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I.Introduction
Revenue is a key component of all businesses, including franchisors, and it is important that counsel to franchisors have an understanding of the potential effects that accounting changes relating to revenue recognition can have on a franchisor. An important change in the rules related to revenue recognition became effective in 2019 and 2020 due to the adoption of Accounting Standards Codification, "Revenue from Contracts with Customers" (Topic 606)1 (ASC 606) by the Financial Accounting Standards Board2 (FASB) on May 28, 2014.3
For many businesses, the impact of ASC 606 has been minimal; however, for the franchising industry, the impact of the new rules is sweeping. Before ASC 606, franchisors were generally allowed to recognize initial franchise fees as revenue when a franchise opened for business under ASC 952-605.4 In contrast, ASC 606 results in the allocation of the initial franchise fee on a straight-line basis over the term of the franchise agreement unless the franchisor demonstrates that certain pre-opening services comprise a "distinct" deliverable.5 For most franchisors, the new standard causes some portion of the initial franchise fee to appear as a contract liability (deferred revenue) on the balance sheet, as opposed to revenue on the income statement.
ASC 606 has largely been met with confusion and concern by the franchise industry. In particular, the franchise industry has raised concerns about the varying interpretations of timing of revenue recognition under ASC 606 for initial franchise fees, and the costs of implementing ASC 606.6 In addition, although the underlying cash flows and operations of a business are unchanged, ASC 606 could negatively impact financials and may have a considerable effect on key valuation inputs, such as earnings before interest, taxes, depreciation, and amortization (EBITDA). The deferred recognition of initial franchise fee revenue could ultimately hinder growth in the franchise segment and potentially result in business closures and job losses.7
On April 8, 2020, in response to these concerns and citing the coronavirus pandemic, the Financial Accounting Standards Board (FASB) announced the delayed implementation of ASC 606 for franchisors that are not public entities.8 On July 22, 2020, the FASB stated that it intends to add a project to its technical agenda to provide franchisors with a practical expedient for the recognition of initial franchise fees...