Franchise Disclosure Documents | Item 21: Financial Statements

Item 21: Financial Statements

Consistent with the UFOC Guidelines, the amended Rule requires franchisors to include in Item 21 copies of their financial statements audited in accordance with generally accepted accounting principals (“GAAP”) for the most recent three fiscal years to show the financial condition of the franchisor. 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 the subsidiaries. Financial disclosures must be in tabular format that compares at least two fiscal years. This provides prospective franchisees with information with which to assess financial trends in a franchise system.

GAAP Requirement

The amended Rule requires franchisors to prepare financial statements according to “United States generally accepted accounting principles, as revised by any future government mandated accounting principles, or as permitted by the Securities and Exchange Commission.” The amended Rule updates the UFOC Guidelines by recognizing that what currently complies with “GAAP” may change as a result of federal government oversight of the accounting profession. Accordingly, it provides that franchisors must use GAAP, as revised by any future government mandated accounting principles.

At the same time, the amended Rule provides flexibility by permitting franchisors to comply with the Rule’s audited financial statement requirement by looking to principles articulated by the Securities Exchange Commission (“SEC”). This is most important for foreign franchisors wishing to sell outlets to be located in the United States. The amended Rule permits foreign franchisors to use United States GAAP or to reconcile their financial statements to United States GAAP, consistent with SEC law.

The SEC currently permits foreign companies registering securities to prepare financial statements using accounting procedures other than United States GAAP if such statements are prepared “according to a comprehensive body of accounting principles.” The company must also disclose the specific comprehensive body of accounting principles used to prepare the statements and explain material differences between the principles and United States GAAP. The company must also reconcile its statements with United States GAAP. For example, through additional notes, foreign franchisors must reconcile figures for net income and total shareholders’ equity for the period presented. Finally, the statements must provide all additional disclosures required by United States GAAP and applicable SEC regulations. Any foreign franchisor may take advantage of the SEC’s standard, whether or not the franchisor registers or intends to register securities. Of course, this approach may change in the future, especially if the SEC and the European Union, as planned, harmonize their accounting standards.

This flexibility, however, pertains solely to the preparation of financial statements. Even if a foreign company reconciles its financial statements to United States GAAP, it must audit the financials according to United States Generally Accepted Auditing Standards (“United States GAAS”), and the auditor must comply with the United States standards for auditor independence.

Parent Financial Information

Item 21 of the amended Rule provides that a franchisor must also disclose the financial statements of any parent corporation in two circumstances: (1) when the parent commits to perform post-sale obligations for the franchisor; or (2) when the parent guarantees obligations of the franchisor. In such circumstances, prospective franchisees may reasonably consider the parent’s financial status in their investment decision-making. Accordingly, the parent’s financial status is material. Also note that where a parent guarantees a franchisor’s performance, Item 21 requires the franchisor to include a copy of the guarantee in the attachments to the disclosure document in Item 22.

Affiliate Financial Information

The amended Rule also permits a franchisor to substitute the financial statements of an affiliate for its own financial statements if the affiliate’s statements meet the Rule’s requirements for audited statements and the affiliate absolutely and unconditionally guarantees to assume the duties and obligations of the franchisor to the franchisee under the franchise agreement. A copy of the guarantee, which need not extend to third parties, must be included in the attachments to the disclosure document in Item 22.

Subfranchisor Financial Information

The amended Rule requires the disclosure of financial information of any subfranchisor. The term “subfranchisor” is limited by the definition in Section 436.1(k) of the amended Rule to circumstances where the subfranchisor steps into the shoes of the franchisor by engaging in presale activities and performing post-sale obligations. It does not include those individuals who may be called “subfranchisors,” but who act like brokers or salepersons, having no post-sale commitments to franchisees. Where a person engages in pre-sale activities and commits to perform under the franchise agreement, his or her financial information becomes material in order to provide prospective franchisees with the opportunity to assess that person’s financial condition.

Phase-In of Audited Financial Statements

Like the original Rule, Item 21 of the amended Rule permits franchisors to phase-in the use of audited financial statements over the course of three years. The phase-in applies only to companies that are new to franchising and that do not yet have audited financial statements. If an existing company has prepared audited financial statements in the ordinary course of business before embarking on franchise sales it may not use the phase-in. Moreover, the phase-in is not available to spin-offs, affiliates, or subsidiaries of existing franchisors that have prepared audited financial statements in the past. In short, an existing franchise system cannot avoid the obligation to provide full audited financial statements by forming a spin-off company.

The phase-in works like this: When a new franchisor first prepares a disclosure document to begin selling franchises, it may meet the financial statement requirements by providing only an unaudited opening balance sheet. In the second fiscal year, the franchisor must include an audited balance sheet opinion on its financial condition based on its opening balance sheet and a balance sheet prepared at the end of its first fiscal year. During the third fiscal year, and thereafter, the franchisor must include all required audited financial statements required by the amended Rule.

Note that the amended Rule requires new franchisors to prepare audited financial statements as soon as practical, and mandates that unaudited financial statements must be in a form that conforms as closely as possible to audited statements. This requires the use of GAAP (or SEC-permitted accounting standards), as discussed above. Also, the amended Rule requres that one or more years of unaudited financial statements, as available, should be provided. If the franchisor has not been in business for three years or more, then it must clearly and conspicuously state in Item 21 that the franchisor has not been in business for three years or more and cannot include all the financial statements required by the Rule.

This article is part of a series of articles on starting a franchise in Minnesota.
CREDIT: The content of this post has been copied or adopted from the Federal Trade Commission’s Franchise Rule Compliance Guide.

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