Chapter 3 – Revenue Recognition Lesson 11 – Franchise Accounting

LESSON 11
FRANCHISE ACCOUNTING
I. THEORETICAL FRAMEWORK

Franchise – a privilege, granted by government authority, sanctioning a monopoly or permitting the use of public property, usually
subject to regulation, known as franchise between the government and a private company or an individual ; or a privilege, often exclusive,
conferred on a dealer by a manufacturer, to sell the manufacturer’s products within a specified territory, known as franchise between
private companies and an individual (Punzalan, 2012). It is a means of distributing goods or services.

Parties Involved in a Franchise

1. Franchisor – grants the right to sell the granting party’s goods or services
2. Franchisee – receiver of the grant

Franchise Agreement – involves the granting of business rights by the franchisor to a franchisee who will operate the franchise outlet in
certain geographical area or location

Four Types of Franchising Arrangements

1. Manufacturer-retailer
2. Manufacturer-wholesaler
3. Service sponsor-retailer
4. Wholesaler-retailer

CONCEPT MAP
[SILENT ASSUMPTION]
collection of notes is reasonably assured
ACCRUAL

YES
[SILENTcollection of notes is NOT reasonably assured
ASSUMPTION] w/ cost
Substantial performance? INSTALLMENT
w/o cost DP = revenue
Bal (NR) = unearned

GENERALNO RULE:
Unearned (ALL DP and Bal)
Exceptions:
DP is nonrefundable or DP is refundable but the period of refund[SILENT ASSUMPTION]
has already lapsed
can be presumed
must be both present

AND DP is considered revenue if collection of the note is reasonably a

DP represents fair measure of the service already rendered
there is substantial performance if
must be explicitly stated

At least 90%
If stated Accrual
Franchise has commenced business operations Cash
NR
Fran.
DFR

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
The 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.

Franchise Fees
1. Initial Franchise Fee (IFF) – represents initial payment for establishing the franchise agreement, and for providing certain
initial services associated with the agreement
2. Continuing Franchise Fee (CFF) – represents continuous payment to the franchisor for providing specific future services.
These fees are usually based on the operations of franchises.

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Three Conditions to Recognize Initial Franchise Fee as Revenue

1. Services – all initial services required under the contract had been performed or substantially performed
2. Period of refund – payment received already expired or non-refundable
3. Collectibility – collectibility of the note is reasonably assured

Continuing Fees as Revenue

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.

II. PRACTICAL APPLICATION: WITH SUBSTANTIAL PERFORMANCE, NOTES REASONABLY AND NOT REASONABLY
ASSURED, INTEREST-BEARING NOTES, INITIAL FRANCHISE FEE, CONTINUING FRANCHISE FEE

Illustrative Problem
On January 1, 2014, 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 P6,250,000, payable as follows: P3,750,000 cash to be paid upon signing of the
contract, and the balance in four equal annual payments of P625,000 to start on December 31, 2014. RAINBOW COMPANY signs 10%
interest-bearing notes for the balance. The agreement further provides that the franchisor will assist the franchisee in locating the
business site, in designing and supervising the construction of the building, and in the training of management and employees. The
agreement also provides that RAINBOW must pay a continuing franchise fee equal to 5% of its monthly gross sales. On October 31, 2014,
UNIVERSE completed the initial services required in the contract at a cost of P1,500,000. The franchisee commenced business operations
on November 2, 2014. The gross sales reported to the franchisor for the months of November and December are P562,500 and P750,000
respectively.
Required:
1. Assuming that the collection of the notes is reasonably assured, prepare the journal entries in the books of UNIVERSE for the
year 2014.
2. Assuming that the collection of the notes is not reasonably assured, prepare the journal entries in the books of UNIVERSE for
the year 2014.
Solution:
Requirement #1: With substantial performance, collection is reasonably assured  Accrual Method
The indicators that tells us that there is a substantial performance are (1) “UNIVERSE completed the initial services required in the
contract”, and (2) “the franchise commenced business operations”. Since collection is reasonably assured, accrual (full recognition)
method is used. If collection is not reasonably assured, installment method shall be used.
(Day-to-Day Entries)
Cash 3,750,00
0
Deferred
Notes Receivable 2,500,00 See NOTE
Franchise
0 1
Revenue
Deferred Franchise Revenue – IFF 6,250,00
0
Deferred Franchise Cost 1,500,00
Deferred
0
Franchise
Cash / Accounts Payable 1,500,00
Cost
0
Continuing Cash / Accounts Receivable 65,625 See NOTE
Franchise Franchise Revenue – CFF 65,625 2
Supporting Computation
Fee [(562,500 + 750,000) × 5%]
Cash 875,000
Installment See NOTE
Notes Receivable 625,000
Payment 3
Interest Income (2,500,000 × 10%) 250,000
(Year-End Adjustments)
Deferred Franchise Revenue – IFF 6,250,00
Franchise 0
Revenue Franchise Revenue – IFF 6,250,00
0
Franchise Cost 1,500,00
Franchise 0
Cost Deferred Franchise Cost 1,500,00
0
NOTE 1
Note that although there is a substantial performance, we still use the account title “ deferred franchise revenue – IFF” because it is
assumed that at the date of signing the contract, there is still no services performed. Substantial performance is assumed to be done at
year-end.
NOTE 2
Continuing franchise fees are treated as an outright revenue. On the other hand, indirect costs are treated as an outright expense because
these costs usually pertain to the general, administrative, and selling expenses of the company.
NOTE 3

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Notes are often classified into (1) interest bearing- and (2) non-interest-bearing notes. Interest bearing notes often has a realistic
interest rate. Notes having a realistic interest rate are recorded at face value. However, if an interest-bearing note carries an unrealistic
interest rate, then that note is recorded at its present value. Non-interest bearing notes are recorded at their present value.

Realistic interest rate record at FACE VALUE

Interest bearing notes
Unrealistic interest rate record at PRESENT VALUE
NOTES
Non-interest bearing notes record at PRESENT VALUE
Income Statement
Franchise Revenue – Initial Franchise Fee 6,250,000
Franchise Cost (1,500,000)
Gross Profit from Franchise 4,750,000
Franchise Revenue – Continuing Franchise 65,625
Fee
Interest Income ____250,000
Net Income 5,065,625
There are a variety of questions that can be asked relating to the net income. For instance;
 Total net income: (4,750,000 + 65,625 + 250,000) = 5,065,625
 Revenue from franchise fees: (6,250,000 + 65,625) = 6,315,625
 Total revenue: (6,250,000 + 65,625 + 250,000) = 6,565,625
Requirement #2: With substantial performance, collection is not reasonably assured  Installment Method
If collection of the notes is not reasonably assured, we will use the installment method which means getting the gross profit rate (GPR).
Note that if there will be no cost given, the down payment is automatically considered as revenue and the balance of notes receivable is
unearned.
(Day-to-Day Entries)
Cash 3,750,00
0
Deferred
Notes Receivable 2,500,00 See NOTE
Franchise
0 1
Revenue
Deferred Franchise Revenue – IFF 6,250,00
0
Deferred Franchise Cost 1,500,00
Deferred
0
Franchise
Cash / Accounts Payable 1,500,00
Cost
0
Continuing Cash / Accounts Receivable 65,625 See NOTE
Franchise Franchise Revenue – CFF 65,625 2
Supporting Computation
Fee [(562,500 + 750,000) × 5%]
Cash 875,000
Installment See NOTE
Notes Receivable 625,000
Payment 3
Interest Income (2,500,000 × 10%) 250,000
(Year-End Adjustments)
Deferred Franchise Revenue – IFF 6,250,00
Franchise 0
Revenue Franchise Revenue – IFF 6,250,00
0
Franchise Cost 1,500,00
Franchise 0
Cost Deferred Franchise Cost 1,500,00
0
Franchise Revenue – IFF 6,250,00
0
Franchise Cost 1,500,00 See NOTE
DGP
0 4
Deferred Gross Profit 4,750,00
0
Deferred Gross Profit 3,325,00
0
Realized Gross Profit 3,325,00 See NOTE
RGP
0 5
Supporting Computations
[(3,750,000 + 625,000) × 76%]
NOTE 4
This is similar with Installment Sales. GPR = Gross Profit / Revenue. GPR = 4,750,000 / 6,250,000. GPR = 76%.
NOTE 5

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The collection considered applies only for the principal. Interest is excluded. In interest-bearing notes, this plainly refers to the annual
payment of 625,000. If however, this is a non-interest-bearing note, the collection applying to principal refers only to the principal
column (collection minus interest). Down payments are always included in the collections.
For interest-bearing notes:
Down payment P xx
Principal payments ___xx
Total collections P xx
For non-interest-bearing notes:
PV of down payment (DP × P xx
1.00)
Collections excluding interest ___xx
Total collections P xx
Income Statement
Realized Gross Profit 3,325,000
Franchise Revenue – Continuing Franchise 65,625
Fee
Interest Income __250,000
Net Income 3,640,625

III. PRACTICAL APPLICATION: WITH SUBSTANTIAL PERFORMANCE, NOTES REASONABLY AND NOT REASONABLY
ASSURED, NON-INTEREST-BEARING NOTES, INITIAL FRANCHISE FEE, CONTINUING FRANCHISE FEE, INDIRECT COST

Illustrative Problem
On January 2, 2014, GRAND FOODS, INC. signed an agreement to operate as a franchisee of SILVERLUCK CORPORATION for an
initial franchise fee of P7,000,000. Of this amount, P2,625,000 was paid when the agreement was signed and the balance is payable in
five annual payments, to begin on December 31, 2014. GRAND FOODS signed a non-interest bearing note for the balance. GRAND FOOD’s
credit rating indicates that it can borrow money at 20% interest for a loan of this type. The present value of an annuity of 1 at 20% for 5
periods is 2.990. The contract includes a continuing franchise fee of 5% of the franchisee’s gross sales, to be collected monthly.
On November 25, 2014, SILVERLUCK substantially performed the initial services provided in the contract at a cost of
P786,187. Indirect cost is P37,500. The franchisee’s outlet commenced operations on December 1, 2014. The gross sales of GRAND
FOODS for the month of December, 2014 is P350,000.
Required:
Prepare journal entries on the books of the SILVERLUCK CORPORATION for 2014, assuming:
(1) collection of the note is reasonably assured, and
(2) collection of the note is not reasonably assured.
Solution:
Requirement #1: With substantial performance, collection is reasonably assured  Accrual Method
(Day-to-Day Entries)
Cash 2,625,00
0
Notes Receivable 4,375,00
Deferred
0 See NOTE
Franchise
Unearned Interest Income 1,758,75 1
Revenue
0
Deferred Franchise Revenue – IFF 5,241,25
0
Deferred Franchise Cost 786,187
DFC
Cash / Accounts Payable 786,187
Indirect Expenses 37,500
Costs Cash / Accounts Payable 37,500
Continuing Cash / Accounts Receivable 17,500
Franchise Franchise Revenue – CFF 17,500
Supporting Computation
Fee (350,000 × 5%) = 17,500
Installmen Cash (4,375,000 / 5) 875,000
t Notes Receivable 875,000
Payment
(Year-End Adjustments)
Interest Unearned Interest Income 523,250 See NOTE
Income Interest Income 523,250 2

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Deferred Franchise Revenue – IFF 5,241,25

Franchise 0
Revenue Franchise Revenue – IFF 5,241,25
0
Franchise Franchise Cost 786,187
Cost Deferred Franchise Cost 786,187
NOTE 1
Notes Receivable
Initial Franchise Fee 7,000,000
Less: Down Payment (2,625,000)
Notes Receivable 4,375,000
Deferred Franchise Revenue – IFF
PV of Down Payment (today) (2,625,000 × 2,625,000
1.000)
PV of Notes Receivable [(4,375,000 / 5) × 2.990] 2,616,250
PV of Cash Flows (DFR – IFF) 5,241,250
Unearned Interest Income
Face Value of Notes Receivable 4,375,000
Present Value of Notes Receivable (2,616,250)
Unearned Interest Income 1,758,750
Statement of Financial Position – 1/2/2014
Notes Receivable 4,375,000
Less: Unearned Interest Income (1,758,750)
Carrying Amounts of Notes Receivable 2,616,250
NOTE 2
DATE COLLECTIO INTEREST PRINCIPAL BALANCE
N (20%)
January 2, 2014 2,616,250
December 31, 875,000 523,250 351,750 2,264,500
2014
December 31, 875,000 452,900 422,100 1,842,400
2015
December 31, 875,000 368,480 506,520 1,335,880
2016
December 31, 875,000 267,176 607,824 728,056
2017
December 31, 875,000 146,944 728,056 ---
2018
TOTALS 4,375,000 1,758,750 2,616,250

Ledger Balances:
Statement of Financial Position – 12/31/2014
Notes Receivable (4,375,000 – 875,000) 3,500,000
Less: Unearned Interest Income (1,758,750 – (1,235,500)
523,250)
Carrying Amounts of Notes Receivable 2,264,500
Requirement #2: With substantial performance, collection is not reasonably assured  Installment Method
(Day-to-Day Entries)
Cash 2,625,00
0
Notes Receivable 4,375,00
Deferred
0 See NOTE
Franchise
Unearned Interest Income 1,758,75 1
Revenue
0
Deferred Franchise Revenue – IFF 5,241,25
0
Deferred Franchise Cost 786,187
DFC
Cash / Accounts Payable 786,187
Indirect Expenses 37,500
Costs Cash / Accounts Payable 37,500
Continuing Cash / Accounts Receivable 17,500
Franchise Franchise Revenue – CFF 17,500
Supporting Computation
Fee (350,000 × 5%) = 17,500
Installmen Cash (4,375,000 / 5) 875,000
t Notes Receivable 875,000
Payment

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(Year-End Adjustments)
Interest Unearned Interest Income 523,250 See NOTE
Income Interest Income 523,250 2
Deferred Franchise Revenue – IFF 5,241,25
Franchise 0
Revenue Franchise Revenue – IFF 5,241,25
0
Franchise Franchise Cost 786,187
Cost Deferred Franchise Cost 786,187
Franchise Revenue – IFF 5,241,25 See NOTE
DGP
0 3
Franchise Cost 786,187
Deferred Gross Profit 4,455,06
3
Deferred Gross Profit 2,530,23
8 See NOTE
RGP
Realized Gross Profit 2,530,23 4
8
NOTE 3
This is similar with Installment Sales. GPR = Gross Profit / Revenue. GPR = 4,455,063 / 5,241,250. GPR = 85%.
NOTE 4
Down payment 2,625,000
Collections applying to principal (refer to NOTE 2 – Amortization __351,750
Table)
Total collections 2,976,750
Multiply by GPR (4,455,063 / 5,241,250 = 85%) ______85%
Realized Gross Profit 2,530,238

IV. PRACTICAL APPLICATION: BARGAIN PURCHASES, COMMINGLED REVENUE, REPOSSESSED FRANCHISE, AND OPTIONS
TO PURCHASE

COMMINGLED REVENUE AND BARGAIN PURCHASES

Commingled Revenue – it refers to a single initial franchise fee for franchise rights, initial services, tangible property such as supplies,
and equipment. The fair value of the tangible property is recognized as revenue when title to such property passes to the franchisee, even
though substantial performance has not occurred for other services included in the franchise agreement.

Continuing Sale of Supplies – these sales are necessary to maintain uniformity in the quality of the supplies used by all of the franchisees.
The sale is recorded by the franchisor in the usual manner.
 Bargain Purchases – it occurs when the franchise agreement grants the franchisee the right to make bargain purchases of
equipment or supplies after the initial franchise fee is paid. Bargain purchases are deferred. The amount to be deferred shall
be either of the following:
o A portion of the initial franchise fee  if bargain price < normal selling price
o (Bargain Price – Cost) + Markup
 The deferred portion would be accounted for as an adjustment of the selling price when the franchisee subsequently
purchases

Illustrative Problem
Zeke, Inc. charges P90,000 for a franchise, with P18,000 paid when the agreement is signed and the balance in four annual payments. The
present value of the annual payments discounted at 9% is P58,315. The franchise has the right to purchase P20,000 of equipment for
P16,000. Collectability of payments is reasonably assured and substantial performance by Zeke, Inc. has occurred. On January 8, the
franchisee subsequently purchases the equipment.
Required: Prepare the necessary journal entries.
Solution:
Since there is already a substantial performance performed by Zeke, Inc. franchise revenue is already recognized.
(Day-to-Day Entries)
Cash 18,00
0
Notes Receivable (90,000 – 18,000) 72,00
Franchise
0
Revenue
Unearned Interest income (72,000 – 58,315) 13,685
Franchise Revenue – IFF (18,000 + 58,315 – 4,000) 72,315
Unearned Franchise Revenue – equipment sale 4,000
Exercise Cash / Accounts Receivable 16,00
of 0
Bargain Unearned Franchise Revenue 4,000
Purchase Franchise Revenue – equipment sale 20,000

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Franchise Cost – equipment sale 16,00

Franchise
0
Cost
Equipment inventory 16,000

REPOSSESSED FRANCHISE

Repossessed Franchise – it is the right of the franchisor to cancel the franchise rights given to a franchisee when the franchisee violated
the terms of the franchise contract.
 Accounting Treatment for Franchise Repossessions
o Cancel previously recognized revenues and/or notes receivables
o Record cash refunds given less any accrued interest
o Compute for the gain or loss on franchise repossession

Illustrative Problem
On April 1, 2014, Weston Inc. entered into a franchise agreement with a local businessman. The franchisee paid P240,000 and gave a
P160,000, 8%, 3-year note payable with interest due annually on March 31. Weston, Inc. recorded the P400,000 initial franchise fee as
revenue on April 1, 2014. On December 31, 2014, the franchisee decided not to open an outlet under Weston’s name. Weston, Inc.
canceled the franchisee’s note and refunded P128,000, less accrued interest on the note, of the P240,000 paid on April 1.
Required: Prepare the necessary journal entries.
Solution:
Cash 240,000
Franchise
Notes Receivable 160,000
Revenue
Franchise Revenue – IFF 400,000
Franchise Revenue – IFF 400,000
Interest Income (160,000 × 8% × 9,600
Franchise 9/12)
Repossessio Notes Receivable 160,000
n
Cash (128,000 – 9,600) 118,400
Gain on Repossessed Franchise 112,000

OPTIONS TO PURCHASE

Options to Purchase – the right of the franchisor to purchase the franchisee’s business when it is a profitable franchised outlet or when it
is in a financial difficulty
 Accounting Treatment for Options to Purchase
o If it is probable that the option will be exercised, the initial franchise fee should be deferred (liability)
o If the option is exercised, derecognize the liability and deduct it from the franchisor’s investment in the outlet
o Record the gain or loss on exercise of franchise purchase option

Illustrative Problem
ACC Inc. sells franchises for an initial franchise fee of P360,000. On March 15, 2014, a franchisee signed a franchise contract, paying
P60,000 down payment, the balance due over 5 years with interest. Collectability of the notes is assured. The agreement provides that
ACC has the option to purchase within 5 years to acquire franchisee’s business and is certain that ACC will exercise the option. Direct
franchise costs amounts to P200,000. Taxes and licenses related to the franchise amounts to P40,000. The option is exercised after 5
years by paying P70,000 to the franchisee.
Required: Prepare the necessary journal entries.
Solution:
Cash 60,000
Franchise
Notes Receivable 300,00
Purchase
0
Option
Deferred Franchise Purchase Option Liability 360,000
Deferred Franchise Cost (200,000 + 40,000) 240,00
DFC 0
Cash 240,000
Exercise Deferred Franchise Purchase Option Liability 360,00
of 0
Franchise Deferred Franchise Cost 240,000
Purchase Cash 70,000
Option Gain on exercise of franchise purchase option 50,000

Practice Problem #1
On January 1, 2014, MAXX SERVICES INC. signed an agreement authorizing LALLA COMPANY to operate as a franchisee over a 20-year period for an initial franchise fee of P137,500
received when the agreement was signed. LALLA commenced operations on July 1, 2014, at which date all of the initial services required of MAXX SERVICES had been performed. The
agreement also provides that LALLA must pay annually to MAXX a continuing franchise fee equal to 5% of the revenue from the franchise. LALLA COMPANY’s franchise revenue for
2014 was P1,100,000.
Required: For the year ended December 31, 2014, how much should MAXX SERVICES record as revenue from franchisee fees with respect to the LALLA account?
Solution:

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ANSWER: 192,500
Franchise Revenues – IFF (recognize in full) 137,500
Franchise Revenues – CFF (1,100,000 × 55,000
5%)
Revenue from franchise fees 192,500
The first question to be asked is that if there is a substantial performance or not. Since the problem explicitly mentions that “initial services required of MAXX SERVICES had been
performed” and “LALLA commenced operations”, it is assured that substantial performance had been done. The next question to ask is the collectability of notes. If collection is certain,
use the accrual (full recognition) method. If collection is uncertain, use the installment method. Since there is no notes receivable issued, accrual method is automatically used.

Practice Problem #2
GREAT DANE, INC., franchisor entered into a franchise agreement with PITBULL COMPANY, franchisee, on July 1, 2014. The total franchise fees agreed upon is P550,000, of which
P50,000 is payable upon signing and the balance is to be covered by a note payable in four equal annual installments. The direct franchise cost incurred was P325,000. Indirect
franchise expenses of P31,250 was also paid. The relevant interest rate is 12% and the note is reasonably assured of collection. The franchise outlet commences its operations on July
25, 2014.
Required:
1. Assuming the note payable is interest-bearing, how much is the net income to be reported in the July, 2014 interim income statement?
2. Assuming the note payable is non-interest-bearing (use two decimal places for the present value factor), how much net income is to be reported in the July, 2014 interim
income statement?
Solution:
Requirement #1: 198,750
Franchise Revenues – IFF 550,000
Franchise Costs (325,000)
Gross Profit from Franchise 225,000
Expenses (indirect franchise expenses) (31,250)
Interest Income (500,000 × 12% × 5,000
1/12)
Net Income 198,750
Requirement #2: 77,550
Franchise Revenues – IFF:
PV of Down Payment (50,000 × 1.00) 50,000
PV of Notes Receivable [(500,000 / 4) × 380,000 430,000
3.04]
Franchise Costs 325,000
Gross Profit from Franchise 105,000
Expenses (indirect franchise expenses) (31,250)
Interest Income (380,000 × 12% × 1/12) ___3,800
Net Income 77,550
Amortization Table
DATE COLLECTIONS INTEREST PRINCIPA BALANCE
(12%) L
July 1, 2014 380,000
June 30, 125,000 45,600 79,400 300,600
2015
June 30, 125,000 36,072 88,928 211,672
2016
June 30, 125,000 25,401 99,599 112,073
2017
June 30, 125,000 12,927 112,073 ---
2018
TOTALS 500,000 120,000 380,000

Practice Problem #3
On January 2, 2014, JELLYFISH, INC. entered into a franchise agreement with KOOKIE COMPANY to sell their products. The agreement provides for an initial franchise fee of
P2,812,500 payable as follows: P787,500 cash to be paid upon signing of the contract and the balance in five equal annual payments every December 31, starting December 31, 2014.
JELLYFISH signs a 15% interest-bearing-note for the balance. The agreement further provides that the franchisee must pay a continuing franchise fee equal to 5% of its monthly gross
sales. On October 31 the KOOKIE COMPANY completed the initial services required in the contract at a cost of P900,000 and incurred indirect costs of P180,000. The franchise
commenced business operations on November 3, 2014. The gross sales reported to the franchisor are November sales, P92,250 and December sales, P106,875. The first installment
payment was made on due date. Assume collection of the note is not reasonably assured.
Required: In its income statement for the year ended December 31, 2014, how much is the net income recognized by KOOKIE COMPANY?
Solution:
ANSWER: 944,606
Deferred Franchise Revenues – IFF 2,812,500 100%
Deferred Franchise Costs 900,000 32%
Deferred Gross Profit 1,912,500 68%
Franchise revenues and franchise costs accounts are non-existent in installment method of recording the notes.
Realized Gross Profit:
Down payment 787,500
Collections on principal [(2,812,500 – 787,500) / __405,000
5]
Total collections 1,192,500
Multiply by GPR ______68% 810,900
Expenses (indirect costs) (180,000)
Franchise Revenue – CFF [(92,250 + 106,875) × 5%] 9,956
Interest Income [(2,812,500 – 787,500) × 15%] 303,750
Net Income 944,606

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Practice Problem #4
On January 2, 2014, EXTREME COMPANY signed an agreement to operate as a franchisee of BASIC PRODUCTS, INC. for an initial franchise fee of P2,500,000 for 10 years. Of this
amount, 40% was paid when the agreement was signed and the balance payable in four semi-annual payments beginning on June 30, 2014. EXTREME signed a non-interest bearing
note for the balance. EXTREME’s rating indicates that it can borrow money at 24% on a loan of this type. Assume that substantial services amounting to P617,500 had already been
rendered by BASIC PRODUCTS, INC.
Required: If the collection of the note is not reasonably assured, the realized gross profit to be reported by BASIC for the year ended December 31, 2014 is:
Solution:
ANSWER: 1,070,646
Deferred Franchise Revenues – IFF:
PV of down payment [(2,500,000 × 40%) × 1,000,000
1.00]
PV of notes receivable [(1,500,000 / 4) × 3.04**] 1,140,000 2,140,000
Deferred Franchise Costs (617,500)
Deferred Gross Profit (GPR = 71.14%) 1,522,500
**Note that the wording used here is “four semi-annual payments”, therefore PVF is computed as follows: {[1 – (1.12)^-4]/0.12}. 12% is used because “semi-annually”.
Amortization Table
DATE COLLECTIONS INTEREST PRINCIPAL BALANCE
(12%)
January 2, 2014 1,140,000
June 30, 2012 375,000 136,800 238,200 901,800
December 31, 375,000 108,216 266,784 635,016
2014
June 30, 2015 375,000 76,202 298,798 336,218
December 31, 375,000 38,782 336,218 ---
2015
TOTALS 1,500,000 360,000 1,140,000
Computation of Realized Gross Profit
Collection – Down payment 1,000,000
Collection – Principal, 6/30/2014 238,200
Collection – Principal, __266,784
12/31/2014
Total Collections 1,504,984
Multiply by GPR __71.14%
Realized Gross Profit 1,070,646

Practice Problem #5
On January 1, 2014, ABC signed an agreement to operate a franchisee of XYZ for an initial franchise fee of P8,000,000 for 10 years. Of this amount P1,600,000 was paid when the
agreement was signed and the balance is payable in four equal annual payments beginning December 31, 2014. ABC signed a non-interest-bearing note for the balance. ABC’s rating
indicates that it can borrow money at 24% for a loan of this type. Present value factor of an annuity of 1 for four periods at 24% is 2.4. Assume that the substantial services amounting
to P816,000 had been already rendered by XYZ and an additional indirect franchise cost of P217,600 was also incurred.
Required: If the collection of the note is not reasonably assured, what is the realized gross profit for the year ended December 31, 2014 reported by XYZ?
Solution:
ANSWER: 1,936,640
Deferred Franchise Revenues – IFF:
PV of down payment (1,600,000 × 1.0) 1,600,00
0
PV of notes receivable [(6,400,000 / 4) × 3,840,00 5,440,000
2.4] 0
Deferred Franchise Cost __816,000
Deferred Gross Profit (GPR = 85%) 4,624,000
Amortization Table
DATE COLLECTIONS INTEREST PRINCIPAL BALANCE
(24%)
January 1, 2014 3,840,000
December 31, 1,600,000 921,600 678,400 3,161,600
2014
December 31, 1,600,000 758,784 841,216 2,320,384
2015
December 31, 1,600,000 556,892 1,043,108 1,277,276
2016
December 31, 1,600,000 322,724 1,277,276 ---
2017
TOTALS 6,400,000 2,560,000 3,840,000
Computation of Realized Gross Profit
Collection – Down payment 1,600,000
Collection – Principal, __678,400
12/31/2014
Total Collections 2,278,400
Multiply by GPR ______85%
Realized Gross Profit 1,936,640

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