Chapter 6

Franchises Chapter 6
Franchises

Franchises are rights to sell a specific brand of product or services in a certain geographic area.
There are two parties involve in franchising, namely the franchisor who grants the right to sell
his brand of product or services to another party called the franchisee. Each party contributes
resources.

The franchisor contributes his trade name, product, and company’s reputation. He also imparts
his expertise and on continuing basis provides guidance and duties on the manner in which the
franchisee must operate his establishment. The franchisee on the other hand, provides
operating capital for the operation of the franchised business.

Problems on franchising are seldom given in the actual CPA board examination but with
increasing number of businesses requiring arrangement especially that of a service sponsor-
retailer arrangement, e.g. operation of restaurants, it is likely that franchise problems will be
included in the CPA examination more often. Candidates should therefore be familiar with the
accounting techniques and procedures applicable to this topic.

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

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

Revenue Recognition-Initial Franchise Fee

Before a franchise is granted, an initial franchise fee is paid by the franchisee to the franchisor.
Usually, the initial franchise fee is paid by the franchisee via a down payment with the balance
evidenced by a note payable in installment.

In the actual CPA board examination problems involving franchise accounting may require the
computation of the revenue (earned) from initial franchise fee to be recognized by the franchisor
and the amount of the unearned franchise fee at the end of the year. The determination of
revenue earned on the initial franchise fees lies on the following factors: (1) the point at which
fee is to be considered earned; and (2) the assurance of collectability of the unpaid portion of
the fee, if the initial franchise fee is not paid in full.
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 agreement have been
substantially performed. There is substantial performance by the franchisor when the following
conditions are met:

a. The franchisor is not obliged in any way to refund cash already received or forgive unpaid
debt.
b. The initial services required of the franchisor have been substantially performed.
c. No other material conditions or obligations exist.

It is assumed that substantial performance occurs when the franchisee actually commences
operations of the franchise business.

Cost of Services

Direct franchise costs of initial services rendered by the franchisor shall be deferred until related
revenue is recognized. These costs should not exceed anticipated related revenue. Indirect
costs that occur on a regular basis should be expensed when incurred. Costs yet to be incurred
should be accrued and charged against income not later that the period in which the related
revenue is recognized.

The earned and the unearned revenue from the initial franchise fee are computed using the
following approaches:

With Direct Franchise Costs.

a. If collection of the note is assured:

Earned franchise fee = Cash collection plus the balance of the note (accrual method)
Unearned franchise fee= None

b. If collection of the note is not assured:

Earned franchise fee = Cash collections applying to principal X Gross profit rate
(installment method)
Unearned franchise fee = Balance of the note

Without Direct Franchise Costs

a. If collection of the note is assured:

Earned franchise fee = Cash collection plus the balance of the note
Unearned franchise fee = None

b. If collection of the note is not assured:

Earned franchise fee = Cash collections
Unearned franchise fee = Balance of the note

Revenue Recognition-Continuing Franchise Fee

Continuing franchise fee is usually collected from the franchisee at the end of each month in
payment of the continuing services rendered by the franchisor. This is usually based on a
certain percentage of the monthly sales of the franchisee. Continuing franchise fees are
recognized as revenue when actually received.

All direct and indirect costs related to continuing franchise fees are recognized as expense.

Option to Purchase

The 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 agreement
is signed, the initial franchise fee is to be deferred. When the option is exercised and the
franchisor acquires the franchise business, the deferred revenue from the initial franchise fee is
treated as a reduction from the franchisor’s investment.

PROBLEMS

1) On December 31, 2013, Mocha Blends, Inc. authorized Jose Miguel to operate as a
franchise for an initial franchise fee of P1,500,000. Of this amount, P600,000 was received
upon signing the agreement and the balance, represented by a note, is due in three annual
payments of P300,000 each beginning December 31, 2014. The presented value on
December 31, 2013, of the three annual payments appropriately discounted isP720,000.
According to the agreement, the non-refundable down payment represents a fair measure of
the services already performed by Mocha Blends, Inc. Collectability of the note is
reasonable. On December 31, 2013, Mocha Blends, Inc. should record the initial franchise
fee with the following entry:

Cash 600,000
Notes receivable 900,000
Unearned interest income 180,000
Franchise revenue 600,000
Deferred revenue from franchise fee 720,000

Franchise fee revenue is recognized when all material services have been substantially
performed by the franchisor. Substantial performance means the franchisor has and has no
remaining obligation to refund any cash received. The P600,000 non-refundable down payment
applies to the initial services already performed by Rice. Therefore, theP600,000 may be
recognized as revenue in 2013. The three remaining P300,000 installments relate to substantial
future services to be performed by Rice. The present value of these payments (P720,000) is
recorded as unearned franchise fee and recognized as revenue once substantial performance
of the future services has occurred. The difference between the face value of the note
(P900,000) and its present value (P720,000) is recognized as unearned interest income.

2) Each of the Coffee Beanery Company’s21 new franchisee contracted to pay an initial
franchise fee of P30,000. By December 31, 2013, 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, 2014, and December 31, 2015. Experience indicates that one
franchise will default on the additional payments. Services for the initial fee will be performed
in 2014.What amount of net unearned franchise fees would Coffee Beanery report at
December 31, 2013?

Initial franchise fees are not recognized as revenue until the franchisor makes substantial
performance of the required services, and collection is reasonably assured. Since Beanery
Coffee has not yet performed the required services, the initial franchise fee (21 x P30,000 =
P630,000) is reported as unearned franchise fees at 12/31/2013. The estimated uncollectible
amount (P20,000) normally would be recorded as debit to bad debt expense and a credit to
allowance for uncollectible accounts. However, since no revenue has yet been recognized, it is
inappropriate to record bad debt expense. Instead, unearned franchise fees is debited, because
an unearned revenue should not be recorded when, in effect, no related asset has been
received. Therefore, the net unearned franchises fees is P610,000 (P630,000 – P20,000).