Lavazza Case

To: The board of directors of Lavazza Group S.p.a.

Re: Suggestions of appropriate accounting and reporting principles

We, Silvia Coran and Petr Maxmilian Hajkr, have examined and reviewed the operations associated with the franchise agreement of Lavazza Group S.p.a. The company is considering adopting the IFRS for the preparation of its financial statements given its worldwide position. This report is going to be used for the discussion at the meeting of the board of directors.

Our resposability is to express our opinions and give recommendations referring to IFRS accounting principles.

1. Initial franchise fee I

At the signature of the contract Lavazza receives 50.000€ in cash, which represents 20 % of initial fee. The rest of the initial fee (200.000€) will be paid in equal annual instalments over 4 years, with the first payment due 12 months after the franchise is opened. Therefore, this remaining amount will be recorded as Notes Receivable. The present value of the Notes Receivables should be calculated as follows:

initial fee 250.000 €

cash received 50.000 €

remainder 200.000 €

4 annual payments 50.000 €

borrowing 158.493 € at 10%

balance payment interest capital balance

31.12.12 158.493 € 50.000 € 15.849 € 34.151 € 124.343 €

31.12.13 124.343 € 50.000 € 12.434 € 37.566 € 86.777 €

31.12.14 86.777 € 50.000 € 8.678 € 41.322 € 45.455 €

31.12.15 45.455 € 50.000 € 4.545 € 45.455 € - €

The amount of Notes Receivable is 158.493 €. Given that 25.000€ represent entrance fee which is not refundable by Lavazza, it should be recorded as Revenue. The remaining amount should be recorded as Unearned Revenue differed and recognized as revenue as the services (listed in the point 6) provided by Lavazza are rendered.

Cash 50.000 €

Notes Receivable 158.493 €

Revenue (entrance fee) 25.000 €

Unearned revenue 183.493 €

2. Continuing franchise fee

Lavazza charges additional 5 % of the franchisee's gross revenue, paid for the use of continuing rights granted by the agreement, or for other services provided during the period of the agreement. Therefore, this continuing franchise fee should be recognized as the franchisee's gross revenue is calculated. Presumably this happens at the end of the accounting year.

3. Duration of the franchise agreement

The franchise agreement has a duration of 5 years and it can be renewed for additional 5 years. Every year Lavazza sells to its franchisee discounted merchandise (point 4). The difference between the market price and the charged price is approximately 13.750€ and this amount every year is recognized as Sales Revenue. Furthermore, there are some ongoing services (on average 10.000€ a year) that have to be rendered by Lavazza during the whole duration of the franchise agreement (point 6). We can calculate the portion of Unearned Revenue which should cover the initial and subsequent services stated in the contract.

number of years 5

discount 13.750 € 68.750 €

ongoing services 10.000 € 50.000 €

Total amount over 5 years 118.750 €

Unearned revenue recognized

at the signature of the contract 183.493 €

Portion of Unearned Revenue to cover

the initial and subsequent services 64.743 €

This portion of Unearned Revenue should be deferred and recognized as Service Revenue as these initial and subsequent services will be rendered. If Lavazza provides services whose value exceeds this amount, the continuing franchise fee should be used to cover the difference.

The franchise agreement is renewable for an additional 5 years. The initial fee should not be charged again, but there might be some renewal fees or other additional ongoing fees that should cover the services provided by Lavazza as stated in the first contract.

4. Supply of initial and subsequent services I

The franchise agreement provides for Lavazza to supply inventory and merchandise, at a price that is about 5 % lower than what charged to others. In this case part of the initial fee that covers the difference between the market price and the price charged by Lavazza to the franchisee is deferred and recognized as Sales Revenue in the period in which the goods are sold (once a year).

Merchandise bought once a year = 275.000 €

discount = 5%

Price of discounted merchandise = 261.250 €

Difference = 13.750 €

Cash 261.250 €

Sales Revenue 261.250 €

COGS 275.000 €

Inventory 275.000 €

Unearned revenue 13.750 €

Sales revenue 13.750 €

5. Initial franchise fee II

In the case the franchisee doesn't open the coffee shop, Lavazza is obliged to refund the initial franchise fee except for a 25.000€ entrance fee, recorded as Revenue at the signature of the contract. The entrance fee is supposed to cover the initial services that Lavazza is committed to provide before the eventual opening of the coffee shop. In other words, this fee is a "guarantee" for Lavazza's initial effort and therefore not refundable.

The