The franchise laws require that franchisors include three years of audited financial statements in Item 21 of the franchise disclosure document (FDD). The included financial statements must be for the franchise company's most recently completed fiscal three year period and include income statements, cash flow statements, and balance sheets. The audited financial statements must be presented in a three year column format, be prepared by a peer-reviewed Certified Public Accountant, and include an auditor's consent letter and opinion letter. This requirement is limited to the financial statements of the franchise company and does not require an audit or disclosure of the financial statements of any affiliated companies or parent company, unless the affiliate or parent company undertakes to guaranty financial or performance obligations of the franchisor company.
For start-up franchisors that are new to franchising, the franchise company should be a newly formed entity with limited operational history that has only initially begun operations or that has been in operation for less than three years. For these new franchisors, the franchise laws provide a financial statement phase-in process that, during the first year of franchising, is limited to the preparation of an initial opening balance sheet and a year-end audited closing balance sheet. Following the first year of operations, complete audited financial statements are phased-in. In most states, the initial opening balance sheet required at the time of issuing an FDD does not require an audit. However, state franchise laws within the franchise registration states require that a new franchisors initial opening balance sheet be audited and, for this reason, we recommend that all start-up franchisors include an audited opening balance sheet within their FDD.
Below is a summary of FDD Item 21 financial statement disclosure obligations.
What Financial Statements Must Be Included in an FDD?
Within Item 21 of the franchise disclosure document franchisors must disclose and include three years of audited financial statements of the franchise company. The financial statements must be comprised of income statements, cash flow statements, and balance sheets for the fiscal three year period preceding the issuance of the FDD. The financial statements must be audited by a Certified Public Accountant and include an auditors consent letter and audit opinion letter. As discussed below, start-up franchisors that are new to franchising are afforded a limited phase-in period that allows them to start-off with the Item 21 disclosure of an opening balance sheet and to then phase in more complete audited financial statements.
New Franchisor Financial Statement Phase-In Process
For new franchisors that have, for the first time, issued their FDD and have not in the past, either directly or indirectly through a parent or subsidiary company, offered franchises, there is an Item 21 financial statement phase-in process. This phase-in process allows a new franchisor, with a newly formed franchise entity, to initially issue its FDD with an Item 21 financial statement disclosure that is limited to an opening balance sheet. Below we discuss specific requirements for new franchisors.
For new franchisors, at the time of first issuing its FDD, the only financial statement that needs to be disclosed in its FDD is an opening balance sheet. Under the federal franchise laws and the majority of states, this initial opening balance does not need to be audited. However, franchise registration states including, California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, Virginia, Washington, and Wisconsin, requires that the initial opening balance sheet be audited by a certified public accountant. This applies even if the franchisor is a newly formed entity. Because of the audit requirement imposed by the franchise registration states, it is recommended that every new franchisor proceed with the disclosure of an audited opening balance sheet in Item 21 of their FDD. Without the audited opening balance sheet, the FDD cannot be registered in the franchise registration states.
The following FDD Item 21 financial statement disclosure requirements apply for new franchisors that qualify under the financial statement phase-in process:
- Initial Issuance FDD (Year 1)
Financial statements that must be disclosed in Item 21 are limited to an an opening balance sheet. This opening balance sheet must be audited for franchisors that intend to offer or sell franchises within a franchise registration states. This financial statement requirement applies at the time that the franchisor's FDD is issued for the very first time.
- Second Year FDD (Year 2)
Financial statements that must be disclosed in Item 21 are limited to: (a) the year 1 opening balance sheet, and (b) an audited year end closing balance sheet. If the franchise company's fiscal year is the same as a calendar year, then the year-end audited closing balance sheet must be as of December 31 of year 1. This financial statement requirement applies to the FDD that is issued, updated and renewed for the franchisors second year in franchising.
- Third Year FDD (Year 3)
Financial statements that must be disclosed in Item 21 include: (a) the year 1 opening balance sheet, (b) the audited year end closing balance sheet, and (c) full audited financial statements that include an income statement, cash flow statement, and year end balance sheet for year 2. This financial statement requirement applies to the FDD that is issued, updated and renewed for the franchisors third year in franchising.
A franchisor's Item 21 financial statement disclosure requirements will be impacted by the franchisor's fiscal year-end reporting period and whether or not the franchisor's fiscal year is the same as a calendar year. Learn more about when an FDD expires and must be renewed.
What is the Purpose of Item 21 Financial Statement Disclosures and Do State Regulators Review Them?
The purpose of the Item 21 and a franchisors financial statement disclosure requirements is to provide prospective franchise buyers with financial information about the franchisor. State regulators do review the financial statements. During the FDD review and registration process, within the franchise registration states, state regulators evaluate the financial statements disclosed by a franchisor. When reviewing and evaluating a franchisor's financial statements, state regulators make the following determinations:
- Sufficiency of Disclosed Financial Statements
Whether or not the FDD satisfies the Item 21 financial statement disclosure requirements including, whether or not the financial statements have been audited, whether or not the auditor is properly qualified as a peer-reviewed auditor, whether or not the financial statements and notes to the financial statements are complete.
- Solvency and Capital Sufficiency
Whether or not, as indicated by the financial statements, the franchisor is solvent and whether or not the franchisor maintains sufficient equity and assets necessary to support the franchisee training and pre-opening obligations. In most of the franchise registration states, if a state regulator believes that a franchisor is either insolvent or lacks sufficient capital to support franchisees, the state may condition franchise registration on the imposition of a financial assurance requirement such as the deferral of initial franchise fees, the posting of a bond, or escrow requirements. Learn more about franchise financial assurance requirements and when they are imposed.