A relatively recent change to accounting standards promulgated by the Financial Accounting Standards Board (FASB) may in certain instances significantly impact the financial statements of franchisors which regulators will be reviewing this year in Item 21 of such franchisors' Franchise Disclosure Documents (FDDs) during FDD “renewal season” (March-May). This is especially so in the case of newer, emerging franchisors.

Let us explain. A few years ago, FASB promulgated Accounting Standards Codification 606 (ASC 606) governing when a franchisor may recognize as revenue initial franchise fees received from franchisees. Under prior accounting principles, a franchisor could generally recognize as revenue a franchisee's initial franchise fee once the franchised unit opened for business.

However, ASC 606 views the franchise right granted under a franchise agreement as a distinct “performance obligation” that transfers over the term of the franchise. Thus, under ASC 606, the total initial franchise fee may no longer be recognized at the opening of the franchised unit but must, instead, be recognized over the term of the franchise agreement governing that unit. The only exception is when a franchisor can show that any of its upfront obligations represent separate performance obligations that are distinct from the franchise right. For example, if a franchisor's training program consists only of non-brand specific business advice and suggestions, then the franchisor can recognize that portion of the franchisee's initial franchise fee ascribable to its training program (how that amount may be quantified is beyond the scope of this column). Same with site selection assistance—if the franchisor is furnishing only generic, non-brand specific site selection advice, then the franchisor can recognize as revenue from the franchisee's initial franchise fee the value of that site selection advice as soon as it has been furnished. Another example of when initial franchise fee revenue can in part be recognized immediately by a franchisor is when, in partial consideration of that initial fee, the franchisor furnishes goods (such as inventory) which have a precise value.

Otherwise, a franchisor under ASC 606 can now only recognize initial franchise fee revenue pro rata over the term of the franchise. In simple terms, under the old protocol, if a franchisor was granted a new franchise for an initial franchise fee of $40,000 and the term of the franchise was 10 years, that franchisor could recognize the entire $40,000 initial fee as revenue as soon as the subject unit opened for business. Under ASC 606, however, unless the franchisor furnishes non-brand specific services of the types referenced above, then the franchisor can only recognize $4,000 per year as revenue over each of the 10 years of the franchise.

What this means, in the above example, is that the franchisor will show as revenue in the year it was collected the full $40,000 initial franchise fee. But now, under ASC 606, since the franchisor can only recognize $4,000 of the initial fee as revenue in the year it was received, it must show a corresponding liability in its financial statements in the amount of $36,000. Quite naturally, this increased liability will impact the franchisor's shareholders' equity (sometimes referred to as “net worth”). For example, if a newly established franchisor was registered last year showing shareholders' equity of $100,000 in its audited financial statements, but sold five franchises for $40,000 each in 2018, then in its audited financial statements for 2018 (soon to be reviewed by examiners in connection with the franchisor's 2019 FDD renewal effort), the franchisor will show initial fee revenue in the amount of $200,000 (5 x $40,000). But since under ASC 606 the franchisor can only recognize as revenue 10 percent of that amount (the first year, or one-tenth, of the 10-year term), the remaining $180,000 of collected initial franchise fees must be spread out over the term of the franchise and will now show as a liability. For simplicity's sake, assuming no other changes to that franchisor's shareholders' equity, what was a shareholder's equity of $100,000 will turn to -$60,000 ($100,000 + 20,000 recognizable initial fees – $180,000 = -$60,000), that franchisor having to schedule as a liability the amount of collected initial franchise fees which can only be recognized over the balance of the term of the franchise.

Area development fees are similarly impacted by ASC 606. They may now only be recognized as revenue over the terms of the franchise agreements to which they will apply (as whole or part of those agreements' initial fees).

Moreover, franchisors are further financially burdened by ASC 606 by having to feature a “retrospective adjustment” to their currently stated retained earnings (generally, profits minus dividends) so as to reflect the cumulative effect of previously received and recognized initial franchise fees, a portion of which must now be deferred under ASC 606. To take a simple example, if a franchisor sold a franchise in 2016 and recognized an initial franchise fee of $40,000 that year because the franchised unit opened in 2016, the franchisor under ASC 606 must revert to recognizing only three years' worth of that initial fee (2016/2017/2018), or $12,000, with the $28,000 balance constituting a “retrospective adjustment” to be subtracted from the franchisor's retained earnings, which will further negatively impact the franchisor's shareholders' equity.

While newer franchisors will be particularly impacted by ASC 606, even larger franchisors may confront issues as a consequence of their refranchising activities or expansion of their franchise networks.

The inability of franchisors to recognize initial franchise fee revenue up front may thus cause some franchisors to no longer qualify for a franchise regulating state's “large franchisor” exemption from registration because of decreased shareholders' equity prompted by ASC 606. Other franchisors may now feature a negative shareholders' equity entirely for the very first time.

A number of critical issues are prompted by ASC 606. How will the franchise regulating states address a franchisor whose financial statements reflect negative shareholders' equity solely due to ASC 606? Require fee deferral or escrow? Before doing so, we believe that the regulators should take into account whether the franchisor's current ratio is positive (current ratio = current assets–liabilities due within the year)/sufficiency of working capital to cover projected franchised unit openings/recent fiscal year's net income/presence of fixed assets/history of financial well-being.

Those states whose franchise laws feature “large franchisor” exemptions from registration (available when a franchisor's shareholders' equity equals or exceeds varying thresholds, $3/$5/$15 million) will have to consider how to address a franchisor which previously satisfied the minimum shareholders' equity requirements but no longer does solely due to ASC 606 compliance. Somehow permit such a franchisor to qualify for the “large franchisor” exemption? More likely, grant the franchisor a discretionary exemption from registration (in those states where discretion is afforded the franchise regulator)? In either case, we believe that reference should be made to the various financial considerations set forth in the immediately preceding paragraph.

Each franchise examiner will confront the difficulty of reviewing the most recent fiscal year's financial statement prepared in accordance with ASC 606 without having the benefit of comparing that statement to the prior year's audited financial statement (pre-ASC 606), as the two years' financial statements are reporting revenue using different standards even though there may be absolutely no change in how the franchisor is conducting business. For this and other reasons, it is imperative that franchise examiners read and understand the franchisor's financial statement footnote related to its adoption of ASC 606, as this required footnote disclosure must present the impact of the adoption of ASC 606.

David J. Kaufmann is senior partner of Kaufmann Gildin & Robbins in New York City. He authored the New York Franchise Act while serving as Special Deputy Attorney General of New York.