PRACTICAL ACCOUNTING II

P2.1405-Franchise Accounting

LECTURE NOTES

FRANCHISE ACCOUNTING bookkeeping services. The credit rating of the franchisee

Parties to a franchise contract are (a) the franchisor indicates that money can be borrowed at 8 percent. The
(owner) and (b) the franchisee (user). The franchisee pays present value of an ordinary annuity of five annual receipts
the franchisor 2 types of franchise fees: of P80,000 each discounted at 8 percent is P31,941.68.
1. Initial franchise fee – paid in consideration of the right The discount of P8,058.32 represents the interest revenue
to use the franchisor’s name, products, and processes, to be accrued by the franchisor over the payment period.
as well as for initial services to be rendered by the The franchise cost by the franchisor in rendering the initial
franchisor; and services was P25,165.00.
2. Continuing franchise fee – paid in consideration of
The journal entries for the above information at various
continuing services provided by the franchisor.
dates follow:
Discussions are from the standpoint of the franchisor, in
terms of revenue and profit recognition as they vary from (1) At date of signing/agreement:
those accounted under the point-of-sale-revenue Cash 10,000.00
recognition principles. Notes Receivable 40,000.00
Discount on N/R 8,058.32
Not much problem is posed by continuing franchise fees as Unearned Franchise Fees 41,941.68
they are paid by the franchisee when the outlet has started
operations. It is normally a certain percentage of the (2) Summary entry for incurred franchise cost:
franchisee’s revenues and is income receivable to the Deferred Franchise Cost 25,165.00
franchisor when already billable. Revenue recognition on Cash 25,165.00
the initial franchise fee, however, has some complexities in
that the franchisor must first have substantial performance (3) Entry for collection on N/R at Dec.31:
of services before it can be recognized as revenue. Cash 8,000.00
Substantial performance means the franchisor has no N/R 8,000.00
obligation to refund any amounts already received nor
intention to forgive any amounts not yet collected AND (4) Entry for the recognition of interest for 2012.
that it must have substantially performed the services Discount of N/R 2,555.33
promised under the terms of the agreement. The earliest Interest Revenue 2,555.33
point substantial performance can be claimed by the (31,941.68 x 8%)
franchisor is the opening of the franchisee’s outlet. In
other words, the initial franchise fee can only be (5) Entries for profit recognition on Dec.31 assuming:
recognized as revenue when the franchise contract is
virtually consummated. Franchisor has substantially performed the initial
services and:
When substantial performance is had the profit recognition (a) Collection of the N/R is reasonably assured:
method to be used depends on reasonable assurance of Unearned Franchise
collecting the promissory notes that accompany the cash Revenue 41,941.68
down payment. If collection is reasonably assured the Franchise Rev. 41,941.68
accrual method is used, otherwise, use of the installment
sales method is preferable. Without substantial Franchise Cost 25,165.00
performance the franchisor uses the deposit method in Def. Franchise Cost 25,165.00
accounting for all transactions pertaining to franchise
revenues and costs. Therefore: RGP= 41,941.68-25,165.00=16,776.68

Some exceptions to the above revenue recognition (b) Collection of the N/R is not reasonably assured:
principles follow: Aside from the two accrual entries in 5(a):
1. If there is a substantial performance and installment
sale method is to be used BUT the franchise cost is not Franchise Revenue 41,941.68
available, only the cash down payment is earned Franchise Cost 25,165.00
revenue and the present value of the note receivable Deferred Gross
unearned revenue. Profit 16,776.68
2. If there is yet no substantial performance but the down
payment is not refundable and if it represents a fair
Deferred Gross Profit 6,177.87
measure of the costs of services already provided by
Realized Gross Profit 6,177.87
the franchisor then the cash down payment is earned
(c) If initial services have not been substantially
revenue and the present value of the note is unearned
performed by franchisor, note receivable is
revenue.
reasonably assured of collection, and the down
payment is not refundable.
Illustrative Entries for Initial Franchise Fees.
Unrealized Franchise
To illustrate, assume on January 1, 2012 Jessie’s Pizza inc.
Revenue 10,000.00
charges an initial franchise fee of P50,000 for the right to
Franchise revenue 10,000.00
operate as a franchise of Jessie’s Pizza. Of this amount,
P10,000 is payable when the agreement is signed, and the
Continuing Franchise Fees
balance is payable in five annual payments of P8,000 each.
Continuing franchise fees are received in return for the
In return for initial franchise fee, the franchisor will help
continuing rights granted by the franchise agreement and
locate the site, negotiate the lease or purchase of the site,
for providing such services as management training,
supervise the construction activity, and provide the
advertising and promotion, legal, assistance, and other
support. Continuing fees should be reported as revenue
when are earned and received from the franchise, unless
portion of them has been designated for a particular
purpose, such as providing a specified amount for building
maintenance or local advertising. In that case, the portion
deferred shall be an amount sufficient to cover the
estimated cost in excess of continuing franchise fees an
amount provide a reasonable profit on the continuing
services.
Bargain Purchases
In addition to paying continuing franchise fees, franchise
frequently purchase some or all of their equipment and
supplies from the franchisor. The franchisor would account
for these sales as it would for any other product sales.
Sometimes, however, the franchise agreement grants
the franchise the right to make bargain purchases of
equipment or supplies after the initial franchise fee is paid.
If the bargain price is lower than the normal selling price of
the same product, or if it does not provide the franchisor a
reasonable profit, then a portion of the initial franchise fee
should be deferred. The deferred portion would be
accounted for as an adjustment of the selling price when
the franchisee subsequently purchases the equipment or
supplies.
Options to Purchase
A franchise may give the franchisor an option to purchase
the franchisee’s business. As a matter of management
policy, the franchisor may reserve the right to purchase a
profitable franchise outlet, or to purchase one that is in
financial difficulty. If it is probable at the time the option is
STRAIGHT PROBLEMS
Problem 1
On January 1, 2013, KITKAT COMPANY entered into a
franchise agreement with BROOKLYNNE CORPORATION to
sell BROOKLYNNE Products. The agreement provides for an
initial franchise fee of P7,812,500 payable as follows:
P4,687,500 cash to be paid upon signing of the contract,
and the balance in four equal annual payments of
P781,250 to start December 31, 2013. Rose signs 10%
interest-bearing notes for the balance. The agreement
further provides that the franchisor will assist the
franchisee in locating the business site, in designing and
supervising the construction of the building, and in the
training of management and employees. The agreement
also provides that franchisee must pay a continuing
franchise fee equal to 5% of its monthly gross sales. On
October 31, 2013, the franchisor completed the initial
services required in the contract at a costs of P1,875,000.
The franchisee commenced business operations on
November 2, 2013. The gross sales reported to the
franchisor for the months of November and December are
P703,125 and P937,500 respectively.
Requirements:
1. Assuming that the collection of the notes is reasonably
assured, prepare the journal entries in the books of the
franchisor for the year 2013.
2. Assuming that the collection of the notes is not
reasonably assured, prepare the journal entries in the
books of the franchisor for the year 2013.
given that the franchisor will ultimately purchase the
outlet, then the initial franchise fee should not be
recognized as revenue but should be recorded as a
liability. When the option is exercised, the liability would
reduce the franchisor’s investment in the outlet.
Franchisor’s Cost
Franchise accounting also involves proper accounting for
the franchisor’s cost. The objective is to match related
costs and revenues by reporting them as components of
income in the same accounting period. Franchisors should
ordinarily defer direct costs (usually incremental costs)
relating to specific franchise sales for which revenue has
not yet been recognized. Costs should not be deferred,
however, without reference to anticipated revenue and its
realizability5. Indirect costs of a regular and recurring
nature, such as selling and administrative expenses that
are incurred irrespective of the level of franchise sales,
should be expensed as incurred.
Disclosures of Franchisors
Disclosure of all significant commitment and obligations
resulting from franchise agreements, including a
description of services that have not yet been substantially
performed, is required. Any resolution of uncertainties
regarding the collectibility of franchise fees should be
disclosed. Initial franchise fees should be segregated from
other franchise fee revenue if they are significant. When
possible, revenues and costs related to franchisor-owned
outlets should be distinguished from those related to
franchised outlets.
- done -
Problem 2
On January 2, 2013, CANDY signed an agreement to
operate as a franchisee of BRUNO, INC. for an initial
franchise fee of P8,750,000 Of this amount, P3,281,250
was paid when the agreement was signed and the balance
is payable in five annual payments of P1,093,750
beginning December 31, 2013. CANDY signed a non-
interest bearing note for the balance. CANDY credit rating
indicates that she can borrow money at 20% interest for a
loan of this type. The present value of an annuity of P1 at
20% for 5 periods is 2.990. The contract includes a
continuing franchise fee of 5% of the franchisee’s gross
sales, to be collected monthly.
On November 25, 2013, the franchisor substantially
performed the initial services provided in the contract at a
cost of P982,835. Indirect cost is P46,875. The franchisee’s
outlet commenced operations on December 1, 2013. The
gross sales of CANDY for the month of December, 2013 is
P437,500.
Required: Prepare journal entries on the books of the
franchisor for 2013, assuming (1) collection of the note
is reasonably assured and (2) collection of the note is
not reasonably assured.
 MULTIPLE CHOICE
On January 1, 2012, XEROX SERVICES, INC. signed an
agreement authorizing YOURS TRULY COMPANY to operate
as a franchisee over a 20-year period for an initial
franchise fee of P171,875 received when the agreement
was signed. YOURS TRULY commenced operations On July
1, 2012 at which date all of the initial services required of
XEROX SERVICES had been performed. The agreement
also provides that YOURS TRULY must pay annually to
XEROX a continuing franchise fee equal to 5% of the
revenue from the franchise. YOURS TRULY’S franchise
revenue for 2012 was P1,375,000.
1. For the year ended December 31, 2012, how much
should XEROX record as revenue from franchise fees
with respect to the YOURS TRULY’S franchise?
a. P240,625 c. P154,687.50
b. P171,875 d. P 75,625
GREAT DANE, INC., franchisor, entered into a franchise
agreement with PITBULL COMPANY, franchisee, on July 1,
2012. The total franchise fees agreed upon is P687,500, of
which P62,500 is payable upon signing and the balance is
to be covered by a note payable in four equal annual
installments. The direct franchise cost incurred was
P406,250. Indirect franchise expenses of P39,062.50 was
also paid. The relevant interest rate is 12% and the note is
reasonably assured of collection. The franchise outlet
commences its operations on July 25, 2012.
2. Assuming the note payable is interest-bearing, how
much is the net income to be reported in the July,
2012 income statement?
a. P248,437.50 c. P242,187.50
b. P 96,937.50 d. P 92,187.50
3. Assuming the note payable is non-interest-bearing
(use two decimal places for the present value factor),
how much net income is to be reported in the July
2012 income statement?
a. P248,437.50 c. P 96,937.50
b P242,187.50 d. P 92,187.50
On January 2, 2012, JELLYFISH, INC. entered into a
franchise agreement with KOOKIE COMPANY to sell their
products. The agreement provides for an initial franchise
fee of P3,515,625 payable as follows: P984,375 cash to be
paid upon signing of the contract and the balance in five
equal annual payments every December 31, starting
December 31, 2012. JELLYFISH signs a 15% interest-
bearing-note for the balance. The agreement further
provides that the franchisee must pay a continuing
franchise fee equal to 5% of its monthly gross sales. On
October 31 the franchisor completed the initial services
required in the contract at a cost of P1,125,000 and
incurred indirect costs of P225,000. The franchise
commenced business operations on November 3, 2012.
The gross sales reported to the franchisor are November
sales, P115,312.50 and December sales, P133,593.75. The
first installment payment was made on due date. Assume
collection of the note is not reasonably assured.
4. In its income statement for the year ended December
31, 2012, how much is the net income?
a. P1,216,068.70 c. P1,059,257.80
b. P 801,070.31 d. P1,180,757.80
On January 2, 2012, EXTREME COMPANY signed an
agreement to operate as a franchisee of BASIC
PRODUCTS, INC.. for an initial franchise fee of P3,125,000
for 10 years. Of this amount, 40% was paid when the
agreement was signed and the balance payable in four
semi-annual payments beginning on June 30, 2012.
EXTREME signed a non-interest-bearing note for the
balance. EXTREME’s rating indicates that it can borrow
money at 24% on a loan of this type. Assume that
substantial services amounting to P771,875 had already
been rendered by BASIC PRODUCTS, INC.
5. If the collection of the note is not reasonably assured,
the realized gross profit for the year ended December
31, 2012:
a. P1,321,345.50 c. P1,101,069.50
b. P1,069,031.50 d. P1,338,307.00
6. On January 1, 2012, ABC signed an agreement to
operate a franchise of XYZ for an initial franchise fee of
10M pesos for 10 years. Of this amount P2,000,000
was paid when the agreement was signed and the
balance is payable in four equal annual payments
beginning December 31, 2012. ABC signed a non
interest bearing note for the balance. ABC’s rating
indicates that it can borrow money at 24% for a loan
of this type. Present value factor of an annuity of 1 for
four periods at 24% is to 2.4. Assume that the
substantial services amounting to P1,020,000 had
been already rendered by XYZ. An the additional
indirect franchise cost of P272,000 was also incurred.
If the collection of the note is not reasonably assured,
the realized gross profit for the year ended December
31, 2012 is:
a. P5,780,000
b. P2,420,800
c. P5,508,000
d. P2,502,400