Audit & Assurance for Franchisors & Franchisees

Item 21 is the financial statements section of the Franchise Disclosure Document, and for most franchisors it is the reason an auditor is engaged at all.

The FTC Franchise Rule requires financial statements prepared according to United States generally accepted accounting principles and audited by an independent certified public accountant using generally accepted United States auditing standards.

The disclosure is not a single year. Item 21 calls for balance sheets as of the previous two fiscal year-ends, plus statements of operations, stockholders’ equity, and cash flows for each of the franchisor’s previous three fiscal years.

A brand-new franchisor is not expected to produce audited history it does not have, and the rule contains an explicit phase-in for exactly that situation.

In its first year a start-up franchisor may satisfy Item 21 with an unaudited opening balance sheet alone. In the following year it must include an audited balance sheet covering both that opening balance sheet and a balance sheet prepared at the end of its first fiscal year. From the year after that, the full set of audited statements is required.

The phase-in carries conditions: audited statements have to be prepared as soon as practicable, unaudited statements have to follow the format of audited statements as closely as possible, and the document has to disclose clearly and conspicuously that the franchisor has not been in business for three years or more.

The relief is narrower than it looks. It is meant for companies genuinely new to franchising, not for a spin-off, affiliate, or subsidiary of an existing system that already has audited statements, so we confirm you actually qualify before scoping to it.

We coordinate directly with your franchise counsel so the statements and the disclosure document tell the same story, and we work back from your renewal date so the opinion is signed before it is needed.

Franchisor revenue sits under ASC 606, with franchise-specific guidance in Subtopic 952-606, and it is where most of the audit judgment concentrates.

We start with the franchise agreement itself: what the initial fee actually buys, which promises are distinct performance obligations, and how the transaction price was allocated among them.

The recurring finding is an initial fee recognized in full on opening day. Where that fee compensates the franchisor for a license running across the whole franchise term rather than for distinct pre-opening services, recognizing it at once overstates revenue in the year of sale.

Ongoing royalties follow a different path. A sales-based royalty promised in exchange for a license of intellectual property falls under a specific exception in ASC 606 and is recognized at the later of the franchisee’s underlying sale occurring or the related performance obligation being satisfied, rather than estimated up front.

That makes the underlying gross sales data an audit matter rather than a bookkeeping one, so we test how the system captures, validates, and follows up on the sales figures franchisees report.

Private franchisors have a practical expedient under ASU 2021-02: an accounting policy election that lets a defined list of pre-opening services, among them site selection, facility assistance, and training, be treated as a single performance obligation instead of assessed for distinctness one by one.

Where an election has been made, we test that it was applied consistently across agreements and disclosed, because an expedient used on some deals and not others produces statements that are hard to defend.

The result is fee and royalty revenue documented well enough to survive a state examiner’s questions, a prospective franchisee’s counsel, and a successor auditor’s review.

Advertising fund money is collected from the system and spent on the system’s behalf, and that framing drives how we approach it.

Franchisees contribute a percentage of sales into a fund the franchisor collects and administers, and the franchise agreement usually constrains what that money can be spent on.

The first question is presentation: whether the franchisor is acting as principal or as agent, which drives whether fund activity is reported gross or net, and whether that activity appears in the statements at all rather than being held off to one side.

We trace contributions from reported gross sales through into the fund, because a fund that is under-collected is a receivable from franchisees that someone has to recognize.

On the spending side we test that disbursements match the purposes the agreement permits, and we look specifically at administrative overhead charged to the fund beyond what the agreement allows.

Surplus and deficit balances get particular attention. A large accumulated surplus raises the question of whether contributions were actually spent on the system, and a deficit raises the question of who funded the gap and on what terms.

Many franchisors do not audit the fund separately at all. The activity is instead covered inside the audit of the franchisor’s own statements, which is where we test it.

Where the point is to show franchisees their contributions were spent as promised, a separate audit or review of the fund produces a report they can actually be handed.

Item 11 of the disclosure document tells prospective franchisees whether the fund is audited, whether they can see its financial statements, and how last year’s money split across production, media placement, and administration. We check that what the document claims and what the accounting shows are the same story.

Multi-unit operators rarely run a single legal entity, and the structure is where the reporting gets difficult.

Locations are often held in separate limited liability companies, sometimes with different partners in each, and the real estate is frequently held apart from the operating business.

Scope is settled first: which companies sit inside the reporting entity, which are variable interest entities, and whether your reader wants consolidated or combined statements.

Private companies may elect an accounting alternative that keeps an entity under common control, typically the owner-affiliated property company, outside the consolidated statements where the conditions for it are met.

Elimination is next. Rent, management fees, and notes running between the operating companies and the property companies come out of the consolidated figures, and whatever is left has to appear in the related-party note.

That note is mandatory and lenders go to it early, because rent set under market by a company the owners also hold makes a unit look stronger than it is.

Leases are the third piece. ASC 842 took effect for private companies for fiscal years beginning after December 15, 2021, and it moved operating leases onto the balance sheet as a right-of-use asset with a matching lease liability.

For an operator with dozens of locations that gross-up is substantial, and it moves the leverage and coverage ratios your lender measures, so the figures get walked through with you ahead of issuance rather than explained afterwards.

Every unit lease needs its classification, discount rate, and term written up, renewal options you are reasonably certain to exercise included, and at a franchised location those options usually follow the remaining franchise term.

Franchise systems tend to cross this line the year after an aggressive opening schedule.

The test applies at the plan, not at the brand. Once a plan files as a large plan, audited financial statements have to accompany its Form 5500.

Counting changed for plan years beginning on or after January 1, 2023. A defined contribution plan now counts only those participants who held an account balance at the start of the plan year, rather than everyone eligible.

For hourly crews spread across many units and turning over quickly, that is a meaningful shift. Employees who were eligible and never deferred no longer carry the plan across 100.

The 80-120 rule can postpone the answer again, letting a plan continue in its prior filing category while counts sit near the line.

Counting gets harder when several of your entities participate in one plan. Participants are counted at the plan level rather than unit by unit, so the controlled group and affiliated service group questions get worked through with you before anyone assumes a number.

When an audit is required and a qualified institution certifies the investment information, an ERISA Section 103(a)(3)(C) engagement limits our testing of that piece. It replaced what everyone still calls a limited scope audit and it produces a two-part opinion, not a disclaimer.

We test eligibility, contributions, distributions, participant data, and how faithfully the plan document was followed, raising operational failures while correction is still straightforward.

The report is scheduled to be finished before the Form 5500 is due, extension included, working alongside your recordkeeper and third-party administrator to get there.