This is the game I played when I was a kid, and, thanks to the new bugs, we're playing again:
I dunno, I think I might say something like, "Well that's not really a Bug Car -- only VW Bugs [a little explanation] are Bug Cars. We can change the rules to include some other cars if you want to, though."
With the writing, I think I'd probably do about what it sounds like you're doing. Go ahead and praise the positives, like, "Wow, I love this story! The part where the princess figures out how to get out of the castle was really good. Thanks for helping me out with the parts I couldn't read. You're getting better and better at writing in a way that I don't even need your help to figure it out, I can see just by reading it -- that's so cool! I'm sure [teacher name] will help you figure this stuff out as soon as school starts [etc.]"
As in, there is plenty to praise in the fact that she's writing phonetically, that's cool, you can go ahead and praise that while still honestly getting in there what she needs to work on -- with the implicit expectation that she'll get there, of course.