Before the adoption of Topic 606, under Topic 952, Franchisors, the initial franchise fee typically is recognized when the location opens. Because of the existence of industry-specific GAAP, franchisors historically have not had to assess whether pre-opening services are a separate deliverable.

Under the new guidance, the franchisor determines if the pre-opening activities contain any distinct goods or services. The guidance on identifying performance obligations is included in paragraphs 606-10-25-14 through 25-22. Paragraph 606-10-25-19 provides guidance on determining whether goods or services are distinct.

The transaction price is then allocated to distinct performance obligations based on standalone selling prices (paragraph 606-10-32-28). The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. Typically, the best evidence of a standalone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers. However, if a standalone selling price is not directly observable, an entity estimates the standalone selling price. The guidance does not prescribe any particular method for estimation but provides the following examples of estimation methods:

A sales-based royalty stream is recognized over time under Topic 606, which is consistent with how entities account for sales-based or usage-based royalties today (paragraph 606-10-55-65).

Consider the following example:

On the basis of the guidance in paragraph 606-10-55-65, the entity in the example does not estimate the royalties for the entire franchise period. The 4 percent royalty is allocated entirely to the license because the variable payment relates specifically to an outcome from the performance obligation to transfer the license. As such, the entity records revenue related to the 4 percent royalty as the customer’s subsequent sales occur.

When implementing Topic 606, the common question in the fact pattern above has been whether the $25,000 fee relates to a single performance obligation for the license of intellectual property, which must be spread over the 10-year term of the arrangement, or whether the entire $25,000 fee may be allocated to separate performance obligations associated with the activities of the location opening, which would be recognized upfront consistent with current GAAP. Because the allocation of revenue depends on determining whether the goods or services are distinct (which some, all, or none may be), as well as determining the standalone selling price for each distinct good or service, the answer may differ from franchisor to franchisor.

If the franchisor determines that some or all of the pre-opening services are distinct, then it would recognize revenue when (or as) those services are performed (that is, typically upfront).

In this example, the entity determines that the training services are distinct because they are not highly interrelated with the franchise license. In this case, the entity determines that the training is not highly brand specific and consists principally of training that could be relevant to the operations of a similar business or businesses in general. In this example, the entity also determines that the site selection services are distinct from the license because they are not specific to the brand and could be provided by a third party. Next, the entity would need to determine the standalone selling price of the services that are separate performance obligations and allocate the transaction price to them based on the standalone selling prices.

The guidance does not prescribe a single method to determine standalone selling price. In applying the guidance on standalone selling price, the staff has considered how that analysis might be performed for training if it is considered a distinct performance obligation. The first step is to determine if the standalone selling price is observable (that is, the price charged if the entity provides any training services apart from the franchise license). For example, after the agreement for the franchise license, what would the franchisor charge to train new employees of the franchisee? Does the contract include a component of training for free for a minimal number of employees and then charge for additional employees (for example, free training for the first five employees but $X per additional employee)? If the entity does not have an observable standalone selling price for training, it might consider (a) the price that a third party typically charges for comparable education or (b) the cost of training plus an expected margin.

Consider that in this example a portion of the initial franchise fee, rather than the entire fee, is allocated to the pre-opening services (for example, $20,000). In this case, the entity determines that allocating the fixed consideration related to the standalone selling price of the pre-opening services and allocating a portion of the initial franchise fee and sales-based royalty to the license is consistent with the allocation objective.

Assume that the example above is modified so that the standalone selling prices of the preopening services is $30,000. Therefore, the standalone selling price of the pre-opening services ($30,000) is greater than the amount of the initial franchise fee ($25,000). In this case, the entity would recognize the entire fee ($25,000) as the pre-opening services are performed because the guidance does not allow pulling forward a portion of the future sales-based royalty (because of the guidance in paragraph 606-10-55-65).

The example above illustrates the following key takeaways in this inquiry when implementing the revenue standard: