Accounting for Franchise Contracts

Sample Problems

Introduction
In addition to the general principles of PFRS 15 (5-step model of revenue recognition), an entity
shall apply specific principles for licensing.

License - establishes a customer's rights to the intellectual property of an entity.

Examples:
1. Software and Technology
2. Motion pictures, music, and other forms of media and entertainment
3. Franchises; and
4. Patents, Trademarks, and Copyrights

Franchise Accounting: Franchisor

Franchise - is a contractual arrangement under which the franchisor grants the franchisee the right to sell
certain products or services, to use certain trademarks or trade names, or to perform certain functions,
usually within a designated geographic area.

● Definition: A franchise is a privilege, usually a monopoly, granted by government authority,

allowing the use of public property or rights. It can be between a government and a private
entity or between private entities.
● Components: Franchise operations often include an exclusive right to sell a manufacturer's
products within a specified territory.

Franchise Operation should be accounted for using the PFRS 15 general and specific principles:

Step 1: Identify General Principles Accounting:

Contracts with 1. Approved Contract parties and
Customers commitment to their respective
obligations
2. Known rights as regards goods and
services to be transferred
3. Identify payment terms
4. Contract should have Commercial
Substance
5. Consideration is “Probable of
Collection”
All criteria are present - Treat the
contract in accordance with PFRS 15.
One or all criteria is missing - No
Revenue unless there’s
performance of obligation (all or
substantial) or contract is
terminated / completed with
non-refundable consideration
received. Otherwise, considerations
received are “liability” - deferred.

Step 2: Identify General Principles Accounting

Performance 1. Each distinct goods and services = 1. Over time - Defer the
Obligations separate performance obligation recognition of revenue, and
a. Customer can benefit wait for the PO to be
b. Separately identifiable satisfied
2. Satisfaction of performance 2. At a point in time - Accrual
 obligations
a. Over time
b. At a point in time

Specific Principles for Licensing

3. Granting of License - “not distinct” Accounting
4. Granting of License - “distinct” 1. Use the general principles
a. Right to Access above
b. Right to Use 2. Recognize revenue
a. RTA - over the
Note: Refer to your textbook for the period
guidance to determine if the licence is RTA b. RTU - at a point in
or RTU page 368-370. time

Step 3: General Principles: If Transaction Price contains a

Determine the 1. Transaction Price may equal to significant financing component (e.g
Transaction Price contract price received note from a franchisee) -
2. Affected by Variable Considerations discount the note when determining
a. Expected Value the transaction price and recognize
b. Most likely value approach unearned interest income.
3. Considerations with Financing
Components At a point in time:
Cash
Specific to Franchise: Notes Receivable
1. Franchise Fees Revenue
a. Initial Franchise Fee Unearned Interest Revenue
b. Continuing Franchise Fees Over time
i. Management fees, Cash
training fees, Notes Receivable
marketing fees, etc Contract Liability (DFR)
ii. Sales-based and Unearned Interest Revenue
usage-based -
Recognize revenue
when it occurs
2. Other Fees
a. Sale of Equipment and
Other Assets.

Upfront Fees:
No revenue should be recognized upon
receipt of an upfront fee, even if it is non-
refundable if the fee does not relate to
the satisfaction of a performance
obligation.

Nonrefundable upfront fees are included in

the transaction price and allocated to the
separate performance obligations in the
contract. Revenue is recognized as the
performance obligations are satisfied.

The recognition of upfront fees must be

 subject to the application of time value of
money if it is significant.

Step 4: Allocate General Principles: N/A

the Transaction 1. Allocate the transaction price to
Price to the the performance obligations using
Performance *
Obligation ● “stand-alone selling prices”
● Market Value adjustment
approach
● Expected Cost-plus margin
approach
● Residual Value Approach
2. If a single performance obligation,
the transaction price will be
allocated to that obligation.

Step 5: General Principles: Accounting:

Recognize 1. Over time - revenue is also 1. Over time - Defer the
Revenue when recognized over time as the entity recognition of revenue, and
(or as) a progresses towards the completion wait for the PO to be
performance of obligation satisfied
obligation is 2. At a point in time - recognize a. Percentage of
satisfied revenue when the performance Completion
obligation is satisfied. b. Zero-Profit Method
(Collection not
reasonable)
c. Installment Method
(straight-line) if
reasonable
2. At a point in time - Accrual
a. Check
reasonableness of
collection in Step 1.

Revenue Recognition under IFRS 15

● Principle: Revenue from franchise fees is recognized based on the transfer of promised goods
or services to customers in an amount that reflects the consideration to which the entity expects
to be entitled.
● Key Sources of Revenue:
● Initial Franchise Fee: Payment for franchise establishment and initial services/equipment.
● Continuing Franchise Fee: Ongoing payments for rights granted by the franchise.

Initial Franchise Fee

● Recognition: Recognized when the franchisor has substantially satisfied its performance
obligations.
● Deferred Revenue: Portion of fee related to future services or goods is deferred until those
obligations are fulfilled.
 ● Collectibility: If the collectibility of the initial fee is uncertain, revenue is recognized as cash
installments are received, ensuring that revenue recognition reflects the entity's entitlement to
the fee.

Continuing Franchise Fee

● Recognition: Allocated over the period services are provided or as rights are used.
● Expenses: Costs related to these fees are expensed as incurred.
● Continuing Rights: Fees for the use of continuing rights or for ongoing services provided
during the agreement period are recognized as revenue as the services are provided or as the
rights are used.

Bargain Purchase Option

● Description: Right for the franchisee to purchase equipment at less than fair value.
● Accounting Treatment: The difference is recognized when the franchisee exercises the option.

Commingled Revenue

● Complex Fees: If initial franchise fee includes multiple elements, revenue recognition is based
on the timing of transfer of each element.

Repossessed Franchise

● Scenario: Franchisor repossesses rights if a franchisee decides not to open an outlet.

● Accounting Treatment: Consideration refunded may lead to reversal of revenue recognized.

Option to Purchase the Franchise Outlet

● Potential Agreement: A franchisor may have the option to purchase the franchisee's business,
affecting how initial franchise fees are accounted for.
● Accounting for the Option: If the franchisor is likely to exercise this option, the initial
franchise fee recognized as revenue may be adjusted. The portion of the initial franchise fee that
is considered a payment for the option to purchase must be deferred.

Contract Costs
General Principles:
● Incremental cost to obtain a contract
● Cost to fulfill the PO in the contract

Specific to Franchise agreements:

● Direct Costs [cost to obtain and/or cost to fulfill] - avoidable costs directly associated with the
franchise agreement.
○ Initially recognized as an asset
○ Subsequently amortized as an expense when related franchise revenue is recognized.
● Indirect Costs - costs such as selling and administrative costs not directly related to the franchise
agreement and incurred even in the absence of a franchise agreement.
○ Immediately recognized as an expense.
Financial Statement Disclosures

● Requirements: Disclosure of significant commitments and the stage of performance of the

services.

Recognition and Measurement - Franchise

On December 1, 20x1, ABC Co. entered into a franchise contract with XYZ, Inc. The franchise provides
XYZ, Inc. with the right to use ABC's trade name and sell ABC's products for five years. The contract
requires an initial franchise fee of P120,000 and a continuing franchise fee of 3% of XYZ's sales, payable
at the end of each month.

The P120,000 initial franchise fee is non-refundable and payable in full at contract inception. ABC Co., as
a franchisor, has developed a customary business practice to undertake the following pre-opening
activities:
a. Assistance in site selection, lease negotiations, and fitting-out of the premises.
b. Initial training in all facets of operating the business.
c. Assistance with staff recruitment and training.
d. Advertisement and promotion..
e. Preparations for and professional execution of the grand opening.

ABC Co. does not provide the activities above separately from the granting of the franchise right.

The new franchise business started operations in December, and as of December 31, 20x1, ABC has no
remaining obligation or intent to refund any of the cash received, and all of the services (i.e., the pre-
opening activities) required under the franchise agreement have been performed. XYZ, Inc. reports total
sales of P2,000,000 in December 20x1.

Requirement: Provide the journal entries on December 1, 20x1, and December 31, 20x1, respectively.

Recognition and Measurement- Franchise

On December 31, 20x1, Mr. Eugene H. Krabs Co. enters into a contract with Sheldon J. Plankton Co. to
transfer a license for a fixed fee of P100,000 payable as follows:
● 20% is payable upon signing of the contract.
● 80% is represented by a note receivable collectible in 4 equal annual installments starting
December 31, 20x2. The appropriate discount rate is 12%.

Read the following independent cases:

1. The license provides Plankton the right to use Mr. Krabs' patented secret formula for a burger
patty. Plankton continues to operate using its trade name and has the discretion of developing
product names for the products it will produce using the secret formula . The license does not
explicitly require Mr. Krabs to undertake activities that will significantly affect the intellectual
property to which Plankton has rights. Neither does Plankton expect that Mr. Krabs will undertake
 such activities. Mr. Krabs provided the secret formula to Plankton on December 31, 20x1. Provide
relevant entries.
2. The license provides Plankton the right to use Mr. Krabs' patented secret formula for a burger
patty. The agreement requires Plankton to discontinue using its trade name instead of Mr. Krabs'
trade name. Plankton is bound by the terms of the contract to abide by Mr. Krab's policies on the
use of the secret formula but is given the right to any subsequent modifications to the secret
formula. Provide the relevant entries.
3. Refer to #2 above. In addition, the contract requires Mr. Krabs to undertake pre-opening
activities of training Plankton in operating the new business, assisting in the recruitment and
training of staff, and assisting in the grand opening of the new business. The P20,000 cash
down payment is non-refundable and represents a fair measure of services already rendered
as of December 31, 20x1. Provide relevant entries.
4. Refer to #2 above. In addition, the contract does not require Mr. Krabs to undertake any pre-
opening activities. Mr. Krabs has no past practice of voluntarily undertaking such activities. The
P20,000 cash downpayment is non-refundable, and the collectibility of the note is reasonably
assured. Provide relevant entries.

Contract Costs:
On December 1, 20x1, ABC Co, enters into a contract with a customer to grant a license over a patented
technology. The consideration in the contract is a fixed fee of P1,000,000, payable at contract inception.
The license period is 4 years. During December 20x1, ABC Co. incurs direct contract costs of P120,000
and indirect costs of P30,000. The license is transferred to the customer on January 2, 20x2.

Answer the requirements under the following independent cases:

a. The license provides the customer the right to use the entity's intellectual property as it exists at
the point in time at which the license is granted. Provide the journal entries.
b. The license provides the customer the right to access the intellectual property as it exists
throughout the license period, ABC Co. uses a time-based method in measuring its progress
towards the complete satisfaction of the performance obligation. Provide the journal entries.

Uncertainty in Collection
On January 1, 20x1, ABC Co. enters into a contract with a customer to transfer a license for a fixed fee of
P100,000 payable as
● 20% is payable upon signing of the contract.
● 80% is represented by a note receivable collectible in 4 equal annual installments starting
December 31, 20x1. The appropriate discount rate is 12%.
● The license was transferred to the customer on January 3, 20x2.
● During 20x1, ABC Co. incurs direct contract costs of P20,000.
● Collectability of the note is reasonably assured.
● The license provides the customer with the right to use ABC's intellectual property as it exists a t
the point in time at which the license is granted.

Provide the requirements under the following independent cases:

1. Prepare the journal entries and compute the profits in 20x1 and 20x2, respectively.
2. Assume that collectibility of the note is not reasonably assured at the inception of the contract.
Prepare the relevant journal entries.
3. Assumes that the collectibility of the note is not reasonably assured at the end of the second
year, and the recoverable amount of the note is P15,000. Prepare the relevant journal entries.

**Nothing Follows**