AFAR-06 (Revenue - Franchise and Consignment) PDF

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCYCPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 6ADVANCED FINANCIAL ACCOUNTING & REPORTING A. Dayag  G. Caiga  M. NginaAFAR-06: PFRS 15 – Revenue from Contractswith Customers: Franchise & ConsignmentFranchise AccountingA fr...

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY CPA Review Batch 41  May 2021 CPA Licensure Examination  Week No. 6

ADVANCED FINANCIAL ACCOUNTING & REPORTING

A. Dayag  G. Caiga  M. Ngina

AFAR-06: PFRS 15 – Revenue from Contracts with Customers: Franchise & Consignment Franchise Accounting A franchise agreement involves the granting of business rights by the franchisor t o a f ranchisee 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, and  Wholesaler-retailer 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. Franchisors commonly charge an initial franchise fee and continuing franchise fees: 1. Initial franchise fee (payment for establishing the relationship and providing some initial services). 2. Continuing franchise fees received a. In return for continuing rights granted by the agreement b. For providing management training, advertising, legal assistance, and other support.

Initial Franchise Fee 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

Continuing Franchise Fee (Royalty Fee) Continuing franchise fees (royalty fee) 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, and other support. Continuing fees (royalty fee) should be reported as revenue when they are earned (overt time) and receivable from the franchisee, unless a portion of them has been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. In that case, the portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services (point in time). The continuing fees (royalty payments), which are typically computed as a percentage of the franchisee's sales but can also be a fixed periodic amount, are recognized by the franchisor as revenue in the same period that the sales are made by the franchisee. Page 1 of 12

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

AFAR-06

Week No. 6: FRANCHISE & CONSIGNMENT

Occasionally, the continuing franchise fee (royalty payments) is not large enough to cover the franchisor's cost of the continuing services provided. However, the initial franchise fee is unusually large (so, in effect it involves a prepayment by the franchisee for the continuing services). In such cases, the franchisor records a portion of the initial fee as a liability and amortizes the amount to franchise revenue over the life of the franchise (over time). I – Initial Franchise Fee/Commingled Revenue and Continuing Franchise Fee (Royalty) Dominador’s Pizza Inc. enters into a franchise agreement on December 31, 20x7, the right to operate as a franchisee of Dominador’s Pizza for 5 years. Dominador’s charges Doming an Of this amount, and the . Consider the following for allocation of the transaction price at December 31, 20x7. Services – training, etc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Machinery and equipment, etc. (costing, P95,000). . . . . . . . . . . . . . . . . . . . . . . Total transaction price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

P 190,000.00 94,591.50 _133,000.00 P 417,591.50

The credit rating of Doming indicates that money can be borrowed at 8%. The present value of an ordinary annuity of five annual receipts of P57,000 each discounted at 8% is P227,591.50. The discount of P57,408.50 represents the interest revenue to be accrued by Dominador’s Pizza Inc. over the payment period. Training is completed in , franchise opens. Dominador’s Doming also promises to pay ongoing royalty payments of 1% of its annual sales (payable every January 31 of the following year) and is obliged to purchase products from Dominador’s at its current standalone selling prices at the time of purchase. 1. How many performance obligations exist in this contract for franchise? a. 2 c. 4 b. 3 d. 5 2. When Dominador should recognize revenue for the rights (combined) to the trade name, market area and proprietary know-how which give rise to a single performance obligation? a. No transaction c. Point in Time b. No revenue d. Over Time 3. How much revenue (franchise revenue, service revenue and sales revenue – machinery and equipments) be recognized on December 31, 20x7? a. . c. P133,000.00 b. P 94,591.50 d. P190,000.00 4. How much revenue (franchise revenue, service revenue and sales revenue – machinery and equipment) be recognized on February 4, 20x8? a. P 94,591.50 c. P190,000.00 b. P133,000.00 d. P417,591.50 5. How much continuing franchise revenue be recognized on December 31, 20x8, assuming the sales of P4,987,500 was generated for the first year of operations ? a. Zero. c. P190,000.00 b. P 49,875.00 d. P417,591.50 6. How much total franchise revenue (in relation to Nos. 4 and 5) on December 31, 20x8? a. P372,466.50 c. P417,591.50 b. P390,673.82 d. P467,466.50 7. In relation to No. 6, the net income on December 31, 20x8 amounted to? a. Zero. c. P390,673.82 b. P 372,466.50 d. P467,466.50 Answers/Solutions: 1. b – There are three performance obligations in the contract for franchise: PO 1 - Rights to the trade name, market area, and proprietary know-how for 5 years are not individually distinct. Each one is not sold separately and cannot be used with other goods or services that are readily available to the franchisee. Combined rights give rise to a single performance obligation, PO 2 - Training services, and PO 3 - Equipment Note: It should be noted that training (similar) services and equipment are distinct and can be sold separately. Commingled Revenue (Point in Time and Over Time) - It refers to a single initial franchise fee for franchise rights, initial services, tangible property such as supplies and equipment . The portion of the fee applicable to these assets shall be based on their fair values and these assets are recognized upon transfer of ownership regardless when substantial performances of services were made.

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

AFAR-06

Week No. 6: FRANCHISE & CONSIGNMENT 

Dominador’s cannot recognize revenue for the royalty payments because it is not reasonably assured to be entitled to those sales-royalty amounts. That is, these payments represent variable consideration (variable consideration encompasses any amount that is variable under a contract, including, for example, performance bonuses, penalties, discounts, rebates, price concessions, incentives and the customer’s right to return products. Variable consideration is considered to be a component of the transaction price. It is part of the consideration to which an entity expects to be entitled in exchange for transferring promised goods or services and therefore should be estimated and included in the transaction price for revenue recognition purposes) Therefore, Dominador’s recognizes revenue for the royalties when (or as) the uncertainty is resolved.

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Dominador’s promise to stand ready to PROVIDE PRODUCTS/SERVICES to the franchisee in the future at a standalone selling price is NOT ACCOUNTED for as a SEPARATE PERFORMANCE OBLIGATION (PO) in the contract because it (a “material right” is something the customer wouldn’t get otherwise, so the seller is obligated to provide it or if the customer is in effect paying in advance for future goods and services such option provides the customer with a “material right”, then the option should be accounted for as a separate performance obligation) Thus, revenue from those sales is recorded in the future when the sales are made.

2.

3.

c – Those combined rights (trade name, market areas and proprietary know-how) give rise to a single performance obligation. Dominador’s satisfies performance obligation at point in time when Doming obtains CONTROL of the RIGHTS. . Dominador has no further obligation with respect to these rights. It should be noted that training (similar) services and equipment are distinct and can be sold separately. Dominador’s satisfies those performance obligations (services and equipment) when it transfer the services and equipment to Doming. a - As of December 31, 20x7, only signing of agreement and receipts of upfront payment and note were made. Consider the following for allocation of the transaction price at December 31, 20x7. Rights to the trade name, market area, technical and proprietary know-how. P 190,000.00 Services – training, etc.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,591.50 Machinery and equipments, etc. (costing, P95,000). . . . . . . . . . . . . . . . . . . . . . . _133,000.00 Total transaction price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . P 417,591.50

4.

The entries on December 31, 20x7: Dominador’s signs the agreement and receives upfront payment and note. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000.00 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285,000.00 Unearned interest income (or Discount on notes receivable) . . . 57,408.50 Unearned franchise revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000,00 Unearned service revenue – training, etc. . . . . . . . . . . . . . . . . . . . 94,591.50 Unearned sales revenue – machinery and equipments, etc. . . . 133,000.00 Training is completed in February 1, 20x8, the equipment is installed in February 2, 20x8, and Doming holds a grand opening on February 4, 20x8. d - February 4, 20x8: Franchise opens. Dominador’s satisfies the performance obligations (point in time) related to the franchise rights, training and equipment. That is, Dominador’s has no further obligations related to these elements of the franchise. Therefore, franchise revenue amounted to P417,591.50 (P190,000 + P94,591.50 + P133,000). Unearned franchise revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000.00 Franchise revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000.00 – – Unearned sales revenue – machinery and equipment, etc.. . . . . . . 133,000.00 Sales revenue – machinery and equipment, etc. . . . . . . . . . . . . . 133,000.00 Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000.00 Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000.00 Dominador’s Pizza satisfies the performance obligations (point in time) related to the franchise rights, training and equipment under the franchise agreement . That is, Dominador’s has no further obligations related to these elements of the franchise.

5.

b - Dominador’s recognizes revenue for the royalties (continuing fee) when (or as) the uncertainty is resolved (over time). On December 31, 20x8, the continuing (royalty) franchise fees: Accounts receivable (P4,987,500) x 1%). . . . . . . . . . . . . . . . . . . . . . . . 49,875.00 Franchise revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,875.00 December 31, 20x8: To record payment received and interest income on note: Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000.00 Notes receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,000,00 Unearned interest income (or Discount on notes receivable). . . . . . . 18,207.32 Interest income (P227,591.50 x 8%). . . . . . . . . . . . . . . . . . . . . . . . . . . 18,207.32

Date 12/31/20x7

Collection

Interest

Principal

Unpaid Balance P417,591.50

12/31/20x8 12/31/20x9 12/31/20y0 6. d - Therefore, the total amount of franchise revenue recognized on December 31, 20x8 amounted to P467,466.50 computed as follows: Franchise Revenue: (Point in time, February 4, 20x8): Initial Franchise Fee.............................................................................. P 417,591.50 (Over time) Continuing franchise fee , P4,987,500 x 1%)....................................... 49,875.00 Total Franchise revenue.......................................................................................P 467,466.50

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

AFAR-06

Week No. 6: FRANCHISE & CONSIGNMENT 7.

c - Therefore, the total amount of income of P390,673.82) computed as follows: Franchise Revenue: (Point in time, February 4, 20x8): Initial Franchise Fee.............................................................................. P (Over time) Continuing franchise fee , P4,987,500 x 1%)...................................... Total Franchise revenue...................................................................................... P Less: Cost of goods sold............................................................................................... Gross profit.....................................................................................................................P Less: Operating expenses............................................................................................ P Add: Interest income................................................................................................... Net income...................................................................................................................P

(net

417,591.50 49,875.00 467,466.50 95,000.00 372,466.50 0.00 372,466.50 18,207.32 390,673.82

Recognition of Franchise Rights Revenue Over Time Depending on the economic substance of the rights, the franchisor may be providing access to the right rather than transferring control of the franchise rights. In this case, the franchise revenue is recognized over time, rather than at a point in time.

II – Initial Franchise Fee/Commingled Revenue Frozen Delight, Inc. charges an initial franchise fee of P75,000 for the right to operate as a franchisee of Frozen Delight. Of this amount P25,000 is collected immediately. The remainder is collected in four equal annual instalments of P12,500 each. These instalments have a present value of P41,402. As part of the total franchise fee, Frozen Delight also provides training (with a fair value of P2,000) to help franchisees get the store ready to open. The franchise agreement is signed of April 1, 20x5, training is completed, and the store opens on July 1, 20x5. 1. The amount of revenue from training and franchise on April 1, 20x5 to: a. Zero. c. P66,402 b. P64,402 d. P75,000 2. The amount of revenue from training and franchise on July 1, 20x5 to: a. Zero. c. P66,402 b. P64,402 d. P75,000 III – Initial Franchise Fee Items 1 to 7 are based on the following information:

Pacific Crossburgers Inc. Thereafter, three annual payments of P14,000 are required. The credit rating of the franchisee is such that it would have to pay interest at 10% to borrow money. The and the 1. The amount of franchise revenue on May 1, 20x5 assuming no future services are required by the franchisor once the franchise starts operations: a. c. P62,816 b. P28,000 d. P70,000 2. In relation to No. 1, the amount of franchise revenue on July 1, 20x5: a. Zero. c. P b. P28,000 d. P70,000 3. The amount of franchise revenue on May 1, 20x5 assuming that t he franchisor has substantial

services to perform, once the franchise begins operations, to maintain the value of the franchise. b.

P28,000

4. In relation to No. 3, the amount of a. Zero. b. P13,959

c. P62,816 d. P70,000 c. P62,816 d. P70,000

5. The amount of franchise revenue on May 1, 20x5 assuming that the total franchise fee includes training services (with a value of P2,400) for the period leading up to the franchise opening and for two (2) months following opening. a. Zero. c. P62,816 b. P60,416 d. P70,000 6. In relation to No. 5, the amount of franchise revenue excluding service revenue – training on July 1, 20x5: a. Zero. c. P61,616 b. P60,416 d. P63,616 7. In relation to Nos. 5 and 6, the amount of service revenue on September 1, 20x5: a. Zero. c. P 2,400 b. P1,200 d. P70,000

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY Week No. 6: FRANCHISE & CONSIGNMENT Solution: 1. a May 1, 20x5 (Date of Signing) Cash …………………………………………………………………………………………………. . 28,000 Notes Receivable (P70,000 – P28,000)…………………………………………………………………. 42,000 Discount on Notes Receivable /Unearned Interest Income [P42,000 – (2.48685* x P14,000)]……………………………………………………… Unearned Franchise Revenue (P28,000 + P42,000 – P7,184)…………..………………. 2.

3.

4.

5.

c July 1, 20x5 (Date of Opening – Point in Time) Unearned Franchise Revenue…………………………………………………………………………. 62,816 Franchise Revenue……………………………………………………………………………. a May 1, 20x5 (Date of Signing) Cash ………………………………………………………………………………………………….. 28,000 Notes Receivable (P70,000 – P28,000)………………………………………………………………… 42,000 Discount on Notes Receivable /Unearned Interest Income [P42,000 – (2.48685* x P14,000)]……………………………………………………… Contract Liability (franchise) (P28,000 + P42,000 – P7,184)…………..………………. Note: A contract liability is generally referred to as Unearned Sales Revenue, Unearned Service Revenue, or any appropriate account title. b - December 31, 20x5 ( – Unearned Franchise Revenue…………………………………………………………………………. 13,959 Franchise Revenue……………………………………………………………………………. a May 1, 20x5 (Date of Signing) Cash ………………………………………………………………………………………………….. 28,000 Notes Receivable (P70,000 – P28,000)………………………………………………………………… 42,000 Discount on Notes Receivable /Unearned Interest Income [P42,000 – (2.48685* x P14,000)]……………………………………………………… Unearned Service Revenue (Training)…………………………………………………… Unearned Franchise Revenue (P28,000 + P42,000 – P7,184 – P2,400)..……………...

6. b July 1, 20x5 (Date of Opening – Point in Time and Over Time) Unearned Franchise Revenue………………………………………………………………………….. 60,416...