Franchising

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UNIT 5: FRANCHISING

➔ Follows IFRS 15 (5-step method):


1. Identifying the contract
2. Identify the separate performances of obligations
3. Determination of transaction price
4. Allocate transaction price to the separate performance obligation
5. Recognize revenue when each performance of obligation is satisfied

➔ In franchising, there are two parties involved:


1. Franchisor
2. Franchisee

FRANCHISING = one party is giving permission to another party to use its own property
○ This property gives benefit to the parties in the long run
○ Example: Jollibee, McDo
■ Jollibee is the franchisor
■ The one using the name of Jollibee is the franchisee

Before, recognizing revenue in franchising must meet three criteria (NOT USED
ANYMORE):

1. There is substantial performance of the obligation


a. Substantial for franchisee to start and operate the franchise
b. Franchisor obligations = find crew, staff

2. Refundable period is already expired


a. After franchisee paid downpayment

3. Collectibility of note is reasonably assured


a. Since franchise fee can be large, structural payment is arranged and made
i. Example: 20% by cash and remaining is by payable

● Now, analyze if performance obligation revenue is satisfied/ recognized over time


or at a point in time.
ILLUSTRATIVE PROBLEMS:

Illustrative Problem 1

On January 1, 20x1, TAMISHA Co. grants a franchisee the right to operate a restaurant in a
specific location using TAMISHA’s trade name, concept and menu over a 10-year period. The
franchise agreement states an upfront fee of P1,200,000 which includes P200,000 for kitchen
equipment that TAMISHA will purchase for the franchisee, plus 10% royalty based on the
franchise’s sales. The P200,000 amount reflects the stand-alone selling price of the equipment.
TAMISHA regularly undertakes activities such as marketing research, product development,
advertising campaigns and implementing operational efficiencies and pricing strategies to
support the franchise name.

TAMISHA delivers the equipment on February 1, 20x1. The restaurant opens on April 1, 20x1,
at which date the license period starts to run. The franchisee reports sales of P900,000 for the
year.

Prepare the journal entries.

Solution:

Step 1: There is a contract between the franchisor (TAMISHA) and franchisee.

Step 2:

There are two separate and distinct obligations:


1. Let the franchisee to use the name, concept and menu of the company over a 10-year
period (franchise license)
2. Franchisor will buy franchisee kitchen equipment

● The obligations are distinct because the customer can benefit from each promise on
their own or together with other resources that are readily available, and the franchise
license and equipment are separately identifiable.

● Supporting activities are:marketing research, product development, advertising


campaigns and implementing operational efficiencies and pricing strategies. The
supporting activities are not performance obligations because these do not directly
transfer goods or services to the franchisee. These are part of TAMISHA’s promise to
grant the license and, in effect, change the intellectual property to which the franchisee
has rights.

The entity determines whether each performance obligation is satisfied over time or at a point in
time:
1. Franchise license = Franchise fee is divided over ten years.
Since the license is distinct, TAMISHA applies the specific principles whether the
franchisee has the right to access or use TAMISHA’s intellectual property. The problem
states that TAMISHA undertakes activities to support the franchise. Accordingly, the
franchisee can validly expect that its rights will change (example, rights to sell additional
products that TAMISHA will produce. Thus, since the customer has the right to access,
the performance obligation is satisfied over time.

2. Equipment = Since the control over the equipment transfers to the customer upon
delivery, the performance obligation is satisfied at a point in time.

● RIGHT TO ACCESS = over time (continuing franchise fee)


○ Example: “Plus 10% royalty based on the franchise’s sales”
● RIGHT TO USE = at a point in time

Step 3:

The transaction price includes:


● Fixed consideration of P1,200,000
● Variable consideration for sales-based royalty

Step 4: Allocation of transaction price (since there are two distinct performance obligations)

The P1,200,000 upfront fee is allocated as follows:


● P200,000 of the equipment
● P1,000,000 balance to the franchise license. The 10% sales-based royalty is allocated
entirely to the franchise license.

Step 5:

a. The 200,000 is recognized as revenue when the equipment is transferred to the


franchisee (February 1).

b. For the 1,000,000, TAMISHA applies the general principles to determine a measure of
progress that best depict its performance. Because the contract provides the franchisee
with unlimited use of the intellectual property for a fixed term (10 years), an appropriate
measure of progress may be a time-based method. TAMISHA starts to amortize the
1,000,000 on April 1 (commencement) because on this date the franchisee is able to use
and obtain the economic benefits of the license.

c. Sales Based royalty is recognized as the sales occur.

Entries:
Jan 1, 20x1 Cash 1,200,000
Contract Liability 1,200,000

Feb 1, 20x1 Contract Liability 200,000


Revenue 200,000
Dec 31, 20x1 Contract Liability 75,000
Revenue 75,000
*(1,000,000/10 years) * (9/12)
* April to December Sales

Cash 900,000
Sales 900,000
*9,000,000 * 10%

Illustrative Problem 2

On December 1, 20x1, TALULA Co. granted a customer a franchise license to use TALULA’s
trade name and sell TALULA’s products for 5 years. The contract requires an upfront fee of
P120,000 and monthly royalty fees of 3% of sales. The upfront fee is non-refundable.

TALULA Co., as a franchisor, has developed a customary business practice to undertake the
following pre-opening/set-up activities:
a. Assistance in site selection and fitting-out the premises
b. Management and staff training
c. Advertisement and promotion
d. Preparations for, and execution of the grand opening

TALULA Co. does not provide the pre-opening/set-up activities separately from the granting of
franchise right and the franchise agreement does not state separate fees for these activities.
TALULA regularly conducts national advertising campaigns to promote the trade name.

The franchise started operations in December and as of December 31, 2021, TALULA has no
remaining obligation or intent to refund any of the cash received. All the initial services (pre-
opening activities) have been performed. The customer reported sales of P2, 000,000 in
December 20x1.

Provide the journal entries.

Solution:

Step 1: There is a contract between franchisor and franchisee

Step 2:

There is only one performance obligation:


● Grant a customer a franchise license to use TALULA’s trade name and sell TALULA’s
products for 5 years.
● The pre-opening/set-up activities (supporting activities) are not performance
obligations because these do not directly transfer goods or services to the franchisee.
These are part of the entity’s promise to grant the license.

● RIGHT TO ACCESS = “The contract requires monthly royalty fees of 3% of sales”.


Thus, performance obligation is satisfied over time.

Step 3:

The transaction price includes a


● Fixed consideration of P120,000 (initial franchise fee)
● Variable consideration of 3% of customer sales (continuing franchise fee)

Step 4:

Both the fixed and variable considerations are allocated to the sole performance obligation of
granting the license.

Step 5:

a. The P120,000 is recognized over the 5-year license period using the straight-line
method

b. Sales-based royalty is recognized as the sales occur

Entries:

Dec 1, 20x1 Cash 120,000


Contract Liability 120,000

Dec 31, 20x1 Contract Liability 2,000


Revenue 2,000
*(120,000/ 5 years) * 1/12
*December sales only

Cash or Receivable 60,000


Revenue 60,000
*2, 000,000 * 3%
Illustrative Problem 3 (Costs and Revenue)

On December 1, 20x1, SIMONE Co. grants a customer a license to use SIMONE’s patented
technology over a 4-year period. The contract price is P1,000,000 payable in full at contract
inception. During December 20x1, SIMONE Co. incurs direct contract costs of P120,000 and
indirect costs of P30,000. The customer obtains control of the license on January 2, 20x2.

Case 1: Right to use


The license provides the customer the right to use SIMONE’s intellectual; property as it
exists at the time the license is granted.

Case 2: Right to access


The license provides the customer the right to access SIMONE’s intellectual property as
it exists throughout the license period. SIMONE uses a time-based method in measuring
its progress towards the complete satisfaction of the performance obligation.

Provide the journal entries.

Solution:

Note:
● Direct cost = directly attributable to franchise (will form part of franchise cost); aligned
with recognition of revenue
○ Right to Use = satisfied at a point in time
○ Right to Access = satisfied over time

● Indirect cost = not directly attributable to franchise (always an outright expense


whether right to use or right to access)

Case 1

Dec 20x1 Cash 1,000,000


Contract Liability 1,000,000

Deferred Contract Costs 120,000


Expense (Indirect Costs) 30,000
Cash 150,000

Jan 2, 20x2 Contract Liability 1,000,000


Revenue 1,000,000
*isang bagsakan lang

Cost of License 120,000


Deferred Contract Cost 120,000
Case 2

Dec 20x1 Cash 1,000,000


Contract Liability 1,000,000

Deferred Contract Costs 120,000


Expense (Indirect Costs) 30,000
Cash 150,000

Jan 2, 20x2 NO ENTRY


No revenue is recognized on Jan 2, 20x1 because the performance obligation is
satisfied over time. SIMONE will start recognizing revenue on Jan 31, 20x2
onwards.

Jan 31, 20x1 Contract Liability 20,833.33


Revenue 20,833.33
*(1,000,000* 4 years) * 1/12
*January fee only

Cost of License 2,500


Deferred Contract Costs 2,500
*(120,000/ 4years) * 1/12

If December 31 yung entry:

Contract Liability 250,000


Revenue 250,000
*(1,000,000* 4 years)

Cost of License 2,500


Deferred Contract Costs 2,500
*(120,000/ 4years)

Illustrative Problem 4 (Financing Component)

On January 1. 20x1, NALA Co. enters into an contract with a customer to transfer a license for a
fixed fee of P100,000 payable as follows:
● 20% upon signing of contract
● Balance due in 4 equal annual installments starting December 31, 20x1. The discount
rate is 12%.
NALA incurs direct contract costs of P20,000 in 20x1. NALA transfers the license to the
customer on Jan. 3, 20x2. The license provides the customer with the right to use NALA’s
intellectual property as it exists at grant date.

Compute for the profits in 20x1 and 20x2.

Solution:
*Note: Review time value of money

Downpayment (100,000 * 20%) 20,000


PV of note (100,000 * 80%)/ 4 years)) * PVOA 12%, 4 years 60,747
Transaction Price 80,747

Date Collections Interest Income (12%) Amortization (C-I) PV

1/1/x1 80,747

12/31/x1 20,000 7,289.64 12,710.36 48,036.64

12/31/x2 20,000 5,764.40 14,235.60 33,801.04

12/31/x3 20,000 4,056.12 15,943.88 17,857.16

12/31/x4 20,000 2,142.86 17,857.14 0.00

Profits:
20x1 20x2
Revenue - 80,747
Cost of Franchise - (20,000)
Gross Profit - 60,747
Interest Income 7,290 5,764
Indirect Costs - -
Profit for the Year 7,290 66,511
Illustrative Problem 5 (Uncertainty in Collection)

LATIFA Co. uses a standard contract for the granting of a license to customers. The standard
contains the following:
● Fixed fee of P100,000 payable as follows: P20,000 downpayment and balance due in 4
equal annual installments to start a year after the signing of contract.
● The license provides the customer the right to use LATIFA’s intellectual property as it
exists at grant date.

On January 1, 20x1, LATIFA signs three contracts. The licenses are also transferred to the
customers on this date. The discount rate is 12%. Accordingly, the present value of the note of
each contract is 60,747. LATIFA assesses the collectibility of the note from each customer and
concludes the following:

Customer 1 Probable
Customer 2 Doubtful
Customer 3 Significantly uncertain

The receivable from Customer 2 is doubtful because the region where the customer operates is
undergoing economic difficulty. However, LATIFA believes that the region’s economy will
recover in the near term and the license will help Customer 2 increase its sales. Accordingly,
LATIFA will provide Customer 2 with a price concession and estimates that it is probable that
LATIFA will collect only half of the note.LATIFA constrains its estimate of the variable
consideration and determines an adjusted transaction price of P50,373 (P20,000 downpayment
and P30,373 PV of the note). The discount rate is 12%.

Provide the journal entries.

Solution:

Customer 1
PV of note (given) 60,747
Downpayment 20,000
Transaction Price 80,747

1/1/x1 Cash 20,000 (downpayment)


Note Receivable 80,000
Revenue 80,747 (right to use)
Unearned Interest 19,253 (80,000- PV of 60,747)
Customer 2
PV of note (given) 30,373
Downpayment 20,000
Transaction Price (given) 50,373

1/1/x1 Cash 20,000 (downpayment)


Note Receivable 40,000 (half of 80,000)
Revenue 50,373 (right to use)
Unearned Interest 9,627 (40,000- PV of 50,737)

Customer 3
PV of note (given) 60,747
Downpayment 20,000
Transaction Price 80,747

1/1/x1 Cash 20,000 (downpayment)


Note Receivable 80,000
Contract Liability* 80,747 (right to use)
Unearned Interest 19,253 (80,000- PV of 60,747)
*Contract liability since collectibility is sigificantly uncertain

Note: If the customer is significantly uncertain, recognize profits only if the collection is greater
than your cost (cost recovery method).
● Cost recovery method = you are anticipating to collect profits equal to your cost. If
there is an excess between your collections and cost, that will be your profit.

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