We all must have read about “Jubilant Food” i.e. Domino’s pizza which is essentially under a franchise agreement with Domino’s pizza USA (as per its annual report). Current accounting practices in India does not have any specific guidance on such franchise agreements in relation to its accounting specifically, However under Ind-AS/ IFRS which is now/ will be applicable as per MCA roadmap and hence the implications/ requirements under these new accounting rules might change some of these structure in which current accounting follows.
Reader must note that Domino’s has been taken for just as an example for illustration purposes and without knowing full facts of any information, no one should use this article in any other manner.
The annual report of Jubilant food can be access by using the link http://www.jubilantfoodworks.com/wp-content/uploads/2015/07/JFL_Annual_Report2014-15.pdf
First let’s have Ind-As requirements where such franchise agreement has been referred into and its applicable accounting-
As per Ind-As -110 – Consolidated Financial Statements – Appendix B–
Para -B29 –A franchise agreement for which the investee is the franchisee often gives the franchisor rights that are designed to protect the franchise brand. Franchise agreements typically give franchisors some decision-making rights with respect to the operations of the franchisee.
Para -B30– Generally, franchisors’ rights do not restrict the ability of parties other than the franchisor to make decisions that have a significant effect on the franchisee’s returns. Nor do the
rights of the franchisor in franchise agreements necessarily give the franchisor the current ability to direct the activities that significantly affect the franchisee’s returns.
Para -B31– It is necessary to distinguish between having the current ability to make decisions that significantly affect the franchisee’s returns and having the ability to make decisions that protect the franchise brand. The franchisor does not have power over the franchisee if other parties have existing rights that give them the current ability to direct the relevant activities of the franchisee.
Para -B32– By entering into the franchise agreement the franchisee has made a unilateral decision to operate its business in accordance with the terms of the franchise agreement, but for its own account.
Para -B33– Control over such fundamental decisions as the legal form of the franchisee and its funding structure may be determined by parties other than the franchisor and may significantly affect the returns of the franchisee. The lower the level of financial support provided by the franchisor and the lower the franchisor’s exposure to variability of returns from the franchisee the more likely it is that the franchisor has only protective rights.
Let us have an overall approach/ guidance by which a reader can navigate/ use this concept while using/ analyzing other similar type for franchise agreements-
1. Franchisor (who actually provide its brand name and/or its specialized services etc.) i.e. Domino’s pizza, USA would have signed an agreement with Jubilant Food i.e. Franchisee to provide its brand name and recipe etc in order to have a business in India or elsewhere as may be defined. Usually such agreement may have a clause to monitor the use of brand and kind of power vest with franchisor (i.e. Domino’s USA) to specify its way of use in order to maintain the integrity/ values of such brands;
2. As per the Ind-As 110 which talks about “Control” as investor (i.e. Franchisor in our example) must have exposure or right to variable returns from its involvement with the investee by directing relevant activities of investee (Jubilant Food in this example)” which essentially means that all sort of activities/ efforts which can affect the variability of returns/ results (either profit or loss) of Investee i.e. Jubilant food then it will be considered a presence of Control and hence consolidation will apply (even voting shares etc are lesser in numbers e.g. less than 50% etc.),
Example -1 – Where Investor have power to remove or appoint key management persons who actually takes decisions about the relevant activities (relevant activities means those which are required to generate returns either profit or loss but not fixed returns) and hence can affect variability in returns. Hence control can be established,
Example- 2 – An ability to direct certain activities to enter into some large transactions (e.g. some new business purchase or machinery etc) which essentially can affect variability in returns then a control can be established.
3. There is another concept called “Protective rights” which has been defined in Appendix A of Ind-AS -110 which states that these are kind of rights given to the investor (i.e. franchisor in our example) to protect the interest of its investment, In other words these are kind of rights which gives power to those investors to avoid certain actions which can/ may affect their interests in the Company by using these protective rights,
Example – 1 – Rights to approve some re-structuring related to existing capital which essentially changes the overall rights of existing shareholders,
Example – 2 – Approving any amendments to a Memorandum of an entity or its rules for such operations,
4. Now, after the overall understanding about the above rights (protective or substantive), one has to take a careful assessment about the relevant terms and structure of such franchise agreement. It means that where the Franchisor makes/ involves into some kind of funding decisions/ or structuring of the franchisee business then it could possibly be leading towards a presence of control over such franchises, Other example could be right to approve/ reject location of Domino’s pizza outlet, right to approve prices or discounts of products, right to approve salary of staff and or bonus etc where Franchisor actually directing/ influencing relevant activities of the Investee (i.e. Jubilant food) and hence control can be established,
5. Sometime Franchisor requires to inspect or oversee the usage of its brand in terms of maintaining its quality and integrity without interfering into the decisions where a franchisee (i.e. Jubilant food in our example) decides where to open outlets/ investments etc then one can establish the fact that these are more of protective rights rather to the one which controls the business of franchisee,
6. Financial assistance could be another indicator to establish whether Franchisor influence business of franchises as it would actually be directing franchisee’s relevant activities which ultimately result into either profit or loss,
7. Hence decision making rights which prevents brand will be treated as protective rights and decisions which affects variability (performance of the Franchises’ business activities) of Franchisees’ business will be treated as substantive and will be concluding as under “Control” which will end up consolidating franchises business into the financial statement of the Franchisor,
8. While establishing the facts whether the rights are protective in nature or substantive (i.e. actually control exists), all potential voting rights (e.g. call options. Futures etc) which are currently exercisable or substantive in nature would be considered. For example deeply out of the money options will NOT be construed as substantive as it will not be opted to exercise by any holder hence will not be considered.
The above discussion only provides glimpse of the concept and many material judgments would be required in order to conclude whether such franchise agreement will be subject to consolidation into Franchisor’s financial statements or not. There would be more subjective analysis would be involved. The Jubilant food has been used to illustrate the concept only so that it can be remembered / catchy to all readers and they can actually navigate or take decisions while using 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 protected] or whatsapp +91-9634706933)
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