Item 21 of the Franchise Disclosure Document (FDD) requires franchisors to disclose certain financial statements that reflect their financial condition. This requirement further assists prospective franchisees in the investment-decision-making process. What financial statements and how they must be disclosed largely depend on which fiscal year the franchise is operating in.
Generally, franchisors operating in their first or second fiscal year of the franchise have less stringent and quantitative disclosure requirements, while franchisors operating in their third fiscal year and every year thereafter must disclose a greater quantity of financial statements, with more stringent requirements.
The Franchise Rule (the “Rule”) generally requires that a franchisor disclose audited multi-year financial statements to comply with Item 21 of the FDD. However, there is a lenient, phase-in exception for franchisors operating within their first fiscal year. To fall within this exception, a franchisor must be one who is new to franchising, operating within its first fiscal year; and whose company is not a spin-off, affiliate, subsidiary, entity related to an existing franchisor, or entity that used or produced audited financial statements in the past.
A franchisor who meets these conditions is a “start-up franchisor,” and is permitted to phase-in the use of audited financial statements over the course of its first three fiscal years. Therefore, when a start-up franchisor first prepares its FDD to begin selling franchises, it may meet the financial statement requirements in Item 21 by providing only an unaudited, initial opening balance sheet, and a document known as an “accountant’s consent”. This documentation is a signed letter from the franchisor’s accountant, authorizing inclusion of the prepared financial statements in the franchisor’s FDD.
The Rule requires that a start-up franchisor’s unaudited financial statements conform as closely as possible to audited statements, which requires compliance with Generally Accepted Accounting Principles (GAAP) in the United States, or as permitted by the Securities and Exchange Commission (SEC). What currently complies with “GAAP” may change over time, because of federal government oversight of the accounting profession. These standards, however, pertain solely to the preparation of unaudited financial statements. In a franchisor’s second, third, and every fiscal year thereafter, its financial statements must be audited according to United States Generally Accepted Auditing Standards (GAAS).
For the purpose of Item 21, an “established franchisor” is a franchisor in its second fiscal year and every year thereafter. To reflect the financial condition of a franchisor operating in its second fiscal year, an established franchisor must include an audited balance sheet based on its initial opening balance sheet and a balance sheet prepared at the end of its first fiscal year. The significant difference between the financial-statement-disclosure requirements in a franchisor’s first and second fiscal year is that, in the second fiscal year, the balance sheet must be audited and comply with GAAS.
An audited financial statement complies with GAAS if the auditor is an independent certified public accountant who complies with the United States standards for auditor independence. The franchisor must also include the accountant’s consent letter in the FDD.
In its third fiscal year and every year thereafter, to satisfy the disclosure requirements of Item 21, an established franchisor must disclose the following financial statements, which must be audited: (1) the franchisor’s latest annual balance sheet as of the end of the two most recent fiscal years; (2) a statement of operations for the three most recent fiscal years; (3) a statement of any stockholders’ equity in the company for the three most recent fiscal years; and (4) a statement of cash flows for the three most recent fiscal years.
In addition to disclosing financial statements that reflect the franchisor’s financial condition, both start-up and established franchisors may be required or permitted to disclose additional financial statements in Item 21 if the franchisor has a parent, affiliate, or sub-franchisor. The circumstances in which a franchisor must disclose the financial statements of a parent, affiliate, or sub-franchisor are particular. Therefore, these franchisors should consult with their attorney to determine the necessary disclosures.
There are two circumstances in which a franchisor must disclose the financial statements of a parent company in Item 21 of its FDD. These situations include when a parent commits to perform post-sale obligations for the franchisor, and when a parent guarantees the obligations of the franchisor. If a parent guarantees the obligations of the franchisor and its financial statements must be disclosed, the franchisor must also include a copy of the guarantee in the attachments to the FDD in Item 22.
A franchisor must also disclose the financial statements of its sub-franchisors. However, “sub-franchisor,” for purpose of Item 21, entails only those persons or entities that engage in presale activities and perform post-sale obligations for the franchisor. It does not include those individuals who may be called “sub-franchisors,” but who really act like brokers or salespersons and have no post-sale commitments to franchisees. Additionally, the financial statements of franchisors that own a direct or beneficial controlling financial interest in one or more subsidiaries must also reflect the financial condition of those subsidiaries. Financial disclosures must be in tabular format that compares at least two fiscal years.
In some instances, a franchisor may substitute disclosure of its own financial statements for that of an affiliate. This is permissible if the affiliate’s financial statements meet the Rule’s requirements for audited statements and the affiliate absolutely and unconditionally guarantees to assume the franchisor’s duties and obligations to the franchisee under the franchise agreement. A franchisor substituting disclosure of its own financial statements for that of an affiliate must also include a copy of the guarantee, which need not extend to third parties, in the attachments to the FDD in Item 22.
Franchisors often overlook their financial-statement-disclosure obligations under Item 21, and in doing so, either violate federal and state law, or cause an unnecessary delay in the completion, registration, and renewal of their FDD. To ensure that a franchisor is meeting these obligations under Item 21 for each fiscal year of operation, it is best practice for these individuals to contact its franchise attorney. One of our lawyers could determine the type, nature, and scope of financial statements that must be disclosed in Item 21 of your FDD.