Question

A franchise agreement grants the franchisor an option to purchase the franchisee's

business. It is probable that the option will be exercised. When recording the initial
franchise fee, the franchisor should
a. record the entire initial franchise fee as a deferred credit which will reduce the
franchisor's investment in the purchased outlet when the option is exercised.
b. record the entire initial franchise fee as unearned revenue which will reduce the amount of cash paid when the option is exercised.
c. record the portion of the initial franchise fee which is attributable to the bargain
purchase option as a reduction of the future amounts receivable from the franchisee.
d. None of these.

Answer 1

The correct treatment is to record the initial franchise fee as a deferred credit, which will later reduce the franchisor's investment in the franchisee's business when the purchase option is exercised.

Step-by-step explanation:

When a franchise agreement includes an option for the franchisor to purchase the franchisee's business, and it is probable that this option will be exercised, the proper accounting treatment of the initial franchise fee requires careful consideration.

The initial franchise fee should not be recognized immediately as revenue but instead should be handled as a deferred item.

Among the provided choices, the most accurate accounting treatment would be to record the entire initial franchise fee as a deferred credit. This deferred credit would then reduce the franchisor's investment in the purchased outlet when the option is exercised.

This option aligns with the revenue recognition principle, as the franchisor has a future obligation to perform, which is the purchase of the franchisee's business.

Consequently, choice (a) 'record the entire initial franchise fee as a deferred credit which will reduce the franchisor's investment in the purchased outlet when the option is exercised' is the correct treatment.