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FRANCHISE ACCOUNTING
FRANCHISING: ACCOUNTING BY FRANCHISOR
Franchise companies derive their revenue from one or both of two sources:
1. From sale of initial franchises and related assets or services, and
2. From continuing fees based on the operations of franchises.
Franchisor - the party who grants business rights under the franchise.
Franchisee - the party who operates the franchised business.
Normal services performed by franchisor:
1. Assistance in site selection.
a. Analyzing location.
b. Negotiating lease.
2. Evaluating 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. 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. Employee and management training.
7. Quality control.
8. Advertising and promotion.

INITIAL FRANCHISE FEES

The initial franchise fee is consideration 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
Substantial performance occurs when the franchisor 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. Commencement of operations by the franchisee shall be presumed to be the earliest point
at which substantial performance has occurred, unless it can be demonstrated that

substantial performance of all obligations, including services rendered voluntarily, has occurred before
that time.

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 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. 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.

BARGAIN PURCHASES
In addition to paying continuing franchise fees, franchisees frequently purchase some or all of
their equipment and supplies from the franchisor. The franchisor would account for these sales as it
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would for any other product sales. Sometimes, however, the franchise agreements, grants the franchisee
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.
OPTIONS TO PURCHASE
A franchise agreement may give the franchisor an option to purchase the franchisee’s business.
As a matter of management policy, the franchisor may reserve the right to purchase a profitable
franchised 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 franchisee 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 COSTS
Franchise accounting also involved proper accounting for the franchisor’s costs. 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 realizability. 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 commitments 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. Where
possible, revenues and costs related to franchisor-owned outlets should be distinguished from those
related to franchised outlets.
ILLUSTRATION OF ENTRIES FOR INITIAL FRANCHISE FEE
Assume that Jollibee Inc. charges an initial franchise fee of P5,000,000 for the right to operate a
franchisee of Jollibee. Of this amount, P1,000,000 is payable when the agreement is signed and the
balance is payable in five annual payments of P800,000 each. In return for the 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 24%.

1. If there is reasonable expectation that the down payment may be refunded and if substantial future
services remain to be performed by Jollibee Inc., the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on Notes Receivable 1,803,680
Unearned Franchise Fee 3,196,320

2. If the probability of refunding the initial franchise fee is extremely low, the amount of future services
to be provided to the franchisee is minimal, collectibility of the note is reasonably assured, and
substantial performance has occurred, the entry should be:
Cash 1,000,000
Notes Receivable 5,000,000
Discount on Notes Receivable 1,803,680
Revenue from Franchise Fee 3,196,320
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3. If the initial down payment is not refundable, represents a fair m.easure of the services already
provided, with a significant amount of services still to be performed by the franchisor in future
periods, and collectibility of the note is reasonably assured, the entry should be:
Cash 1,000,000
Notes Receivable 4,000,000
Discount on Notes Receivable 1,803,680
Revenue from Franchise Fee 1,000,000
Unearned Franchise Fees 2,196,320

4. If the initial down payment is not refundable and no future services are required by the franchisor,
but collection of the note is so uncertain that recognition of the note as an asset is unwarranted, the
entry should be:
Cash 1,000,000
Revenue from Franchise Fees 1,000,000
5. Under the same conditions as those listed under 4 except that the down payment is refundable or
substantial services are yet to be performed, the entry should be:
Cash 1,000,000
Unearned Franchise Fees 1,000,000
In cases 4 and 5, where collection of the note is extremely uncertain, cash collections may be
recognized using the installment method or the cost recovery method.

DISCUSSION PROBLEMS

Problem 1
On December 31, 2021, RAP, Inc. authorized JIN to operate as a franchisee
for an initial franchise fee of P150,000. Of this amount, P60,000 was
received upon signing the agreement, and the balance, represented by a
note, is due in three annual payments of P30,000 each, beginning December
31, 2022. The present value on December 31, 2021 of the three annual
payments appropriately discounted is P72,000. According to the
agreement, the nonrefundable down payment represents a fair measure of
the services already performed by RAP, however, substantial future services
are required of RAP. Collectability of the note is reasonably certain.

On December 31, 2021, RAP should record unearned franchise fees in respect
of the JIN franchise of
A. 150,000 C. 72,000
B. 90,000 D. -0-

Problem 2
Hope Corp. sells a franchise for an initial fee of P1,400,000. A down
payment of P400,000 is required, with the balance covered by a P1,000,000,
10% note payable in five equal annual installments.

If all the material services have been performed and collectability of

the notes is reasonably assured, but the refund period has not yet
expired, what journal entry is needed to record the transaction?
A. Cash 400,000
Notes Receivable 1,000,000
Franchise Fees 1,400,000
B. Cash 400,000
Notes Receivable 1,000,000
Unearned Franchise Fees .. 1,400,000
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C. Cash 400,000
Notes Receivable 1,000,000
Franchise Fees 400,000
Unearned Franchise Fees .. 1,000,000
D. Cash 400,000
Notes Receivable 1,000,000
Franchise Fees 1,000,000
Unearned Franchise Fees .. 400,000

Problem 3
Kami, Inc. charges an initial franchise fee of P500,000 for the right to
operate to operate as a franchise of Kami. Of this amount, P100,000 is
payable when the agreement was signed and the balance is payable in a
noninterest bearing note in five annual payments of P80,000 each. In
return for the 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%.
The present value of an ordinary annuity of five annual receipts of P80,000
each discounted at 8% is P319,416.80. The discount represents the interest
revenue to be accrued by the franchisor over the payment period.

If the probability of refunding the initial franchise fee is extremely low,

the amount of future services to be provided to the franchisee is
minimal, collectability of the note is reasonably assured and substantial
performance has occurred:

The earned and unearned franchise fees would be as follows:

Earned Unearned
A. P -0- P500,000.00
B. -0- 419,416.80
C. 419,416.80 -0-
D. 319,416.80 100,000.00

Problem 4
SAPPHIRE CO. charges new franchisees an initial fee of P5,000,000. Of this
amount, P2,000,000 is payable in cash when the agreement is signed, and the
remainder is to be paid in three equal annual installments which are
evidenced by an interest-bearing promissory note. In consideration
therefore, SAPPHIRE CO. will assist in locating the business site,
conduct a market study to estimate earnings potential, supervise
construction of a building, and provide initial training to employees.

On December 3, 2021, Sapphire Co. entered into a franchising agreement

with EMERALD, INC. by the end of the year, SAPPHIRE CO. has completed
about 25% of the initial services at a cost of P300,000 and it has
ascertained that collection of the notes is reasonably assured.

For 2021, SAPPHIRE CO. should recognized franchise revenue of:

A. 5,000,000 C. 1,700,000
B. 2,000,000 D. -0-

Problem 5
SHAWARMA Inc. sells franchises to independent operators. The contract
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with the franchise includes the following provisions:

1. The franchise is charged an initial franchise fee of P120,000. Of
this amount, P20,000 is payable when the agreement is signed and
a P20,000, zero-interest bearing note, payable at the end of 5
subsequent years.
2. All of the initial franchise fee collected by the company is to
be refunded and the remaining obligation cancelled if, for any
reason, the franchise becomes unprofitable.
3. In return, for the initial franchise fee, the franchisor agrees
to (a) assist the franchisee in selecting the location for the
business, (b) negotiate the lease of the land, (c) obtain
financing and assist with building design, (d) supervise
construction, establish accounting and tax records, and (f)
provide expert advice over a 5-year period relating to such
matters as employee and management training, quality, control and
promotion. This continuing involvement by the franchisor helps
maintain the brand value for the franchise.
4. In addition to the initial franchise fee, the franchisee is
required to pay the franchisor a monthly fee of 2% of sales for
continuing services.
5. Management of the franchisor estimates that the value of the
services rendered to the franchisee at the time the contract is
signed amounts to at least P20,000. All franchisees to date have
opened their locations at the scheduled time, and none have
defaulted on any of the notes receivable. The credit ratings of
all franchisees would entitle them to borrow at the current
interest rate of 10%. The present value of an ordinary annuity
of five annual receipts of P20,000, each discounted at 10% is
P75,816.
What is the amount of franchise revenue assuming the franchise
agreement is signed at the beginning of the year?
A. Zero C. 100,000
B. 95,816 D. 120,000

If the franchisor completes the franchise startup tasks and the

franchise opens on July 1 of the current year, what is the current
year’s amount of franchise revenue?
A. Zero C. 95,816
B. 20,000 D. 100,000

Problem 6
At the beginning of the year, Drin got the franchise of Vin, a known
steak house of upscale patronage. The franchise agreement required a
P1,000,000 franchise fee payable P200,000 upon signing of the franchise and
the balance in four annual installments starting the end of the current
year. At present value using 12% as discount rate, the four installments
would approximate P399,300. The fees once paid are refundable. The
franchise may be cancelled subject to the provisions of the agreement.
Should there be unpaid franchise fee attributed to the balance of the main
fee (P1,000,000), same would become due and demandable upon
cancellation. Further, the franchisor is entitled to a 5% fee on gross
sales payable monthly within the first ten days of the following month.

The Credit Investigation Bureau rated Drin as AAA credit rating. The balance
of the franchise fee was guaranteed by a commercial bank.

The first year of operations yielded gross sales of P18,000,000, PIZZA's

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earned franchise fees for the first year is:

A. 900,000 C. 1,499,300
B. 1,100,000 D. 1,900,000

Problem 7
DJ Builders Enterprises, a franchisor, charges franchisees a "franchise fee"
of P1,000,000. Of this amount, a nonrefundable P400,000 is paid upon the
signing of the contract with the balance payable in three equal
installments after each year thereafter. DJ Builders will assist in locating
a suitable business site, conduct a market study, oversee the construction
of facilities, and provide initial training for employees.

On December 1, 2021, DJ Builders signed a franchising agreement for the U-

belt area. By the end of 2021, it was determined that the substantial
performance of the initial services had cost DJ Builders a total of
P300,000 and that collection of the balance of the franchise fee has been
reasonably assured. In its 2021 income statement, DJ Builders should report
franchise revenue and net income:
Franchise
Net Income
Revenue
A. P1,000,000 P700,000
B. 1,000,000 1,000,000
C. -0- -0-
D. 700,000 700,000

Problem 8
On September 1, 2021, ACE Company entered into franchise agreements with
two franchisees. The agreements required an initial fee payment of
P700,000 plus four P300,000 payments due every four (4) months, the first
payment due December 31, 2021. The market interest rate is 12%. The initial
deposit is refundable until substantial performance has been completed. The
following table describes each agreement:
Services
Performed Total Costs
Probability of by Franchisor Incurred to
Franchis Full Collection Dec. 31, 2021 Dec. 31, 2021
ee
A Likely Substantially P700,000
B Doubtful 25% N/A

The present and future value tables at 4% for four (4) periods were as
follows:
Present value of P 1 0.8548
Present value of an ordinary annuity of P1 3.6299
Future value of P 1 1.1699
Future value of an ordinary annuity of P1 4.2465

What amount of net income to be reported in 2021, assuming P1,000,000 was

received from each franchisee during the year:
Franchisee A Franchisee B
A. P1,088,970 P 0
B. 1,788,970 0
C. 1,132,529 0
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D. 1,132,529 43,559

Problem 9
On April 1, 2021, Motorola, Inc. entered into a franchise agreement with
a local businessman. The franchisee paid P90,000 and gave a P60,000, 8%, 3
year note payable with interest due annually on March 31. Motorola recorded
the P150,000 initial franchise fee as revenue on April 1, 2021. On December
30, 2021, the franchisee decided not to open the outlet under Motorola's
name. Motorola cancelled the franchisee's note and refunded P48,000 less
accrued interest on the note, of the P90,000 paid on April 1.
What entry should Motorola make on December 30, 2021?
A. Loss on Repossessed Franchise 48,000
Cash 48,000
B. Loss on Repossessed Franchise 44,400
Cash 44,400
C. Loss on Repossessed Franchise 104,400
Cash 44,400
Notes Receivable 60,000
D. Revenue from Franchise Fees 150,000
Interest Income 3,600
Cash 44,400
Notes Receivable 60,000
Revenue from Repossessed Franchise 42,000

Diamond’s Pizza Inc. enters into a franchise agreement on December 31, 2019, giving Domino Corp. the
right to operate as a franchisee of Diamond’s Pizza for 5 years. Diamond charges Domino an initial
franchisee fee of P475,000 for the right to operate as a franchisee. Of this amount, P190,000 is payable
when Domino Corp. signs the agreement, and the balance is payable in five annual payments of P57,000
each on December 31.

Consider the following for allocation of the transaction price at December 2019.
Rights to the trade name, market area, technical and propriety know-how P190,000.00
Services – training, etc 94,591.50
Machinery and equipment etc. (costing, P95, 000) 133,000.00
Total Transaction price P417,591.50

The credit rating of Domino 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 Diamond’s Pizza Inc. over the payment
period.
Training is completed in January 2020, the equipment is installed in January 2020 and Domino holds a
grand opening on February 4, 2020. On February 4, 2020 the franchise opens.
Domino also promises to pay on going royalty payments of 1% of its annual sales (payable every January
31 of the following year) and is obliged to purchase products from Diamond’s at its current stand alone
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 should Diamond recognize revenue for the rights (combined) to the trade name, market
area and propriety know-how which give rise to a single performance obligation?
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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
equipment) would be recognized on December 31, 2019?
A. Zero C. P 133, 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) should be recognized on February 4, 2020?
A. P 94, 591.50 C. P 190, 000.00
B. P 133, 000.00 D. P417, 591.50

5. How much continuing franchise revenue be recognized on December 31, 2020 assuming the sales
of P 4,987,500 was generated for the first year of operations?
A. Zero C. P 190, 000.00
B. P 49, 875.00 D. P417, 591.50