FRANCHISING:
ACCOUNTING BY FRANCHISOR
Franchise
companies derive their revenue from one or both of two sources:
1.
From sale of initial franchises and related assets or services, and
2.
From continuing fees based on the operations of franchises.
Franchisor - the
party who grants business rights under the franchise.
Franchisee - the
party who operates the franchised business.
Normal services
performed by franchisor:
1. Assistance in site selection.
a.
Analyzing location.
b. Negotiating lease.
2. Evaluating potential income.
3. Supervision of construction activity.
a. Obtaining financing.
b. Designing building.
c. Supervising contractor while
building.
4. Assistance in the acquisition of signs,
fixtures, and equipment.
5. Bookkeeping and advisory services.
a. Setting up franchisee’s records.
b. Advising on income, real estate,
and other taxes.
c. Advising on local regulations of
the franchisee’s business.
6. Employee and management training.
7. Quality control.
8. Advertising and promotion.
INITIAL
FRANCHISE FEES
The initial franchise fee is consideration
for establishing the franchise relationship and providing some initial
services. Initial franchise fees are to be recorded as revenue only when and as
the franchisor makes “substantial performance” of the services it is obligated
to perform and collection of the fee is reasonably assured.
SUBSTANTIAL
PERFORMANCE
Substantial performance occurs when the
franchisor has no remaining obligation to refund any cash received or excuse
any nonpayment of a note and has performed all the initial services required
under the contract. Commencement of operations by the franchisee shall be
presumed to be the earliest point at which substantial performance has
occurred, unless it can be demonstrated that substantial performance of all
obligations, including services rendered voluntarily, has occurred before that
time.
CONTINUING
FRANCHISE FEES
Continuing franchise fees are received in
return for the continuing rights granted by the franchise agreement and for
providing such services as management training, advertising and promotion,
legal assistance, and other support. Continuing fees should be reported as
revenue when they are earned and receivable from the franchisee, unless a
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 and provide a reasonable profit on the
continuing services.
BARGAIN
PURCHASES
In addition to paying continuing franchise
fees, franchisees 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
agreements, grants the franchisee 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 agreement 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
franchised outlet, or to purchase one that is in financial difficulty. If it is
probable at the time the option is given that the franchisor will ultimately
purchase the outlet, then the initial franchisee 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
COSTS
Franchise accounting also involved proper
accounting for the franchisor’s costs. 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 realizability. 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 commitments
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. Where possible, revenues and
costs related to franchisor-owned outlets should be distinguished from those
related to franchised outlets.
ILLUSTRATION
OF ENTRIES FOR INITIAL FRANCHISE FEE
Assume that Jollibee Inc. charges an
initial franchise fee of P5,000,000 for the right to operate a franchisee of
Jollibee. Of this amount, P1,000,000 is payable when the agreement is signed
and the balance is payable in five annual payments of P800,000 each. In return for the initial
franchise fee, the franchisor will help locate the site, negotiate the lease or
purchase of the site supervise the construction activity, and provide the
bookkeeping services. The credit rating of the franchisee indicates that money
can be borrowed at 24%.
1. If there is
reasonable expectation that the down payment may be refunded and if substantial
future services remain to be performed by Jollibee Inc., the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on
Notes Receivable 1,803,680
Unearned
Franchise Fee 3,196,320
2. If the
probability of refunding the initial franchise fee is extremely low, the amount
of future services to be provided to the franchisee is minimal, collectibility
of the note is reasonably assured, and substantial performance has occurred,
the entry should be:
Cash 1,000,000
Notes Receivable 5,000,000
Discount on
Notes Receivable 1,803,680
Revenue from
Franchise Fee 3,196,320
3. If the initial
down payment is not refundable, represents a fair measure of the services
already provided, with a significant amount of services still to be performed
by the franchisor in future periods, and collectibility of the note is
reasonably assured, the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on
Notes Receivable 1,803,680
Revenue from
Franchise Fee 1,000,000
Unearned
Franchise Fees 2,196,320
4. If the initial
down payment is not refundable and no future services are required by the
franchisor, but collection of the note is so uncertain that recognition of the
note as an asset is unwarranted, the entry should be:
Cash 1,000,000
Revenue from
Franchise Fees 1,000,000
5. Under the same
conditions as those listed under 4 except that the down payment is refundable
or substantial services are yet to be
performed, the entry should be:
Cash 1,000,000
Unearned
Franchise Fees 1,000,000
In cases 4 and
5, where collection of the note is extremely uncertain, cash collections may be
recognized using the installment method or the cost recovery method.
A. PROBLEMS
1.
Sapphire Inc. franchises its name to different enterprise throughout the
country. The franchise agreement requires the franchisee to make an initial
payment of P80,000 on the agreement date and the balance, covered by a P160,000
noninteresting – bearing note, in four equal annual payments beginning one year
from the agreement date. The franchisor agrees to make market studies, find a
location, train the employees, and perform a few other minor related services.
The initial payment is refundable until the date of opening. The following
describe the relationship with a newly appointed franchisee: (assume an
interest rate of 10%).
July 01,
‘8: Entered into franchise
agreement.
Aug.
15,‘8: Completed market study at
cost of P25,000.
Nov.
10,‘8: Found suitable location;
service cost, P10,000.
Jan. 10,
‘9: Completed training of employees;
cost, P35,000.
Jan. 15,
‘9: Franchise outlet is opened.
Required:
Give
the journal entries in 19-8 and 19-9 record the above transactions, including
any adjusting entry/entries at the 19-8 year-end.
2.
Jade Enterprises, a franchisor, charges new franchisees a “franchise fee” of
P500,000. Of this amount, P200,000 is payable at the time the agreement is
signed and the balance in P100,000 non- interest bearing notes due every year
thereafter. Jade agrees to assists in locating a suitable business site,
conduct a market study, supervise construction of facilities, and provide
initial training for employees.
Required:
Assuming
an implicit interest rate of 12%, prepare first year entries relating to each
of the following assumptions:
1.
Down payment is refundable, but no services
have been rendered so far; collection of notes is reasonably assured.
2.
Down payment is nonrefundable, and
substantial services, costing P250,000, have been performed; collections of
notes is certain.
3.
Down payment is nonrefundable, and
substantial services, costing P300,000 have been performed; collection of notes
is doubtful.
4.
Same as #3, except cost recovery method will
be used.
B. MULTIPLE CHOICE QUESTIONS
1.
On December 31, 2003, Chowqueen, Inc. authorized Mr. Chun to
operate as a franchisee for an initial franchise fee of P150,000. Of this
amount, P60,000 was received upon signing the agreement and the balance
represented by a note due in three annual payments of P30,000 each beginning December 31, 2004. The
present value on December
31, 2003, for three annual payment appropriately discounted is
P72,000. According to the agreement, the non- refundable down payment
represents a fair measure of the services already performed by Chowqueen and
substantial future services are still to be rendered. However, the
collectibility of the note is not reasonably assured. Chowqueen’s December 31, 2003, balance
sheet unearned franchise fee from Mr. Chun’s franchise should report as:
|
a. P132,000
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b. P100,000
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c. P - 0 -
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d. P72,000
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2.
On December 31, 2004, Shabu-Shabu Inc. signed an agreement
authorizing Alrene Company to operate as a franchise for an initial franchise
fee of P50,000. Of this amount, P20,000 was received upon signing of the
agreement and the balance is due in three annual payment of P10,000 each,
beginning December 31, 2005.
No future services are required to be performed. Alrene Company’s credit rating
is such that collection of the note is reasonably assured. The present value at
December 31, 8 of the three annual payments discounted at 14% (the implicit
rate for a loan of this type) is P23,220. On December 31, 2004, Shabu-Shabu should record
earned franchise fees of:
|
a. P23,220
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b. P43,220
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c. P30,000
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d. P 0
|
3.
On December 31, 2002, Da Girl Company signed an agreement to
operate as franchisee of Wendy’s for a franchise fee of P80,000. Of this
amount, P30,000 was paid upon signing of the agreement and the balance is
payable in five annual payments of P10,000 each beginning December 31, 2003. The present value
of the five payment, at an appropriate rate of interest, is P56,000 at December 31, 2002. The
agreement provides that the down payment is not refundable and no future
services are required of the franchisor. The collection of note receivable is
reasonably certain. Wendy’s Company should report unearned revenue from
franchise fee in its December
31, 1998 balance sheet at:
|
a.
P80,000
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b.
P30,000
|
c.
P66,000
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d.
P 0
|
4.
Each of the Yellowwich Pizza Company’s 21 new
franchisees contracted to pay an initial franchise fee of P30,000. By December 31, 2000, each
franchise had paid a nonrefundable P10,000 fee and signed a note to pay P10,000
principal plus the market rate of interest on December 31, 2001, and December 31, 2002. Experience
indicates that five franchisees will default on the additional payments. What
amount of earned franchise fees would Yellowwich Pizza Company report at December 31, 2000:
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a.
P400,000
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b.
P610,000
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c.
P600,000
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d.
P530,000
|
5.
Mel’s Pizza Hot, Inc. grants a franchise to
Mr. AA for an initial franchise fee of P1,000,000. The agreement provides that
Mel’s Pizza Hot, Inc. has the option within the one year to acquire
franchisee’s business and its seems certain that Pizza Hot, Inc. will exercise
the option. On Pizza Hot, Inc. books, how should the initial franchise fee be
recognized?
|
a. Deferred revenue and to be
amortized.
b. Realized revenue.
c. Extraordinary revenue.
d. Deferred revenue
and treated as a reduction from Pizza’s investment when the option is
exercise.
|
6.
On Dec. 29, 2005, FIESTA HAT signed a franchising agreement
for the operation of an outlet in Dagupan
City by Sombrero Co. The
franchising agreement required the franchisee, Sombrero Co., to make an initial
payment of P200,000 upon signing of the contract and three payments each of
P100,000 beginning one year from the agreement date and yearly thereafter. The
franchisor agrees to prepare market studies, find a suitable location, train
employees, and perform some other related services. The location, train
employees, and perform some other related services. The initial payment is
refundable until substantial performance is effected. In 2005, FIESTA HAT
should report franchise fee revenue of:
|
a.
P-0-
|
b.
P200,000
|
c.
P125,000
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d.
P500,000
|
7.
Jollibee, franchisor, entered into a
franchising agreement with Jo Levy, franchisee, on October 31, 2003. The total franchise
fee is P500,000, of which P100,000 is payable upon signing of the agreement
with the balance payable in four equal annual installments. The down payment is
refundable in the event the franchisor fails to render stipulated services and,
thus far, none has been performed. When Jollibee prepares its October 31, 2003 financial
statements, the franchise fee revenue to be reported is:
|
a.
- 0 -
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b.
P400,000
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c.
P100,000
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d.
P500,000
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8.
The franchise agreement between Jolly-R and
Mr. Chris which was signed at the beginning of the year required a P500,000
franchise fee payable P100,000 upon signing of the franchise and the balance in
four annual installments starting the end of the current year. At the time of
the granting of the franchise, the present value using 12% as discount rate of
the four installments would approximate P199,650. The fees once paid are not
refundable. The franchise may be cancelled subject to the provisions of the
agreement. Should there be unpaid franchise fee attributed to the balance of
main fee (P500,000), same would become due and demanable upon cancellation.
Further, the franchisor is entitled to a 5% fee on gross sale payable monthly
within the first ten days of the following month. The Credit Investigation
Bureau rated Mr. Chris as AAA credit rating. Further the balance of the
franchise fee was guaranteed by a commercial bank. The first year of operations yielded gross
sales of P9 million. As of the signing of the franchise agreement, Jolly-R’s
unearned franchise fee amounted to
|
a. P649,650
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b.
P400,000
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c.
zero
|
d.
P199,650
|
9.
Croley Snack granted a franchise to Eat N Eat
for the Ortigas area. Eat N Eat was to pay franchise fee of P100,000 payable in
five equal annual installments starting with the payment upon signing of the
agreement. The franchise was to pay monthly 1% of gross sales of the preceding
month. Should the operations of the outlet prove to be unprofitable, the
franchise may be cancelled with whatever obligations owing Croley Snack in
connection with the P100,000 franchise fee waived. The first year generated a
gross sales of P500,000. Croley Snack earned franchise fee for the first year
amounted to
|
a. P5,000
|
b.
P25,000
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c.
P105,000
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d.
P20,000
|
10.
Kitchenics Inc. awarded its franchise to
Wings Co. in Cebu for a total fee of P100,000.
Of said amount, P50,000 was payable upon the signing of the franchise agreement
and the balance, payable in two annual payments of P25,000 each. Kitchenics had
been very successful in Metro Manila with 100 franchisees but Cebu
was the first outside Metro Manila. Kitchenics’ agreement with Wings provided
that in the event the first year of operations would result to an operating
loss, the franchising agreement may be cancelled without need of returning any
portion of paid franchise fee and there would be no need to pay any balance of
the unpaid franchise fee. The entry to
record the granting of the franchise to Wings was
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a.
|
Cash
|
P50,000
|
|
|
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Notes receivable
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50,000
|
|
|
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Unearned franchise fee
|
|
P100,000
|
|
|
|
|
|
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b.
|
Cash
|
50,000
|
|
|
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Notes receivable
|
50,000
|
|
|
|
Revenue from franchise fee
|
|
50,000
|
|
|
Unearned franchise fee
|
|
50,000
|
|
|
|
|
|
|
c.
|
No entry
|
|
|
|
|
|
|
|
|
d.
|
Cash
|
50,000
|
|
|
|
Notes receivable
|
50,000
|
|
|
|
Revenue from franchise fee
|
|
100,000
|
11.
On December 31, 2004, Mc Dowell Inc. signed an agreement
authorizing MN Co. to operate as a franchise for an initial franchise fee of
P50,000. Of this amount, P20,000 was received upon signing of the agreement and
the balance is due in 3 equals annual payments beginning December 31, 2005. The agreement
provides that the down payment (representing a fair measure of services already
performed by Mc Dowell) is not refundable and no substantial future services
are required to be performed. MN Co.’s credit rating is such that collection of
the note is reasonably assured. The implicit interest rate on this type of loan
is 14%. On December 31,
2004, Mc Dowell should record unearned franchise fees of
|
a. P23,220
|
b.
P42,220
|
c.
P30,000
|
d.
-- 0 --
|
12.
Coney Island Inc. sells franchises for ice
cream outlets in Metro Manila. One contract has been signed on January 15,1999. The
agreement calls for an initial franchise fee of P6,000,000 to be paid by the
franchise upon signing of the contract. The franchisor initial cost of services
is P2,250,000 to be incurred uniformly over the 6 month period / prior to the
scheduled opening date of July
15, 2000. No return payments are to be made by the franchisor,
although there will be continuing costs of P180,000 per year for services
rendered during the 10 year term of contract. The normal return for the
franchisor on continuing operation involving franchise outlets is 10%. How much
net income would be recognized by the franchisor on July 15, 2000?
|
a. P3,750,000
|
b.
P6,000,000
|
c.
P5,750,000
|
d.
P1,750,000
|
13.
On January 1, 2003 Dokito Inc. authorized Mr. T to operate as
franchise for an initial franchise fee of P150,000. Of this amount, P60,000 was
received upon signing the agreement and the balance, represented by a note, is
due in a 3 annual payments of P30,000 each beginning December 31, 2003. The present value
on January 1, 2003,
for three annual payments appropriately discounted is P72,000. According to the
agreement, the non-refundable down payment represents a fair measure services
already performed by Dokito and substantial future services are still to be
rendered. However, collectibility of the note is reasonably certain. Dokito’s December 31, 2003 balance
sheet, unearned franchise fees from Mr. X franchise should be reported as
|
a. P132,000
|
b.
-- 0 --
|
c.
P100,000
|
d.
P72,000
|
14.
Each of Potter Pie Co’s. 21 new franchisees
contracted to pay an initial franchise fee of P30,000. By December 31,2001, each franchise had
paid a non- refundable P10,000 fee and signed a note to pay P10,000 principal
plus the market rate of interest on December 31, 2002 and 2003. Experience indicates that one
franchise will default on the additional payments. Services for the initial fee
will be performed in 2001. What amount of net unearned franchise fees would
Potter report at Dec. 31,
2000?
|
a. P400,000
|
b. P600,000
|
c. P610,000
|
d. P630,000
|
15.
PIZZA HOT, franchisor, entered into a
franchising agreement with Jo Levy, franchisee, on October 31, 2000. The total franchise
fee is P500,000, of which P100,000 is payable upon signing of the agreement
with the balance payable in four equal annual installments. The down payment is
refundable in the event the franchisor fails to render stipulated services and,
thus far, none has been performed. When PIZZA HOT prepares its Oct. 31, 2000 financial
statements, the franchise fee revenue to be reported is:
|
a. -- 0 --
|
b.
P400,000
|
c.
P100,000
|
d.
P500,000
|
16. At the
beginning of the year, Zita Eat Haus got the franchise of Max, a known steak
house of upscale patronage. The franchise agreement required a P500,000
franchise fee payable P100,000 upon signing of the franchise and the balance in
four annual installments starting the end of the current year. At present value
using 12% as discount rate, the four installments would approximate P303,735.
The fees once paid are not refundable. The franchise may be canceled subject to
the provisions of the agreement. Should there be unpaid franchise fee
attributed to the balance of main fee (P500,000), the same would become due and
demandable upon cancellation. Further, the franchiser is entitled to a 5% fee
on gross sales payable monthly within the first ten days of the following
month. The Credit Investigation Bureau rated Zita as AAA credit rating. The
balance of the franchise fee was guaranteed by a commercial bank. The first
year of operations yielded gross sales of P9 million. Max’s earned franchise
fees from Zita for the first year of operation, amounted:
a. P950,000 b. P853,735 c.
P500,000 d. P403,735
17.
Domino Pizza grants a franchise to KM
for an initial fee of P1,000,000. The agreement provides that Domino has the
option within one year to acquire franchisee business, and it seems certain
that Domino will exercise this option. On Domino’s books, how should the
initial fee be recorded?
|
a.
|
realized revenue
|
|
b.
|
extraordinary
revenue
|
|
c.
|
deferred revenue
to be amortized.
|
|
d.
|
deferred and
treated as reduction in Domino’s investment.
|
18. Year-Round Golf sells franchises for indoor
golf driving ranges and putting greens. For each franchise, the company charges
a non-refundable initial franchise fee of P400,000. The franchise agreement
requires a down payment of P100,000, with balance covered by the issuance of a
P300,000, 10% note, payable by the franchisee at the end of 5 years. Interest
does not begin to accrue until the franchise opens, and first interest payment
is required 12 months after the franchise opens. The company only sells to
qualified buyers so the collectibility of the note is always reasonably
assured. The services required for the initial franchise fee are completed 6
months after the agreement is signed. How much franchise revenue earned must be
recognized upon signing of the agreement by Year-Round?
a.
P400,000 b. P100,000 c. P286,276 d. P0
