Introduction

1. The Accounting Standards Codification is amended as described in paragraphs 2–5. In some cases, to put the change in context, not only are the amended paragraphs shown but also the preceding and following paragraphs. Terms from the Master Glossary are in bold type. Added text is underlined, and deleted text is

struck out

.

Introduction

BC1. The following summarizes the Board’s considerations in reaching the conclusions in this Update. It includes reasons for accepting certain approaches and rejecting others. Individual Board members gave greater weight to some factors than to others.

BC2. The Board decided to undertake this project to address issues raised by stakeholders in accounting for pre-opening services by private company franchisors.

Background Information

BC3. On May 28, 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606). During the implementation of Update 2014-09, private company stakeholders in the franchise industry raised concerns about the cost and complexity of applying Topic 606 to determine the amount and timing of revenue recognition for initial franchise fees, especially for franchisors that are start-ups or that have a small number of franchise units. The initial franchise fee is a fee paid to a franchisor in exchange for establishing a franchise relationship, along with the provision of varying levels of pre-opening services. Before the adoption of Topic 606, under the industry-specific guidance in Topic 952, Franchisors, the initial franchise fee typically was recognized when the franchise location opened. Under the current guidance in Topic 606, franchisors are required to analyze pre-opening activities in their franchise agreements to identify whether the goods and services provided are distinct from the franchise license and, therefore, are performance obligations. If the goods or services are determined to be performance obligations, entities are then required to analyze each performance obligation to determine the standalone selling prices, allocation of the consideration, and timing of revenue recognition. Nonpublic franchisors expressed concern about the cost and complexity of applying the Topic 606 guidance to pre-opening services and that without a practical expedient accounting results may generally be inconsistent with the intent of Topic 606 for those entities because of an incorrect view that those pre-opening services always would not be distinct from the franchise license and the initial franchise fee therefore would always be recognized over the license term rather than applying the Topic 606 model to identify performance obligations.

BC4. The Board discussed this issue at a public Board meeting in November 2017, in which the Board explained that Topic 606 does not include presumptions about the number of performance obligations in an arrangement. The Board also shared its views that when assessing the standard, an entity should consider the facts and circumstances of its specific arrangements and not overgeneralize. The handout for the Board meeting and a recording of the Board meeting were posted to the FASB’s revenue implementation website. In November 2018, the FASB staff drafted an educational paper, including an example of the application of Topic 606 to pre-opening services, and produced a short educational video, which also were posted to the revenue implementation website.

BC5. In early 2020, nonpublic stakeholders in the franchise industry again raised concerns about Topic 606 adoption. At the time, nonpublic franchisors had begun the audits of their 2019 annual financial statements, and they observed that it was costly and complex to complete the evaluation required to account for pre-opening services as distinct from the franchise license, despite analyses performed by some franchisors that were intended to support their view that a portion of pre-opening services is distinct from the franchise license. The Board also became concerned that some entities that are not public business entities presumed that the pre-opening services would not be distinct from the franchise license and that the initial franchise fee would always be recognized over the license term rather than applying the Topic 606 model to identify performance obligations. Accordingly, the Board decided to add a research project to its agenda to evaluate how to reduce the costs and complexity related to applying Topic 606 to pre-opening services and how to improve the application of the guidance to achieve accounting results more consistent with the objective of Topic 606. In July 2020, the Board decided to move the project from its research agenda to its technical agenda and to pursue a private company practical expedient.

BC6. The guidance in Update 2014-09 was effective for calendar-year-end public business entities on January 1, 2018. For all other entities with calendar year-ends, the guidance was set to be effective as of January 1, 2019, for annual reporting periods (and interim reporting periods in 2020). At the April 8, 2020 Board meeting, the Board decided to delay the effective date of Topic 606 for all nonpublic entities that had not yet issued financial statements, including franchisors that are not public business entities, to provide the Board with time to identify a cost-effective solution for the pre-opening services issue. The effective date deferral was finalized in June 2020 when the Board issued Accounting Standards Update No. 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for Certain Entities, which deferred the effective date for nonpublic entities to annual reporting periods beginning after December 15, 2019, for entities that had not issued financial statements (or made financial statements available for issuance) as of June 3, 2020 (the date the Update was issued). The Board observes that some franchisors had adopted the guidance in Topic 606 before the deferral of the effective date. The timing of an entity’s adoption of Topic 606 (that is, whether the entity previously adopted Topic 606 or whether it will be applying the deferred effective date) does not affect the applicability of the amendments in this Update.

Benefits and Costs

BC7. The FASB’s Rules of Procedure states:

BC8. In fulfilling that mission, the Board follows certain precepts, including issuing standards only when the expected benefits of the resulting information justify the expected costs. The Board strives to determine that a standard will fill a significant need and that the costs imposed to meet that standard, as compared with other alternatives, are justified in relation to the overall benefits of the resulting information. The Board’s assessment of the costs and the benefits of applying new guidance is unavoidably more qualitative than quantitative because there is no method to objectively measure the costs to implement new guidance or to quantify the value of improved information in financial statements.

BC9. Paragraph OB2 of FASB Concepts Statement No. 8, Conceptual Framework for Financial Reporting, Chapter 1, The Objective of General Purpose Financial Reporting, and Chapter 3, Qualitative Characteristics of Useful Financial Information, states the following:

BC10. Because the amendments in this Update introduce a practical expedient for applying Topic 606 to pre-opening services, the Board believes that the amendments will provide the benefit of reducing the cost and complexity of applying Topic 606 for franchisors and their auditors as well as providing financial reporting results that are generally more consistent with the Topic 606 revenue model for those entities that are nonpublic business entities. The practical expedient allows nonpublic franchisors to apply a simplified Step 2, Identify the Performance Obligations in the Contract, of the five-step revenue recognition model, which should eliminate some of the judgment required in applying Topic 606.

BC11. The Board has been working for several years with nonpublic stakeholders in the franchising industry on the issue of the cost and complexity of revenue recognition for pre-opening services. In response to the issue, the FASB communicated with industry stakeholder groups, discussed the topic at a public Board meeting, and published educational materials on the subject. Despite the FASB’s educational efforts to clarify the purpose of the guidance in Topic 606 and to reduce the cost and complexity associated with applying the guidance to pre-opening services, the issue has not been resolved. Furthermore, the issue seems to be pervasive among nonpublic franchisors. Therefore, the Board concluded that it is appropriate to resolve the issue through standard setting and that a limited-scope solution that results in narrow-scope changes to GAAP is appropriate to address the issue.

BC12. The Board acknowledges that there may be a cost for financial statement users in analyzing the financial statements affected by amendments in this Update. The primary users of nonpublic franchisor financial statements are regulators and franchisees (both current and prospective). Because of the importance of the financial statement information to regulators, extensive research was performed about franchising regulations at both the federal level and the state level, including outreach with a state regulator. The Board understands that regulators are concerned about inconsistent application of Topic 606. Given the challenges franchisors that are not public business entities have had in applying the provisions of Topic 606, the Board expects that the practical expedient should improve the consistency in the application of Topic 606, resulting in cost reduction for financial statement users. However, because application of the practical expedient is optional, financial statement users may incur some ongoing costs to assess the financial statements of both franchisors that choose to apply the practical expedient and franchisors that do not. Additionally, because the practical expedient is not applicable to public business entities, there may be an ongoing cost of comparing financial statements between public business entities and nonpublic entities. Overall, the Board concluded that the benefits of reducing the cost and complexity from applying the amendments in this Update exceed the potential costs for financial statement users.

BC13. On September 21, 2020, the Board issued proposed Accounting Standards Update, Franchisors—Revenue from Contracts with Customers (Subtopic 952-606): Practical Expedient. The Board received 21 comment letters on the proposed Update. Overall, the comment letter feedback was mixed about whether to provide a practical expedient as proposed. Approximately half of the respondents agreed with the amendments in the proposed Update and indicated that the proposed amendments would reduce the cost and complexity of applying Topic 606. Those respondents also noted that the proposed amendments were generally operable. The other half of the respondents disagreed with the proposed amendments because they noted that the proposed amendments would introduce industry-specific guidance to a principles-based standard or that they would represent, in their view, an accounting exception and not a practical expedient. No financial statement users provided feedback through the comment letter process. In addition, the Board did not receive any feedback that would indicate that financial statement users would have concerns about the amendments in this Update, and it did not receive user input noting concerns about franchisor accounting related to initial fees prior to the adoption of Topic 606. The Board also solicited feedback from the Private Company Council and Small Business Advisory Committee about the amendments in this Update. Members of those groups that shared feedback generally supported the amendments and did not raise concerns about introducing a private company practical expedient. Many of the concerns raised by comment letter respondents that disagreed with the proposal had previously been considered by the Board during initial deliberations and did not change the Board’s conclusions that the benefits of the amendments justify the costs. However, most of the comment letter respondents that disagreed with the practical expedient agreed with limiting the scope of the amendments to franchisors that are not public business entities.

Basis for Conclusions

Practical Expedient

BC14. Nonpublic stakeholder feedback indicated that significant cost and complexity for nonpublic franchisors were associated with identifying performance obligations related to pre-opening services under a franchise agreement. In response to that feedback, the Board decided to introduce a practical expedient to allow nonpublic franchisors to account for pre-opening services provided to a franchisee as distinct from the franchise license if the services are consistent with those included in a predefined list within the guidance. Additionally, the Board expects that, for nonpublic business entities, applying the practical expedient directionally will result in accounting outcomes generally consistent with the intent of Topic 606 for those entities and will counter biases that appear to have emerged in practice.

BC15. The Board concluded that the amendments in this Update represent a practical expedient to the application of the guidance in Topic 606 rather than an exception or an accounting alternative. An exception or accounting alternative allows an entity to forgo applying certain accounting guidance or allows different guidance to be applied, leading to a different accounting outcome. An example of an existing accounting exception in Topic 606 is the sales-based or usage-based royalty exception to the general revenue recognition principles in paragraph 606-10-55-65.

BC16. As defined in the Private Company Decision-Making Framework, a practical expedient is a more cost-effective way of achieving the same or a similar accounting or reporting objective. Nonpublic franchisors may use the practical expedient to simplify the determination of whether the promise of pre-opening services is distinct from the intellectual property performance obligation in a franchise agreement. Those entities will then need to apply the existing allocation model in Topic 606 to allocate the consideration in the contract among the license, pre-opening services, and any other goods or services in the arrangement (for example, equipment). Identifying performance obligations and allocating consideration in the contract are two objectives of Topic 606. Therefore, the Board concluded that the guidance should simplify the achievement of those objectives.

BC17. The Board observes that the revenue recognition outcome of applying Topic 606 without the practical expedient may differ in some cases from the outcome of applying Topic 606 with the practical expedient. Some comment letter respondents suggested that because the practical expedient will not always result in the same outcome as applying the Step 2 guidance in Topic 606, the guidance represents an exception rather than a practical expedient. However, the Board concluded that the practical expedient has the same objectives as Topic 606. The Board observes that, given the nature of the pre-opening services in a typical franchise arrangement, identifying performance obligations will involve significant judgments. The Board understands that in some cases accountants that exercise reasonable judgment in similar or even the same fact patterns may come to different conclusions. The Board views the practical expedient in this Update as simplifying the judgments needed to apply Step 2 guidance for franchisors. The Board understands that in many cases application of the practical expedient may provide a result closer to the intent of Topic 606 but acknowledges that in some cases the practical expedient may allow for identification of some pre-opening services as distinct that otherwise might have been deemed not to be distinct without use of the practical expedient. While the application of the practical expedient may not always result in exactly the same outcome as applying the Step 2 guidance in Topic 606, the Board observes that this can be the case with other practical expedients as well (for example, transition practical expedients in Topic 606 may result in differences in the timing of revenue recognition). Additionally, introducing this practical expedient is not meant to imply that when applying the guidance in Topic 606 (absent the practical expedient) the Board would expect entities to always conclude that pre-opening services are distinct from the franchise license or to conclude that it is appropriate to default to a conclusion that pre-opening services are not distinct. Rather, entities not applying the practical expedient should apply the Topic 606 guidance on identifying performance obligations. The Board observed that, as with the other practical expedients in Topic 606, an entity should apply the practical expedient consistently to similar contracts in similar circumstances.

BC18. The practical expedient simplifies the guidance on identifying performance obligations for franchisors that perform pre-opening services. Rather than evaluating each promise to perform a pre-opening service to determine whether it is both capable of being distinct from the franchise license promise and distinct in the context of the contract, the practical expedient allows a franchisor to account for pre-opening services as distinct from the franchise license if they are consistent with those services included in a predefined list of pre-opening services. That list of services in the practical expedient was developed by leveraging the definition of initial services that currently exists in the Glossary of Topic 952 (which was superseded by Topic 606). That definition has been updated to reflect stakeholders’ feedback and the Board’s views about which services should be included. One service was entirely removed from the previous list—assistance in advertising, either for the individual franchisee or as part of a general program. The Board observed that the description of advertising services may cover a wide array of services, some of which may be distinct and others that may not be distinct. Therefore, if a franchisor has provided advertising services, it should apply the Topic 606 guidance to assess whether the advertising services are distinct rather than apply the practical expedient. Accordingly, the list of pre-opening services is for purposes of applying the practical expedient and is not meant to imply that services not included on that list cannot be distinct from a franchise license. Rather, if an entity provides pre-opening services that are not consistent with the services on the list, the entity should apply the Topic 606 guidance on identifying performance obligations to determine whether the services are distinct. Additionally, as required by paragraph 952-606-25-4, the practical expedient should be applied consistently. That does not mean that the practical expedient, if elected, must be applied to all of the initial services listed. Rather, if an entity chooses to apply the practical expedient to certain services but not others, the entity should do so consistently.

BC19. The amendments in the proposed Update would have required that an entity identify the bundle of pre-opening services as one separate performance obligation. This was because the Board had believed that (a) determining the standalone selling price for the bundle would have been easier than determining the standalone selling price for each individual service and (b) the combined unit of account would have eliminated the need to determine whether the pre-opening services were distinct from each other (not only distinct from the franchise license). However, comment letter respondents noted that it may be operationally challenging to determine the standalone selling price of the pre-opening services as a bundle and that franchisors would need to determine the price of each service independently to use in the allocation analysis. Additionally, comment letter respondents noted concern that accounting for the services as a single performance obligation could complicate the judgments for when revenue should be recognized under Step 5 of Topic 606. The Board considered that while the accounting for some scenarios may be simplified by the single unit of account, others may be complicated by this requirement. Accordingly, the Board decided not to require a single unit of account and, instead, provided for an accounting policy election to recognize the pre-opening services as a single performance obligation.

BC20. The amendments in this Update simplify the process of identifying performance obligations but do not amend the guidance on allocating the transaction price and determining standalone selling prices as well as recognizing revenue. The Board concluded that retaining this guidance is important to maintain a close link to the existing Topic 606 guidance. Counter to some of the feedback received from comment letter respondents, in the Board’s view the guidance in this Update represents a practical expedient to applying the guidance on identifying performance obligations in Topic 606 and that introducing a private company practical expedient is consistent with the Private Company Decision-Making Framework. In the Board’s view, retaining the requirement to apply the allocation guidance in Topic 606 ensures that the revenue recognized correlates to the services provided and will aid in preventing abuse. For example, if an entity charges a large initial franchise fee but the services provided are minimal, then the standalone selling price should naturally provide a ceiling for how much revenue could be recognized. In the proposed Update, the Board suggested that an entity should be required to assess the ongoing fees and the relationship of those fees to ongoing services to determine whether it is eligible to apply the practical expedient. The Board decided that such a requirement was not needed in the final Update because the evaluation of standalone selling prices should be sufficient to prevent abuses. After allocating the transaction price, an entity should apply the guidance in Topic 606 to determine when to recognize revenue. Under that guidance, an entity should evaluate whether revenue should be recognized over time (paragraph 606-10-25-27) or at a point in time (paragraph 606-10-25-30).

Alternative Approaches Considered but Dismissed by the Board

BC21. The Board considered three alternative approaches that would have significantly amended Topic 606 as compared with the amendments in this Update. These approaches are discussed in detail below. All of those approaches would have introduced industry-specific guidance for franchisors that are not public business entities. The Board ultimately dismissed those approaches because it concluded that the benefits would not justify the costs.

BC22. The first alternative that the Board considered would have allowed a franchisor to presume that an initial franchise fee can be recognized, in its entirety, when an entity has transferred control of the goods or services to which the consideration that has been received relates, unless certain conditions are met. Those conditions are that (a) the sales-based or usage-based royalty does not reflect the standalone selling price of the franchise license, (b) the initial franchise fee relates to multiple franchise units, or (c) the costs incurred by the franchisor in opening the franchise location are significantly less than the initial franchise fee. If any of those conditions are met, an entity would be precluded from applying the practical expedient. That alternative leveraged the existing practical expedient in paragraph 606-10-55-18, which allows an entity to recognize revenue if the consideration received corresponds directly to the value to the customer of the entity’s performance to date. The Board ultimately rejected this alternative because it disregards the requirement in Topic 606 to identify performance obligations and to allocate the transaction price based on the standalone selling prices of those performance obligations.

BC23. The second alternative that the Board considered would have allowed an entity to account for yet-to-be-determined pre-opening services as not distinct from the franchise license. This approach would have generally resulted in the deferral of the initial franchise fee, which would be recognized as revenue ratably over the license term. That approach would have eliminated the need to evaluate and document whether each pre-opening service is distinct, as well as the need to estimate the standalone selling price for the services, both of which seem to be a point of difficulty for nonpublic franchisors. However, the Board rejected this approach because it would have exacerbated stakeholders’ concerns about the accounting treatment of pre-opening services and reinforced biases that appear to have emerged in practice that are inconsistent with the objectives of Topic 606. Because this approach would have deferred the timing of revenue recognition for pre-opening services that might have been deemed to be distinct had the Topic 606 model been applied, Board members were concerned that this approach would deviate from the intent of Topic 606. Board members also were concerned that such an approach would further separate the timing of the recognition of revenue from the timing of provision of the service. Furthermore, such an approach, in addition to reinforcing a presumption that does not exist in the guidance that it is appropriate to default to a conclusion that pre-opening services are not distinct, would further distance the accounting from the economics and the timing of satisfaction of performance obligations.

BC24. The third alternative considered would have allowed a predetermined percentage of the initial franchise fee to be recognized upon completion of the pre-opening services. The Board had concerns about drawing an arbitrary threshold and that such an approach would require ongoing maintenance of the guidance (for example, periodically reevaluating the threshold). The Board rejected this alternative because it is inconsistent with the objectives of Topic 606.

Scope

BC25. Nonpublic franchisors voiced concerns about the cost and complexity of applying Topic 606 to pre-opening services. On the basis of outreach with stakeholders, the Board understands that initial franchise fees related to pre-opening services are typically a more significant portion of revenue for nonpublic franchisors than for public franchisors, generally because nonpublic franchisors are more likely than public franchisors to be in a start-up or growth phase. Additionally, the Board understands that nonpublic franchisors are experiencing more difficultly in applying the guidance on identifying performance obligations as compared with public franchisors.

BC26. The Board observes that public business entities have previously adopted Topic 606 and is unaware of questions being raised recently about the application of Topic 606 by public franchisors. Furthermore, limiting the amendments to entities that are not public business entities substantially retains convergence between GAAP and International Financial Reporting Standards (IFRS Standards), as described further in paragraphs BC34–BC36. For those reasons, the Board decided to limit the applicability of the practical expedient to entities that are not public business entities.

BC27. The Board observes that a private company practical expedient is allowable under the Private Company Decision-Making Framework, which states that if the guidance provides relevant information, the Board should consider whether using one or more practical expedients could satisfy the needs of the users of private company financial statements while reducing the cost for preparers of those financial statements.

BC28. The Private Company Decision-Making Framework provides that effective dates for private companies should be deferred as compared with the effective dates for public companies because private companies require additional time to effectively and efficiently implement new guidance and because many private companies and/or their public accountants acquire valuable knowledge and become efficient from observing the earlier implementation experiences of public companies. The Board observes that a longer implementation period has provided private companies with the time necessary to identify the issues in applying Topic 606 to pre-opening services and has provided insights into how to become efficient in adopting the guidance through the introduction of a new practical expedient.

Entities That Are Franchisors

BC29. In undertaking this project, the Board decided to limit the applicability of the guidance to entities that are franchisors. The Master Glossary defines franchisor as “the party who grants business rights (the franchise) to the party (the franchisee) who will operate the franchised business.”

BC30. Because the intent of the amendments in this Update is to limit the use of the practical expedient to entities that are franchisors, the Board decided to create a new Subtopic, Subtopic 952-606, Franchisors—Revenue from Contracts with Customers, to reduce the costs of applying the guidance by clarifying the scope for stakeholders. The Board determined that the Topic 606 application issue and the need for a practical expedient are unique to franchisors. While the Board acknowledged that other industries may provide upfront services or collect upfront fees, the Board decided not to expand the scope of the amendments to other entities. Therefore, the amendments specify that the guidance should not be applied directly or by analogy by entities that are not within the scope of Subtopic 952-606.

BC31. The amendments in this Update apply to pre-opening services. During outreach, stakeholders highlighted that there are other fees that a franchisor collects that may be similar to an initial franchise fee that a franchisor collects in exchange for performing pre-opening services, such as area franchise fees, renewal fees, and transfer fees. The Board decided to limit the scope of the amendments to pre-opening services in franchise agreements because the stakeholders’ concerns relate to recognition of revenue for those services. Additionally, the Board has not received feedback indicating a need for clarification or a practical expedient relating to other fees or services. Also, pre-opening services are well defined and share a certain level of commonality among franchisors and transactions that other types of fees may lack. For example, area arrangement fees are typically unique and may have complex structuring, and the accounting for a renewal depends on applying the contract modification framework and, therefore, the applicability of a practical expedient may depend on the structure of the renewal.

BC32. Paragraph 606-10-50-22 of Topic 606 currently includes a disclosure requirement about the use of practical expedients. The Board concluded that this disclosure will be important to the users of franchisor financial statements (a) because of the potential effect on comparability between those franchisors that apply the practical expedient and those that do not and (b) to ensure that the financial statements provide transparency for the primary users of franchisor financial statements, franchise regulators, and prospective franchisees about a practical expedient being applied. Accordingly, the Board included this disclosure requirement in Subtopic 952-606.

BC33. Because the Board decided that a franchisor that elects the practical expedient in paragraph 952-606-25-2 may make an accounting policy election to recognize the pre-opening services as a single performance obligation, the Board included a disclosure about that election.

International Financial Reporting Standards

BC34. On May 28, 2014, the FASB and the International Accounting Standards Board (IASB) jointly issued converged guidance on the recognition of revenue from contracts with customers. The guidance on revenue recognition for intellectual property (IP) has substantially converged, although there are some differences because GAAP includes evaluation of symbolic IP and functional IP to determine whether a license may be recognized over time or at a point in time, which does not exist in IFRS Standards. Despite those differences, the Board expects that franchise licenses would be recognized over time under both GAAP and IFRS Standards. Additionally, the guidance about identifying performance obligations and allocating the transaction price (and standalone selling price guidance) has converged. Because the amendments in this Update cannot be applied by public business entities, the Board concluded there is no effect on the convergence of Topic 606 and IFRS 15, Revenue from Contracts with Customers, for public business entities.

BC35. While IFRS 15 and Topic 606 have substantially converged, there is a significant difference between GAAP and IFRS Standards when it comes to the guidance for nonpublic entities. Under GAAP, both nonpublic entities and public business entities follow the same guidance. Private companies may elect to apply private company accounting alternatives, but largely they follow the same GAAP as public companies. Accordingly, the revenue guidance under GAAP for public and private companies is the same (except for some disclosure differences).

BC36. The IFRS Standards differ from GAAP because under IFRS Standards nonpublic entities may use the IFRS Standards for small and medium-sized entities (SMEs), although many nonpublic franchisors may choose to apply IFRS 15. The revenue section of the IFRS Standards for SMEs has not yet been updated to apply IFRS 15 principles. Accordingly, while the revenue guidance for public business entities has largely converged, revenue guidance for nonpublic entities that apply IFRS Standards for SMEs has not converged between GAAP and IFRS Standards.

Effective Date and Transition

BC37. The Board is providing the following two sets of transition guidance for entities that have not yet adopted Topic 606 and entities that have previously adopted Topic 606:

The amendments to the FASB Accounting Standards Codification ® in this Accounting Standards Update do not require improvements to the U.S. GAAP Financial Reporting Taxonomy (Taxonomy).