Choice Hotels International, Inc. and Subsidiaries

Revenue Recognition

The Company enters into numerous franchise agreements committing to provide franchisees with various marketing services, a centralized reservation system and limited rights to utilize the Company’s registered tradenames. These agreements are typically for a period of twenty years, with certain rights to the franchisee to terminate after five, 10, or 15 years. Initial franchise fees are recognized upon sale because the initial franchise fee is non-refundable and the Company has no continuing obligations related to the franchisee. Royalty fees, primarily based on gross room revenues of each franchisee, are recorded when earned. Reserves for uncollectible accounts are charged to bad debt expense and included in selling, general and administrative expenses in the accompanying consolidated statements of income.

The Company’s franchise agreements require the payment of franchise fees which include marketing and reservation fees. These fees, which are based on a percentage of the franchisees’ gross room revenues, are used exclusively to reimburse the Company for expenses associated with providing such franchise services as central reservation systems, property and yield management systems, national marketing, and media advertising. The Company is contractually obligated to expend the reservation and marketing fees it collects from franchisees in accordance with the franchise agreements; as such, no income or loss to the Company is generated. During the second quarter of 1998, the Company changed its presentation of marketing and reservation fees such that the fees collected and associated expenses are reported net. All prior periods have been reclassified to conform to the new presentation.

The total marketing and reservation fees received by the Company (previously reported as revenue) for the years ended December 31, 1999 and 1998, the seven months ended December 31, 1997, and the fiscal year ended May 31, 1997 amounted to $146.0 million, $127.4 million, $72.3 million, and $104.2 million, respectively. Depreciation and amortization charged to the marketing and reservation funds for the years ended December 31, 1999 and 1998, the seven months ended December 31, 1997, and the fiscal year ended May 31, 1997 amounted to $9.6 million, $6.2 million, $2.2 million, and $2.8 million, respectively. Under the terms of the franchise agreements reservation fees and marketing fees not expended in the current year are carried over to the next fiscal year and expended in accordance with the franchise agreements. Shortfall amounts are similarly recovered in subsequent years. Excess or shortfall amounts from the operation of these programs are recorded as a payable or receivable, respectively, from the particular fund. As of December 31, 1999 and 1998, the Company’s balance sheet includes advances to marketing and reservation funds of $37.7 million and $18.7 million, respectively. The advances made are composed of 1999 and 1998 marketing ($12.5 million and $7.8 million, respectively) and 1999 and 1998 reservation ($25.2 million and $10.9 million, respectively) funds. The Company has the ability under existing franchise agreements and expects to recover these advances through future marketing and reservation fees.

Transactions with Sunburst

Subsequent to the Manor Care Distribution, the Company participated in a cash concentration system with Sunburst and as such maintained no significant cash balances or banking relationships. Substantially all cash received by the Company was immediately deposited in and combined with Sunburst’s corporate funds through its cash management system. Similarly, operating expenses, capital expenditures and other cash requirements of the Company have been paid by Sunburst and charged to the Company. The net result of all of these intercompany transactions were reflected in Investments and advances from Parent.

As part of the Sunburst Distribution, Sunburst and the Company have entered into a strategic alliance agreement. Among other things, the agreement provides for: (i) a right of first refusal to the Company to franchise any lodging properties to be acquired or developed by Sunburst; (ii) certain commitments by Sunburst for the development of Sleep Inn and MainStay Suites hotels; (iii) continued cooperation of both parties with respect to matters of mutual interest, such as new product and concept testing; (iv) continued cooperation with respect to third party vendor arrangements; and (v) certain limitations on competition in each others’ line of business. The strategic alliance agreement extends for a term of 20 years with mutual rights of termination on the fifth, 10th and 15th anniversaries. In December 1998, the parties amended the strategic alliance agreement: (i) to eliminate Sunburst’s option to acquire the MainStay Suites brand; (ii) to amend Sunburst’s development commitments; and (iii) to provide certain global amendments to Sunburst’s franchise agreements.

In connection with the Sunburst Distribution, the Company borrowed $115 million under its Credit Facility in order to fund a Subordinated Term Note to Sunburst. The Subordinated Term Note of $115 million accrues interest monthly at an initial simple rate of 11% per annum through October 14, 2000. In connection with the amendment of the strategic alliance agreement discussed above, effective October 15, 2000 interest shall accrue at a rate of 11% per annum compounded daily. On January 1, 1999, the Company began recognizing interest on the outstanding principal and accrued interest amounts at an effective rate of 10.58%. The note is payable in full, along with accrued interest, on October 15, 2002. Total interest accrued as of December 31, 1999 and 1998 was $27.0 million and $12.8 million, respectively.