AFAR 2815 Franchise Accounting past questions PDF

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AFAR Construction Contracts, Consignment, and Franchise Accounting with notes and practical exercises, solutions, guides and many more....

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Since 1977

AFAR 2817-FRANCHISOR ACCOUNTING (OLD)

DE LEON/DE LEON/ DE LEON MAY 2020

LECTURE NOTES FRANCHISE ACCOUNTING Parties to a franchise contract are (a) the franchisor (owner) and (b) the franchisee (user). The franchisee pays the franchisor 2 types of franchise fees: 1. Initial franchise fee – paid in consideration of the right to use the franchisor’s name, products, and processes, as well as for initial services to be rendered by the franchisor; and 2. Continuing franchise fee – paid in consideration of continuing services provided by the franchisor. Discussions are from the standpoint of the franchisor, in terms of revenue and profit recognition as they vary from those accounted under the point-of-sale-revenue recognition principles. Not much problem is posed by continuing franchise fees as they are paid by the franchisee when the outlet has started operations. It is normally a certain percentage of the franchisee’s revenues and is income receivable to the franchisor when already billable. Revenue recognition on the initial franchise fee, however, has some complexities in that the franchisor must first have substantial performance of services before it can be recognized as revenue. Substantial performance means the franchisor has no obligation to refund any amounts already received nor intention to forgive any amounts not yet collected AND that it must have substantially performed the services promised under the terms of the agreement. The earliest point substantial performance can be claimed by the franchisor is the opening of the franchisee’s outlet. In other words, the initial franchise fee can only be recognized as revenue when the franchise contract is virtually consummated. When substantial performance is had the profit recognition method to be used depends on reasonable assurance of collecting the promissory notes that accompany the cash down payment. If collection is reasonably assured the accrual method is used, otherwise, use of the installment sales method is preferable. Without substantial performance the franchisor uses the deposit method in accounting for all transactions pertaining to franchise revenues and costs. It defers the initial fee revenues and the direct franchise costs. An exception to the to the above revenue recognition principle is: even without substantial performance, if the down payment is not refundable and it represents a fair measure of the costs of services already provided by the franchisor, the cash down payment will be recognized as EARNED revenue and the present value of the note as UNEARNED revenue. (Sometimes the franchisor would provide initial services prior to formal contract signing.) Illustrative Entries for Initial Franchise Fees. To illustrate, assume on January 1, 2017 Jessie’s Pizza inc. charges an initial franchise fee of P50,000 for the right to operate as a franchise of Jessie’s Pizza. Of this amount, P10,000 is payable when the agreement is signed, and the balance is payable in five annual payments of P8,000 each. In return for initial franchise fee, the franchisor will help locate the site, negotiate the lease or purchase of the site, supervise the construction activity, and provide the

bookkeeping services. The credit rating of the franchisee indicates that money can be borrowed at 8 percent. The present value of an ordinary annuity of five annual receipts of P8,000 each discounted at 8 percent is P31,941.68. The discount of P8,058.32 represents the interest revenue to be accrued by the franchisor over the payment period. The franchise cost by the franchisor in rendering the initial services was P25,165.00. The journal entries for the above information at various dates follow: (1) At date of signing/agreement: Cash 10,000.00 Notes Receivable 40,000.00 Discount on N/R Unearned Franchise Fees

8,058.32 41,941.68

(2) Summary entry for incurred franchise cost: Deferred Franchise Cost 25,165.00 Cash 25,165.00 (3) Entry for collection on N/R at Dec.31: Cash 8,000.00 N/R

8,000.00

(4) Entry for the recognition of interest for 2017. Discount of N/R 2,555.33 Interest Revenue 2,555.33 (31,941.68 x 8%) (5) Entries for profit recognition on Dec.31 assuming: Franchisor has substantially performed the initial services and: (a) Collection of the N/R is reasonably assured: Unearned Franchise Revenue 41,941.68 Franchise Rev. 41,941.68 Franchise Cost 25,165.00 Def. Franchise Cost

25,165.00

Therefore: RGP= 41,941.68-25,165.00=16,776.68 (b) Collection of the N/R is not reasonably assured: Aside from the two accrual entries in 5(a): Franchise Revenue 41,941.68 Franchise Cost Deferred Gross Profit

25,165.00 16,776.68

Deferred Gross Profit 6,177.87 Realized Gross Profit 6,177.87 (c) If initial services have not been substantially performed by franchisor, note receivable is reasonably assured of collection, and the down payment is not refundable as it represents fairly costs of initial services already rendered by the franchisor Cash 10,000.00 Notes receivable 40,000.00 Discount on NR 8,058.32

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EXCEL PROFESSIONAL SERVICES, INC Franchise revenue Unearned FR

10,000.00 31,941.68

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, legal, assistance, and other support. Continuing fees should be reported as revenue when are earned and received from the franchise, unless 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 an amount provide a reasonable profit on the continuing services. Bargain Purchases In addition to paying continuing franchise fees, franchise frequently purchase some or all of their equipment and supplies from the franchisor. The franchisor would account for these sales as it would for any other product sales. Sometimes, however, the franchise agreement grants the franchise the right to make bargain purchases of equipment or supplies after the initial franchise fee is paid. If the bargain price is lower than the normal selling price of the same product, or if it does not provide the franchisor a reasonable profit, then a portion of the initial franchise fee should be deferred. The deferred portion would be accounted for as an adjustment of the selling price when the franchisee subsequently purchases the equipment or supplies.

policy, the franchisor may reserve the right to purchase a profitable franchise outlet, or to purchase one that is in financial difficulty. If it is probable at the time the option is given that the franchisor will ultimately purchase the outlet, then the initial franchise fee should not be recognized as revenue but should be recorded as a liability. When the option is exercised, the liability would reduce the franchisor’s investment in the outlet. Franchisor’s Cost Franchise accounting also involves proper accounting for the franchisor’s cost. The objective is to match related costs and revenues by reporting them as components of income in the same accounting period. Franchisors should ordinarily defer direct costs (usually incremental costs) relating to specific franchise sales for which revenue has not yet been recognized. Costs should not be deferred, however, without reference to anticipated revenue and its realizability5. Indirect costs of a regular and recurring nature, such as selling and administrative expenses that are incurred irrespective of the level of franchise sales, should be expensed as incurred. Disclosures of Franchisors Disclosure of all significant commitment and obligations resulting from franchise agreements, including a description of services that have not yet been substantially performed, is required. Any resolution of uncertainties regarding the collectibility of franchise fees should be disclosed. Initial franchise fees should be segregated from other franchise fee revenue if they are significant. When possible, revenues and costs related to franchisor-owned outlets should be distinguished from those related to franchised outlets.

Options to Purchase A franchise may give the franchisor an option to purchase the franchisee’s business. As a matter of management

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STRAIGHT PROBLEMS Exercise 1 GOLDILOCKS CAKES charges an initial franchise fee of P140,000. Upon signing of the agreement, a payment of P56,000 is due. Thereafter, three annual payments of P28,000 are required. The credit rating of the franchisee is such that it would have to pay interest of 10% to borrow money. Required: Prepare the entries to record the initial franchise fee on the books of the franchisor under the following assumptions. (Round to the nearest peso). (a) The down payment is not refundable, no future services are required of the franchisor, and collection of the note is reasonably assured. (b) The franchisor has substantial services to perform, the down payment is refundable, and the collection of the note is very uncertain. (c) The down payment is not refundable, collection of the note is reasonably certain, the franchisor has yet to perform a substantial amount of services, and the down payment represents a fair measure of the services already performed. Exercise 2 On January 1, 2020, FOODS, INC. signed an agreement to operate as a franchisee of RED RIBBON PASTRIES. for an initial franchise fee of P100,000. The amount of P20,000 was paid when the agreement was signed, and the balance is payable in five annual payments of P16,000 each, beginning January 1, 20 21. The agreement provides that the down payment is not refundable and that no future services are required of the franchisor. FOODS, INC’s’ credit rating indicates that it can borrow money at 11% for a loan of this type. Required:

(a) How much should RED RIBBON PASTRIES record as revenue from franchise fees on January 1, 2020? At what amount should FOODS, INC. record the acquisition cost of the franchise on January 1, 2020? (b) What entry would be made by RED RIBBON PASTRIES on January 1, 2020, if the down payment is refundable and substantial future services remain to be performed by Franchisor, Inc. (c) How much revenue from franchise fees would be recorded by RED RIBBON PASTRIES on January 1, 2020 if: (1) The initial down payment is not refundable, it represents a fair measure of the services already provided, a significant amount of services is still to be performed by RED RIBBON in future periods, and collectibility of the note is reasonably assured? (2) The initial down payment is not refundable and no future services are required of the franchisor, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted. (3) The initial down payment has not been earned and the collection of the note as an asset is unwarranted. Exercise 3 On January 1, 2020, RAINBOW COMPANY entered into a franchise agreement with UNIVERSE CORPORATION to sell the latter’s products.. The agreement provides for an initial franchise fee of P7,812,500 payable as follows: P4,687,500 cash to be paid upon signing of the contract, and the balance in four equal annual payments of P781,250 to start on December 31, 2020. RAINBOW COMPANY signs 10% interest-bearing notes for the balance. The agreement further provides that the

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