Chapter 11:

FRANCHISE ACCOUNTING

Jovit G. Cain, CPA

 Franchise Accounting
Franchising is a means of distributing goods or
services:

Ice Cream (Coney Island, Dairy Queen, and Dreyers)

Food Drive Ins (McDonald’s, Kentucky Fried
Chicken, and Jollibee)
Restaurants (Pizza Hut and Shakeys)
Others (Seven-Eleven stores)
 Franchise Accounting
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.
 Franchise Fees
Franchise agreement usually requires the franchisee
to make payments, called the franchise fee to the
franchisor in consideration for the reputation, skill,
products, and services contributed by the
franchisor.
 Two types of Franchise Fees:
1. Initial Franchise Fee
- This represents initial payment for establishing the
franchise agreement, and for providing certain initial
services associated with the agreement.

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.
Revenue Recognition – Initial Franchise Fees
Two issues:
1. The point at which the fee is to be considered
earned; and
2. The assurance of collectability of any unpaid
portion of the fee, if the total initial franchise fee
is not paid in full.
Revenue Recognition – Initial Franchise Fees
The following accounting principle and procedures are to be
used in the recognition of revenue from the initial franchise
fee:
1. 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.
2. Direct franchise costs of initial services rendered by the
franchisor shall be deferred until related revenue is
recognized. (Indirect costs, expensed immediately).
Revenue Recognition – Initial Franchise Fees
Once substantial performance is achieved, revenue from the
initial franchise fee should be recognized using the following
methods:
1. Accrual Basis.
- If the IFF is collectible over a period of time and the collectability is
reasonably assured.

2. Installment method or Cost Recovery method.

- IFF is collectible over a period of time and the collectability is
uncertain.
Illustration: Case 1. The initial franchise fee is paid in full
when the agreement is signed on July 2, 2013.
Jan. 5, 2013: McDo, Inc. granted a franchise to Mr. A. De Jesus to sell McDo
productions. The IFF is P10,000,000.

Cash 10,000,000
Deferred Revenue from IFF 10,000,000
To record the receipt of the IFF.

Feb. to Nov: McDo, Inc. rendered the following initial services under the
franchise contract:
Direct cost of initial services P2,000,000
Indirect costs of services 50,000
Deferred cost of franchise revenue 2,000,000
Franchise expenses 50,000
Cash 2,050,000
To record the payment of franchise costs.
Illustration: Case 1. The initial franchise fee is paid in full
when the agreement is signed on July 2, 2013.
December 1: The franchisee, Mr. A. De Jesus started business operations.

Dec. 31: Adjusting Entries:

Cost of franchise revenue 2,000,000
Deferred cost from franchise revenue 2,000,000
To record cost of franchise revenue.

Deferred Revenue from IFF 10,000,000

Revenue from IFF 10,000,000
To recognize fully as revenue the initial franchise fee.
 Illustration: Case 2.
Case 2. The initial franchise fee is payable as follows: P1,000,000 cash
when the contract is signed and the balance in five annual installments
payable every December 31, evidence by a 12 percent promissory note.

Method 1: Accrual Method.

2013
Jan. 5: Cash 1,000,000
Notes receivable 9,000,000
Deferred revenue from IFF 10,000,000
To record the initial franchise fee.

Feb-Nov. Deferred cost of franchise revenue 2,000,000

Franchise expense 50,000
Cash 2,050,000
To record costs of services rendered.
 Illustration: Case 2.

Method 1: Accrual Method.

2013
Dec. 31: Cash 2,880,000
Notes receivable 1,800,000
Interest income (9M x 12%) 1,080,000
To record collection of the first installment.

Adjusting entries:
Cost of franchise revenue 2,000,000
Deferred cost of franchise revenue 2,000,000

Deferred revenue from IFF 10,000,000

Revenue from IFF 10,000,000
 Illustration: Case 2.
Case 2. The initial franchise fee is payable as follows: P1,000,000 cash
when the contract is signed and the balance in five annual installments
payable every December 31, evidence by a 12 percent promissory note.

Method 1: Installment Method.

2013
Jan. 5: Cash 1,000,000
Notes receivable 9,000,000
Deferred revenue from IFF 10,000,000
To record the initial franchise fee.

Feb-Nov. Deferred cost of franchise revenue 2,000,000

Franchise expense 50,000
Cash 2,050,000
To record costs of services rendered.
 Illustration: Case 2.
Method 1: Installment Method.
2013
Dec. 31: Cash 2,880,000
Notes receivable 1,800,000
Interest income (9M x 12%) 1,080,000
To record collection of the first installment.

Adjusting entries:
Cost of franchise revenue 2,000,000
Deferred cost of franchise revenue 2,000,000
To recognized cost of franchise revenue.

Deferred revenue from IFF 10,000,000

Cost of franchise revenue 2,000,000
Deferred gross profit from IFF 8,000.000
To set up deferred gross profit from franchise fee.
 Illustration: Case 2.
Method 1: Installment Method.
2013
Dec. 31: Deferred gross profit from IFF 2,240,000
Realized gross profit from IFF 2,240,000

Collections, excluding interest:

Down payment P 1,000,000
First installment 1,800,000 P 2,800,000
GPR (P8M/10M) 80%
RGP from IFF P 2,240,000
 Illustration: Case 3.
Case 3: The initial franchise fee is payable as follows: cash of P1,000,000 upon
signing of the contract and the balance in five equal installments every
December 31, evidenced by a non-interest bearing note. Credit investigation
indicates that the franchisee can borrow money at 12% and the present value of
an ordinary annuity of 1 at 12% for 5 periods is 3.6048. Thus the present value of
five payments of P1,800,000 would be P6,488,640 (P1,800,000 x 3.6048).
Assume that the collectability of the note is not reasonably assured, using the
installment method of revenue recognition, the required entries in the books of
the franchisor during 2013 are:
Jan. 5, 2013: Cash 1,000,000
Notes receivable 9,000,000
Unearned interest income 2,511,360
Deferred revenue from IFF 7,488,640

Face value of the note P 9,000,000 Down payment P1,000,000

Present value of the note 6,488,640 Present value of the note 6,488,640
Unearned interest income P 2,511,360 Adjusted sales value of F P7,488,640
 Illustration: Case 3.
Feb. to Nov. Deferred cost of franchise revenue 2,000,000
Franchise Expense 50,000
Cash 2,050,000
To record cost of services rendered.

Dec. 31: Cash 1,800,000

Notes receivable 1,800,000
To record the collection of the first installment.

Adjusting Entries:
Unearned interest income 778,637
Interest income 778,637
To adjust interest income (P6,488,640 x 12%)

Cost of franchise revenue 2,000,000

Deferred cost of franchise revenue 2,000,000
To adjust cost of franchise revenue
 Illustration: Case 3.
Adjusting Entries:
Deferred revenue from IFF 7,488,640
Cost of franchise revenue 2,000,000
Deferred gross profit from IFF 5,488,640
To defer gross profit from franchise fee.
Gross profit rate (P5,488,640 / P7,488,640) 73.29%

Deferred gross profit from IFF 1,481,147

Realized gross profit from IFF 1,481,147
To recognize realized gross profit computed as follows:
Collections applying to principal:
Downpayment P 1,000,000
First installment (P1.8M-P778,637) 1,021,363 P2,021,363
Gross profit rate 73.29%
Realized gross profit from IFF P 1,481,147
 Illustration: Case 3.
Alternative Method: If the collectability of the notes receivable is not
reasonably assured, the cash basis of revenue recognition may also be used
instead of the installment method. This method is usually used when the direct
costs of the initial services is minimal. Under this method revenue is recognized
as cash is received. Using the data in Case 3 except that the direct cost of initial
services is only P200,000, the required journal entries are:
Jan. 5, 2013: Cash 1,000,000
Notes receivable 9,000,000
Unearned interest income 2,511,360
Deferred revenue from IFF 7,488,640

Face value of the note P 9,000,000 Down payment P1,000,000

Present value of the note 6,488,640 Present value of the note 6,488,640
Unearned interest income P 2,511,360 Adjusted sales value of F P7,488,640
 Illustration: Case 3.

Feb. to Nov. Prepaid franchise expense 200,000

Franchise Expense 50,000
Deferred revenue from IFF 250,000
To record cost of services rendered.

Dec. 31: Cash 1,800,000

Notes receivable 1,800,000
To record the collection of the first installment.

Adjusting Entries:
Unearned interest income 778,637
Interest income 778,637
To adjust interest income (P6,488,640 x 12%)
 Illustration: Case 3.
Adjusting Entries:
Deferred revenue from IFF 2,021,363
Revenue from IFF 2,021,363
To recognize revenue from the initial franchise fee equal to the
otal collections excluding interest.
Collections applying to principal:
Downpayment P 1,000,000
First installment (P1.8M-P778,637) 1,021,363 Total
2,021,363

Franchise expense 200,000

Prepaid franchise expense 200,000
To adjust prepaid expenses
 Revenue Recognition – Continuing
Franchise Fees
Continuing franchise fees are recognized as revenue
when actually earned and receivable from the
franchisee. The required entry is as follows:
Cash xxx
Revenue from CFF xxx

All direct and indirect costs related to CFF are

recognized as expense by the following entry:
Franchise expense xxx
Cash xxx
 Other concerns
1. Revenue Recognition – Area Franchise Fees
2. Continuing Sale of Supplies
3. Tangible Assets Included in Franchise Fee
4. Option to Purchase
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