Sunkick Accounting Policy Recommendations Regarding the New Franchise Operations

To: Wendy Torrence, Controller

From: CPA

Re: Accounting policy recommendations regarding the new franchise operations

In the current fiscal year, Sunkick has started selling franchises.  Ray Mack has also implemented a new bonus program where senior management will receive a bonus based on the percentage increase in net income year over year.  As such, our accounting policy choices will impact the senior management’s bonuses.

Initial franchise fee

Issue: Sunkick is charging an initial franchise fee of $250,000.  With the franchise agreement, Sunkick is obligated to select the store location, provide leasehold improvements and provide training, on-going advertising and promotional support and information technology support for the length of the contract.  The contract is valid for a period of 10 years.

Bias: Senior management’s bias would be to record the fee all upfront in order to increase net income and thus, their bonus.

GAAP & Analysis: According to IFRS 15, revenue can be recognized after the following steps:

1. Identify the contract

• There is a franchise agreement between Sunkick and the franchisees.  Collectability is probable as the cash is received upfront.  The franchise agreement details the rights to goods or services and payment terms.  The agreement has commercial substance because Sunkick will be receiving a franchise fee and the franchisee will be receiving Sunkick’s support in order to operate their franchise.  There will be a change in cash flow and risk for each party.  The franchise agreement would be signed and thus, it is approved and the parties are committed to their obligations.  Thus, there is a contract.

2. Identify performance obligations

• Sunkick is required to 1) select a store location, 2) provide leasehold improvements, 3) provide training, 4) provide on-going advertising and promotional support and 5) provide information technology support for the length of the contract.  In evaluating whether these are distinct performance obligations, criteria 2 is met as each good/service is separately identifiable in the contract.  For criteria 1, the franchisee could benefit from help selecting a store without the other goods/services.  The franchisee could also benefit if Sunkick provided only the leasehold improvements.  They could also benefit from the other support services separately.  Thus, criteria 1 and 2 are met and five performance obligations can be identified.

3. Determine the transaction price

• The transaction price is the $250,000 stated in the contract.  There are no significant variable or financing components to this price.

4. Allocate the transaction price

• There could be an observable price for consulting and/or on-going services on a fixed or hourly basis for similar services on the market.  A quote could be obtained for services in selecting a store location, getting a contractor to provide leasehold improvements and for the training, advertising and information technology services.  Thus, the $250,000 should be allocated to the 5 performance obligations based on the stand-alone selling prices on a pro-rata basis.

5. Recognize revenue

• In evaluating whether Sunkick should record revenue over time, criteria 1 is met as the franchisee simultaneously receives and consumes the benefits provided as Sunkick provides each of the 5 performance obligations.

Recommendation: Revenue allocated to the store selection can be recognized once the store location is chosen.  The revenue allocated to the leasehold improvements can be recorded once the construction or delivery of the leasehold improvements are complete.  The price allocated to the training, advertising and IT services can be provided evenly over the 10-year contract.  This would defer some of the revenue, which would decrease the current year net income and management bonuses.

Sudbury location

During the year, the franchisee in Sudbury began experiencing difficulties and could not pay its staff for over a month.  As a result, Sunkick took control and is running it as a corporate-owned store.  Sunkick paid the Sudbury franchisee $100,000 and assumed the ten-year lease.

One option for Sunkick is to record the $100,000 as a reduction to the revenue recorded because in substance, this is a refund of part of the initial franchise fee.

Another option would be for Sunkick to record the transaction as a reacquisition of tangible assets as Sunkick is repossessing the franchise’s store and operations.  Per the handbook, this would be recorded at fair market value.  The obligations would also need to be recorded.  If the obligations exceed the tangible assets, the amount would be recorded as an expense.

I recommend that Sunkick record the transaction as a reacquisition of tangible assets and obligations as this better reflects the growth of the company in terms of its tangible assets.  Both options would reduce net income and thus, management bonuses.

Loans to franchisees

Sunkick has made loans of $75,000 at a 12% interest over five years to five franchisee locations.  Three of the five locations are having difficulty repaying the loan.  Two are only able to pay the interest and one has made no payments.  This leads me to believe that at least three of the loans are impaired.

Per IAS 39.63, “If there is objective evidence that an impairment loss on loans and receivables or held-to-maturity investments carried at amortised cost has been incurred, the amount of the loss is measured as the difference between the asset's carrying amount and the present value of estimated future cash flows (excluding future credit losses that have not been incurred) discounted at the financial asset's original effective interest rate (ie the effective interest rate computed at initial recognition). The carrying amount of the asset shall be reduced either directly or through use of an allowance account. The amount of the loss shall be recognised in profit or loss.”

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