Topic 4: Franchise Operations – Franchisor’s point of view

Learning Objectives

Explain a franchise contract.

Apply the general and specific principles of PFRS 15 in recognizing revenue from franchise
contracts.
Prepare journal entries related to franchise operations.

Introduction

An entity applies PFRS 15 Revenue from Contracts with Customers to account for revenues from
contracts with customers. PFRS 15 supersedes PAS 18 Revenue.

Core principle under PFRS 15

An entity recognizes revenue to depict the transfer of promised goods or services to customers in an
amount that reflects the consideration to which the entity expects to be entitled in exchange for those
goods or services.

Summary of the Revenue recognition Principles under PFRS 15:

Step 1: Identify the contract with the customer The contract is with a customer and (among
others) the collectability of the consideration is
probable.

Step 2: Identify the performance obligations in Each promise to deliver a distinct good or
the contract service in the contract is treated as a separate
performance obligation.

A promised good or service is distinct if:

a. The customer can benefit from the good or

service either on its own or together with
other resources that are readily available to
the customer; and

b. The promise to transfer the good or service

is separately identifiable from other
promises in the contract.

Step 3: Determine the transaction price The transaction price is the amount that the
entity expects to be entitled to in exchange for
satisfying a performance obligation.

Step 4: Allocate the transaction price to the The transaction price is allocated to the
performance obligations performance obligations based on the relative
stand-alone prices of the distinct goods or
services.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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 Step 5: Recognize revenue when (or as) a - For a performance obligation satisfied over
performance obligation is satisfied time, revenue is recognized as the entity
progresses towards the complete satisfaction of
the performance obligation.

- For a performance obligation satisfied at a

point in time, revenue is recognized when the
entity completely satisfies the performance
obligation.

Revenue is measured at the amount of the

transaction price allocated to the performance
obligation satisfied.

Licensing

The “licensing” section of PFRS 15 (par.B52-B63) provides specific principles that relate directly to the
accounting for franchises. The specific principles are to be applied in addition to the general principles.

PFRS 15 defines a license as one that “establishes a customer’s rights to the intellectual property of
an entity.” Examples of licenses of intellectual property include:
a. Software and technology;
b. Motion pictures, music and other forms of media and entertainment;
c. Franchises; and
d. Patents, trademarks and copyrights.

Franchise

A 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 geographical area.

We deal with franchises everyday: a Jollibee fast-food restaurant, a 7-eleven convenience store, an
FM radio station, and a public utility vehicle are all examples of franchises.

Franchises are two types:

1. Contractual arrangement between two private entities or individuals.
2. Contractual arrangement between a private entity or an individual and the government.

Between two private entities or individuals

The franchisor, having developed a unique concept or product, protects that concept or product
through a patent, copyright, or trademark or trade name. The franchisee acquires the right to exploit
the franchisor’s idea or product by signing a franchise agreement.

Between a private entity or an individual and the government

In another type of franchise arrangement, a municipality (or other governmental body) allows a
private entity to use public property in performing its services. Examples: the use of public waterways
for a ferry service, use of public land for telephone or electric lines, use of phone lines for cable TV,
use of city streets for a bus line, or use of the airwaves for radio or TV broadcasting. Such operating
Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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rights, obtained through agreements with governmental units, are frequently referred to as licenses
or permits.

Franchises and licenses may be for a definite period of time or for an indefinite period of time or
perpetual.

Application of the Principles of PFRS 15

Step 1: Identify the contract with the customer

A contract with a customer is accounted for only when all of the following criteria are met:
a. The contracting parties have approved the contract (in writing, orally or implied in the customary
business practices) and are committed to perform their respective obligations;
b. The entity can identify each party’s rights regarding the goods or services to be transferred;
c. The entity can identify the payment terms for the goods or services to be transferred;
d. The contract has commercial substance (i.e., the risk, timing or amount of the entity’s future cash
flows is expected to change as a result of the contract); and
e. The consideration in the contract is probable of collection. When assessing collectability, the
entity shall consider only the customer’s ability and intention to pay the consideration on due
date.

No revenue is recognized on a contract that does not meet the criteria above. Any consideration
received from such contract is recognized as a liability and recognized as revenue only when either of
the following has occurred:
a. The entity has no remaining obligation to transfer goods or services to the customer and all, or
substantially all, of the consideration has been received and is non-refundable; or
b. The contract has been terminated and the consideration received is non-refundable.

The entity need not reassess the criteria above if they have been met on contract inception unless
there is an indication of a significant change in facts and circumstances, for example, when the
customer’s ability to pay subsequently deteriorates significantly.

Example: Reassessment of the criteria for identifying a contract

Hannah Co. licenses its proprietary processes to Samuel, Inc. in exchange for usage-based royalty.
At contract inception, criteria ‘a’ to ‘e’ above are met.

Accounting: Hannah accounts for the contract in accordance with PFRS 15 and recognizes revenue
when Samuel’s subsequent usage occurs.

In Year 2, Samuel continues to use Hannah’s processes but Samuel’s financial condition declines.
Samuel pays only a portion of the year’s billings. Samuel’s current access to financing is limited.

Accounting: Hannah continues to recognize revenue based on Samuel’s usage but accounts for any
impairment of the existing receivable in accordance with PFRS 9 Financial Instruments.

In Year 3, Samuel continues to use Hannah’s processes but Samuel has lost major customers and
access to financing. Thus Samuel’s ability to pay significantly deteriorates.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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 As a result of this significant change in facts and circumstances, Hannah reassessed criteria ‘a’ to ‘e’
above and determines that it is no longer probable that Hannah will collect the consideration to
which it will be entitled.

Accounting: Hannah stops recognizing further revenue from Samuel’s future usage of the processes
and accounts for any impairment of the existing receivable in accordance with PFRS 9.

Step 2: Identify the performance obligations in the contract

General principles:
Each promise to transfer the following is a performance obligation to be accounted for separately:
a. A distinct good or service (or a distinct bundle of goods or services); or’
b. A series of distinct goods or services that are substantially the same and have the same pattern of
transfer to the customer.

A promised good or service is distinct if:

a. The customer can benefit from the good or service either on its own or together with other
resources that readily available to the customer; and
b. The promise to transfer the good or service is separately identifiable from other promises in the
contract.

Performance obligations include only activities that involve the transfer of a good or service to a
customer. Performance obligations do not include administrative tasks to set up a contract.

Satisfaction of performance obligations

At contract inception, the entity shall determine whether the identified performance obligations will
be satisfied either:
a. Over time; or
b. At a point in time

A performance obligation is satisfied over time if one of the following criteria is met:
a. The customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs.
b. The entity’s performance creates or enhances an asset (e.g., work in progress) that the customer
controls as the asset is created or enhanced.
c. The entity’s performance does not create as asset with an alternative use to the entity and the
entity has an enforceable right to payment for performance completed to date.

If the entity cannot demonstrate that a performance obligation is satisfied over time, it is presumed
that the performance obligation is satisfied at a point in time.

Specific principles: (‘Licensing’ section)

A contract to grant a license to a customer may include other promises to provide additional goods or
services to the customer, whether explicitly stated in the contract or implied by the entity’s customary
business practices. Just like with other types of contracts, the entity shall apply the general principles
in “Step 2” above to identify each of the performance obligations in the contract.

Promise to grant license is not distinct

If the promise to grant a license is not distinct from the other promises in the contract, all of the
promises are accounted for together as a single performance obligation. The entity determines
Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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whether the performance obligation will be satisfied over time or at a point in time using the general
principles above.

Examples of licenses that are not distinct from other goods or services promised in the contract:
a. A license that is integral to the functionality of a tangible good (e.g., software embedded to a
machine); and
b. A license that the customer can benefit from only in conjunction with a related service (e.g.,
software with web hosting arrangement).

Promise to grant a license is distinct

If the promise to grant a license is distinct from the other promises in the contract, the promise to
grant the license is treated as a separate performance obligation.

The entity determines whether the separate promise to grant a license will be satisfied over time or
at a point in time by determining whether the license provides the customer with either:
a. A right to access the entity’s intellectual property as it exists throughout the license period; or
b. A right to use the entity’s intellectual property as it exists at the point in time at which the license
is granted.
If the customer has the right to access the intellectual property as it exists throughout the
license period, the performance obligation is satisfied over time. Therefore, the amount of
consideration allocated to the promise to grant the license is recognized as revenue over the
license period.
If the customer has the right to use the intellectual property as it exists at the point in time at
which the license is granted, the performance obligation is satisfied at a point in time.
Therefore, revenue is recognized at the time when the license is provided.

Right to access
The customer has the right to access the entity’s intellectual property as it exists throughout the
license period if the customer cannot direct the use of, and obtain substantially all of the remaining
benefits from, the license at the point in time at which the license is granted. This is the case if the
intellectual property to which the customer has rights changes throughout the license period.

The intellectual property changes throughout the license period if:

a. The entity continues to be involved with its intellectual property; and
b. The entity undertakes activities that significantly affect the intellectual property to which the
customer has rights.

The customer has the right to access the entity’s intellectual property if all of the following criteria are
met:
a. 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;
b. The rights granted by the license directly expose the customer to any positive or negative effects
of the entity’s activities identified in (a) above; and
c. Those activities do not result in the transfer of a good or a service to the customer as those
activities occur.

Although not determinative, the existence of a shared economic interest (for example, a sales-based
royalty) between the entity and the customer related to the intellectual property to which the
customer has rights may also indicate that the customer could reasonably expect that the entity will
undertake such activities.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

Page 5 of 10
If the customer has the right to access the intellectual property, the promise to grant a license is a
performance obligation satisfied over time because the customer will simultaneously receive and
consume the benefit from the entity’s performance of providing access to its intellectual property as
the performance occurs.

The entity shall apply an appropriate method to measure its progress towards the complete
satisfaction of that performance obligation to provide access.

Right to use
The customer has the right to use the entity’s intellectual property as it exists at the point in time at
which the license is granted if the customer can direct the use of, and obtain substantially all of the
remaining benefits from, the license at the point in time at which the license is granted. This is the
case if the intellectual property to which the customer has rights will not change.

Any activities undertaken by the entity merely change its own asset (i.e., the underlying intellectual
property), which may affect the entity’s ability to provide future licenses; however, those activities
would not affect the determination of what the license provides or what the customer controls.

If the customer has the right to use the intellectual property, the promise to grant a license is a
performance obligation satisfied at a point in time.

The entity shall consider the following indicators of transfer of control when determining the point in
time at which the license transfers to the customer:
a. The entity has a present right to payment for the asset.
b. The customer has legal title to the asset.
c. The entity has transferred physical possession of the asset.
d. The customer has the significant risks and rewards of ownership of the asset.
e. The customer has accepted the asset.

However, revenue shall not be recognized before the point in time where the customer is able to use
the license. For example, if a software license period begins before an entity provides to the customer
a code that enables it to use the software, no revenue is recognized before that code is provided.

Sales-based or usage-based royalties

Whether a license is distinct or not, and whether a distinct a license provides a ‘right to access’ or
‘right to use’, revenue from a sales-based or usage-based royalty is recognized only when (or as) the
later of the following event occurs:
a. The subsequent sale or usage occurs; and
b. The performance obligation to which the sales-based or usage-based royalty has been allocated
has been satisfied (or partially satisfied).

Summary of Principles:
Promise to grant license is:
Not distinct Distinct
➢ Treat all promises in the contract as a single ➢ Treat the promise to grant the license as a
performance obligation. separate performance obligation.
➢ Use general principles to determine whether ➢ Use specific principles to determine if the
the performance obligation is satisfied over promise provides the customer a:
time or at a point in time.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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 a. Right to access – performance
obligation is satisfied over time. Revenue
is recognized over the license period.
b. Right to use – performance obligation is
satisfied at a point in time. Revenue is
recognized at the time when the license
is provided.

Promise to grant license is distinct:

Right to access Right to use
➢ The customer cannot direct the use of, and ➢ The customer can direct the use of, and
obtain all the remaining benefits from, the obtain all the remaining benefits from, the
license at the time it was granted. license at the time it was granted.
➢ Intellectual property (IP) changes ➢ Intellectual property (IP) does not change
throughout the license period. throughout the license period.
a. The entity continues to be involved with
the IP; and
b. The entity undertakes activities that
significantly affect the IP.
➢ May be evidenced by a sales-based royalty
agreement between the entity and the
customer.

Illustration: Identifying a distinct license (Based on IFRS 15.IE281-288)

An entity, a pharmaceutical company, licenses to a customer its patent rights to an approved drug
compound for 10 years and also promises to manufacture the drug for the customer. The drug is a
mature product; therefore the entity will not undertake any activities to support the drug, which is
consistent with its customary business practices.

Case 1: License is not distinct

No other entity can manufacture this drug because of the highly specialized nature of the
manufacturing process. As a result, the license cannot be purchased separately from the
manufacturing services.

Step 2: Identify the performance obligations in the contract

Application of the General principles:

Step 2: Identify the performance obligations in the contract
Concept: Analysis:
Each promised good or service that is distinct is The promises are not individually distinct
treated as a separate performance obligation. A because:
good or service is distinct if: a. the customer cannot benefit from the
a. the customer can benefit from it on its own; license without the manufacturing service
and b. the promises are highly interrelated, and
b. it is separately identifiable from the other thus not separately identifiable
promises in the contract.
❖ Conclusion: The promises are treated as a single performance obligation.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

Page 7 of 10
The entity determines whether thee single performance obligation is satisfied over time or at a point
in time using the general principles. The entity need not apply the specific principles to determine
whether the customer has the ‘right to access’ or ‘right to use’ the entity’s intellectual property.

Under the general principles, the single performance obligation is satisfied over time because the
customer simultaneously receives and consumes the benefits of the entity’s performance as it occurs,
i.e., as the entity provides the manufacturing services.

Case 2: License is distinct

The manufacturing process used to produce the drug is not unique or specialized and several other
entities can also manufacture the drug for the customer.

Application of the General principles:

The promises to provide the license and the manufacturing service are distinct because the customer
can benefit from the license without the manufacturing service and the promises are separately
identifiable from each other.

Conclusion:
There are tow separate performance obligations in the contract, namely: (1) License of patent rights
and (2) Manufacturing service.

The entity determines whether each of the performance obligations is satisfied over time or at a point
in time.

Since the license is distinct, the entity applies the specific principles to determine whether the
customer has the right to access or right to use the entity’s intellectual property.

Application of the Specific principles:

Concept Analysis
➢ Right to access
- Customer cannot direct the use of, and
obtain all the benefits from, the license
at grant date.
- Intellectual property changes
throughout the license period.
- May be evidenced by a sales-based
royalty agreement.
➢ Right to use The license qualifies with this one because of the
- Customer can direct the use of, and following statement:
obtain all the benefits from, the license “The drug is a mature product; therefore the
at grant date. entity will not undertake any activities to
- Intellectual property does not change support the drug, ….”
throughout the license period. - From the statement above, it can be inferred
that the intellectual property does not
change throughout the license period.
Conclusion: The customer has the right to use the entity’s intellectual property as it exists at a point
in time. Accordingly, the performance obligation to provide the license is satisfied at a point in time.

Step 3: Determine the transaction price

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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The transaction price is “the amount of consideration to which an entity expects to be entitled in
exchange for transferring promised goods or services to a customer, excluding amounts collected on
behalf of third parties (e.g., some sales taxes).” (PFRS 15.Appdx.A)

The transaction price is normally the contract price. However, the transaction price may not be equal
to the contract price if the consideration in the contract is affected by any of the following:
a. Variable consideration;
b. Constraining estimates of variable consideration (an entity is exempt from applying this principle
on sales-based or usage-based royalty);
c. The existence of a significant financing component in the contracts;
d. Non-cash consideration; or
e. Consideration payable to a customer.

The transaction price in a franchise contract is commonly referred to as franchise fees.

Franchise fees
Franchise fees refer to the fees that the franchisee agrees to pay to the franchisor in a franchise
agreement. The fees may cover the supply of know-how, initial and subsequent services, and
equipment and other tangible assets.

Franchise fees come in the form of:

1. Initial franchise fee – this is the one-off payment made by the franchisee to the franchisor to
obtain the franchise right. Initial franchise fees are normally paid at the signing of the franchise
agreement and are normally paid at the signing of the franchise agreement and are normally non-
refundable. However, some franchise agreements allow initial franchise fees to be paid over an
extended period of time and provide for the right of refund up to a certain amount.

Aside from consideration for the supply of know-how, initial franchise fees may also cover for the
franchisor’s initial services in assisting the franchisee in establishing the new business. Examples
of initial services include the following:
a. Assistance in site selection, lease negotiations, financing, fitting-out of the premises, and
supervision of the construction activity
b. Initial training in the operating the business
c. Assistance with staff recruitment and training
d. Access to preferential purchasing arrangements the franchisor has put in place
e. Provision of systems (e.g., accounting, information, and quality control)
f. Advertisement and promotion
g. Preparations for, and execution of, the grand opening
h. Initial presence of a trouble-shooter for the first few days after the opening

Initial franchise fees do not normally include costs of initial inventory.

2. Continuing franchise fees – these are the periodic payments made by the franchisee to the
franchisor for the ongoing franchisee support. Continuing franchise fees are also referred to as
royalty fees and are usually based on a certain percentage of the franchisee’s sales, but can also
be set up as a fixed amount or on a sliding scale, and are payable periodically.

In some cases, continuing franchise fees may be charged separately for the following:
a. Management fees – these pay primarily for ongoing franchisee support and are usually
calculated as percentage of franchisee’s sales.

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

Page 9 of 10
 b. Training and conference fees
c. Accounting and other special services fees – in some franchises, the franchisor provides
bookkeeping services or maintains the information system of franchisees. Separate fees may
be charged for these services.
d. Marketing services fund – additional fee may be charged as contribution to the national
product advertising and marketing activities of the franchisor.
e. Renewal fund – a fund may be established to cover for the renewal fee of the franchise when
it expires.

Contributions to funds are not recognized as revenue until the related performance obligation
is satisfied (e.g., when the advertisement is made or when the franchise is renewed).

3. Sale of equipment and other tangible assets – in most franchise agreements, the franchisor
provides equipment and other tangible assets to the franchisee for a separate fee. Also, the
franchisor may purchase goods centrally and supplies directly to franchisees. A markup,
purchasing fee or handling fee may be charged on tangible assets transferred to franchisees.

Step 4: Allocate the transaction price to the performance obligations

The transaction price is allocated to the performance obligations based on the relative stand-alone
prices of the distinct goods or services.

The stand-alone selling price is the price at which a promised good or service can be sold separately
to a customer.

If there is only one performance obligation in a contract, the transaction price is allocated only to that
single obligation.

Step 5: Recognize revenue when (or as) a performance obligation is satisfied

A performance obligation is satisfied when the control over a promised good or service is transferred
to the customer.
If the performance obligation in the contract is satisfied over time, revenue is recognized over
time as the entity progresses towards the complete satisfaction of the obligation.
If the performance obligation in the contract is satisfied at a point in time, the entity
recognizes revenue when the performance obligation is satisfied.

Revenue is measured at the amount of the transaction price allocated to the satisfied performance
obligation.

---End---

Reference: Accounting for Special Transactions (Advanced Accounting 1) 2020 Edition by Zeus Vernon B. Millan.
Note: This module shall be used for classroom learning purposes only and shall not be distributed outside the class.

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