FRANCHISE ACCOUNTING
Revenue from Contracts with Customers: Franchise Accounting
A franchise agreement involves the granting of business rights by the franchisor for a franchisee that will operate the franchise outlet in certain
geographical area or location.
Four types of franchising arrangements have evolved:
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•
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Manufacturer-retailer,
Manufacturer-wholesaler,
Service sponsor-retailer, and
Wholesaler-retailer
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.
2.
3.
4.
5.
6.
7.
Assistance in site selection
a. Analyzing location
b. Negotiating lease
Evaluation of potential income
Supervision of construction activity
a. Obtaining financing
b. Designing building
c. Supervising contractor while building
Assistance in the acquisition of signs, fixtures, and equipment
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
Provision of employee and management training
Provision of quality control
The initial franchise fee is considered for establishing the franchise relationship and providing some initial services. Initial franchise fees are to be
recorded as revenue only when and as the franchisor makes “substantial performance” of the services it is obligated to perform and collection of
the fee is reasonably assured.
Substantial performance occurs when the franchisor:
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Has no remaining obligation to refund any cash received or excuse any nonpayment of a note, and
Has performed all the initial services required under the contract.
As a general rule or for the purpose of practicality, to determine the performance rendered, “substantial” means “90% or more” of the services
required under the contract.
The commencement of the operations by the franchisee shall be presumed to be the earliest point at which substantial performance as occurred,
unless it can be demonstrated that substantial performance of all obligations, including services rendered voluntarily, has occurred before that
time.
At this point, it recognizes revenue under the accrual method (time of sale/point of sale) and this is justified when there is a reasonable
assurance as to the collectability of the receivable.
In summary, there are three conditions to recognize initial franchise fee as revenue and they are as follows:
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•
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Services – all initial services required under the contract had been performed or substantially performed.
Period of refund – payment received already expired or non-refundable, and
Collectibility of the note is reasonably assured.
If the collectibility of the receivable is not reasonably assured or no reasonable basis for estimating collectability or when revenue is collectible
over an extended period of time, then the franchisor recognizes revenue using either installment sales method or cost recovery method
(time of collection)
Regardless of revenue recognition method used, the amount of revenue recognized is reduced by an appropriate provision for estimated
uncollectibles.
Franchisor’s Cost
Franchisor must match related costs and revenues by reporting them as components of income in the same accounting period. Franchisor
should ordinarily defer direct costs (usually incremental costs) related to specific franchise sales for which revenue has not yet been recognized.
Costs should not be deferred, however, without reference to anticipated revenues and its realizability.
Indirect costs of a regular and recurring nature that are incurred irrespective of the level of franchise sales such as selling and administrative
expenses (and other fixed costs) should be expensed as incurred.
Continuing Franchise Fee
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, quality control, budgeting and other accounting services, legal assistance and other support.
Continuing franchise fee should be reported as revenue when they are earned 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.
The continuing fees which are typically computed as a percentage of the franchisee’s sales, are recognized by the franchisor as revenue in the
same period that the sales are made by the franchisee.
Effect of PFRS 15 to Franchise Arrangements
PFRS 15 on Franchise Arrangements identifies two sources of revenue:
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From sale of initial franchises and related assets or services (Initial Franchise Fee) and
From continuing fees based on the operations of franchises.
Performance obligations relate to:
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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:
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Initial franchise fee (payment for establishing the relationship and providing some initial services).
Continuing franchise fees received
o In return for continuing rights granted by the agreement
o For providing management training, advertising and promotion, legal assistance, and other support.
Recognition of Franchise Rights Revenue Over Time
Depending on the economic substance of the rights, the franchisor may be providing access to the rights 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.
Bargain Purchases
In addition to providing services as part of the continuing franchise fee, a franchisor often sells supplies to the franchisee. These sales occur
because the franchisor may be able to obtain quantity discounts from manufacturers or wholesalers, or to ensure the quality of the supplies.
The franchisor records these sales and related expenses in the normal manner.
In addition to paying continuing fees, franchisees 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
franchisee the right to make bargain purchases of equipment or supplies after the initial franchise fee is paid.
The amounts to be deferred shall be either of the following:
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The reasonable profit if indicated bargain price or option price is lower than the normal selling price of the same product,
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Or if it does not provide the franchisor a reasonable profit, then a portion or the full amount of the initial franchise fee should be
deferred.
The deferred portion would be accounted for as adjustment of the selling price when the franchisee subsequently purchases the equipment or
supplies.
Commingled Revenue
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.
Repossessed Franchise
Franchisors occasionally have the right to repossessed franchises. When a franchisee decides not to open an outlet or there are violators of the
franchise contract, which warrants its cancellation, the franchisor may recover franchise rights through repossession. In such cases, previously
recognized revenue would have to be canceled against the period of repossession’s franchise revenue if the franchise fee is refunded. If no
refund is made upon repossession, the franchisor would make adjustments to any uncollectible receivables. Eliminate deferred revenues, and
recognize any revenue on any retained, but not previously recognized considerations.
Option to Purchase
A franchise agreement may give the franchisor an option to purchase the franchisee’s business. 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.
1. On January 1, 2021, YVD Inc. signed a franchise agreement to grant a license to Don Avan for a
term of 2 years commencing on the date of contract. The payment terms indicated on the contract
called for a non-refundable P207,000 down payment and a 10% interest-bearing promissory note
with face value of P138,000 and is payable in two equal annual installments, with the first payment
due on December 31, 2021.
1. What if the agreement granted Don Avan the right to use the intellectual property, how
much is the total revenue recognized by YVD Inc?
a. 379,500
b. 358,800
c. 345,000
d.
0
2. What if the agreement granted Don Avan the right to access the intellectual property,
how much is the total revenue recognized by YVD Inc?
a. 358,800
b. 186,300
c. 179,400
d.
0
2. On January 1, 2021, ITZ Inc. entered into a franchise agreement with Jaypee for an initial franchise
fee of P750,000 payable as follows: P250,000 down payment payable immediately and two
P250,000 annual payments evidenced by a non-interest bearing note, with the first payment due on
December 31, 2021. With an effective rate of 9%, the present value of the note is P439,750.
The following excerpts were taken from the franchise contract:
a. The franchise license is granted to Jaypee for a term of 5 years. Jaypee has the right to any
subsequent modification made by ITZ Inc. to the franchise license. The license has an
observable stand-alone selling price of P319,875.
b. ITZ Inc. is to construct a food stall for Jaypee. The food stall is fully customized for Jaypee,
thus it has no alternative use for the franchisor. The food stall has no observable stand-alone
selling price but has an estimated cost of P85,300 and a normal profit of 20% based on sales.
c. ITZ Inc. must conduct training for the employees of Jaypee.
It was determined that the three performance obligations were separate and distinct from one
another. By the end of the year, the food stall was 80% completed as to construction and the
training was 100% accomplished.
1. Assuming that the stand-alone selling price of the training of the employees was highly
variable, how much is the total revenue recognized by the franchisor for the year ended
December 31, 2021?
A.
B.
C.
D.
319,875
348,550
412,525
689,750
2. Assuming that the stand-alone selling price of the training of the employees amounted to
P639,750 based on the adjusted market assessment approach, how much is the total
revenue recognized by the franchisor for the year ended December 31, 2021?
A.
B.
C.
D.
510,415
523,775
689,750
789,025
3. On January 1, 2021, Your Song Franchising entered into a franchising contract which granted
Luhan a franchise license for an initial franchise fee of P5,175,000. The term of the agreement will
last for 4 years from the date of contract. Luhan paid a non-refundable down payment amounting to
P1,035,000 and signed a non-interest bearing note for four annual payments of P1,035,000, with
the first installment due on December 31, 2021. With the effective rate in the market of 16%, the
present value of the note is computed as P2,898,000. In addition, Luhan is to pay an annual sum to
franchisor equivalent to 5% of his net sales. Direct costs incurred by Your Song Franchising to
fulfill the contract amounted to P1,552,500, while indirect costs totaled P100,000. Net sales of
Luhan amounted to P2,000,000 for the year.
1. Assume that the agreement allowed Luhan to obtain substantially all of the benefits from
the license at the point in time at which it was granted, how much is the franchisor’s net
income for the year ended December 31, 2021?
A. 595,125
B. 1,058,805
C. 2,380,500
D. 2,844,180
2. Assume that the agreement provides that Luhan is granted the right to obtain any
benefits from further modification made to the intellectual property of the franchisor,
how much is the franchisor’s net income for the year ended December 31, 2021?
A. 595,125
B. 1,058,805
C. 2,380,500
D. 2,844,180