Understanding ASC 606: New Revenue Recognition Rules for Franchisors, Slides of Accounting

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What Every Franchisor Must Know About the New

Revenue Recognition Rules –

Understanding and Navigating ASC 606

OBJECTIVES FOR TODAY’S SESSION:

• Background of the Revenue Recognition Standard

and the IFA’s Role

• Understand the Business Impact to Franchising and

Why it’s Important to you

• Gain a General Understanding of How to Apply

• Discuss Practical Considerations and Next Steps

• Q&A

BACKGROUND ON THE NEW STANDARD

► FASB and IASB - Single, comprehensive revenue recognition model for all contracts with customers will lead to greater consistency in the recognition and presentation of revenue and will improve comparability within industries, across industries, and across capital markets. ► ASC Topic 606 was introduced via ASU 2014-09. The topic and its subsequent amendments and clarifications are over 700 pages long making it the longest standard ever written. ► Some scope exceptions, for example lease contracts are excluded, but franchise licenses are specifically included in the new standard ► Potential for significant impact on timing of revenue recognition for upfront franchise fees EFFECTIVE DATES ► Public business entities − Fiscal years beginning after 12/15/17 (and interim periods within) ► Nonpublic entities − Fiscal years beginning after 12/15/18 (and interim periods within, beginning after 12/15/19)

• Early adoption is permitted

STATE REVIEW OF THE AUDITED FINANCIAL STATEMENTS

► State Examiners look at a variety of factors in determining whether a

franchisor is sufficiently capitalized, including:

• Positive net worth (excess of total assets over total liabilities);
• Positive current ratio (excess of cash and other current assets over

liabilities due within the year);

• Sufficient working capital to cover projected openings;
• Presence of fixed assets;
• Income; and
• History.

STATE REVIEW OF THE AUDITED FINANCIAL STATEMENTS

● Cash and cash equivalents must at least equal:

Current Liabilities

+ (cost to establish franchisee x number of projected openings during

coming fiscal year)

+ (cost to establish franchisee x number of franchisees signed but not

yet open as of year end)

● May impose a “financial assurance requirement”

− Bond, escrow or deferral of initial fees

WHY THE NEW STANDARD MATTERS

► Brokers don’t wait for their commissions (and the true cost per sale is

likely much higher).

► Taxes likely due on fees received but not yet recognizable.

► Increased administrative and professional costs.

► Accelerates the need for additional capital or financing event.

► Potential claims related to the prior years’ restatement.

Understanding Revenue Recognition and its

Application to Franchisors

STEP 2: PERFORMANCE OBLIGATIONS

► A performance obligation is a promise to provide goods or services (or a bundle of goods or services) that are distinct. To qualify as distinct the following criteria must be met:

• The franchisee can benefit from the good or service either on its own or together with other resources readily available to the franchisee.
• The promise to transfer the good or service is separately identifiable from other promises in the contract. Franchisor Considerations ► Generally the various activities to be undertaken to support the brand are considered a single performance obligation (transfer of the franchise license). ► The franchisor must assess each of the additional promises in the franchise agreement and FDD to determine whether they are distinct, for example:
• Assistance in selecting a site and/or in obtaining facilities, including related financing and architectural services.
• Training of the franchisee’s personnel.
• Equipment necessary to operate the franchise.
• Establishment of suppliers, and inspection, testing and other quality control programs. Note: Identification of distinct performance obligations is required. A franchisor cannot simply assume that all promises are part of the franchise license.

STEP 2: PERFORMANCE OBLIGATIONS

Area Development Arrangements ► Provides a franchisee with the right to develop multiple locations within a geographic region. ► Exclusivity in and of itself is not considered a performance obligation, but instead is considered an attribute of the franchise right and will be recognized in line with the franchise fee. ► Subfranchise rights provided by master franchise agreements may be considered a distinct performance obligation. Material Rights ► Discounts − If an option for a future purchase provides a material right to the customer, the option itself is a performance obligation, which is satisfied upon exercise. − The right must be valued and this portion of the initial fee should be deferred until the right is exercised. − An example would be discounted franchising fees for subsequent franchises.

STEP 5: RECOGNIZE REVENUE

 Revenue is recognized as/when a franchisor satisfies each performance obligation: − Over time - franchise licenses are considered symbolic IP and are recognized over time. − At a point in time – when equipment is delivered.  Sales/Usage-based fees - recognized as revenue when (or as) the later of the following (i.e., the “royalty constraint”): − The subsequent sale or usage occurs; and − The performance obligation to which some or all of the sales- or usage-based royalty has been allocated has been satisfied (or partially satisfied) ► Effectively, royalties fees will continue to be recognized as they are incurred. ► However, in the event of a lag in reporting of the sales on which the royalty fee is based, estimated revenues will be required

ADOPTION IMPACT AND NEXT STEPS

OTHER CONSIDERATIONS DURING AND

AFTER ADOPTION

► Cannot change performance obligations or transaction price by merely rewording contracts, BUT, for new contacts, consider restructuring payment streams in order to support stand-alone selling price determination and potentially minimize portion of initial fees required to be deferred: − Identify distinct performance obligations and spell out in the contract. − Specifically state a price for each distinct performance obligation that can reasonably be supported. ► Any resulting changes to accounting can impact more than just the financial statements. Communicate proactively to impacted parties: − Investors/Lenders:

• Net Income/EBITDA
• Company Valuations
• Debt Compliance Ratios (ST/LT Deferred Revenue) − States and Franchisees
• FDD Disclosures/FTC Reporting
• Franchisees/Potential Franchisees − Internal stake-holders
• Compensation benchmarks
• Key metrics
• Performance indicators − IRS and Other Tax matters
• Schedule M adjustments
• Method of Accounting Changes (M-3) Note: The new standard must be adopted on a retrospective basis, with a cumulative adjustment to retained earnings. Franchisors should consider the impact of this adjustment on state equity requirements.

ASC 606 IMPLEMENTATION TIMELINE

Private Companies (12/31 Year End)

PHASE 1 – SCOPING AND GAP ANALYSIS Identify revenue streams to be impacted. Prepare a “gap analysis” of ASC 605 vs. ASC 606 for those revenue streams addressing: Transition method/issues; Five steps of ASC 606; Contract costs; Disclosures PHASE 2 - TECHNICAL ANALYSIS Determine specific application of issues identified in Phase 1, including method of determining standalone selling price, pricing controls, identifying specific contracts costs to be capitalized, amortization periods and methodologies and lookback periods for revenue contracts and contract costs. Identify broad systems and business process requirements. PHASE 3 – SYSTEMS CONFIGURATION AND BUSINESS PROCESSES Reconfigure systems and business processes based on Phase 2 findings. PHASE 4 – TESTING/TRANSACTION AUDITING INTERNAL CONTROLS Run historical transactions through parallel systems and business processes reconfigured for ASC 606. Auditors to perform detail transaction testing. PHASE 5 – FINANCIAL REPORTING AND DISCLOSURES Assess results of Phase 4 and record ASC 606 adoption entries and develop disclosures including contract liability rollforwards, summary of remaining performance obligations, etc. Sept 2017 - April 2018 April-Sept 2018 Oct-Dec 2018 Jan-March 2019 Timeline