Amigos Burrito Inc. sells franchises to independent operators throughout the northwestern part of the United States. The contract with the franchisee includes the following provisions.
1. The franchisee is charged an initial fee of $120,000. Of this amount, $20,000 is payable when the agreement is signed, and a $100,000 zero-interest-bearing note is payable with a $20,000 payment at the end of each of the 5 subsequent years. The present value of an ordinary annuity of five annual receipts of $20,000, each discounted at 10%, is $75,816.
2. All of the initial franchise fee collected by Amigos is to be refunded and the remaining obligation canceled if, for any reason, the franchisee fails to open his or her franchise. 3. In return for the initial franchise fee, Amigos agrees to
(a) Assist the franchisee in selecting the location for the business,
(b) Negotiate the lease for the land,
(c) Obtain financing and assist with building design,
(d) Supervise construction,
(e) Establish accounting and tax records,
(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 Amigos helps maintain the brand value of the franchise.
4. In addition to the initial franchise fee, the franchisee is required to pay to Amigos a monthly fee of 2% of sales for menu planning, recipe innovations, and the privilege of purchasing ingredients from Amigos at or below prevailing market prices.
Management of Amigos Burrito estimates that the value of the services rendered to the franchisee at the time the contract is signed amounts to at least $20,000. 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%.
Instructions
(a) Discuss the alternatives that Amigos Burrito Inc. might use to account for the franchise fees.
(b) Prepare the journal entries for the initial and continuing franchise fees, assuming:
(1) Franchise agreement is signed on January 5, 2017.
(2) Amigos completes franchise startup tasks and the franchise opens on July 1, 2017.
(3) The franchisee records $260,000 in sales in the first 6 months of operations and remits the monthly franchise fee on December 31, 2017.
(c) Briefly describe the accounting for unearned franchise fees, assuming that Amigos has little or no involvement with the franchisee related to expert advice on employee and management training, quality control, and promotion, once the franchise opens.