 Hello and welcome to this session in which you would look at franchise accounting. What is franchise accounting? Well franchise accounting is when we have a franchisee and a franchisee or who is a franchisee and who is the franchisee or Let's think about this individual. This individual is an entrepreneur. They would like to start their own business That's one option So rather than starting their own business and taking risk by starting a business that no one knows about no one It's not a recognized name What an entrepreneur can do they can contact a franchisee or like for example McDonald's That's a common one or subway or five guys burgers and fries or Dunkin Donuts And what they can do or Burger King and what they can do and they will open a Business under those franchises. What is the benefit of this? Well, these businesses, whether it's Burger King Dunkin Donuts or Domino's Pizza. They've been in business for so long So they have a proving system that you could use to make a profit So that's the reason why you will buy a franchise rather than starting your own business So we're going to be doing accounting for the franchisor for the businesses What are the revenue for the franchisor? Well, the franchisor will have two sources of revenues They will have the initial franchise fee and related assets or services Simply put what that means is when you start when you sign a contract with them You have to pay a price and that price could include Buying assets or services, but the most important is giving you the right to use their name So to operate under their name so you cannot just put up a McDonald's sign You have to pay them a fee to use the trade name or other intellectual property of the franchisor Sometimes they help you with initial advertising as part of the fee to set up your accounting information system To train your employees to help purchasing and purchasing equipment science fixtures so on and so forth That's one source of revenue for the franchisor The other source of revenue is the continuous commission or royalty fees based on the operation of the franchise So after you open your door and you start to selling burgers speeds coffee, whatever you are selling The franchisor would like to have a fee of that as well. That's that's called a continuous commission And what what's the justification for this? Well, they're going to help you with promotion and marketing the business Hiring and training employees maybe so although they might do this at the beginning train your employees They also might do that continuously So it all depends how the contract is written between the franchisee and the franchisor and different franchisor They have different agreements Supplying with inventory and inventory management like when you see McDonald's truck on the road They're basically supplying their franchisor with fries meat hamburger buns so on and so forth They might help you with accounting and bookkeeping services And what's going to happen is this they're going to recognize the revenue based on the performance obligation So what's going to happen is this and we have to be very careful in Revenue for franchisor because we have to read the contract We have to read the detail and based on that based on the details What is the obligation of the franchisor if they meet their obligation? They would recognize the revenue Now some franchisor They don't provide any service beyond the initial franchise fee stage So once they set you up you say you're on your own we're done Under those circumstances they can recognize the whole franchise fee upfront Other agreement what's going to happen is when you pay that fee upfront The franchisor will be involved in your business for a period of time When that's the case they cannot recognize the revenue upfront In this in this session, we will assume that once you Once the franchisor Help you open your business. Then that's a dirt involvement is finished basically. Okay Now The best way to illustrate this concept is to look at an actual example But before we do so, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website barhatlectures.com I don't replace your CPA review course I am a useful addition to your CPA review course, whether you are a student or a CPA candidate I can help you do better on your Exam CPA exam performance during your courses by providing you with lectures multiple choice true false exercises This is a partial list of my accounting courses. My CPA material is aligned with your becker Roger Wiley gleam miles. I also provide you with 1500 previously released AI CPA questions in their original format Plus detailed solution. If you have not not connected with me on LinkedIn, please do so Take a look at my LinkedIn recommendation like this recording. Share it with other connect with me on instagram Facebook twitter and reddit. I also started a group me for my CPA candidate the The group is called CPA exam support the group if you haven't joined, please join us So to discuss CPA exam issues and meet other CPA candidate So let's take a look at this example to see how it works five guys and fries enters into a franchise agreement on December 31st 20 x 1 given adam corporation the right to operate a franchise of five guys and fries fgf And the period is five years Five guys and fries charges adam an initial franchise fee of $60,000 right to operate the business as a franchise Of this amount, so they're going to charge adam 60,000 immediately 30,000 to be paid immediately And as soon as we sign the agreement, this is what we mean immediately and the note which is the 30,000 remaining Adam will pay in five installments. So you're going to pay $30,000 today. Then you're going to pay $6,000, $6,000, $6,000, $6,000 and another $6,000. So this is how it ended up to be $60,000 together Now we know from the time value of money that when you have a series of payment You have to find the present value of the payment. So you have to record the payment at present value This is your obligation. So if we do discount the payment if we find the present value We're going to assume an 8% interest that if adam wants to go to the bank They will they will charge them 5% for the loan So 5,000 times the present value annuity factor of 4.7914 the present value of this obligation is 23,957 so although you'll be paying 30,000 in total The difference between 30,000 and 23,957 the difference it's going to be a discount which is the amount of the interest revenue So just make a note of this we're going to see this later Now as part of this arrangement and once we see as part of this arrangement You have to read now very carefully because this is how we're going to be Separating the separate performance obligation Five guys and fries help locate the site negotiate the lease Maybe they have a good experience negotiating the leases because they do this on a regular basis Purchase the site supervise the instruction the construction and provide employee training and equipment as necessary To be to be a distributor of its product Now bear in mind That training services and equipment are sold separately What does that mean? Well, it means that the Everything that they do for us except training and equipment In everything else what I mean by this negotiating the lease purchasing the site supervising the instruct the construction and Our separate obligation and training and equipment are also a separate obligation So the other help is basically part of the initial fee, but training and equipment are sold separately So we have to account for them separately. So they have to They have to perform their obligation before we recognize the revenue for training and equipment They they cannot recognize the revenue until they meet those obligations Also part of the agreement Adam is to pay a two percent royalty payment On its annual sales on January 10th of the following year So the year ends December 31st Adam will have to determine what's their total sales Then 10 years 10 days later will have to pay Five guys and fries the amount of royalty, which is two percent of sales So let's kind of break down the performance obligation of the franchisor five guys and fries. Well Right to trade name operating the business and business now how for four five years are not individually distinct So everything that we talked about here except training and equipment Everything else prior to this is part of the part of the initial fee When do they meet this initial fee when do they satisfy this initial fee when the restaurant is open? We're going to assume the restaurant will open on February 5th And after February after February 5th the franchisor will have no more involvements in the process So once we open the business The franchise or involvement is technically done Okay, also we have training services as a separate obligation And when is that satisfied when the training is provided? We're going to assume that's going to be done in the month of January because we're going to be opening the store February 5th And the equipment is the third obligation. When is that satisfied when they deliver the equipment? We're also going to be assuming it's going to be delivered in January So here's how we're going to break down the $60,000. Remember, we have a $60,000 contract Of what of which $30,000 is to be paid immediately in cash And this $30,000 is for for all the obligation except the training and the equipment So the $30,000 right to trade name market area and proprietary know-how Then the remaining of the money, which is the remaining $30,000. Remember this $30,000 Will be will be paid will be made in payment and we already computed the present value to be $23,957 This amount $23,957 we're going to allocate and just I'm going to I'm going to tell you this now in case You're saying where is this number coming from? I just told you that the training services are worth $9,957 and the equipment which was which were installed by January 15th are worth $14,000 Together they're worth $23,957 So if we add them all up the total transaction price is $53,957 But we said when we looked at this when we started this contract when we started discussing this contract It was for $60,000 So what's the difference? Well, if we take $60,000 minus $53,957 the difference is $6,043 And that's the discount on the note the discount on the note It means the interest revenue that the franchisor is going to earn interest revenue Because although we're going to be making five payments of this amount of this five $6,000 payment $6,043 will be interest revenue and the other amount is for the training services and the equipment Now, so let's go ahead and generalize the entry on the day that we sign this deal And we're going to sign this deal December 31st 20x1 On this date the franchisor would receive $30,000 and they will have a note receivable of $30,000 Remember this $30,000 is six payments times Now five five payments Times $6,000 each which will amount to $60,000 we debit cash we debit's notes payable We said that the notes receivable the discount, which is the difference between The note and the notes receivable is $6,043, which is a which is future interest revenue the discount We have unearned franchise revenue of $30,000 remember the initial $30,000 is for the unearned franchise revenue and when do we when do we when do we earn this when we when we when we when they open the store it means our obligation is done we can recognize it as revenue We have unearned service revenue for training $99.57 and when do we recognize this revenue when we provide the training We have unearned sales revenue for the equipment which is worth $14,000 So this is the entry that we make on when the agreement was signed on December 31st 2021 Now let's let's fast forward till February 5th which is a month later the store is opened So this is the entry that we made on December 31st Now the store is open now we're going to start to recognize the revenue Well we can recognize this $30,000 of revenue this unearned franchise revenue on February 5th The store is open we will reduce unearned service revenue and we'll increase revenue by $30,000 Also remember that the training was completed by the end of January Now we are ready to recognize the training revenue That doesn't have to happen I just I'm assuming that the training happened Maybe the training did not happen till March and we'll have to wait till March To recognize the revenue but we're going to assume it happened by the end of by the end of By the end of January they trained their employee they trained our employees Adam's employee which it makes sense because Adam's employee need to run the business Therefore they need to be trained before the store opened Also they deliver the equipment for Adam's business on January 15th So they will again they would they get root of the unearned revenue for training They get root of the unearned revenue for the sale for the equipment They will debit unearned revenue credit revenue notice here they are recognizing the revenue And also their cost for the equipment is $10,000 They will debit cost of goods sold and they will credit inventory So this is the entry that we make on February 5th when the when the business opened And if it looks like they earned older revenue because they delivered older separate performances Now it doesn't have to happen all February 5th including the initial franchise fee As I just mentioned earlier we're going to assume in this example that once they Once the store is open the franchise or fries five guys and fries They're done with their obligation they no longer have to service Adam from this point Going forward unless they have a new agreement of course but they have no obligation going forward Now during 20x1 Adam total sales was 750,000 that's the total sales Now what's going to happen most likely the franchisor will have will have access to Your accounting information system their fee is 2% their commission is 2% They're going to book a count receivable 750,000 times 2% They will credit franchise revenue of 15,000 This is part of the continuous commission the continuous royalty Then Adam will have to make the first payment of $6,000 Remember Adam owes them five payments of $6,000 The franchisor will debit cash 6,000 credit notes receivable 6,000 Now remember part of this note is interest they're going to have to compute the interest And the interest happens to be 1,917 they would reduce the note And they will increase interest revenue Now how did we come up with interest revenue you have to know this The note receivable has a face value of 30,000 minus the discount of 6043 So the book value of the note is 23,957 What we do is we'll take the carrying value of the note times 8% And the interest for year one is 1,917 Now you're a different color What color? We can't see that that's okay let me use the let me use the orange okay Wait actually I want the purple Okay we never used purple No problem So 23,957 times 8% that's going to be the interest for year one Now bear in mind you might be asked to compute the interest for year two For year two notes receivable is still 30,000 However the discount the discount initially was 6043 Well the purple is nice Adam Minus the discount the discount is 1,917 So what's left in this count is 4,126 Therefore the book value of year two note is 25,874 times 8% So the interest revenue in year two is 2,070 2,070 in case you are being asked what is the interest revenue for year two But you need to be familiar with how you compute interest revenue From when we talked about you know notes receivable I'm sure you are comfortable with that What should you do now at the end of this recording I'm going to remind you to go to farhatlectures.com And work MCQ's multiple choice questions to reinforce this concept Your education is important invest in yourself invest in your career Invest in your education study hard good luck and of course stay safe