10 years and the franchise commenced operations on January 1 of Year Two.
- Upon expiration of the term of the franchise agreement the franchisee may extend the term by another 10 years by paying a renewal fee of $10,000.
- Ongoing royalty fees of 5% of futures sales are due monthly. No royalty payments were received in Year One and royalty fees of $50,000 were received in Year Two.
- Ongoing advertising fees of 1% future sales are due monthly. No advertising payments were received in Year One and $10,000 in advertising fees were received in Year Two.
Question: How much revenue should be recognized in Year One and Year Two, under ASC 952-605 and ASC 606?
Analysis under current guidance (ASC 952-605):
Under ASC 952-605, “Franchise 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.” The current guidance makes it clear that generally, the franchisor has “substantially performed” when the franchise is opened. The future renewal option fee is not considered for purposes of revenue recognition until such option is exercised as the intent of renewal is not known. Regarding the ongoing fees (royalty and advertising) those fees would be recognized monthly, as the fees become earned and are receivable from the franchisee.
Accordingly no revenue would be recognized in Year One. While the initial franchise fee is refundable, the franchisor had not “substantially performed” their obligations under the franchise agreement until the franchise opened in Year Two. In Year Two, the franchisor would record revenue of $85,000, which would be the entirety of the franchise fee, and royalty and advertising fees received in Year Two.
Analysis under future guidance (ASC 606):
Under ASC 606, the standard prescribes a five-step process for determining how much and when to recognize revenue. In going through an analysis of the five-step process, the key determination is whether the initial franchise fee and ongoing fees are “distinct” performance obligations. If the fees are not considered distinct performance obligations, then the various fees would be combined and recognized over the same period. In determining whether the initial and ongoing fees are distinct under ASC 606, they must meet both of the following criteria:
As the initial franchise fee and ongoing royalty fees provide primarily the same benefit (license of intellectual property), the payments are not considered distinct and should be recognized over the same time period. 
Using the example above, no revenue would be recognized in Year One and an amount of $62,500 would be recognized in Year Two, which would include the entirety of the ongoing royalty and advertising fees and 1/10th of the initial franchise fee.
Conclusion: While ongoing fees for royalties, advertising fees and the like will be recognized in the same manner under the new guidance in ASC 606, the initial franchise fees will be recognized over the term of the initial franchise agreement in most cases. Prior to adoption of the new standard, franchisors need to understand the potential impact that this standard will have on their financials and net equity position and be able to plan accordingly. Private companies were required to adopt the new standard effective December 15,2 018, while public companies must adopt the standard in the first quarter of 2018.
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 As additional support for deferral of initial franchise fees, below is an excerpt from McDonald’s 10Q filing for the period ended September 30, 2017:
In May 2014, the FASB issued guidance codified in Accounting Standards Codification (“ASC”) 606, “Revenue Recognition – Revenue from Contracts with Customers,” which amends the guidance in former ASC 605, “Revenue Recognition.” The core principle of the standard is to recognize revenue when promised goods or services are transferred to customers in an amount that reflects the consideration expected to be received for those goods or services. The standard also calls for additional disclosures around the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The Company will adopt the standard effective January 1, 2018.
The standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption (“modified retrospective method”). The Company currently expects to apply the modified retrospective method upon adoption.
The Company does not believe the standard will impact its recognition of revenue from Company-operated restaurants or its recognition of royalties from restaurants operated by franchisees or licensed to affiliates and developmental licensees, which are based on a percent of sales. While we continue to assess the potential impacts to other less significant revenue transactions, we currently expect the standard will change the way initial fees from franchisees for new restaurant openings or new franchise terms are recognized.
The Company's current accounting policy is to recognize initial franchise fees when a new restaurant opens or at the start of a new franchise term. In accordance with the new guidance, the initial franchise services are not distinct from the continuing rights or services offered during the term of the franchise agreement, and will therefore be treated as a single performance obligation. As such, initial fees received will likely be recognized over the franchise term.
Although the standard will impact the manner in which we record revenue from initial fees, we do not anticipate this impact to be material to the Company’s consolidated statement of income. The cumulative catch-up adjustment to be recorded as deferred revenue upon adoption is expected to be approximately 2% of the Company's consolidated long-term liabilities. No impact to the Company's consolidated statement of cash flows is expected as the initial fees will continue to be collected upon the restaurant opening date or the beginning of a new franchise term.