FASB Proposes a Practical Expedient for Private-Company Franchisors on the Identification of Performance Obligations Under ASC 606 (September 22, 2020)

FASB Proposes a Practical Expedient for Private-Company Franchisors on the Identification of Performance Obligations Under ASC 606

by Nicole Nelson and Sandie Kim, Deloitte & Touche LLP

On September 21, 2020, the FASB issued a proposed ASU 1 that would allow a franchisor2 that is not a public business entity3 (“private-company franchisor”) to use a practical expedient when identifying performance obligations in its contracts with customers (i.e., franchisees) under ASC 606.4 Under the practical expedient, a private-company franchisor that enters into a franchise agreement5 would be able to account for certain preopening services provided to a franchisee as a single performance obligation. The practical expedient is intended to reduce the cost and complexity of applying ASC 606 to preopening services associated with initial franchise fees.

Comments on the proposed ASU are due by November 5, 2020. For ease of reference, the proposal’s questions for respondents are reproduced in Appendix B.

Background

ASC 606 currently requires entities to identify whether the goods or services promised in a contract with a customer are distinct performance obligations. Franchisors applying the revenue guidance in ASC 606 may need to exercise significant judgment to determine whether preopening services provided to franchisees (e.g., site selection assistance, training, and other services) are distinct from one another, the franchise license, and any other goods or services promised in the contract. This determination will affect the timing of revenue recognition related to the franchisee’s payment of initial franchise fees to the franchisor.

Private-company franchisors expressed concerns about the cost and complexity of applying ASC 606, particularly with respect to the accounting for initial franchise fees. Many franchise agreements include an up-front payment (i.e., the initial franchise fee) plus a royalty paid to a franchisor throughout the term of the arrangement. Under legacy industry guidance in ASC 952-605-25-1, the initial franchise fee is generally recognized “when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchisor” (typically, upon the opening of the franchise location). However, under ASC 606, some franchisors may be required to defer revenue recognition related to some or all of the initial franchise fee over the term of the franchise license.

In June 2020, the FASB issued ASU 2020-05,6 which permits certain private entities7 that have not yet issued their financial statements or made financial statements available for issuance as of June 3, 2020, to adopt ASC 606 for annual reporting periods beginning after December 15, 2019, and for interim reporting periods within annual reporting periods beginning after December 15, 2020. This deferral of the effective date was provided, in part, to enable the Board to evaluate whether it can reduce the costs of applying ASC 606 to initial franchise fees.

Key Provisions of the Proposed ASU

The proposed ASU would add a new Subtopic 952-6068 to provide a practical expedient that would allow a private-company franchisor that enters into a franchise agreement to account for certain preopening services provided to a franchisee as a single performance obligation. Those preopening services would be limited to the following activities:

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 local regulations affecting the franchisee’s business
Inspection, testing, and other quality control programs.

A private-company franchisor would be precluded from electing to use the practical expedient “[i]f it is probable that the continuing fee will not cover the cost of the continuing services to be provided by the franchisor and a reasonable profit on those continuing services.” Such might be the case if the franchise agreement is structured to include a large initial franchise fee with small ongoing royalty payments. While the proposed practical expedient would simplify step 2 of ASC 606 (i.e., identifying the performance obligations), entities would still be required to apply the rest of the guidance in ASC 606, including the guidance on (1) identifying other performance obligations (e.g., equipment sales), (2) determining the stand-alone selling prices of the performance obligations, (3) allocating the transaction price to the performance obligations, and (4) determining the timing of revenue recognition.

The proposed ASU includes illustrative examples on how a private-company franchisor might apply the revenue guidance in ASC 606 to identify performance obligations in franchise arrangements (1) if the practical expedient is not elected9 and (2) if the practical expedient is elected. Under the proposed ASU, a private-company franchisor that elects to use the practical expedient would be required to disclose that election.

Effective Date and Transition

If an entity has not yet adopted ASC 606, the existing effective dates and transition requirements of ASC 606 would be applicable to the amendments in the proposed ASU. If an entity has already adopted ASC 606, the proposed amendments would be effective for fiscal years beginning after December 15, 2020, including interim periods within those fiscal years. Early adoption would be permitted. For those entities that have already adopted ASC 606, the proposed amendments would be applied retrospectively as of the date of initial application of ASC 606, with a cumulative-effect adjustment to opening retained earnings. For entities that have already adopted ASC 606, the following transition disclosures would be required in the period of adoption of the proposed ASU:

The nature of the change in accounting principle, including an explanation of the newly adopted accounting principle
The method of applying the change
The effect of the adoption on any line item in the statement of financial position as of the beginning of the first period for which the [proposed ASU] is applied
The cumulative effect of the change on retained earnings or other components of equity in the statement of financial position as of the beginning of the first period for which the [proposed ASU] is applied.

Appendix A — Definitions

The ASC master glossary defines a franchise agreement as follows:

A written business agreement that meets the following principal criteria:

The relation between the franchisor and franchisee is contractual, and an agreement, confirming the rights and responsibilities of each party, is in force for a specified period.
The continuing relation has as its purpose the distribution of a product or service, or an entire business concept, within a particular market area.
Both the franchisor and the franchisee contribute resources for establishing and maintaining the franchise. The franchisor’s contribution may be a trademark, a company reputation, products, procedures, manpower, equipment, or a process. The franchisee usually contributes operating capital as well as the managerial and operational resources required for opening and continuing the franchised outlet.
The franchise agreement outlines and describes the specific marketing practices to be followed, specifies the contribution of each party to the operation of the business, and sets forth certain operating procedures that both parties agree to comply with.
The establishment of the franchised outlet creates a business entity that will, in most cases, require and support the full-time business activity of the franchisee. (There are numerous other contractual distribution arrangements in which a local businessperson becomes the authorized distributor or representative for the sale of a particular good or service, along with many others, but such a sale usually represents only a portion of the person’s total business.)
Both the franchisee and the franchisor have a common public identity. This identity is achieved most often through the use of common trade names or trademarks and is frequently reinforced through advertising programs designed to promote the recognition and acceptance of the common identity within the franchisee’s market area.

The payment of an initial franchise fee or a continuing royalty fee is not a necessary criterion for an agreement to be considered a franchise agreement.

The ASC master glossary defines a franchisor as follows:

The party who grants business rights (the franchise) to the party (the franchisee) who will operate the franchised business.

The ASC master glossary defines a public business entity as follows:

A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.

It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.

An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.

Appendix B — Questions for Respondents

The proposed ASU’s questions for respondents are reproduced below for reference.

Question 1: Do you support introducing guidance for franchisors that are not public business entities to account for pre-opening services provided to a franchisee? Please explain why or why not.

Question 2: Should the scope of the amendments in this proposed Update be limited to franchisors that are not public business entities? Alternatively, would it be appropriate for entities in other industries with comparable arrangements that are not within the scope of the proposed Update to analogize to the amendments? Please explain why.

Question 3: Would the proposed amendments to simplify Step 2 — identify the performance obligations — reduce the cost and complexity of applying Topic 606 to pre-opening services? Please explain why or why not.

Question 4: In paragraph 952-606-25-3, the proposed amendments would reinstate superseded guidance from paragraph 952-605-25-4 as a required criterion for applying the practical expedient. Is this guidance operable? Please explain why or why not.

Question 5: Should the scope of the proposed amendments be limited to pre-opening services? If not, please explain why.

Question 6: Is additional guidance about other aspects of applying Topic 606 to pre-opening services needed for the proposed amendments to be operable? If so, what specific guidance is needed?

Question 7: Should entities that elect to apply the practical expedient be required to disclose that fact? Do the proposed amendments provide decision-useful information for users of financial statements? If not, please explain why.

Question 8: Should entities that have not yet adopted Topic 606 be required to apply the transition provisions and effective date in paragraph 606-10-65-1 to the proposed amendments? If not, please explain why.

Question 9: Should entities that have already adopted Topic 606 be required to apply the proposed amendments on a full retrospective basis, including an entity’s first reporting period under Topic 606? If not, please explain why.

Question 10: For entities that have already adopted Topic 606, should the proposed amendments be effective for annual reporting periods beginning after December 15, 2020, including interim reporting periods within that period, with early application permitted? If not, please explain why.

Footnotes

FASB Proposed Accounting Standards Update (ASU), Franchisors — Revenue From Contracts With Customers (Subtopic 952-606): Practical Expedient.

See the definition of “franchisor” in Appendix A.

See the definition of “public business entity” in Appendix A.

For titles of ASC references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”

See the definition of “franchise agreement” in Appendix A.

FASB Accounting Standards Update No. 2020-05, Revenue From Contracts With Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities.

The deferral does not apply to public business entities, public not-for-profit entities, and employee benefit plans that file or furnish financial statements with or to the SEC.

FASB Proposed Accounting Standards Codification Subtopic 952-606, Franchisors — Revenue From Contracts With Customers.

The example in the proposed ASU that illustrates how performance obligations are identified if the practical expedient is not elected would also apply to franchisors that are public business entities.

Heads Up is prepared by members of Deloitte's National Office as developments warrant. This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

The services described herein are illustrative in nature and are intended to demonstrate our experience and capabilities in these areas; however, due to independence restrictions that may apply to audit clients (including affiliates) of Deloitte & Touche LLP, we may be unable to provide certain services based on individual facts and circumstances.

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. In the United States, Deloitte refers to one or more of the US member firms of DTTL, their related entities that operate using the “Deloitte” name in the United States and their respective affiliates. Certain services may not be available to attest clients under the rules and regulations of public accounting. Please see www.deloitte.com/us/about to learn more about our global network of member firms. Copyright © 2024 Deloitte Development LLC. All rights reserved.