Afar2817 Franchise Accounting

Since 1977

AFAR 2817 FRANCHISE ACCOUNTING (NEW)

BATCH MAY 2020

LECTURE NOTES

Sources: IFRS 15 Revenue from Contracts with Customers, mandatorily effective January 1, 2018, replaces IAS 18 Revenue A franchise agreement involves the granting of business rights by the franchisor to all the franchisee who will operate the franchise outlet in a certain geographical area or location. Parties to a franchise contract are (a) the franchisor (owner) and (b) the franchisee (user). Discussions are from the standpoint of the franchisor, in terms of revenue and profit recognition as they vary from those accounted under the point-of-sale-revenue recognition principles. The franchisee pays the franchisor 2 types of franchise fees: 1. Initial franchise fee – paid in consideration of the right to use the franchisor’s name, products, and processes, as well as for ‘initial services’ to be rendered by the franchisor; and 2. Continuing franchise fee – paid in consideration for rights granted by the franchise agreement and providing such services such as management training, advertising, and promotion. Initial services. Common provision of a franchise agreement in which the franchisor usually will agree to provide a variety of services and advice to the franchisee, such as the following: 1. Assistance in the selection of a site. The assistance may be based on experience with factors such as traffic patterns, residential configurations, and competition. 2. Assistance in obtaining facilities, including related financing and architectural and engineering services. The facilities may be purchased or leased by the franchisee, and lease payments may be guaranteed by the franchisor. 3. Assistance in advertising, either for the individual franchisee or as part of a general program 4. Training of the franchisee’s personnel. 5. Preparation and distribution of manuals and similar material concerning operations, administration, and recordkeeping. 6. Bookkeeping and advisory services, including setting up the franchisee’s records and advising the franchisee about income taxes, real estate taxes, and other taxes, or about local regulations affecting the franchisee’s business. 7. Inspection, testing, and other quality control programs. When is Franchise Fee recognized as revenue? Apply the five-step model under IFRS 15: 1. Identify the contract 2. Identify performance obligations 3. Determine the transaction price 4. Allocate the transaction price to the performance obligations in the contract 5. Satisfaction of performance obligations

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The specific provisions of IFRS applicable to Franchises can be found in the application guidance related to Licensing In addition to a promise to grant a licence (or licences) to a customer, an entity may also promise to transfer other goods or services to the customer. Those promises may be explicitly stated in the contract or implied by an entity’s customary business practices, published policies or specific statements. As with other types of contracts, when a contract with a customer includes a promise to grant a licence (or licences) in addition to other promised goods or services, an entity identifies as a separate performance obligations each promise to transfer to a customer a ‘distinct’ good or service and allocate the transaction price to those performance obligations. Accounting for the License If the Licence not distinct from other promised goods or services Accounted for as a single performance obligation the promise to grant a licence together with other promised goods or services If the Licence is distinct from other goods or services Accounted for as a single performance obligation either: •

Over time – if right to access intellectual property throughout licence period. Right to access intellectual property if: • Licensor will undertake activities that significantly affect the intellectual property; • Licence exposes licensee to effects of activities; and • Activities are not a good or service to licensee.

•

At a point in time – if right to use intellectual property as it exists when the licence is granted.

Sales-based or usage-based royalties Recognise revenue for a sales-based or usage-based royalty promised in exchange for a licence of intellectual property only when (or as) the later of the following events occurs: • The subsequent sale or usage occurs • The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied) Allocating the transaction price to the performance obligations in the contract Allocate of the transaction price to each performance obligation on the basis of the relative stand-alone price of each distinct good or service. The ‘stand-alone selling price’ is the price at which an entity would sell a promised good or service separately to a customer.

Cost of initial services [Costs to fulfill a contract] Initial set-up activities or administrative tasks to fulfill the contract but do not transfer goods or services to the customer that do not meet the criteria to be recognized as

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AFAR.2817

EXCEL PROFESSIONAL SERVICES, INC asset are expensed, unless the customer provides a contractual guarantee for reimbursement of the costs.

Treatment of Non-refundable upfront fees If the fee does not result in the transfer of a promised good or service → account for as an advance payment for future goods or services

If the non-refundable upfront fee relates to a good or service → evaluate whether to account for the good or service as a separate performance obligation. -

STRAIGHT PROBLEMS The Gilas Corporation sells franchise licenses to operate outlets for its restaurant business, Dyesebel. The initial fee is not fixed for all agreements, as the total amount depends upon which of the multi-deliverable items under the contract will be subscribed to by the franchisee.

balance. It opted to have the construction of the facilities done by Gilas. Azkal’s credit rating indicates that it can borrow money at 20% interest for a loan of this type. The present value of an annuity of 1 at 20% for 5 periods is 2.990.

The initial fee shall be paid by a 37.5% cash down payment, and the balance by a non-interest bearing note payable in 5 annual periods, the first annual payment to start 12 months after the contract signing. The initial fee is refundable within 60 days upon receipt only. Aside from the initial fee, the franchisee is required to pay a continuing fee of 3% of its sales revenue as a sales-based royalty, to be paid monthly.

The stand-alone-selling prices of the distinct performance obligations are: P2,000,000 for the license; P3,000,000, for the construction of facilities; P900,000 for the delivery of furniture and fixtures; and P300,000 for the delivery of the dinnerware.

In exchange, Gilas promises to perform the following distinct obligations: to grant a franchise license valid for 10 years; to defray the cost of constructing the business facilities; to deliver the necessary furniture and fixtures; and to deliver two (2) complete sets of company dinnerware. Of the contract obligations, only the construction of facilities by Gilas maybe waived, in which case, GILAS will have supervision over the construction now to be done by the franchisee. The stand alone selling price of this alternative performance obligation is P300,000. On January 2, 2019, Azkal Company signed a contract for an initial fee of P8,750,000, paid a cash down-payment of P3,281,250 and issued non-interest-bearing notes for the

The restaurant opened on October 1, 2019 and had sales revenues of P350,000 during the remainder of the year. By the end of 2019, all obligations of the franchisor had been performed, except the delivery of the second set of dinnerware. Required: (a) What is the journal entry recorded by Gilas on January 1, 2019? (b) How much is total franchise revenue in 2019? (c) How much is the combined revenue recognized by Gilas from its constructing activities and dinnerware? (d) How much is the recognized revenue for furniture and fixtures? (e) How much is interest revenue for 2019? (f) Prepare compound journal entry for the recognition of revenue for 2019?

MULTIPLE CHOICE 1. The nature of an entity’s promise in granting a franchise licence is a promise to provide a right to access the entity’s trade name if which of the following criteria is(are) met? I. the contract requires, or the customer reasonably expects, that the entity will undertake activities that significantly affect the intellectual property to which the customer has rights II. the rights granted by the licence directly expose the customer to any positive or negative effects of the entity’s activities III. those activities do not result in the transfer of a good or a service to the customer as those activities occur. a. I only c. II and III b. I and II d. I, II and III 2. ABC Company awarded its franchise to XYZ Corp.. in Cebu for a total fee of ₱100,000. Of said amount, ₱50,000 was payable upon the signing of the franchise agreement and the balance, payable in two annual payments of ₱25,000 each. ABC had been very successful in Metro Manila with 100 franchisees, but Cebu was the first outside Metro Manila. ABC’ agreement with Wings provided that in the event the first year of operations would result to an operating loss, the franchising agreement may be cancelled without need of returning any portion of paid franchise fee and there would be no need to pay any balance of the unpaid franchise fee.

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The entry to record the granting of the franchise to XYZ was a. Cash ₱50,000 Notes receivable 50,000 Unearned franchise fee ₱100,000 b. Cash 50,000 Notes receivable 50,000 Revenue from franchise fee 50,000 Unearned franchise fee 50,000 c. Cash 50,000 Deposit liability 50,000 d. Cash 50,000 Notes receivable 50,000 Revenue from franchise fee 100,000 3. An entity enters into a contract with a customer and promises to grant a franchise license that provides the customer with a right to use the entity’s trade name and sell the entity’s products for 10 years. In addition to the license, the entity also promises to provide the equipment necessary to operate a franchise store. In exchange for granting the license, the entity receives a sales-based royalty of 5% of the customer’s monthly sale. The fixed consideration for the equipment is P150,000 payable when the equipment is delivered. The fixed consideration reflects the stand-alone selling price of the equipment.

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AFAR.2817

EXCEL PROFESSIONAL SERVICES, INC. The entity, as franchisor, has developed a customary business practice to undertake activities such as analysing the customer’s changing preferences and implementing product improvements, pricing strategies, marketing campaigns and operational efficiencies to support the franchise name. Which of the following is incorrect: a. The promise to grant the license and the promise to transfer the equipment are distinct because the customer can benefit from each promise together with other resources that are readily available. b. There are three separate performance obligations: the promises to grant a franchise license, to provide the equipment and implied promise to undertake activities to support the franchise name. c. The implied promise to undertake activities to support the franchise name is not a performance obligation but rather a part of the entity’s promise to grant a franchise license and in effect change the intellectual property to which the customer has rights. d. The transaction price is the fixed consideration of P150,000 and a variable consideration of 5% of customer sales. 4. Which of the following is incorrect: I. In allocating the transaction price the fixed consideration of P150,000 will be allocated entirely to the equipment since it reflects the stand-alone selling price of the equipment. II. The variable consideration of 5% will be recognized as revenue when those sales occur. a. Both statements are correct b. Only Statement I is correct c. Both statements are incorrect d. Only Statement II is correct 5. On January 2, 2018, EXTREME COMPANY signed an agreement to operate as a franchisee of BASIC PRODUCTS, INC.. for an initial franchise fee of P2,500,000 for 10 years. Of this amount, 40% was paid when the agreement was signed and the balance payable in four semi-annual payments beginning on June 30, 2018. EXTREME signed a non-interest-bearing note for the balance. EXTREME’s rating indicates that it can borrow money at 24% on a loan of this type. Assume that substantial services amounting to P617,500 had already been rendered by BASIC PRODUCTS, INC. If the collection of the note is not reasonably assured, the realized gross profit to be reported by BASIC for the year ended December 31, 2018 is: a. P1,057,076 c. P 880,856 b. P 855,225 d. 0 On December 31, 20x1 Mr. Eugene Krabs Co. enters into a contract with Sheldon J. Plankton Co. to the right to use Mr. Krab’s patented formula for a burger patty 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 instalments starting December 31, 20x2. The appropriate discount rate is 12%.

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6. Plankton continues to operate using his own trade name and has discretion of developing new product name for the burger it will produce using the formula. The license does not explicitly require Mr. Krabs to undertake activities that will significantly alter the intellectual property to which Plankton has rights. Neither does Plankton expects that Mr. Krabs will undertake such activities. Mr. Krabs transferred the formula to Plankton on December 31, 20x1. On a. b. c. d.

December 31, 20x1 Mr. Krabs will record a credit to revenue of P100,000. a credit to revenue of P80,747. a credit contract liability of P20,000. a credit to contract liability of P80,747.

7. Using the same information in the preceding number, except that the agreement requires Plankton to discontinue using its trade name and instead use Mr. Krabs trade name. Plankton is bound by the terms of the contract to abide with Mr. Krabs policies on the use of the formula but is given the right to any subsequent modifications to the formula. On a. b. c. d.

December 31, 20x1 Mr. Krabs will record a credit to revenue of P100,000. a credit to revenue of P80,747. a credit contract liability of P20,000. a credit to contract liability of P80,747.

8. Using the same information in the preceding number, and in addition, the contract requires Mr. Krabs to undertake pre-opening activities of training Plankton in operating the new business and assisting in the recruitment and training of staff, and assisting in the grand opening of the new business. The P20,000 cash downpayment is non-refundable and as at December 31, 20x1, represents a fair measure of the pre-opening services already rendered. On a. b. c. d.

December 31, 20x1 Mr. Krabs will record. a credit to revenue of P20,000. a credit to revenue of P80,747. a credit contract liability of P20,000. a credit to contract liability of P80,747.

9. On January 2, 20x2, PATTER SERVICES signed an agreement authorizing CUBICLE COMPANY to operate as a franchisee over a 20-year period for an initial franchise fee of P625,000 received when the agreement was signed. CUBICLE commenced operations on July 1, 20x2, at which date all of the initial services required of PATTER SERVICES had been performed. The agreement also provides that CUBICLE must pay annually to PATTER SERVICES a continuing franchise fee equal to 5% of the revenue from the franchise. CUBICLE's franchise revenue for 20x2 was P1,000,000. For the year ended December 31, 20x2, how much should PATTER SERVICES record as revenue from franchise fees in respect of the CUBICLE franchise? a. 65,625 c. 675,000 b. 625,000 d. 81,250

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AFAR.2817