Question

Revenue recognition has been a concern for the accounting profession for many years – especially as it relates to contracts that may involve several outcomes. The FASB issued ASU 2014-09 in 2014 at which time topic 606 was created covering revenue recognition and contracts with customers. Briefly describe the five steps, in your own words, for the computation of when revenue from contracts is now to be recognized on the income statement

Answer 1

Step 1: Identify the contract with a customer.

This step will typically be straightforward for franchisors because they have a written franchise agreement in place that specifies the parties, each party's rights and obligations, and the payment terms. The agreement will also have "commercial substance," meaning the cash flows of both parties are expected to change as a result of the contract. Franchisors must take the additional step of determining collectability based on its credit underwriting of the franchisee.

Step 2: Identify the performance obligations in the contract.

Franchisors must determine if the services -- such as pre-opening activities, site selection and training -- it provides to the franchisee at the onset of the franchise agreement can be identified as "distinct" from the intellectual property that the franchisee is licensing. This determination should be made based on professional judgment and industry best practices. (In many areas, including this one, privately held franchisors can look at the filings of publicly held franchisors to see how those businesses handled a determination.)

One potential indicator that a service is distinct is that it is broken out separately, with a separate fee in the franchise disclosure document (FDD) and franchise agreement. Another indicator is whether a service is optional or a required component of service. For example, if a franchisor offers site selection as an option and a franchisee could alternatively use an outside vendor for this service, then it is likely the service is distinct.

Franchisors should note that some services will be more difficult to label as distinct, such as training that is specific to the brand and its processes. In the case of training, if the education is available from a third party, such as a business class at a university, then that portion of the training may be distinct. Generally, to be classified as distinct, the service would have to have value to the franchisee regardless if they were a franchisee of the system or not.

Step 3: Determine the transaction price.

For franchisors, this step involves listing all the revenue streams -- including those that will be received up front, and those that will be received over time -- it will collect from the franchisee, including the initial franchise fee, royalties, renewal fees, transfer fees, relocation fees and so on. All revenue streams should be outlined in the franchise agreement.

Franchisors may also need to note significant financing components in arrangements in which the timing of payment is extended or significantly later than when the goods or services are provided, such as area development rights or master franchise rights. Additionally, non-cash services must be valued as part of the transaction price at the inception of the agreement.

Step 4: Allocate the prices to the performance obligations

For this step, franchisors must take each distinct good or service determined in step 2 and assign a transaction price at the inception of the agreement. One or more approved methods may be used to make these determinations, including the adjusted market assessment approach, the expected cost plus a margin approach, and the residual approach. The outcome for each item must be a stand-alone value, meaning the value at which the good or service could be sold on its own.

Step 5: Recognize revenue.

For franchisors to recognize revenue for a particular good or service, that good or service must be transferred to the franchisee, either at a point in time, or over time (over the period of the franchise contract). Royalties have a carve-out exception as sales-based royalties; therefore the franchisor continues to recognize them as the underlying sales occur, and accrues for royalties earned but not yet received.