Audited Financial Statements for New Franchisors

Audited financial statements are a required part of franchising that many first time franchisors do not plan for until late. Item 21 of the Franchise Disclosure Document requires the franchisor's financial statements, and in most cases those statements must be audited by an independent certified public accountant. For a new franchisor, the audit affects when the FDD can be issued, when state registrations can be filed, and whether a state will place conditions on collecting franchise fees. This guide covers what franchisor audited financial statements must include, the phase in the FTC Rule allows for startup franchisors, how registration states review capitalization, and how to fit the audit into the development schedule and the annual renewal calendar.

What does Item 21 require?

Item 21 is the financial statements item of the FDD under the FTC Franchise Rule, 16 CFR Part 436. The statements must be prepared under United States generally accepted accounting principles and audited by an independent CPA. For an established franchisor, the rule calls for audited balance sheets for the two most recent fiscal year ends and audited statements of operations, stockholders' equity, and cash flows for each of the three most recent fiscal years. The FTC Rule also addresses when a franchisor may use a parent company's financial statements, generally where the parent guarantees the franchisor's obligations.

The statements belong to the franchisor entity, the company that signs franchise agreements. That is one reason franchise attorneys usually recommend forming a new franchisor entity rather than franchising from the operating company. Our post on franchisor entity structure explains how that choice affects the audit.

How does the FTC rule phase in audits for startup franchisors?

The FTC Rule allows startup franchisors to phase in audited financial statements rather than requiring three years of audited history on day one. In general terms, a franchisor that has not previously provided audited statements may begin with unaudited statements, such as an unaudited opening balance sheet, and then transition to audited statements as it completes its first fiscal years. The phase in has specific timing rules, and the FDD must explain which statements are included.

The phase in is a federal disclosure rule. It does not override state registration requirements, and that is where many new franchisors find the federal flexibility is not enough. Confirm the specific phase in steps that apply to your franchisor with franchise counsel and your CPA.

Why do some registration states require audited statements before registering?

A group of states require a franchisor to register its FDD with a state regulator before offering or selling franchises there. Several of those states expect audited financial statements as part of the registration application, even for a new franchisor that would qualify for the federal phase in. In practice, a franchisor that wants to sell in registration states usually needs at least an audited opening balance sheet before it files. Our overview of franchise registration states explains how registration works and which states require it, and the franchise laws section covers state rules in more detail.

State requirements change, and examiners have their own practices. Your franchise attorney should confirm the current requirements in each state on your filing plan before you set the audit date.

What is a capitalization review, and what conditions can follow?

State examiners review the franchisor's balance sheet to judge whether the franchisor can meet its obligations to franchisees before they open, such as training, site support, and opening assistance. When a franchisor looks thinly capitalized relative to those obligations, some states impose conditions on registration. The common forms are:

• Fee deferral, where the franchisor may not collect the initial franchise fee until it has completed its pre opening obligations and the franchisee has opened.
• Escrow, where initial fees are held by a third party until the franchisor meets its pre opening obligations.
• A surety bond, posted to cover the franchisor's obligations.

Fee deferral can have a large effect on a new franchisor's cash flow, because the fees it planned to use to fund support arrive months later. Planning the franchisor's opening capitalization with the CPA, and understanding how examiners in your target states have treated similar balance sheets, is part of preparing for registration. Counsel can advise on what a given state is likely to require.

How do you choose an auditor for a new franchisor?

The audit must be performed by an independent CPA, which means the firm that keeps your books or prepares your tax returns may or may not be able to perform it, depending on the services it provides. Ask about independence before you engage anyone.

Experience with franchisors matters as much as independence. Franchise accounting has specific issues, including how initial franchise fees are recognized as revenue, how marketing fund contributions are presented, how deferred revenue is reported, and how related party transactions with the operating company and any IP holding company are disclosed. An auditor who has audited franchisors before will know what state examiners look for and what the FDD needs. Questions worth asking a prospective auditor:

1. 01How many franchisor audits has the firm performed, and for systems at what stage?
2. 02Does the firm meet the independence requirements given any other services it provides to us?
3. 03What does the firm need from us before fieldwork begins, and how long does fieldwork usually take for an opening balance sheet audit?
4. 04Will the firm provide the consent that state regulators require for the audit report to appear in the FDD?
5. 05What is the firm's capacity in the months after our fiscal year end, when our annual audit will be due?

Where does the audit fit in the development schedule?

The audit depends on earlier steps and blocks later ones. The franchisor entity must be formed, funded, and keeping its own books before an opening balance sheet can be audited. The audit must be complete before the FDD can be finalized with Item 21, and in states that require audited statements, before registration can be filed. A practical order is:

1. 01Form the franchisor entity and open its bank account.
2. 02Fund the franchisor with its opening capital and sign the intercompany agreements.
3. 03Engage the auditor and agree on the audit date and deliverables.
4. 04Complete the audit and obtain the auditor's consent for use in the FDD.
5. 05Finalize Item 21 and the rest of the FDD with franchise counsel.
6. 06File in registration states and complete any notice filings.

Starting the auditor search while the entity is being formed avoids a gap where the FDD is otherwise ready but cannot be issued. Our guide on how to become a franchisor shows where the audit sits among the other development steps.

What is the annual audit calendar after launch?

The audit is not a one time event. Under the FTC Rule, a franchisor must update its FDD within 120 days after the close of each fiscal year, and the update includes new financial statements in Item 21. Registration states have their own renewal deadlines, many tied to that same window. A franchisor that misses the deadline may have to stop offering franchises in affected states until the renewal is effective.

That makes the audit a recurring line on the calendar. Most franchisors schedule the audit to begin shortly after fiscal year end, finish in time for counsel to update the FDD, and leave room for state review. The choice of fiscal year end matters too, since it sets when the annual crunch falls. Decide it with your CPA when the franchisor entity is formed.

How does a separate franchisor entity simplify the audit?

A newly formed franchisor has a short history: an opening capital contribution, intercompany agreements, and the first franchise fees and expenses. The auditor can review that history quickly. An operating company franchising directly brings years of unrelated revenue, payroll, inventory, leases, and liabilities into the audit, which raises its cost and its time.

A separate franchisor also produces financial statements that describe the franchise business clearly for prospects and examiners. The related party disclosures still have to be complete, so the trademark license, any services agreements, and intercompany payments need to be documented and followed.

Who should be on the team?

A franchise attorney and a CPA, working together from the start. The attorney prepares the FDD, advises on federal and state requirements, and manages registration. The CPA advises on the franchisor's capitalization and accounting, and an independent auditor performs the audit. Forge does not provide legal, accounting, or audit services. As part of franchise development services, Forge builds the franchisor financial model and coordinates the schedule so entity formation, capitalization, the audit, and registration happen in order.