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Revenue is recognized, with an appropriate provision for bad debts, when the franchisor has
substantially performed all material services or conditions. Only when revenue is collected over an
extended period of time and collectibility cannot be predicted in advance would the use of the cost
recovery or installment methods of revenue recognition be appropriate. Substantial performance
means:
1. The franchisor has no remaining obligation to either refund cash or forgive any unpaid
balance due.
2. Substantially all initial services required by the agreement have been performed.
3. No material obligations or conditions remain.
Even if the contract does not require initial services, the pattern of performance by the
franchisor in other franchise sales will impact the time period of revenue recognition. This can
delay such recognition until services are either performed or it can reasonably be assured they will
not be performed. The franchisee operations will be considered as started when such substantial
performance has occurred.
If initial franchise fees are large compared to services rendered and continuing franchise fees
are small compared to services to be rendered, then a portion of the initial fee is deferred in an
amount sufficient to cover the costs of future services plus a reasonable profit, after considering the
impact of the continuing franchise fee.

Example of initial franchise fee revenue recognition

Shanghai Asian Cuisine sells a Quack’s Roast Duck franchise to Toledo Restaurants. The franchise
is renewable after two years. The initial franchise fee is $50,000, plus a fixed fee of $500 per month. In
exchange, Shanghai provides staff training, vendor relations support, and site selection consulting. Each
month thereafter, Shanghai provides $1,000 of free local advertising. Shanghai’s typical gross margin
on franchise startup sales is 25%.
Because the monthly fee does not cover the cost of monthly services provided, Shanghai defers a
portion of the initial franchise fee and amortizes it over the two-year life of the franchise agreement,
using the following calculation:

Cost of monthly services provided $1,000 × 24 months = $24,000

÷ Markup to equal standard 25% gross margin ÷ .75
= Estimated revenue required to offset monthly services provided = $32,000
Less: Monthly billing to franchise $500 × 24 months $12,000
= Amount of initial franchise fee to be deferred = $20,000
Shanghai’s entry to record the franchise fee deferral follows:

Franchise fee revenue 20,000

Unearned franchise fees (liability) 20,000
Shanghai recognizes 1/24 of the unearned franchise fee liability during each month of the franchise
period on a straight-line basis, which amounts to $833.33 per month.

Area Franchise Sales

Sometimes franchisors sell territories rather than individual locations. In this event, the
franchisor may render services to the area independent of the number of individual franchises to be
established. Under this circumstance, revenue recognition for the franchisor is the same as stated
above. If, however, substantial services are performed by the franchisor for each individual
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franchise established, then revenue is recognized in proportion to mandatory service. The general
rule is that when the franchisee has no right to receive a refund, all revenue is recognized. It may be
necessary for revenue recognition purposes to treat a franchise agreement as a divisible contract
and allocate revenue among existing and estimated locations. Future revisions to these estimates
will require that remaining unrecognized revenue be recorded in proportion to remaining services
expected to be performed.

Example of revenue recognition for area franchise sales

Shanghai Asian Cuisine sells an area Quack’s Roast Duck franchise to Canton Investments for
$40,000. Under the terms of this area franchise, Shanghai is solely obligated to provide site selection
consulting services to every franchise that Canton opens during the next twelve months, after which
Canton is not entitled to a refund. Canton estimates that it will open 12 outlets sporadically throughout
the year. Shanghai estimates that it will cost $2,500 for each site selection, or $30,000 in total. Based on
the initial $40,000 franchise fee, Shanghai’s estimated gross margin is 25%. Canton’s initial payment of
$40,000 is recorded by Shanghai with the following entry:

Cash 40,000
Unearned franchise fees (liability) 40,000

After six months of preparation, Canton requests that four site selection surveys be completed.
Shanghai completes the work at a cost of $10,000 and uses the following entry to record both the
expenditure and related revenue:

Unearned franchise fees (liability) 13,333

Franchise fee revenue 13,333
Site survey expense 10,000
Accounts payable 10,000

By the end of the year, Shanghai has performed ten site selection surveys at a cost of $25,000 and
recognized revenue of $33,333, leaving $6,667 of unrecognized revenue. Since Canton is no longer
entitled to a refund, Shanghai uses the following entry to recognize all remaining revenue, with no
related expense:

Unearned franchise fees (liability) 6,667

Franchise fee revenue 6,667

Other Relationships
Franchisors may guarantee debt of the franchisee, continue to own a portion of the franchise,
or control the franchisee’s operations. Revenue is not recognized until all services, conditions, and
obligations have been performed.
In addition, the franchisor may have an option to reacquire the location. Accounting for initial
revenue is to consider the probability of exercise of the option. If the expectation at the time of the
agreement is that the option is likely to be exercised, the entire franchise fee is deferred and not
recognized as income. Upon exercise, the deferral reduces the recorded investment of the
franchisor.
An initial fee may cover both franchise rights and property rights, including equipment, signs,
and inventory. A portion of the fee applicable to property rights is recognized to the extent of the
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fair value of these assets. However, fees relating to different services rendered by franchisors are
generally not allocated to these different services because segregating the amounts applicable to
each service could not be performed objectively. The rule of revenue recognition when all services
are substantially performed is generally upheld. If objectively determinable separate fees are
charged for separate services, then recognition of revenue can be determined and recorded for each
service performed.
Franchisors may act as agents for the franchisee by issuing purchase orders to suppliers for
inventory and equipment. These are not recorded as sales and purchases by the franchisor; instead,
consistent with the agency relationship, receivables from the franchisee and payables to the
supplier are reported on the statement of financial position of the franchisor. There is, of course, no
right of offset associated with these amounts, which are to be presented gross.
Continuing Franchise and Other Fees
Continuing franchise fees are recognized as revenue as the fees are earned. Related costs
are expensed as incurred. Regardless of the purpose of the fees, revenue is recognized when
the fee is earned and receivable. The exception is when a portion of the fee is required to be
segregated and used for a specific purpose, such as advertising. The franchisor defers this
amount and records it as a liability. This liability is reduced by the cost of the services
received.
Sometimes, the franchisee has a period of time where bargain purchases of equipment or
supplies are granted by the contract. If the bargain price is lower than other customers pay or
denies a reasonable profit to the franchisor, a portion of the initial franchise fee is deferred and
accounted for as an adjustment of the selling price when the franchisee makes the purchase. The
deferred amount is either the difference in the selling price among customers and the bargain price,
or an amount sufficient to provide a reasonable profit to the franchisor.
Costs
Direct and incremental costs related to franchise sales are deferred and recognized when
revenue is recorded. However, deferred costs cannot exceed anticipated future revenue, net of
additional expected costs.
Indirect costs are expensed as incurred. These usually are regular and recurring costs that bear
no relationship to sales.
Repossessed Franchises
If, for any reason, the franchisor refunds the franchise fee and obtains the location, previously
recognized revenue is reversed in the period of repossession. If a repossession is made without a
refund, there is no adjustment of revenue previously recognized. However, any estimated
uncollectible amounts are to be provided for and any remaining collected funds are recorded
as revenue.
Business Combinations
Business combinations where the franchisor acquires the business of a franchisee are
accounted for in accordance with the requirements of ASC 805.
No adjustment of prior revenue is made since the financial statements are not retroactively
consolidated in recording a business combination. Care must be taken to ensure that the purchase
is not a repossession. If the transaction is deemed to be a repossession, it is accounted for as
described in the above section.
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1314 Wiley GAAP 2018

NOT-FOR-PROFIT ENTITIES (ASC 958)22

PERSPECTIVE AND ISSUES

Technical Alert
In August 2016, the FASB issued ASU 2016-14, Presentation of Financial Statements for
Not-for-Profit Entities. This is the first product of a project to improve not-for-profit financial
reporting.
Guidance. Following is a summary of the changes:
Balance Sheet Changes
The existing three category classification of net assets will be streamlined and replaced with a
model that combines temporarily and permanently restricted into a new category—“net assets
with donor restrictions.” Disclosures are required to explain the differences in the nature of donor
restrictions and how and when the resources can be used. Deficiencies in endowments and lapsing
of restrictions have new and simplified accounting guidance. Entities will have to disclose:
• The extent to which the balance sheet comprises financial assets
• The one-year liquidity of those assets, and
• Any limitations on their use.
Statement of Activities
The entity will have to disclose if an operating subtotal includes internal transfers made by the
governing board. Not-for-profit entities will have to disclose how the nature of expenses relates to
programs and supporting activities. Entities will also have to enhance their disclosures about the
methods they use to allocate costs among programs and support functions. Expenses allowed to be
netted will be limited to external investment expenses and direct internal investment expenses. This is
narrower than the extant requirement, but disclosure of netted expenses is not required under the ASU.
Effective Date. The ASU is effective for fiscal years beginning after December 15, 2017 and
interim periods beginning after December 15, 2018. Early adoption is permitted only for an annual
period or for the first interim period within the year of adoption.
Scope. The new guidance applies to entities that use ASC 958 or the not-for-profit provisions
of ASC 954, Health Care Entities. Not in the scope of the ASU are mutual entities, cooperatives,
and similar organizations organized as not-for-profit corporations.
Transition. The new guidance must be applied retrospectively, but entities can opt not to
provide some comparative disclosures in the year of adoption. In the first year of adoption, not-for­
profit entities must disclose
• the nature of any reclassifications or restatements resulting from the adoption of the ASU
and
• their effect on the change in the net asset classes for each period presented.
Overview
Not-for-profit entities have several characteristics that distinguish them from business
entities. First, and perhaps foremost, not-for-profit entities exist to provide goods and services

22 Upon implementation of ASU 2014-09, Revenue from Contracts with Customers, guidance for revenue and deferred
revenue for this industry can also be found in ASC 606.