Topic 606 – is Your Net Worth (Equity) About to be Decimated?

07/09/2018 / Chuck Modell and Todd Lifson

Franchisors who have not been talking to their accountants recently may soon be in for a very big surprise. In the past, franchisors have typically taken their initial franchise fees into income when a franchisee opened for business or, in other words, within a few months after granting a franchise. Under Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2014-09 Topic 606 Revenue from Contracts with Customers (Topic 606), which is in effect now for public companies, and will be effective next year for private companies, generally requires up-front fees to be deferred and taken into income over the term of the franchise agreement.

What does this mean to a franchisor? Assume each of your franchise agreements have a ten-year term, and your franchisees paid you an initial franchise fee of $30,000. Under Topic 606, you will not be able to take the entire $30,000 into income the year you sell the franchise, or even the year the franchisee opens for business, but over a period of ten years from when they opened for business. The impact is even greater as Topic 606 is not only applicable to future franchise sales, but to active agreements as well. Thus, using the example of a franchise with a $30,000 initial franchise fee and a ten-year term, if you had sold one franchise a month, every month during the last ten years, your net worth could possibly be reduced by as much as $1.8 million under Topic 606. As a result, initial franchise fees you previously recorded as revenue would have to be backed out of net worth and recorded as a corresponding liability (deferred revenue) for any unamortized initial franchise fee remaining from the term of the agreement.

Adoption of Topic 606 has no impact on your cash, however, it could have a significant impact on your reported net worth. This result could affect you in several ways including the following:

  • If you have financing, and your loan agreement includes covenants as to your net worth or minimum annual net income, this change may bring you outside your existing covenants and result in a default of your loan agreements. If you have financial covenants that tie to net worth, liabilities, net income or EBITDA, you should be talking to your accountants and your lender today, so that you do not have to deal with this “surprise” when you receive your year-end financial statements.
  • If you are a franchisor who has relied on exemptions from state franchise registration laws as a result of your having a net worth in excess of $5 million, ($5 million in most states that have the exemption, but as much as $15 million, depending on the state), you will want to confirm with your accountant the effect of Topic 606 on your net worth, because if you drop below the minimum requirement for the exemption, you will need to register in these states once you receive your 2018 or 2019 financial statements.
  • If you are a franchisor who does not currently have millions of dollars of net worth, or if you sold a large number of franchises in the last few years, your net worth could drop from a positive to a negative, or to such a small number that some of the franchise registration states may impose an impound, deferral or bonding requirement on the initial fees you receive when you file your financial statements in 2019 or 2020.

There are ways to minimize the effect of Topic 606 on future sales. You can reduce the term of your franchise agreements or be more specific regarding other performance obligations in exchange for the initial fees. But these modifications may have other repercussions. There are also some expenses you will be required to capitalize. We suggest that every franchisor talk to their accountants soon, understand the effect the implementation of Topic 606 will have on their financial statements and consider what changes might be possible to lessen the effect that the change in accounting standards will have on your current net worth and on your income from future sales.

 

* Todd Lifson is a partner in the Minneapolis office of Lurie, LLP.