To further assist a prospective franchisee in the investment-decision-making process, Item 21 of the Franchise Disclosure Document (FDD) requires franchisors to disclose certain financial statements that reflect their financial condition. 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. Our skilled attorneys could discuss what financial statements a franchisor must disclose, as well as the best practices when drafting such disclosures, under Item 21 of the FDD.
The disclosure requirements for Item 21 are set forth under C.F.R 16 §436.5(u). They generally require that the franchisor disclose, in a tabular format, the following financial statements: (1) the franchisor’s balance sheet for the previous two fiscal year ends; and (2) statements of operations, stockholders equity, and cash flows for each of the franchisor’s previous three fiscal years. The financial statements must be presented in accordance with United States generally accepted accounting principles (GAAP), as revised by any future United States government mandated accounting principles, or as permitted by the Securities and Exchange Commission (SEC). With the exception of start-up franchisors, financial statements must also be audited by an independent certified public accountant using generally accepted United States auditing standards (GAAS).
The FTC 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 if a franchisor is operating within its first fiscal year, and the franchise system is not a spin-off, affiliate, subsidiary, entity related to an existing franchisor, or entity that has 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 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 an “accountant’s consent” document, which is a signed letter from the franchisor’s accountant that authorizes the inclusion of the prepared financial statements in the franchisor’s FDD.
Despite the leniency afforded by the phase-in exception, it is nonetheless important that a start-up franchisor’s unaudited financial statements conform as closely as possible to audited statements. This generally is accomplished through compliance with GAAP or principles permitted by the SEC. What currently complies with “GAAP” may change over time, because of federal government oversight of the accounting profession. It is important to note that states like Minnesota, New York, and Virginia do not allow for the phase-in of audited financial statements.
For the purposes of Item 21, an “established franchisor” is a franchisor operating 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 Item 21 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. An established franchisor must also include an accountant’s consent document in the FDD.
To satisfy the disclosure requirements of Item 21, an established franchisor in its third fiscal year and every year thereafter, must disclose the following audited financial statements:
In addition to disclosing financial statements that reflect the franchisor’s financial condition, both start-up franchisors and established franchisors may be required or permitted to disclose additional financial statements in Item 21 of the FDD if the franchisor has a parent, affiliate, or sub-franchisor. There are two circumstances in which a franchisor must disclose the financial statements of a parent company in Item 21 of its FDD: (1) if a parent commits to perform post-sale obligations for the franchisor; or (2) if a parent guarantees the obligations of the franchisor. If a parent guarantees the obligations of the franchisor, the franchisor must also include a copy of the guarantee in the attachments to the FDD in Item 22, in addition to the disclosure of its financial statements.
A franchisor must also disclose the financial statements of its sub-franchisors. “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. Further, 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.
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 FTC 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, as an attachment to Item 22 of the FDD.
Diligence is by far the best practice to employ in drafting the necessary disclosures under Item 21. Franchisors often overlook their financial-statement-disclosure obligations, and in doing so, either violate federal and state law, or cause an unnecessary delay in the completion, registration, and renewal of their FDD. Additionally, the circumstances in which a franchisor must disclose the financial statements of a parent, affiliate, or sub-franchisor are extremely particular, and require careful consideration by the franchisor. Because audited financials are expensive to prepare, start-up franchisors are wise to take advantage of the phase-in exception, but should ensure to begin using GAAP as soon as practicable. To ensure that a franchisor is meeting its disclosure obligations under Item 21 for each fiscal year of operation, it is best practice to contact a seasoned franchise attorney. A lawyer could determine the type, nature, and scope of financial statements to include under Item 21 of the franchise disclosure docuement.