What Financial Statements Must Be Included in Your FDD Item 21 Disclosures?
A Guide to Financial Statement Disclosure Obligations for Start-Up and Established Franchisors
During the franchise and FDD development launch and post-launch stages, it is critical for franchisors and their legal counsel to clearly understand and evaluate the financial statement disclosures that must be included in "Item 21" of every FDD. Many times, franchisors overlook their financial statement reporting obligations and either violate federal and state law or, at a minimum, cause an unnecessary delay in the completion, registration, and renewal of their FDD. A franchisor's responsibility as to the type and nature of the FDD Item 21 financial statement disclosures varies between a start-up franchisor (a franchisor initially launching a franchise offering) and an established franchisor (a franchisor in its second fiscal year and each year thereafter).
Item 21 requires that in their FDD, franchisors disclose and include audited financial statements that include a balance sheet and multi-year statements of operations, shareholders’ equity, and cash flow. However, start-up franchisors – franchisors within their first fiscal year and new to franchising – are afforded a limited "phase-in" period at franchise launch; financial statement FDD disclosures are limited to an initial opening unaudited balance sheet. The nature and scope of this limited phase-in exemption is at times misunderstood and a trap for many franchisors.
Below is a brief guide to some information you will need to know and discuss with your franchise lawyer regarding your financial statement reporting obligations.
I. Summary of the Start-Up Franchisor Limited Audited Financial Statement Phase-In Exemption
STEP 1: UNDERSTAND AND DETERMINE WHETHER OR NOT YOU MEET THE START-UP FRANCHISOR CRITERIA
Typically, franchisors must disclose and include in their FDD "audited" multi-year financial statements. If you are a new franchisor, a limited "phase-in" exemption (where initially, your Item 21 FDD disclosure obligation may be satisfied with the disclosure of an "unaudited" opening balance sheet) may apply, where:
- Your company is new to franchising;
- You are within your first fiscal year;
- Your company (in the past) has not previously used or produced audited financial statements; and
- Your company is not a spin-off, affiliate, subsidiary, and/or related entity to an existing franchisor and/or an entity that prepared audited financial statements in the past.
STEP 2: UNDERSTAND YOUR ITEM 21 DISCLOSURE OBLIGATIONS AS A START-UP FRANCHISOR
If you meet the start-up franchisor criteria (Step 1) and you have reviewed the scope and application of this limited phase-in exception with your franchise lawyer, then the next step (Step 2) is to understand the scope of your financial disclosures during your first fiscal year. For the start-up franchisor that meets this criteria, the initial financial statement that must be included in your FDD is limited to an unaudited opening balance sheet. In addition to the opening balance sheet, you will also need to include in your FDD a document known as an "accountant’s consent" that is basically a signed letter from your accountant authorizing inclusion of the prepared financial statements in your FDD.
SUMMARY: To satisfy FDD Item 21, start-up franchisors who satisfy Steps 1 and 2 need only include the following financial statements during their first fiscal year: (a) opening balance sheet; and (b) an accountant’s consent letter.
II. Item 21 Financial Statement Requirements for Established Franchisors and What Start-Up Franchisors Need to Know About the Phase-In of Audited Financial Statements
For start-up franchisors who meet the phase-in criteria, upon commencement of your second fiscal year (which may be less than twelve months from the launch of your franchise and utilization of an initial franchise launch opening balance sheet), you must include in your Item 21 financial statement disclosures "an audited balance sheet opinion on [the franchisor’s financial condition] based on its opening balance sheet and a balance sheet prepared at the end of [the franchisor’s] first fiscal year."
POST PHASE-IN: What you need to know about future financial statements after expiration of the start-up franchisor phase-in period: franchisor fiscal years 3+
Upon expiration of your first and second fiscal year (assuming you meet the phase-in criteria), for your third fiscal year and beyond, you must operate by way of complete audited financial statements. You must discuss with your accountant and franchise lawyer the procedures to be put in place to ensure a smooth transition to audited financial statements, and the nature and type of financial statements that must be included in your FDD. Franchisors that are not relying on the limited phase-in exemption discussed above must annually include audited financial statements in their Item 21 disclosures.
These audited financial statements include:
- Your latest annual balance sheet as of the end of the two (2) most recent fiscal years;
- A statement of operations for the three (3) most recent fiscal years;
- A statement of stockholders' equity for the three (3) most recent fiscal years; and
- A statement of cash flows for the three (3) most recent fiscal years.
Before submitting this information, these financial statements must be audited by an independent certified public accountant and the accountant’s consent letter must be included in your FDD.
Practical Tip: Don’t Confuse "Fiscal Years" with "Calendar Years"
Every franchisor entity is different, and depending on your accounting and corporate structure, your "fiscal year" may or may not match a calendar year. Also consider and understand that the limited phase-in exemption applies to your status respecting your "fiscal year" and does not depend on the number of months that you have been selling or offering franchises. As an example, if your fiscal year matches the calendar year and assuming that you meet the criteria for the limited phase-in exemption, if you first offer and sell a franchise in August 2013 and 2013 is your first year in operation, your limited "fiscal year 1" phase-in exemption will expire on December 31, 2013, at the close of your "first fiscal year" – even though you have been in business for less than six months.
More Information for Accountants
Are you an accountant who would like to learn more about financial statement reporting requirements? If so, learn more about our CPE-accredited webinar "Franchise Law for Accountants."
- The Franchise Disclosure Document
- Where Does the FDD Get Registered or Filed?
- Documents to Start a Franchise
- FDD Item 19 Disclaimers
- FDD Item 19 Financial Performance Representations