Southern Fried Shrimp sells franchises to independent operators throughout the southeastern part of the United States. The contract with the franchisee includes the following provisions:
1. The franchisee is charged an initial fee of $25,000. Of this amount, $5,000 is payable when the agreement is signed and a $4,000 non-interest-bearing note is payable at the end of each of the five subsequent years.
2. All of the initial franchise fee collected by Southern Fried Shrimp is to be refunded and the remaining obligation canceled if, for any reason, the franchisee fails to open the franchise.
3. In return for the initial franchise fee, Southern Fried Shrimp agrees to (1) assist the franchisee in selecting the location for the business, (2) negotiate the lease for the land, (3) obtain financing and assist with building design, (4) supervise construction, (5) establish accounting and tax records, and (6) provide expert advice over a five-year period relating to such matters as employee and management training, quality control, and promotion.
4. In addition to the initial franchise fee, the franchisee is required to pay to Southern Fried Shrimp a monthly fee of 2% of sales for menu planning, recipe innovations, and the privilege of purchasing ingredients from Southern Fried Shrimp at or below prevailing market prices.
Management of Southern Fried Shrimp estimates that the value of the services rendered to the franchisee at the time the contract is signed amounts to at least $5,000. All franchisees to date have opened their locations at the scheduled time and none has 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 $4,000 each, discounted at 10%, is $15,163.
Required
1. Explain the alternatives that Southern Fried Shrimp might use to account for the initial franchise fee, evaluate each by applying generally accepted accounting principles to this situation, and give illustrative entries for each alternative.
2. Given the nature of Southern Fried Shrimp’s agreement with its franchisees, when should it recognize revenue? Discuss the question of revenue recognition for both the initial franchise fee and the additional monthly fee of 2% of sales and give illustrative entries for both types of revenue.
3. Assume that (a) Southern Fried Shrimp sells some franchises for $35,000 (which includes a charge of $10,000 for the rental of equipment for its useful life of 10 years);
(b) $15,000 of the fee is payable immediately and the balance on non-interest-bearing notes at $4,000 per year; (c) No portion of the $10,000 rental payment is refundable in case the franchisee goes out of business; and (d) Title to the equipment remains with the franchisor. What would be the preferable method of accounting for the rental portion of the initial franchise fee? Explain.