Last month, we discussed the mandated audit requirements for the Franchise Disclosure Document (FDD) and introduced a few guidelines outlined by the Federal Trade Commission (FTC). Today, we will dive deeper into the financial information presented in the FDD and the importance of certain information to the auditor.
As previously mentioned, the FDD generally requires three years of audited statements, which is included in Item 21 of the FDD. There are a few additional considerations that a franchisor should keep top of mind related to Item 21 and outlined by FTC guidelines to ensure you are meeting requirements.
- Parent Financial Statements – parent financial statements are required to be included in the FDD under two circumstances: (1) if the parent commits to perform post-sale obligations on behalf of the franchisor and (2) if the parent guarantees obligations of the franchisor (note that if this applies, a copy of the guarantee is also required to be disclosed in Item 22 of the FDD).
- Affiliate Financial Statements – FTC allows a franchisor to substitute the financial statements of an affiliate for its own financial statements under certain conditions as outlined by the FTC, including an absolute and unconditional guarantee to assume the duties and obligations of the franchisor to the franchisee per the franchise agreement (note that if this applies, a copy of the guarantee is also required to be disclosed in Item 22 of the FDD).
- Sub-franchisor Financial Statements – if a sub-franchisor engages in pre-sale activities and is also obligated to perform post-sale commitments per the terms of the franchise agreement, the financial information of that sub-franchisor must be disclosed in the FDD. This does not relate to circumstances where a person acts as a broker or salesperson and lacks the ongoing commitment to the franchisee.
Other financial information noted in the FDD is included in Item 19: Financial Performance Representations. This section allows a franchisor to include information on financial performance such as sales, profits, etc. It is important to note that these disclosures on financial performance are not required; however, if you choose to disclose them, they come with rules and guidelines for the information presented. These rules and guidelines include, but are not limited to, the following:
- There is a required preamble to this section outlined by the FTC, and it must be included word for word. Further, if the franchisor opts not to make financial performance representations, additional required language outlined by the FTC must be included in this section.
- Financial performance representations must have a reasonable basis, which must be disclosed, along with assumptions made for the representation. It must include factual and supportable information that a reasonable prospective franchisee can understand.
- The information included can be related to historical data or projections; however, it is required that a franchisor explicitly states what the performance representations are based on.
- Historical – if historical representations are made, the FTC requires six elements to be specifically addressed:
- The group measured
- Time period measured
- Number of outlets measured
- Number of outlets reporting
- Number and percentage of outlets that achieved the stated level of performance
- Distinguishing characteristics
- Projected – projected representations must discuss the bases for projected information and include sufficient facts that allow a prospective franchisee to independently analyze and judge the projection. Projected representation requirements aren’t required to follow certain elements; however, they must explicitly state the factors and assumptions used. Validity of the projected information can include market studies, franchisee P&Ls, statistical data, and other information customary to rely on when making decisions.
- Historical – if historical representations are made, the FTC requires six elements to be specifically addressed:
- If needed, a franchisor must make available validation for any financial performance representation included in Item 19 to a prospective franchisee (and to the FTC, if requested).
- Financial performance representations cannot be inconsistent with information discussed in Item 19. This includes that a franchisor (including brokers or other sellers) cannot provide prospective franchisees with financial performance representations outside the FDD Item 19. As such, if a franchisor opts not to include representations in Item 19, it cannot make any financial performance claims.
It is crucial to ensure you are not misrepresenting information in Item 19. We recommend reviewing the FTC compliance guide for a list of all requirements and consulting with a franchise attorney. Additionally, due to the requirement to include audited financial statements in the FDD, your auditor is responsible for reading and considering the information disclosed. This requirement relates to Item 19 and Item 21 discussed here and the FDD as a whole. Financial and non-financial information that is inconsistent could indicate a material misstatement or facts and information that could impact the audit report. Be sure to communicate all FDD deadlines early in the audit planning to ensure no deadlines are missed.
Next month, we will move away from the FDD requirements and move into common accounting factors impacting a franchisor.
If you have questions on any of the topics listed above, please get in touch with Kari Maue or your GBQ advisor.
Article written by:
Kari Maue, CPA
Director, Assurance & Business Advisory Services
