Accounting of pre-existing Franchise Agreement between Domino’s India & USA in case Business acquisition/ business combination took place –“Re-acquired rights” – Ind-As/ IFRS
Those who have not read previous article title Domino’s Pizza- “Franchise Agreement”- An accounting perspective- Ind-As/ IFRS, where we had discussed about the treatment/ analysis of franchise agreement between Domino’s India and its Franchisor USA and assessed if conditions satisfy the criteria of Control and hence to be consolidated accordingly.
Keeping the same example further to understand a situation where its franchisor i.e. Domino’s USA takes over or bought the business of Domino’s India under Business combination. Now, questions which will be arisen related to this existing franchise agreement are-
1. How to treat this pre-existing franchise rights (called it as “re-acquired rights”) at the date of such acquisition (business combination)?
2. and after such acquisition?
There is nothing specific available under current accounting system for such instances where any existing rights are being acquired by an acquirer. However there are specific guidances and its accounting treatments are available under these new accounting standards which can broadly be referred as below –
As per Ind-As 103 – Business Combination
Para -29 – The acquirer shall measure the value of a reacquired right recognised as an intangible asset on the basis of the remaining contractual term of the related contract regardless of whether market participants would consider potential contractual renewals when measuring its fair value. Paragraphs B35 and B36 provide related application guidance.
Para- B35– As part of a business combination, an acquirer may reacquire a right that it had previously granted to the acquiree to use one or more of the acquirer’s recognised or unrecognised assets. Examples of such rights include a right to use the acquirer’s trade name under a franchise agreement or a right to use the acquirer’s technology under a technology licensing agreement. A reacquired right is an identifiable intangible asset that the acquirer recognises separately from goodwill. Paragraph 29 provides guidance on measuring a reacquired right and paragraph 55 provides guidance on the subsequent accounting for a reacquired right.
Para–B-36– If the terms of the contract giving rise to a reacquired right are favourable or unfavourable relative to the terms of current market transactions for the same or similar items, the acquirer shall recognise a settlement gain or loss. Paragraph B52 provides guidance for measuring that settlement gain or loss.
Para- B- 52– “………..(b) for a pre-existing contractual relationship, the lesser of (i) and (ii):
(i) the amount by which the contract is favourable or unfavourable from the perspective of the acquirer when compared with terms for current market transactions for the same or similar items. (An unfavourable contract is a contract that is unfavourable in terms of current market terms. It is not necessarily an onerous contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.)
(ii) the amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavourable.
If (ii) is less than (i), the difference is included as part of the business combination accounting.
Para -55A– reacquired right recognised as an intangible asset shall be amortised over the remaining contractual period of the contract in which the right was granted. An acquirer that subsequently sells a reacquired right to a third party shall include the carrying amount of the intangible asset in determining the gain or loss on the sale.
Now, We will take an example (hypothetical illustration) of Domino’s only and let’s understand the whole concept and what exactly the standard is trying to explain –
Domino’s Pizza, India would had paid an amount of INR 10 million upfront for this Franchise agreement of let’s say for 10 years out of which 2 years have already lapsed when Domino’s Pizza, USA has taken over the business of Domino’s Pizza, India.
Let’s assume, Domino’s USA has valued/ agreed overall purchase consideration to be given to Domino’s India is around INR 150 Million.
Domino’s USA has arranged fair valuation of this franchise rights which were given to Indian entity for its remaining life (i.e. of 8 years) which comes to INR 13 million and as per the agreement there is some penalty clause which requires terminating party to pay 50% of the balance period fees (i.e. INR (10 million/ 10 years ) X 8 years X 50%= INR 4 million).
Now, let’s summarize the information that we got from this example above –
Total purchase consideration for the Business combination = INR 150 Million
Remaining period of franchise agreement = 8 years
Cost (proportionate value of the agreement) = INR 8 million
Fair value of this agreement = INR 13 million
Settlement amount (penalty calculated) = INR 4 million
The amount of gain/ loss on such re-acquired right will be calculated as per “para B52” above –
i.e. LOWER of 1) amount un-favorable to acquirer i.e. INR 13 million – INR 8 million (difference
between the fair value of rights that were given on less amount/ more amount)
= INR 5 million,
2) any settlement provision i.e. INR 4 million
Hence INR 4 million (being lower among two amounts above) will be used as settlement loss and will be adjusted against the purchase consideration i.e. INR 150 million resulting net purchase consideration to INR 146 million i.e. to show full INR 150 million received in cash and then distribute it among INR 146 million as purchase consideration and INR 4 million as settlement loss (treatment as mentioned in para B52).
However, if suppose point number 2 was higher than point number one then the amount will not be net off with the overall purchase consideration and will be shown as separate transaction into PL.
Now, coming to treatment of this right which was assumed to be the part of purchase consideration and hence INR 146 million will have INR 13 million (fair value of this re-acquired right) as one of separable Intangible asset. Reader must note that as per Ind-AS 103 which requires all such assets acquired/ liabilities assumed should be valued at Fair price however this re-acquired rights will be fair valued for the remaining period of the such agreement (by using contractual cash inflows only) and based on that value i.e. INR 13 million in our example will be amortised over the period of balance 8 years under the category of Intangible assets.
One can easily understand that there would be specific mapping/ process Updation which is required to capture these kind of situation and accordingly its accounting will be reflected in the books. A reader of this article would be either accountant who will be making this accounting entry, an auditor who will be auditing these entries or among management who has to think about all possible consequences of these transactions.
As explained above, the Domino’s has been used just for illustration purposes and its nothing based on any facts/ instances related to such group. Hence reader/ users should use this just an example to understand this concept.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as IFRS advisor & corporate trainer. He can be reached via email at email@example.com or whatsapp +91-9634706933)