The preparation of financial statements is often a stressful, burdensome, and expensive process for a business. That is why a start-up franchisor will likely have many questions for its attorneys and accountants about the financials required in an initial Franchise Disclosure Document.
For established franchisors, it is clear that the FTC Rule requires financial statements to be audited by an independent certified accountant using generally accepted United States auditing standards. However, under the FTC Rule, start-up franchisors are permitted to “phase-in” audited statements and use an unaudited opening balance sheet for its first fiscal year selling franchises. Whether it is wise for a franchisor to take advantage of the “phase in” provision depends on two main factors:
- The states where the franchisor will be offering and selling franchises. Not all states follow the FTC Franchise Rule and permit the “phase in” of audited financials. Minnesota, New York, and Virginia all require initial financial statements to be audited. If a start-up franchisor is launching nationwide, then it must have its financial statements audited by an independent accountant. In addition, California requires a start-up to submit a balance sheet that is “reviewed” by a CPA who provides limited assurances that the financials meet GAAP requirements and are free of material misstatements. Finally, it is important to keep in mind that some states, like Illinois, still require that even unaudited statements be prepared by an independent CPA in accordance with GAAP.
- How quickly the franchisor wants to start selling. The initial launch of a franchise system takes time – usually a lot longer than a franchisor anticipates. Even if a start-up franchisor is launching only in states that permit a “phase-in”, a state regulator may have a tendency to exercise a higher level of scrutiny to a franchise registration application that does not provide audited financial statements. This can lead to additional comments and a delay in registration. It is also possible that unless a franchisor is very well capitalized the use of unaudited financials increase the likelihood that a regulator will impose an additional financial assurance requirement (such as an escrow, bond, or deferral of initial franchise fees). Professionals counseling start-up franchisors should make them aware that where audited financials may not be required, in the end it may cost less and take less time if its initial state registrations are filed with audited financials.
In short, while a start-up franchisor may wish to avoid the time and expense of having audited initial financial statements prepared, such statements are advisable if the franchisor is launching in states requiring registration of a franchise offer. Start-up franchisors launching regionally in non-registration states are the best fit for taking advantage of the “phase-in” rule.