Accounting for Special Transactions (ACG017)

Franchise Accounting

Franchising is a means of distributing goods or services. Today we find a growing number of

franchising arrangement such as the service sponsor-retailer arrangement.

Included in this category are such industries and businesses as:

Ice Cream (Coney Island, Dairy Queen, Dreyers)

Food Drive Ins (McDonald’s, Kentucky Fried Chicken, and Jollibee)
Restaurants (Pizza Hut, and Shakeys)
Others (Seven-Eleven Stores)

A franchise generally involves the grant from one party (franchisor) to another party (franchisee), the right
to sell the granting party’s goods or services. Each party contributes resources.

The Franchisor, contributes his trade name, products, company’s reputation and trademarks. He also
imparts his expertise and on continuing basis provides guidance and duties on the manner in which the
franchise must operate his establishment.

The Franchisee. On the other hand, provides operating capital and managerial operational resources
required for the operation of the franchise business.

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 provided by the
franchisor.

There are two types of franchise fees, namely:

1. Initial Franchise Fee – This represents initial franchise payment for establishing the franchise
agreement, and for providing certain initial services associated with the agreement.

The initial services rendered by the franchisor prior to the opening of the franchisee’s operations
usually include the following:

a. Assistance in site selection for the construction of the building.

b. Supervision of the construction activity, which involves obtaining financing, designing building,
and supervising contractor.
c. Assistance in the acquisition of signs, fixtures and equipment.
d. Provision of bookkeeping and advisory services.
e. Provision of employee and management training.
f. Provision of quality control
g. Provision of advertising and promotion.

2. Continuing Franchise Fee – This represents continuous 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.

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The following accounting principle and procedures are to be used in the recognition of revenue from the
initial franchise fee:

1. Revenue from the initial franchise fee should be recognized on the consummation of the transaction, which
occurs when all material services or conditions of the sale have been substantially performed. Substantial
performance by the franchisor occurs when the following conditions are met:
a. The franchisor is not obligated in any way (trade practice, law, intent, or agreement) to refund cash
already received. (Non Refundable)
b. The initial services required have been substantially performed.
c. Collectability (Applicable only to Notes Receivable)
(Accrual Method) A. Assured – Earned Franchise Revenue
(Installment Method) B. Not Assured – Unearned Franchise Revenue

* Interest Bearing – Initial Franchise Fee

= Down payment + Principal amount of the note)

* Non Interest Bearing – Initial Franchise Fee

= (Down payment + Present Value of the month)

FRANCHISE COST

1. Direct Franchise Cost – Lessen the Franchise Fee

2. Indirect Franchise Cost – Part of operating expenses

Computation for Realized Gross Profit

1) Interest Bearing
* Reasonably Assured (Accrual Method)

Initial Franchise Fee (Down payment +

Principal ) Less: Direct Franchise Cost
Illustration:
Realized Gross Profit 2) Non Interest Bearing
* Reasonably Assured (Accrual Method)
* Not Reasonably Assured (Installment
Sales Method)
Initial Franchise Fee (Down payment + PV of the
Note) Less: Direct Franchise Cost
Collection (Down payment + Any
installment collection)
x GP rate (Deferred GP / Initial Franchised Fee) Realized Gross Profit

* Not Reasonably Assured (Installment Sales Method)

Realized Gross Profit Collection (Down payment + Any installment

collection - Interest Income)
x GP rate (Deferred GP / Initial Franchised Fee)

Realized Gross Profit

Jan. 05, 2016 McDo, Inc. granted a franchise to Mr. A. De, Jesus to sell McDO products. The
Initial franchise fee (IFF) is P 10,000,000.

Feb. to Nov. – McDo, Inc. rendered the following initial services under the franchise
contract: Direct costs of initial services – P 2,000,000
Indirect costs of services - 50,000
December 1 – Rhe franchisee, Mr. A. De Jesus started business operations.

Case 1: The initial franchise fee is paid in full when the agreement is signed on July 02, 2016. The
following entries would be made by the franchisor during the year 2016:

Jan. 02, 2016 Cash 10,000,000

Deferred Revenue from IFF 10,000,000
*To record the receipt of the IFF

Feb. to Nov. Deferred Cost of Franchise Revenue 2,000,000

Franchise Expenses 50,000
Cash 2,050,000
* To record the payment of franchise costs.

December 31 Adjusting Entries:

Cost of Franchise Revenue 2,000,000
Deferred Cost of Franchise Revenue 2,000,000
*To adjust cost of Franchise Revenue

Deferred Revenue from IFF 10,000,000

Revenue from IFF 10,000,000
*To recognize fully as revenue the initial franchise fee.

Case 2: The initial franchise fee is payable as follows: P 1,000,000 cash when the contract is signed and
the balance in five annual installments payable every year December 31, evidenced by a 12 percent
promissory note. As discussed earlier, two methods can be used to record franchise operations if the
initial franchise fee is payable for an extended period of time. These methods are discussed below:

Method 1: Accrual Method. This method is used when the collectability of the note is reasonable
assured. Under this methods, the initial franchise fee is fully recognized as revenue. The required
entries are:

Jan. 02, 2016 Cash 1,000,000

Notes Receivable 9,000,000
Deferred Revenue from IFF 10,000,000
*To record the receipt of the IFF

Feb. to Nov. Deferred Cost of Franchise Revenue 2,000,000

Franchise Expenses 50,000
Cash 2,050,000
* To record the payment of franchise costs.

December 31 Cash 2,880,000

Notes Receivable 1,800,000
Interest Income (9,000,000 x 12%) 1,080,000
*To record collection of the first installment.

Adjusting Entries:
Cost of Franchise Revenue 2,000,000
Deferred Cost of Franchise Revenue 2,000,000
*To adjust cost of Franchise Revenue

Deferred Revenue from IFF 1,000,000

Revenue from IFF 10,000,000
*To recognize fully the initial franchise fee as revenue on December 31, since the
collectability of the note is reasonably assured.
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Case 2 (Accrual Method) - The Statement of Comprehensive Income of the franchisor for the year
ended December 31, 2016 will now appear as follows:

Revenue from Franchise Fee 10,000,000 Cost of Franchise Revenue

(2,000,000) Gross Profit 8,000,000 Expenses (50,000)
Operating Income 7,050,000 Interest Income 1,080,000
Net Income 8,130,000

Method 2: Installment Method. This method is used when the collectability of the note is not reasonably
assured. Under this method, revenue from the initial franchise fee is recognized in proportion to cash
collections. The revenue from the initial franchise fee is determined by multiplying the collections during
the year by the gross profit rate.

The pertinent entries are as follows:

Jan. 02, 2016 Cash 1,000,000

Notes Receivable 9,000,000
Deferred Revenue from IFF 10,000,000
*To record the receipt of the IFF

Feb. to Nov. Deferred Cost of Franchise Revenue 2,000,000

Franchise Expenses 50,000
Cash 2,050,000
* To record the payment of franchise costs.

December 31 Cash 2,880,000

Notes Receivable 1,800,000
Interest Income (9,000,000 x 12%) 1,080,000
*To record collection of the first installment.

Adjusting Entries:
Cost of Franchise Revenue 2,000,000
Deferred Cost of Franchise Revenue 2,000,000
*To adjust cost of Franchise Revenue

Deferred Revenue from IFF 1,000,000

Cost of franchise revenue 2,000,000
Deferred Gross Profit from IFF 8,000,000
*To set up deferred gross profit from franchise fee

Deferred Gross Profit from IFF 2,240,000

Realized Gross Profit from IFF 2,240,000
*To record realized Gross Profit
Computation:
Collections, excluding interest:
Down payment 1,000,000
First Installment 1,800,000 2,800,000 Gross Profit rate (P
8,000,000 / P 10,000,000) 80% Realized Gross Profit from IFF
2,240,000
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Case 2 (Installment Method) - The Statement of Comprehensive Income of the franchisor for the
year ended December 31, 2016 will now appear as follows:

Revenue from Franchise Fee 10,000,000

Cost of Franchise Revenue (2,000,000)
Deferred Gross Profit 8,000,000
Deferred Gross Profit, end (5,760,000)
Realized Gross Profit 2,240,000
Expenses (50,000)
Operating Income 2,190,000
Interest Income 1,080,000
Net Income 3,270,000

Case 3: The initial franchise fee is payable as follows: cash of P 1,000,000 upon signing of the contract
and the balance in five equal installments every December 31, evidenced by a non-interest bearing note.

Credit investigation indicates that the franchisee can borrow money at 12% and the present value of
an ordinary annuity of 1 (PV of OA) for 5 periods is 3.6048. Thus the present value of five payments
of P 1,800,000 would be P 6,448,640 (P 1,800,000 x 3.6048).

Assuming that the collectability of the note is not reasonably assured, using the installment method
of revenue recognition, the required entries in the book of the franchisor during 2016 are:

Jan. 02, 2016 Cash 1,000,000 Notes Receivable 9,000,000

Unearned Interest Income 2,511,360
Deferred Revenue from IFF 7,488,640
*To record the receipt of the IFF

Computations:
Face Value of the Note 9,000,000
Present Value of the Note (6,488,640)
Unearned Interest Income 2,511,360

Down payment 1,000,000

Present value of the note 6,488,640
Adjusted sales value of franchise 4,788,640

Feb. to Nov. Deferred Cost of Franchise Revenue 2,000,000 Franchise Expenses

50,000
Cash 2,050,000
* To record the payment of franchise costs.

December 31 Cash 1,800,000 Notes Receivable 1,800,000

*To record collection of the first installment.
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Adjusting Entries:
Unearned Interest Income 778,637
Interest Income 778,637 *To adjust interest income for 2016 (6,488,640 x 12%)

Cost of Franchise Revenue 2,000,000

Deferred Cost of Franchise Revenue 2,000,000 *To adjust cost of Franchise Revenue

Deferred Revenue from IFF 7,488,640

Cost of franchise revenue 2,000,000 Deferred Gross Profit from IFF 5,488,640 *To set up
deferred gross profit from franchise fee
Gross Profit rate (5,488,640 x 7,488,640) = 73.29%

Deferred Gross Profit from IFF 1,481,147

Realized Gross Profit from IFF 1,481,147 *To record realized Gross Profit
Computation:
Collections, excluding interest:
Down payment 1,000,000
First Installment (1,800,000-778,637) 1,021,363 2,021,363 Gross Profit rate (P 8,000,000 /
P 10,000,000) 73% Realized Gross Profit from IFF
1,481,457

Other Illustrative Problems (Franchise Accounting)

Problem 1
On December 31, 2016, Max’s Inc signed an agreement authorizing Maria de Jesus to operate as a
franchisee for an initial franchise fee of P 500,000. Of this amount, P 200,000 was received upon signing
of the agreement and the balance is due in three annual payments of P 100,000 each beginning
December 31, 2017. The agreement provides that the down payment (representing a fair value of the
initial services already performed by Max) is not refundable although future services are yet to be
performed. Maria’s credit rating is such that collection of the note is reasonably assured. The present
value at December 31, 2016 of the three annual payments discounted at 14% is P 232,200.
On December 31, 2016, what amount should be recorded as unearned franchise revenue?

Solution:
⮚ Since no substantial future services are required to be performed by the franchiser, the P200,000
down payment and the present value of the note receivable, P232,200 are recognized as revenue
in 2016, therefore the unearned franchise fee on December 31, 2016 is ZERO.

Problem 2
KC Fried Chicken Inc. granted a franchise to Manuel Villa. Manuel was to pay P 1,000,000 payable in five
equal annual installments starting with the payment upon signing of the franchise agreement. The
franchise was to pay monthly 5% of gross sales of the preceding month. Should the operation of the
outlet prove to be unprofitable, the franchise may be cancelled with whatever obligation owing KC, in
connection with the P 1,000,000 franchise fee, waived.

The first year of operations generated a gross sales of P 500,000. For the first year, KC Fried Chicken,
Inc. should report from franchise fee of?

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Solution:
 Revenue:
Initial franchise fee (P1,000,000 / 5) P200, 000
Continuing franchise fee (P 500,000 x 5%) 25, 000
Total revenue P225, 000

Problem 3
On January 1, 2016, Jolybee Corporation sold a franchise to Mr. AMG for P 10,000,000 for the right to
perate as a franchisee of Jolybee Corporation. Terms of the franchise contract are: ∙ The initial franchise
fee of P 1,000,000 is payable in cash, when the contract is signed and the balance in five equal
installment every December 31, evidenced by a 12% promissory note.
∙ The franchisor will assist in locating the site supervise construction activity and training of
management and employees.

On December 31, 2016 direct cost of services rendered to the franchisee amounted to P 2,000,000.

Assuming that there is substantial performance of services required in the contract and the collectability of
the note receivable is not reasonably assured, using the installment method, how much net income is to
be recognized by Jolybee on December 31, 2016?

Solution:
Realized Gross Profit From Franchisee Fee:
Down payment P1,000,000
Collection of Note Receivable (P9,000,000 / 5) 1,800,000
Total 2,800,000
Gross Profit Rate (P8,000,000 / P10,000,000) 80%
Realized Gross Profit 2,240,000
Interest income (P 9,000,000 x 12%) 1,080,000
Net Income P3,320,000