Which of the following statements correctly describes the accounting rules for a franchise agreement?

• A. Initial franchise fees are recognized as revenue when all material services or conditions relating to the sale have been substantially performed by the franchisor.
• B. All franchise fees are recognized as revenue immediately upon signing the franchise agreement.
• C. Franchise fees are never recognized as revenue and are always recorded as liabilities.
• D. Ongoing royalty payments are recorded as a reduction of the franchisor's expenses.

Answer: (A)

Verified step by step guidance

1. Understand the nature of franchise agreements: A franchise agreement is a legal contract between a franchisor and a franchisee, where the franchisor grants the franchisee the right to operate a business using its brand, systems, and intellectual property in exchange for fees.
2. Identify the types of fees involved in franchise agreements: Franchise agreements typically involve initial franchise fees (paid upfront) and ongoing royalty payments (paid periodically based on revenue or other metrics).
3. Clarify the accounting treatment for initial franchise fees: Initial franchise fees are recognized as revenue by the franchisor only when all material services or conditions related to the sale have been substantially performed. This ensures that revenue recognition aligns with the completion of obligations under the agreement.
4. Clarify the accounting treatment for ongoing royalty payments: Ongoing royalty payments are recognized as revenue by the franchisor when earned, typically based on the franchisee's sales or revenue. These payments are not recorded as a reduction of expenses but as income.
5. Eliminate incorrect statements: Review the options provided and eliminate statements that conflict with the accounting rules. For example, franchise fees are not recognized immediately upon signing the agreement, nor are they always recorded as liabilities. Additionally, ongoing royalty payments are not recorded as a reduction of expenses.