BSA 3101 Accounting for Special Transactions Franchise Accounting

Module 3C – Franchise Accounting

Accounting for franchise sales was chosen because of its popularity, complexity, and applicability to many of
the previously discussed revenue recognition bases. In accounting for franchise sales, the accountant must
analyze the transaction and considering all the circumstances, must use judgment in selecting and applying
one or more of the revenue recognition bases and then possibly, monitor the situation over a long period of
time. Also discussed in this module is the application of PFRS 15.

When one party (franchisor) grants business rights to operate a franchised business to another party
(franchisee), questions arise concerning the accounting status of the initial consideration paid or promised
upon the initiation of the contract. These questions are prompted by uncertainties relating to the collectability of
receivables from the franchisee and the cost of performance or ability to perform required services on the part
of the franchisor. A great deal of professional judgment is required in making such determinations. Although
promulgated standards on this topic provide broad guidelines the general criteria for revenue recognition
govern the accountant's actions in specific cases.

Franchise Accounting

A franchise agreement involves the granting of business fights by the franchisor to a franchisee that will
operate the franchise outlet in certain geographical area or location. Four types of franchising arrangements
have evolved:
• Manufacturer-retailer
• Manufacturer-wholesaler
• Service sponsor-retailer
• Wholesaler-retailer

The fastest growing category of franchising, and the one that caused a reexamination of appropriate
accounting, has been the third category, service sponsor-retailer. Included in this category are: Fastfoods
(McDonald's, Jollibee, Chowking, and Kentucky Fried Chicken); and Hotels (Holiday Inn, Dusit Hotel,
SOFITEL)

In franchise arrangements, the franchisor, such as Jollibee and Chowking grants to the franchisee, quite often
an individual, a right to sell the franchisor's products and use its name for a specified period of time. The
franchisor also typically provides initial start-up services (such as identifying locations, remodeling or
constructing facilities, selling equipment and providing training to the franchisee) as well as providing ongoing
products and services (such as franchise- branded products and advertising and administrative services). So, a
franchise involves a license to use the franchisor's intellectual property, but also involves initial sales of
products and services as well as ongoing sales of products and services. The franchisor must evaluate each
part of the franchise arrangement to identify the performance obligations.

Franchise agreements vary but usually involve an initial payment (called an initial franchise fee) by the
franchisee and ongoing payments of continuing franchise fees. For the initial franchise fee, the franchisor (the
party who grants business rights under the franchise) normally provides the franchisee (the party who operates
the franchised business) with the following services:
1. Assistance in site selection
a. Analyzing location
b. Negotiating lease
2. Evaluation of 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. Provision of 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. Provision of employee and management training
7. Provision of quality control

Sources: Dayag, A. (2018, 2021) Advanced Financial Accounting, Millennium Books, Inc.
Guerrero, P. P. (2017) Advanced Accounting: Principles and Procedural Approach, Volume 1. Manila: GIC Enterprise
BSA 3101 Accounting for Special Transactions Franchise Accounting

PFRS 15 on Franchise Arrangements identifies two sources of revenue:

• Sale of initial franchises and related assets or services, and
• Continuing fees based on the operations of franchises.

Performance obligations relate to:

• Right to open a business.
• Use of trade name or other intellectual property of the franchisor.
• Continuing services, such as marketing help, training, and in some cases supplying inventory and
inventory management.

Franchise Fees

Franchise agreement usually requires the franchisee to make payments, called the franchise fee to the
franchisor in consideration for the reputation, skill, products, and services contributed by the franchisor. There
are two types of franchise fees, namely:

1. Initial Franchise Fee. This represents initial payment for establishing the franchise agreement, and for
providing certain initial services associated with the agreement. The initial franchise fee may be payable
immediately in cash or for an extended period of time.

2. Continuing Franchise Fee. This represent continued payment to the franchisor for providing specific future
services, such as advertising, and for the continued use of intangible rights by the franchisee. These fees are
usually based on the operations of franchises.

Revenue Recognition – Initial Franchise Fees

A company recognizes revenue in the accounting period when a performance obligation is satisfied – same
rules and procedures under IFRS 15.

A key element of the revenue recognition principle is that a company recognizes revenue to depict the transfer
of goods or services to customers in an amount that reflects the consideration that it receives, or expects to
receive, in exchange for those goods or services.

Collectability of the note does not affect revenue recognition under IFRS 15. Therefore, installment method in
recognizing revenue is not applicable anymore.

All expenditures to perform franchise obligations, direct or indirect, are expensed as incurred.

Revenue Recognition – 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, quality control, budgeting
and other accounting services, legal assistance, building maintenance and other support.

Continuing franchise fees (royalty fee) should be reported as revenue when the performance obligations
related to those fees have been satisfied by the franchisor. These revenues are generally recognized over time
as the related product and services are provided or transferred to the franchisee during the franchise period.

A royalty fee (continuing franchise fee) is not a performance obligation but part of the transaction price (a
payment mechanism). Since the royalty payment depends on future sales amounts, it represents as a variable
consideration and is recognized overtime. Continuing product sales would be accounted for in the same
manner as would any other product sales.

Continuing franchise fees are recognized as revenue when actually earned and receivable from the franchisee,
unless a portion of them as been designated for a particular purpose, such as providing a specified amount for
building maintenance or local advertising. The required entry is as follows:
Cash/ Accounts Receivable xx
Revenue from CFF xx
Unearned revenue from CFF(portion not yet satisfied) xx

Sources: Dayag, A. (2018, 2021) Advanced Financial Accounting, Millennium Books, Inc.
Guerrero, P. P. (2017) Advanced Accounting: Principles and Procedural Approach, Volume 1. Manila: GIC Enterprise
BSA 3101 Accounting for Special Transactions Franchise Accounting

All direct and indirect costs related to continuing franchise fees are recognized as expense by the following
entry:
Franchise expense xx
Cash, etc. xx

Continuing Sale of Supplies

As part of the continuing services provided in the franchise contract, franchisor usually sells supplies to the
franchisee. These sales are necessary to maintain uniformity in the quality of the supplies used by all of the
franchisees. The sale is recorded in the usual manner.

Commingled Revenue/Tangible Assets Included in the Franchise Fee

Besides the initial services of the franchisor, the initial franchise fee may include the sale of specific tangible
property, such as inventory, signs, equipment, or real property. Thus, a portion of the initial franchise fee must
be allocated to such tangible property at its fair market value. The fair value of the tangible property is
recognized as revenue when title to such property passes to the franchisee, even though substantial
performance has not occurred for other services included in the franchise agreement.

Illustration
Sweet, Inc. charges P90,000 for a franchise, with P18,000 paid when the agreement is signed and the balance
in four annual payments. The present value of the annual payments, discounted at 9%, is P58,315. The
franchisee has the right to purchase P20,000 of equipment for P16,000. If the collectability of the payments is
reasonably assured and substantial performance by Sweet. Inc. has occurred, the entries to record the above
transactions are as follows:
Cash 18,000
Notes receivable 72,000
Unearned interest income 13,685
Franchise revenue(18,000+58,315-4,000) 72,315
Unearned franchise revenue – equipment sale 4,000

All the criteria to recognize initial franchise fee as revenue was met, except that an amount of equivalent to
indicated reasonable profit (P20,000, selling price less P16,000 option price) will be deferred. When the
franchisee subsequently purchases the equipment, the entries are as follows:
Cash/Accounts receivable 16,000
Unearned franchise revenue – equipment sale 4,000
Franchise revenue 20,000

Cost of franchise – equipment sale 16,000

Equipment inventory 16,000

Repossessed Franchise

Franchisors occasionally have the right to repossessed franchises. When a franchisee decides not to open an
outlet or there are violations of the franchise contract, which warrant its cancellation, the franchisor may
recover franchise rights through repossession. In such cases, previously recognized revenue would have to be
canceled against the period of repossession's franchise revenue if the franchise fee is refunded. If no refund is
made upon repossession, the franchisor would make adjustments to any uncollectible receivables, eliminate
deferred revenues, and recognize any revenue on any retained, but not previously recognized, consideration.

Illustration
On April 1, 20x4, Weston. Inc. entered into a franchise agreement with a local businessman. The franchisee
paid P240,000 and gave a P160,000, 8%, 3-year note payable with interest due annually on March 31.
Weston, Inc. recorded the P400,000 initial franchise fee as revenue on April 1, 20x4. On December 31, 20x4,
the franchisee decided not to open an outlet under Weston's name. Weston, Inc. canceled the franchisee's
note and refunded P128,000, less accrued interest on the note, of the P240,000 paid on April 1. The entries
during 20x4 are as follows:

Sources: Dayag, A. (2018, 2021) Advanced Financial Accounting, Millennium Books, Inc.
Guerrero, P. P. (2017) Advanced Accounting: Principles and Procedural Approach, Volume 1. Manila: GIC Enterprise
BSA 3101 Accounting for Special Transactions Franchise Accounting

April 1, 20x4
Cash 240,000
Notes receivable 160,000
Franchise revenue 400,000

December 31, 20x4

Franchise revenue 400,000
Interest income (160,000*8%*9/12) 9,600
Cash (128,000-9,600) 118,400
Notes receivable 160,000
Gain on revenue from repossessed franchise 112,000

Option to Purchase

Franchise agreement may include a provision to the effect that the franchisor has an option to purchase the
franchise business. If the option is granted at the time the franchise is signed and it is probable at that time that
the option will be exercised, the initial franchise is to be deferred. When the option is exercised and the
franchisor acquires the franchise business, the deferred revenue from the initial franchise is treated as a
reduction from the franchisor's investment.

Illustration
Joey's Pancake Restaurants Inc. sells franchises for an initial fee of P360,000. The initial fee covers site
selection, training, computer and accounting software, and on-site consulting and troubleshooting, as needed,
over the first five years. On March 15, 20x4, Tim Cruise signed a franchise contract, paying the standard
P60,000 down with the balance due over 5 years with interest.

Assume at March 15, 20x4, the time of signing the contract, collectability of the receivable was reasonably
assured and there were no significant continuing obligations. The agreement that Joey has the option to
purchase within five years to acquire franchisee's business and it seems certain that Joey's Pancake
Restaurants Inc. will exercise the option. The journal entry on March 15. 20x4, date of signing would include:
Cash 60,000
Notes receivable 300,000
Deferred franchise purchase option liability 360,000

Despite no significant continuing obligations to be performed, the refund period already expired and the
collectability of the note is reasonably assured, but there is an option to purchase the outlet and it is certain to
be exercised, any franchise fee is recognized as liability. Few years after Joey's Pancake Restaurants Inc.
rendered services to the franchisee amounting to P240,000, the journal entry would be:
Expense 240,000
Cash, etc. 240,000

When the option is exercised after five years and acquires the franchise outlet by paying P70,000, the journal
entry would be:
Deferred franchise purchase option liability 360,000
Cash, etc. 70,000
Gain – option to exercise to purchase outlet 290,000

Sources: Dayag, A. (2018, 2021) Advanced Financial Accounting, Millennium Books, Inc.
Guerrero, P. P. (2017) Advanced Accounting: Principles and Procedural Approach, Volume 1. Manila: GIC Enterprise