MODULE 4: Franchise Accounting

FRANCHISE ACCOUNTING

 Introduction

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. 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 franchisee must
operate his establishment. The franchisee on the other hand, provides
operating capital and managerial operational resources required for the
operation of the franchised business.

 Learning Objectives:

1. To determine the revenue, costs and gross profit under franchise

accounting.
2. To determine how franchise accounting will be presented in Financial
Statements.

Franchise is a system whereby one company grants business rights to

another company or individual through a contract to operate a franchised
business for a specified period of time. The company granting the business
rights is called the franchisor, and the company receiving the business rights
is called the franchisee.

PAS 18 – Franchise fees may cover the supply of initial and subsequent
services, equipment and other tangible assets, and know-how. Accordingly,
franchise fees are recognized as revenue on a basis that reflects the purpose
for which the fees were changed.

 Franchise Fees

1. Initial Franchise Fees.

Initial franchise fees from franchise sales ordinarily must be recognized

(with provision for estimated uncollectible amounts) when all material
services or conditions relating to the sale have been substantially
performed or satisfied by the franchisor. Services are considered to be
substantially performed when:

A. The franchisor has no remaining obligation or intent to refund any

cash received or forgive any unpaid notes or receivables.

B. Substantially all initial services of the franchisor required by the

franchise agreement have been performed.

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 C. No other material conditions or obligations related to the
determination of substantial performance exist.

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.

 Revenue Recognition

a. 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:

i. The franchisor is not obligated in any way (trade practice,

law, intent, or agreement) to refund the cash already
received or forgive unpaid debt.
ii. The initial services required of the franchisor by contract or
otherwise have been substantially performed
iii. No other material conditions or obligations exist.

b. 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. These costs should
not exceed anticipated related revenue. Indirect costs that occur on
a regular basis should be expensed when incurred.

 Revenue Recognition Method

a. Accrual Basis. This method is used when the initial franchise fee is
collectible over an extended period of time and the collectability of
the unpaid portion of the franchise fee is reasonably assured.

b. Installment method or Cost Recovery Method. This method should

be used in exceptional cases, that is, when the initial franchise fee
is collectible over an extended period and the collectability of the
unpaid portion of the initial franchise fee is uncertain.

2. Continuing Franchise Fee

This represents continues 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 usually based on the operations of
franchises.

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  Revenue Recognition

Continuing franchise fee is usually collected from franchisee at the end of

each month base on a certain percentage of their monthly sales. Continuing
franchise fees are recognized as revenue when actually earned and
receivable from the franchisee.

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

In the event that the continuing franchise fees appear to be insufficient to

cover the costs and reasonable profit of the franchisor for the continuing
services required by the franchise agreement, a portion of the initial franchise
fees, if any, is deferred and amortized over the term of the franchise. The
amount deferred should be as sufficient to cover all the costs of the
continuing service plus a reasonable profit.

 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 by the franchisor in the usual manner.

 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.

 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 is treated as
a reduction from the franchisor’s investment.

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 ILLUSTRATIVE PROBLEMS

Multiple Choice Questions

1. On December 31, 2019, 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, 2020. The presented value on
December 31, 2019, of the three annual payments appropriately
discounted is P720,000. 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, 2019, Mocha Blends, Inc. should record the initial
franchise fee with the following entry:

a. Cash 600,000
Notes receivable 900,000
Unearned interest income 180,000
Franchise revenue 600,000
Deferred revenue from franchise fee 720,000
b. Cash 600,000
Note receivable 900,000
Unearned interest income 180,000
Deferred revenue from franchise fee 1,320,000
c. Cash 600,000
Note receivable 900,000
Deferred revenue from franchise fee 1,500,000
d. Cash 600,000
Note receivable 900,000
Unearned interest revenue 180,000
Franchise revenue 1,320,000

2. Each of the Coffee Beanery Company’s 21 new franchisee

contracted to pay an initial franchise fee of P30,000. By December
31, 2019, 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, 2020, and December 31, 2021. Experience indicates
that one franchise will default on the additional payments. Services for the
initial fee will be performed in 2020.

What amount of net unearned franchise fees would Coffee Beanery report
at December 31, 2019?

a. P400,000
b. P600,000
c. P610,000
d. P630,000

3. On January 2, 2019, Pedro Jose got the franchise of Marios Inc. a known
steakhouse 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
December 31, 2019. At present value using 12% as discount rate,
the four installments would approximate P199,650. The fees once paid
are not refundable. The franchise may be cancelled subject to the

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 provisions of the agreement. Should there be unpaid franchise fees
attributed to the balance of main fee (P500,000), same would be due and
demandable upon cancellation. Further, the franchisor is entitled to a 5%
fee on gross sales payable monthly within the first ten days of the
following month. The note receivable for the balance of the franchise
fee was guaranteed by the Metro Bank. The first year of operations
yielded gross sales of 9 million. On December 3, 2019, Marios, Inc.
earned franchise fee is:

a. P550,000
b. P650,000
c. P749,650
d. P950,000

4. On December 31, 2019, Max’s Inc. signed an agreement authorizing

Maria de Jesus to operate as a franchisee for an initial franchise
fee of P500,000. Of this amount, P200,000 was received upon
signing of the agreement and the balance is due in three annual
payments of P100,000 each beginning December 31, 2020. The
agreement provides that the down payment (representing a fair
measure 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
assumed. The present value at December 31, 2019 of the three
annual payments discounted at 14% is P232,200. On December 31,
2019, Max’s, Inc. should record unearned franchise fee of:

a. P232,200
b. P300,000
c. P422,200
d. P-0-

5. Dryers Inc. sell franchise for ice cream outlets in Metro Manila. One
contract has been signed on January 5, 2019. The agreement calls for an
initial franchise fee of P6,000,000 to be paid by the franchisee at the
signing of the contract. The franchisor’s initial cost of services is
P2,250,000 to be incurred uniformly over the six-month period prior
to the scheduled opening date of July 15, 2019. No future payments
are to be made by the franchisee, although there will be continuing
costs of P180,000 per year for services rendered during the ten year
term of the contract. The normal return for the franchisor on continuing
operations involving franchise outlets is 10%. How much net income
would be recognized by Dryers, Inc. on July 15, 2019.

a. P3,750,000
b. P5,750,000
c. P6,000,000
d. P1,750,000

6. On August 31, 2019, KFC, Inc. entered into franchise agreements

with two franchisees. The agreements required an initial franchise
fee payment of P700,000 plus four P300,000 payments due every
four months, the first payment is due on December 31, 2019. The
market interest rate is 12%. The initial deposit is refundable until
substantial performance has been completed. The following data
describes each agreement:

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 Franchise Probability of full Services Total costs
collection performed incurred
by franchisor to Dec.31,2019
Dec. 31,2019
Juan Jose Likely Substantially P700,000
Pedro Doubtful 25% N/A
Pablo

The present and future value tables at 4% for four (4) periods were as follows

Present value of P1 0.8548

Present value of an annuity of P1 3.6299
Future value of P1 1.1699
Future value of an ordinary annuity of P1 4.2465

What amount of net income is to be reported by KFC in 2019, assuming

P1,000,000 was received from each franchisee during the year.

Juan Jose Pedro Pablo

a. P1,088,970 P-0-
b. P1,788,970 P-0-
c. P1,132,529 P-0-
d. P1,132,529 P43,559

7. KFC Fried Chicken Inc., granted a franchise to Manuel Villa. Manuel

was to pay P1,000,000 payable in five equal annual instalments
starting with the payment upon signing of the franchise agreement. The
franchisee was to pay monthly 5% of gross sales of the preceding month.
Should the operating of the outlet prove to be unprofitable, the franchise
may be cancelled with whatever obligation owing KC, in connection
with the P1,000,000 franchise fee, waived.

The first year of operations generated a gross sales of P500,000. For the
first year, KFC Fried Chicken, Inc., should report revenue from the
franchise fee of:

a. P200,000
b. P1,025,000
c. P1,000,000
d. P225,000

8. On June 30, 2019 UCC, Inc. franchisor, entered into a franchise

agreement with May Tuazon, franchisee. The initial fee agreed upon
is P1,100,000 of which P100,000 is payable upon signing of the
contract and the balance payables in four equal annual installments.
It was agreed that the down payment is not refundable, not-
withstanding lack of substantial performance of services by franchisor.
On July 1, 2019 Miss Tuazon was able to start the operation. When UCC,
Inc. prepares its financial statements on December 31,2019, the
unearned franchise fee to be reported is:

a. P1,000,000
b. P1,000,000
c. P-0-
d. P100,000

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9. D Marks Pizza, awarded its franchise to Miguel de Jesus for an
initial franchise fee of P1,000,000. Of the said amount, 50% was
payable upon signing of the agreement and the balance in two equal
annual payments. The contract provided that in the event the first year
would result in an operating loss, the franchising agreement may be
cancelled without the need for returning any portion of the franchise
fee already paid nor the payment of any balance still unpaid. The entry
to record the granting of the franchise to Miguel would be:

a. No entry
b. Cash 500,000
Notes receivable 500,000
Deferred revenue from franchise fee 1,000,000
c. Cash 500,000
Notes receivable 500,000
Revenue from franchise fee 1,000,000
d. Cash 500,000
Notes receivable 500,000
Deferred revenue from franchise fee 500,000
Revenue from franchise fee 500,000

10. On January 2, 2019, David, Inc. signed an agreement authorizing Jose

Pidal to operate as a franchisee for an initial franchise fee of
P5,000,000. Of this amount, P2,000,000 was received upon signing of
the agreement and the balance evidence by a 12% promissory note
which is due in three annual instalment payments of P1,000,000
each beginning December 31,2019, Pidal started franchise operations on
September 1,2019, after David rendered the required initial services at
a total cost of P500,000. Although the first instalment was collected
on due date, collection of the balance was not reasonably assured.
What is the realized gross profit on franchise fee to be recognized by
David at December 31,2019?

a. P2,700,000
b. P4,500 000
c. P3,000,000
d. P5,000,000

11. Ling Nam, Inc. granted a franchise to Robin Reyes to operate a

restaurant. The agreement signed on January 2,2019 called for a
P300,000 down payment plus two P100,000 annual payment
representing the value of initial services to be rendered by Ling
Nam. The present value of two annual payments appropriately
discounted at its implicit rate is P177,355. In addition, the agreement
required the franchisee to pay 5% of its gross sales to the franchisor,
this was deemed sufficient to cover the cost and provide a reasonable
profit margin on continuing franchise services to be performed by Ling
Nam. The restaurant opened early in 2019, and its sales for the
year amounted P1,000,000. How much revenue from the franchise would
be recognized by Ling Name on December 31,2019?

a. P527,355
b. P977,355
c. P300,000
d. P-0-

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12. On June 1,2019, Figaro Corporation, franchisor, receives P200,000
from Angel Sy representing down payment on the franchise agreement
signed that day. Angel Sy gave Figaro a 12% interest bearing promissory
note for the balance of P1,000,000 payable in four semi-annual
instalments. Franchise services was substantially competed by Figaro
on November 15 at a cost of P900,000. On December 1,2019, the
first semi-annual instalment became due and was accordingly paid by
Angel Sy. Figaro appropriately uses the accrual method of recording
franchise revenues. In its December 31,2019 financial statements,
how much will Figaro report as realized franchise income of the year?

a. P112,500
b. P300,000
c. P250,000
d. P187,500

13. On july 1,2019, Manuel Tenng entered into a franchise agreement with
Polo, Inc., to sell their products. The agreement provides for an initial
franchise fee of P1,250,000, payable as follows: P350,000 cash to
be paid upon signing of the contract, and the balance in five equal
annual payments every December 31 starting December 31,2019.
Manuel Teng signs 15% interest bearing note for the balance. The
agreement further provides that the franchisee must pay continuing
franchise fee equal to 5% of its monthly gross sales. On October,
the franchisor completed the initial services required in the contract at a
costs of P787,500 and incurred expenses of P42,900. The franchisee
commenced business operations on November 2,2019. The gross
sales reported to the franchisor are:

November sales P121,000

December sales 147,500

Assuming the collection of the note receivable is not

reasonably assured, in its statement of comprehensive income for the
year ended December 31,2019, how much is the net income?

a. P234,125
b. P301,625
c. P220,700
d. P166,625

14. On December 31,2019, Arcee Ice Cream, Inc. authorized Jose Lee
to operate as a franchisee for an initial franchise fee of P3,000,00.
Of this amount, P1,200,000 was received upon signing of the
contract, and the balance by a non-interest bearing note, due in
three annual payments of P600,000, beginning December 31,2020.
The present value on December 31,2019 of the three annual
payments of appropriately discounted is P1,263,900. The collectability of
the note is not reasonably assured. On December 31,2019, Arce should
record the receipt of the initial franchise fee by the following entry:

a. Cash 1,200,000
Note receivable 1,800,000
Unearned interest income 536,100
Deferred revenue from franchise fee 2,463,900
b. Cash 1,200,000
Note receivable 1,800,000

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 Deferred revenue from franchise fee 3,000,000
c. Cash 1,200,000
Note receivable 1,800,000
Revenue from franchise fee 3,000,000
d. Cash 1,200,000
Note receivable 1,800,000
Unearned interest income 536,100
Revenue from franchise fee 2,463,900

15. On January 2, 2019, David, Inc. signed an agreement authorizing Jose

Pidal to operate as a franchisee for an initial franchise fee of
P5,000,000. Of this amount, P2,000,000 was received upon signing of
the agreement and the balance evidence by a 12% promissory initial
services at a cost of P150,000 and Pedro was able to operate the
franchise on April 27, 2019. Assuming the collection of the note is
not reasonably assured, the realized revenue form the initial franchise
on December 31,2019 is:

a. P360,000
b. P650,000
c. P300,000
d. P450,000

16. Using the date in No. 15, but assuming the collection of the note
is reasonably assured, the net income to be presented in its statement of
comprehensive income on December 31, 2019 is:

a. P654,000
b. P900,000
c. P650,000
d. P750,000

17. Mr. Villa is about to purchase a franchise from Pizza, Inc. the standard
contract provides for a 10-year term and a n initial franchise fee of
P450,000 a payable as follows: P150,000 at the date of signing.
The expected date of signing is January 1, 2019. A continuing fee of
2% of gross sale is also to be paid to the franchisor. Monthly
gross sales are expected to be P200,000 for the first four years and
P375,000 for the remainders of the contract. An additional of P50,000 for
initial services are incurred on January 17, 2019. There are no associated
continuing costs.

What is the net income to be recognized by Pizza Inc. for the fiscal
year ending December 31, 2019 assuming that the franchisor started
operations on February 1, 2019?

a. P444,000
b. P140,400
c. P240,400
d. P440,800

18. Macdo Burger, Inc. sells franchise to independent operators in

Metro Manila. The franchise contract includes the following provisions:

i. The initial franchise fee is P25,000,000. Of this amount, P5,000,000 is

payable when the agreement is signed and a P4,000,000 non-

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 interest- bearing note is payable at the end of each of the five
subsequent years.

ii. All of the initial franchise fee collected by Macdo, Inc. is to be

refunded and the remaining obligation cancelled if for any reason,
the franchisee fails to open the franchise.

iii. In addition to the initial franchise fee, the franchisee is required to pay
Macdo, Inc. a monthly fee of 2% of sales.

Macdo, Inc. estimates that the value of the services rendered to the
franchises after the contract is signed amounts of P5,000,000. All
franchises to date have opened their locations at the scheduled time
and none had defaulted on any of the notes receivable. The credit
rating of all franchises would entitle them to borrow at the current
rate of 10%. The present value of an ordinary annuity of five annual
receipts of P4,000,000 each, discounted at 10% is P5,163,000.

What is the amount of the deferred revenue from the initial franchise
fee to be recorded on the date the agreement is signed?

a. P25,000,000
b. P20,000,000
c. P20,163,000
d. P25,163,000

19. On January 1, 2019, Jolybee Corporation sold a franchise to Mr. AMG for
P10,000,000 for the right to operate as a franchisee of Jolybee
Corporation. Terms of the franchise contract were:

i. 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.

ii. The franchisor will assist in locating the site, supervise

construction activity and training of management and employees.

On December 31, 2019 direct cost of services rendered to the

franchisee amounted to P2,000,000. 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
instalment method how much net income is to be recognized by
Jolybee on December 31, 2019?

a. P1,000,000
b. P1,880,000
c. P3,320,000
d. P2,800,000

20. On January 1, 2019, a Michael 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 10 years. Of this amount P600,000 (not
refundable) was paid when the agreement was signed and the
balance payable in five annual payments of P200,000 beginning
December 31, 2019. Michael signed a noninterest bearing note for the
balance.

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Michael’s credit rating indicates that it can borrow money at 20% for a loan
of this type. Information on present and future value factors is an follows:

Present value of P1 at 20% for 5 periods .402

Present value of an annuity of P1 at 20% for 5 periods 2.9906
Future amount of P1 at 20% for 5 periods 2.488

In return for the initial franchise fee, the franchisor will help in
locating the site, negotiate the lease or purchase the site, supervise the
construction activity and provide training to employees.

On December 31, 2019, the initial services required of the franchisor

are substantially performed. Assuming that the collectability of the
note is reasonably certain, the revenue from franchise fee to be
reported on December 31, 2019 is:

a. P1,198,120
b. P1,600,000
c. P600,000
d. P1,500,000

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 ILLUSTRATIVE PROBLEM ANSWER KEY

Multiple Choice Questions

1. A

2. C

3. C

4. D

5. D

6. C

7. D

8. A

9. B

10. A

11. A

12. B

13. A

14. A

15. A

16. A

17. A

18. C

19. C

20. A

-END OF DISCUSSIONS-

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