It is the almost the end of the year—the time by which privately held franchisors must have responded to the impact of a new accounting rule (ASC 606) governing when initial franchise fees may be recognized as revenue or else confront in 2020 the need to defer or escrow initial franchise fees (or be refused franchise registration altogether). ASC 606 became effective Jan. 1, 2019 for non-public business entities, meaning that their fiscal year end 2019 audited financial statements must be in full compliance therewith.

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 (except to the extent that distinct goods and services are in part paid for by the initial fee). Under ASC 606, a franchisor 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 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, the franchisor can only recognize $4,000 per year as revenue over each of the 10 years of the franchise (except as noted above).

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% of that amount (the first year, or 1/10th, 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 ($100K + 20K 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.

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.

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 for the very first time. Of course, if a franchisor is featuring negative shareholders' equity, then the franchise regulating states may impose what they refer to as "financial assurance conditions" as a precondition to franchise registration—alternatively, the deferral of initial franchise fees until the subject franchised units open; the requirement that such franchisors place all initial franchise fees in escrow until such units open; or, in the extreme, a refusal to register the franchisor's Franchise Disclosure Document on the ground that doing so would pose an unreasonable risk to prospective franchisees or, in rare instances, because a state franchise registration/disclosure statute forbids the registration of any franchisor featuring a negative shareholders' equity.

Hopefully, state franchise regulators will take into account whether a franchisor's now negative shareholders' equity was solely prompted by ASC 606 and will not impose any financial assurance preconditions to Franchise Disclosure Document registration. Ideally, they will review the sufficiency of that franchisor's working capital, its recent fiscal year's net income, the franchisor's fixed assets and/or its history of financial well being.

It should be noted that the North American Securities Administrators Association (NASAA) Franchise Project Group (the quasigovernmental organization representing all federal and state franchise regulators) has devoted much time and resources over the past two years educating the franchise regulatory community on the impact of ASC 606 and how regulators should respond thereto. (Full disclosure: Your author serves, and has served since 1995, as an Advisor to the NASAA Franchise and Business Opportunity Project Group.)

But it is not too late for franchisors to avoid the negative impacts that ASC 606 may have on their financial statements and their ability to secure franchise registrations/renewals without the imposition of the financial assurance measures identified above (deferral of initial franchise fees/escrow of initial franchise fees/refusals to register altogether).

First and foremost, franchisors should ensure that their accountants are fully conversant in ASC 606 and are preparing their FYE 2019 audited financial statements in full compliance therewith. A failure to do so will lead state franchise regulators to swiftly reject an application for franchise registration/renewal. The covering "auditor's report" should make ASC 606 adherence clear and at least one note to the audited financial statements should expansively describe how ASC 606 was in fact recognized and applied to the subject franchisor's financial statements. It is vital that a franchisor's accounting team check and check again with its outside auditor to make certain that these precepts are followed.

Next, the franchisor before Dec. 31, 2019 should analyze whether its forthcoming FYE 2019 financial statements, after taking into account the impact of ASC 606, will result in a statement of shareholders' equity which is either insufficient to qualify that franchisor for its customary "large franchisor" exemption from registration/disclosure (in those states affording such exemption) and/or may result in negative shareholders' equity which will result in the regulatory imposition of financial assurance preconditions to registration (or refusals to register altogether).

In either event, the franchisor can inject new paid-in capital on or before Dec. 31, 2019 either to insure that its consequential shareholders' equity at year end equals or exceeds those thresholds required by state franchise registration/disclosure law "large franchisor" exemptions from registration and/or to make certain that its resulting shareholders' equity is sufficient to avoid the imposition of financial assurance preconditions to FDD registration (fee deferrals/escrows/refusals to register). With respect to what amount of shareholders' equity is required by franchise regulators to avoid the imposition of such financial assurance preconditions to registration, understand that they are nowhere codified but that a well versed franchise attorney is familiar with them (and understands that they vary on a state-by-state basis).

Privately held franchisors thus have some swift homework to do and measures to undertake right now to ensure that 2020 is, indeed, a happy new year for them.

David J. Kaufmann is senior partner of Kaufmann, Gildin & Robbins. He authored the New York Franchise Act while serving as Special Deputy Attorney General of New York, and also serves as an Advisor to the North American Securities Administrators Association (NASAA) Franchise Project Group (the coordinating body of federal and state franchise regulators).