Franchise Accounting

UNIVERSITY OF THE EAST CM RECTO, Manila

AC408 - ADVANCED ACCOUNTING

PROF. ROEL E.

HERMOSILLA

FRANCHISE ACCOUNTING

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, collectability of the note is reasonably assured, and substantial performance has occurred, the entry should be: Cash 1,000,000 Notes Receivable 4,000,000 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 collectability 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. ILLUSTRATIVE 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. July 01, ‘8:

Cash Notes receivable Discount on notes receivable

80,000 160,000

33,200

Franchise Accounting

Page 2 Deposit on franchise or Unearned Franchise Fees P80,000 + (P40,000 x 3.17)

206,800

Aug. 15, ‘8:

Deferred franchise costs Cash

25,000

Nov. 10, ‘8:

Deferred franchise costs Cash

10,000

Dec. 31, ‘8:

Discount on notes receivable Interest revenue (40,000 x 3.17)

6,340

Jan. 10, ‘9:

Deferred franchise costs Cash

35,000

Deposit on franchise Franchise revenue

206,800

Franchise costs Deferred franchise costs

70,000

July 1, ‘9

Cash Notes receivable

40,000

Dec. 31, ‘9

Discount on notes receivable Interest income

11,314

Jan. 15, ‘9:

25,000 10,000 6,340 35,000 206,800 70,000 40,000 11,314

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. Case 1: Deposit Method Cash 200,000 Note receivable 300,000 Discount on notes receivable 59,800 Deposit on franchise 440,200 Case 2:

Case 3:

Full Accrual Method Cash Notes receivable Discount on notes receivable Deposit on franchise

200,000 300,000 59,800 440,200

Deferred franchise costs Cash

250,000

Cost of franchise fee revenue Deposit on franchise Deferred franchise costs Franchise fee revenue

250,000 440,200

Installment Method Cash Notes receivable Discount on notes receivable Deposit on franchise Deferred on franchise Cash Deposit on franchise Deferred franchise costs Deferred gross profit on

250,000

250,000 440,200 200,000 300,000 59,800 440,200 300,000 440,200

300,000 300,000 140,200

Franchise Accounting franchise Deferred gross profit on franchise Realized gross profit on franchise Case 4:

Page 3 63,700 63,700

Cost Recovery Method First 3 entries in case 3 are also the entries in this method. However, since cash received (P200,000) is less than the costs incurred (P300,000), no profit will be realized in this period.

PROBLEMS I. On January 1, 2009, RCute Company signed an agreement to operate as a franchisee of Perfect Pizza, Inc. for an initial franchise fee of P1,600,000 for a period of ten (10) years. Of this amount P600,000 was paid when the agreement was signed and the balance payable in five annual payments of P200,000 beginning December 31, 2009. RCute signed a non interest- bearing note for the balance. RCute’s rating indicates that it can borrow money at 20% for a loan of this type. In return for the initial fee, the franchisor agrees to make market studies, find a location, train the employees, and perform other related services. The following transactions describe the relationship with Perfect Pizza, a franchisee: 2009

Jan. 1: April 1:

Entered into a franchise agreement. Completed a market study at a cost of P59,436. Indirect cost of services (general expenses), P5,000. May 15: Found suitable location. Service cost of P280,000. Nov. 15: Completed training program for employees, cost P20,000. Dec. 20; Franchise outlet opened and business operations started. Dec. 31: Received the first annual payment. Required: Prepare all entries on the books of franchisor for 2009, assuming: 1. The collection of the note is reasonably assured. 2. The collection of the note is not reasonably assured. II. On January 1, 2009, Turquoise Corporation sold a franchise to Mr. D for P10,000,000 for rights to operate as a franchise of Turquoise Corporation. Terms of the franchise contract are: a. The initial franchise fee of P1,000,000 is payable in cash, when the contract is signed and the balance in five equal instalment every December 31, evidenced by a 12% promissory note. b. The franchisor will assist in locating the site, supervise construction activity and training of management and employees. On December 31, 2009, direct costs of services rendered to the franchisee amounted to P2,000,000. Required: Assuming that there is a substantial performance of services required in the contract and the initial down payment is not refundable to the franchisee, prepare journal entries for 2009 in the books of the franchisor, if: 1. The collectability of the note is reasonably assured. 2. The collectability of the note is not reasonably assured. III. On September 1. 2009, Ochie Company entered into franchise agreements with three franchisees. The agreement required an initial fee payment of P70,000 plus four (4) P30,000 payments due every 4 months, the first payment due December 31, 2009. The interest rate is 12%. The initial deposit is refundable until substantial performance has been completed. The following table describes each agreement. Services performed Total cost Probability by Franchiser at Incurred to Franchisee Full collection December 31, 2009 December 31, 2009 A Likely Substantially P 70,000 B Doubtful 25% 20,000 C Doubtful Substantially 100,000 For each franchisee, identify the revenue recognition method that you would recommend considering the circumstances. Prepare the journal entries on the books of Ochie Company to account the franchise. Assume P100,000 was received from each franchisee during the year. IV. On January 1, 2008, Phil. Foods signed an agreement to operate as a franchisee of Snack International for an initial franchise fee of P50,000. The amount of P20,000 when the agreement was signed, and the balance is payable in five annual payments of P6,000 each beginning January 1, 2009. The agreement provides that the down payment is not refundable and that no future services are required of the franchiser. Phil. Foods’ credit rating indicates that the company can borrow money at 11% for a loan of this type. Instructions: a. How much should Snack International record as revenue from franchise fees on Jan. 1, 2008? At what amount should Phil. Foods record the acquisition cost of the franchise on Jan. 1, 2008?

Franchise Accounting Page 4 b. What entry should be made by Snack International on January 1, 2008, if the down payment is refundable and substantial future services remain to be performed by Snack International? c. How much revenue from franchise fees would be recorded by Snack on January 1, 2008, if: 1. The initial down payment is not refundable, it represents a fair measure of the services already provided, a significant amount of services is still to be performed by Snack International in future periods, and collectibility of the note is reasonably assured? 2. The initial down payment is not refundable and no future services are required by the franchiser, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted? 3. The initial down payment has not been earned and collection of the note is so uncertain that recognition of the note as an asset is unwarranted? MULTIPLE CHOICE 1. On December 31, 2008, 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, 2009. The present value on December 31, 2008, 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, 2008, 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, 2009, 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, 2010. 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, 2009, Shabu-Shabu should record earned franchise fees of: a. P23,220 b. P43,220 c. P30,000 d. P 0

3. On December 31, 2012, 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, 2013. The present value of the five payment, at an appropriate rate of interest, is P56,000 at December 31, 2012. 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, 2008 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, 2010, 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, 2011, and December 31, 2012. 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, 2010: 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, 2009, 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 2009, FIESTA HAT should report franchise fee revenue of: a. P-0b. P200,000 c. P125,000 d. P500,000

Franchise Accounting

Page 5

7. Jollibee, franchisor, entered into a franchising agreement with Jo Levy, franchisee, on October 31, 2009. 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, 2009 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 b .

P100,000

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

/reh

100,000