FRANCHISE ACCOUNTING

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

b. P100,000

c. P  - 0 -

d. P72,000

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

b.  P43,220

c.  P30,000

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

b.  P30,000

c.  P66,000

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:

a.  P400,000

b.  P610,000

c.  P600,000

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

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 -

b.  P400,000

c.  P100,000

d.  P500,000

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

b.  P400,000

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

c.  P105,000

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

a.	Cash	P50,000
	Notes receivable	50,000
	Unearned franchise fee		P100,000
b.	Cash	50,000
	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