398 ❘ Part 2 ❘ EM
DEPOSIT METHOD: FRANCHISING INDUSTRY
The U.S. Small Business
Association (SBA) offers an
informational Web site on
franchising (www.sba.gov/
workshops/franchises).
Net Work:
1. Franchising makes up
what percentage of retail
sales?
2. What things should you
consider if you are thinking
about purchasing a
franchise?
❘ Primary Activities of a Business
A special application of the deposit method is found in the franchising industry, one of
the fastest growing retail industries of recent years. Franchisers create faster growth by
selling various rights to use a name and/or a product to operators (franchisees) who man-
age independent units as separate entrepreneurs from the franchiser.
Sales of franchises usually include several different services, products, and/or plant
assets including: (1) intangible rights to use a trademark or name, (2) property owned by
the franchiser, (3) pre-opening services such as helping locate suitable business sites,
constructing a building, and training employees, and (4) ongoing services, products,
and processes as the operations are carried out. Many revenue recognition problems are
present in typical franchises; however, most of them may be solved if the elements are
identified separately and accounted for in the same manner as they would be if the sale
were a separate transaction. The most troublesome revenue recognition problem is the
initial fee. Typically, the franchiser charges a substantial amount for the right to use the
franchise name and to provide for pre-opening services. Sometimes these fees are
payable immediately in cash, but typically they include a long-term note receivable.
Frequently, liberal refund provisions are included in the agreement, especially in the
period prior to opening.
In the early days of franchising agreements, franchisers often reported the initial fee
as revenue when the monetary assets were received. Future estimated costs were pro-
vided as offsets to the revenue. However, this treatment often resulted in questionable
front-end loading of revenue similar to that occurring in the real estate and retail land sale
industries. As a result, the AICPA issued an Industry Accounting Guide in 1973 that estab-
lished revenue recognition guidelines for the franchising industry.14 The essentials of this
guide were later incorporated into FASB Statement No. 45.15 This standard specifies
that no revenue is to be recognized prior to substantial performance of the services
covered by the initial fee. Until that time, any monetary assets received should be offset
by a deposit or deferred credit account, and any costs related to the services rendered
should be deferred until revenue is recognized, except that such deferred costs shall
not exceed anticipated revenue less estimated additional related costs. Once substantial
performance is achieved, revenue should be recognized using the method that best
reflects the probability of cash collection, for example, accrual, installment sales, or cost
recovery method. The latter two methods “shall be used to account for franchise fee
revenue only in those exceptional cases when revenue is collectible over an extended
period and no reasonable basis exists for estimating collectibility.”16
To illustrate, assume that a franchiser charges new franchisees a fee consisting of
$10,000 payable in cash when the agreement is signed followed by four annual payments
of $3,750 each. Assuming the franchisee could borrow money at 10%, the present value
of the four annual payments is $11,887 ($3,750 × 3.1699).17 The agreement provides
that the franchiser will assist in locating the site for a building, conduct a market survey
to estimate potential income, supervise the construction of a building, and provide
initial training to employees.
If the down payment is refundable and no services have been rendered at the time
the arrangement is made, the deposit method would be used as long as collection
on the note is reasonably certain. The following entry would be made to record the
transaction:
14 Committee on Franchise Accounting and Auditing, AICPA, Industry Accounting Guide, “Accounting for Franchise
Fee Revenue,” New York: American Institute of Certified Public Accountants, 1973.
15 Statement of Financial Accounting Standards No. 45, “Accounting for Franchise Fee Revenue,” Stamford, CT:
Financial Accounting Standards Board, March 1981.
16 Ibid., par. 6.
17 See Appendix B for a review of present value calculations.
 Complexities of Revenue Recognition ❘ EM ❘ Chapter 7 ❘ 399

Cash................................................................................................................................ 10,000
Notes Receivable............................................................................................................ 11,887
Deposit on Franchise (or Unearned Franchise Fee) ............................................... 21,887

When the initial services are determined to be substantially performed, the revenue
recognition method to be used and the resulting journal entries depend on the probabil-
ity of future cash collection. If the collection of the note is reasonably assured, the full
accrual method would be used. Assume that substantial performance of the initial serv-
ices by the franchiser costs $14,000. The entries to record this event using the full
accrual method would be as follows:
Cost of Franchise Fee Revenue ...................................................................................... 14,000
Cash .......................................................................................................................... 14,000
Deposit on Franchise (or Unearned Franchise Fee) ..................................................... 21,887
Franchise Fee Revenue............................................................................................. 21,887

If the collection of the note is doubtful, the installment sales method could be used.
In addition to the entries used under the full accrual method, the installment sales
method requires the following entries:
Franchise Fee Revenue................................................................................................... 21,887
Cost of Franchise Fee Revenue ................................................................................ 14,000
Deferred Gross Profit on Franchise ......................................................................... 7,887
Deferred Gross Profit on Franchise ............................................................................... 3,604*
Realized Gross Profit on Franchise ......................................................................... 3,604

*$7,887/$21,887 = 36.04% gross profit percentage; .3604 × $10,000 = $3,604

An example of financial statement disclosure provided by a franchise business is

presented in Exhibit 7–6 for McDONALD’S CORPORATION.

EXHIBIT 7–6 McDonald’s Corporation Disclosure of Franchise Information

Franchise arrangements generally include a lease and a license and provide for payment of initial fees,
as well as continuing rent, service fees and royalties to the Company, based upon a percentage of sales
with minimum rent payments. Franchisees are granted the right to operate a McDonald’s restaurant using
the McDonald’s system as well as the use of a restaurant facility, generally for a period of 20 years.
Franchisees pay related occupancy costs including property taxes, insurance and maintenance.
Beginning in 1998, franchisees in the U.S. generally have the option to own new restaurant facilities while
leasing the land from McDonald’s. In addition, franchisees outside the U.S. pay a refundable, noninterest-
bearing security deposit.

Caution! The deposit method
and consignment accounting
are not revenue recognition
methods. They are methods of
accounting for assets prior to
revenue recognition. When the
point of revenue recognition is
reached, the decision of which
revenue recognition method to
use must still be made.
CONSIGNMENT SALES
Another method of accounting has developed for use when property is
exchanged without a transfer of title and without a sales contract being com-
pleted. This type of arrangement is referred to as a consignment. Under a con-
signment, the potential seller, the consignor, delivers merchandise to another
party, the consignee, who then acts as an agent for the consignor to sell the
goods. Title to the merchandise continues to be held by the consignor until a
sale is made, at which time title passes to the ultimate purchaser. The consignee
usually is entitled to reimbursement for expenses incurred in relation to this
arrangement and also is entitled to a commission if a sale is successfully made.
Because title to the merchandise is held by the consignor but physical
possession is held by the consignee, special accounting records must be