Recognizing revenue is not always straightforward, especially for businesses where payment is based on services rendered or intellectual property royalties instead of distinct product sales. For instance, in the franchise revenue model, the franchisor may have income streams from the franchisee, which include products sold, such as special equipment, IP-like branding rights and ongoing transactions like national advertisement funds.
Identify the Contract
The first step in recognizing revenue is to identify the contract with the customer. For franchisors, this step is met with the written franchise agreement, which has “commercial substance” or results in an expected change in the cash flow of both parties. Franchisors will also have to determine collectibility based on the credit underwriting of the franchisee.
Identify the Performance Obligations
Franchisors will then have to determine which services offered are distinct from the intellectual property being rented to the franchisee. For instance, you will need to decide whether the pre-opening activities, training and site selection are separate enough from the IP to be considered individual items in the transaction. Most services will be distinct if they can be procured from a third party, such as a business school for training, or if they are listed separately in the franchise agreement and franchise disclosure document with individual fees.
Determine the Transaction Price
In a best-practices franchise revenue model, determining the transaction price for recognition means listing each revenue stream received from the franchisee as a separate item, including non-cash services. This list should include up-front payments and those made over time, such as financing payments and renewal fees. Be sure to note financing agreements in the contract where repayment terms are extended past the time when services are rendered.
Assign Prices to Obligations
Franchisors must allocate prices to each obligation at the contract’s inception. You can use the expected cost plus margin approach, an adjusted market assessment approach or the residual approach to assign these prices.
Recognize Revenue
You must first transfer revenue to the franchisee to recognize revenue for a distinct good or service. There is an exception carve-out for sales-based royalties where the franchisor recognizes the revenue as sales occur and accrue for earned royalties before payment is received.
Recognizing revenue can get complicated for franchisors, their attorneys and their accountants. In a best-practices franchise revenue model, many steps can be simplified by drawing up a contract with a list of distinct goods and services provided to the franchisee and assigned values.
