There may come a time when franchising your restaurant concept is attractive in growing the brand without having to take on additional debt or managing the entire restaurant operations yourself. This can help you grow more rapidly in new markets and turn your concept into a successful franchise brand. One requirement that comes with franchising is the need to have annual audited financial statements to accompany the Franchise Disclosure Document (FDD). Previously, your corporate owned restaurant locations might not have been subject to any audit requirement so the need for audited financial statements could be an adjustment for you.
When first getting into franchising, it might be to your benefit to establish a separate operating company strictly for the franchising side of the business. This will allow you to only report the financial activity of the franchising operations without having your existing restaurant locations subject to audit requirements. While your existing locations could be a model for potential franchisees, being able to exclude these existing locations from the audit of your newly formed franchising entity will provide cost savings. However, prior to forming this new entity, you will want to consult with a franchising attorney to ensure that other entities of yours won’t need to get roped into the audited financial statement requirement.
Luckily, the need for audited financial statements could be phased in for the franchising entity. This is going to depend upon specific state requirements. Again, your franchise attorney will help you understand what is going to be required. Some states require audited financial statements from day one. There are others the follow the amended Franchise Rule, which allows for an unaudited opening balance sheet when filing your first FDD, followed with an audited balance sheet in year two and a full set of audited financial statements in year three. For those that require an audit with the first FDD filing, depending upon timing, these financial statements could be rather simple and just include an audited balance sheet consisting of cash and capital contributions for the new franchising entity. This will prove to the states that the franchisor is sufficiently capitalized.
There are a few other requirements with audited financial statements that you will want to be aware of. First, audited financial statements must be presented in accordance with generally accepted accounting principles (GAAP). Therefore, these cannot be on an income tax or other basis of accounting. In addition, the financials cannot contain any GAAP departures. GAAP departures result in a modified audit opinion, which we have seen cause issues with registering to sell franchises in certain states. Also, the audited financial statements must include comparative information. Usually, we see franchisor financial statements including three years’ worth of financial information.
Hopefully with time, your franchised concept will grow, and the audit cost will just be a small part of doing business. Having an annual audit performed will become common place, and you will be able to get that completed quickly so that you can file your FDD and renew your registration in the various states. However, the first few years could be an adjustment period if you have never been subject to an audit previously. Ultimately, prior to getting into franchising you will want to get in front of the structure of the franchising entity and the audited financial statement requirement so there is not any delay in getting this registered in various states so you can start your new, exciting world in franchising!
If you have questions, do not hesitate to reach out to one of our restaurant professionals who can guide you through this process.
Jonathan Poppel, CPA