Prepared by:

Patricia Zima, CAMohawk College of Applied Arts and Technology

Chapter 6Chapter 6 Appendix 6A FranchisesAppendix 6A Franchises

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FranchisesFranchises

• Franchise revenue recognized from two sources:

– Initial Franchise Fee: sale of initial franchises and related assets or services

– Continuing Franchise Fees: based on franchise operations

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Initial Franchise FeeInitial Franchise Fee• Recorded as revenue only when and as the

franchisor has established substantial performance:a) The services obligated to be performed have

been so performed• No obligation to refund any portion of the

fee received to date• Substantial performance of required

servicesb) Collection of the fee is reasonably assured

• The beginning of operations normally considered the earliest time substantial performance has occurred

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Initial Franchise Fee Initial Franchise Fee –– Example Example• Initial franchise fee: $50,000

– Down payment: $10,000

– Balance: five equal annual instalments

– Discount rate: 8%

• PV of $8,000 ordinary annuity = $31,942

• Difference (40,000 – 31,942) = $8,058 is interest revenue to franchisor

• Entries if reasonable expectation of refund and significant performance by franchisor required:Cash 10,000Notes Receivable 40,000

Discount on Note 8,058 Unearned Franchise Fees 41,942

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Initial Franchise Fee Initial Franchise Fee –– Example Example• Initial franchise fee: $50,000

– Down payment: $10,000– Balance: 5 equal annual instalments– Discount rate: 8%

• PV of $8,000 ordinary annuity = $31,942• Difference (40,000 – 31,942) = $8,058 is interest revenue to

franchisor• Entries if low expectation of refund, minimal amount of future

services to be provided by franchisor, and collection of the note reasonably assured:Cash 10,000Notes Receivable 40,000

Discount on Note 8,058 Revenue from Franchise Fees 41,942

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Initial Franchise Fee Initial Franchise Fee –– Example Example• Initial franchise fee: $50,000

– Down payment: $10,000– Balance: 5 equal annual instalments– Discount rate: 8%

• PV of $8,000 ordinary annuity = $31,942• Difference (40,000 – 31,942) = $8,058 is interest revenue to

franchisor• Entries if no refund, substantial performance by franchisor

required, and collection reasonably assured:Cash 10,000Notes Receivable 40,000

Discount on Note 8,058 Revenue from Franchise Fees 10,000

Unearned Franchise Fees 31,942

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Initial Franchise Fee Initial Franchise Fee –– Example Example

• Entries if no refund of initial down payment, no performance by franchisor required, and collection highly uncertain:

Cash 10,000

Revenue from Franchise Fees 10,000

• Entries if down payment refundable, or substantial performance by franchisor required:

Cash 10,000

Unearned Franchise Fees 10,000

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Continuing Franchise FeesContinuing Franchise Fees

• Received in return for continuing rights under the franchise agreement and provision of services by franchisor

• Reported as revenues when they are earned and receivable from the franchisee

• If an amount is included which is “ear-marked” for a specific purpose e.g. for local advertising, that amount is deferred

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Special IssuesSpecial Issues

• Bargain Purchase

– When the franchisee may purchase assets at a lower than market price from the franchisor

– Portion of initial franchise fee is deferred if the bargain price is lower than normal selling price or if franchisor does not make a reasonable profit

– Adjustment to selling price when assets are purchased by the franchisee

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Special IssuesSpecial Issues

• Options to Purchase– Where the franchisor has the right to

purchase the franchisee’s business– Initial franchise fee recorded as a liability if

it is probable that a purchase will occur– When option is exercised, the liability

would reduce the franchisor’s investment

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Special IssuesSpecial Issues

• Franchisor’s Cost– Overall objective is to match related costs

and revenues– Direct costs are deferred for any specific

franchise sale where revenue has not been recognized

– Indirect costs, such as selling and administrative expenses, are expensed as incurred

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Disclosures of FranchisorsDisclosures of Franchisors

• Full disclosure of all significant commitments and obligations is required

• Description of services yet to be performed is also required

• Initial franchise fees are reported as a separate revenue line item if significant

• Revenues and costs of franchisor-owned outlets should be disclosed separate from the revenues and costs of franchised outlets

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