Franchisors – Time To Prepare For Your Fiscal Year End

Franchisors – Time To Prepare For Your Fiscal Year End

As you wrap up sales activities this fiscal year and begin preparing for an audit of your 2016 financials, we think it is important to keep in mind capitalization requirements imposed by state regulatory authorities and the effects of last minute sales on the company’s financials so that the company can avoid impound conditions or other delays in registration caused by inadequate capitalization.  Below is a brief summary of capitalization requirements imposed by state regulatory authorities, as well as a brief discussion of how initial franchise fees may be treated for financial statement reporting purposes.  We hope it will assist you in planning for next year’s registration season.

If you feel that the company’s financial statements have deteriorated year over year, or want to remove impound conditions imposed in prior years, we can assist you in determine how much additional capitalization the company will require, as well as your options for adding in the capital, if you can provide us with updated unaudited statements.  Do not hesitate to contact us should you have any questions.

Capitalization Requirements:

As a preliminary matter, all financial statements must be prepared in accordance with United States Generally Accepted Accounting Principles (“GAAP”), and audited in accordance with United States Generally Accepted Auditing Standards (“GAAS”), unless you are a start-up franchisor eligible to phase the disclosure of audited financial statements.

Although we cannot be certain what examiners may focus on in any particular instance, we know from prior experience that they consider a variety of factors in determining whether a franchisor is sufficiently well capitalized, including: (a) a positive overall net worth (excess of total assets over total liabilities); (b) a positive current ratio (excess of cash and other current assets over liabilities due within the year) plus sufficient working capital to cover projected openings; (c) the presence of fixed assets; and (d) income.

Generally, the net worth aspect of financial review is satisfied if you have a positive net worth, regardless of the amount (with the exception of Washington, which has an informal policy requiring all applicants to have a net worth of $100,000 or more).

In addition, in our experience, the current ratio must be positive and you must have sufficient working capital to support your franchising activities in the coming fiscal year.  Examiners generally use the following formula to determine how much working capital is necessary for a franchisor to obtain a registration without an impound condition:

Cash and cash equivalents must at least equal: 

Current Liabilities

+(Cost to Establish Franchisee * Number of Projected Openings During Coming Fiscal Year)

+ (Cost to Establish Franchisee * Number of Franchisees Signed but not yet Open As of Year End)

Examiners may request additional capital if the applicant experienced a net loss or consecutive net losses during its prior fiscal year ends.

A list of other factors examiners have considered when reviewing financials include:

  1. The auditor’s opinion letter (i.e. were any qualifications placed on the audit opinion letter itself or were any going concern issues raised);
  2. Negative or inconsistent information in the notes to the financial statements;
  3. The proportion of tangible and intangible assets;
  4. The amount and maturities of debts;
  5. The debt/equity ratio;
  6. The amount of equity;
  7. The earnings history;
  8. The proportion of receivables compared to other assets; and
  9. The quality of the receivables themselves (e.g. financial statements reflect receivables that will not be collected, including bad debts, a debt discharge in bankruptcy, or the failure to allow for aged receivables).

Treatment of Initial Franchise Fees

In addition, you should recognize the your franchise sales activities during 2011 can have a positive and negative effects on your on your fiscal year end financials.  We strongly recommend you sit down with your accountant to determine how franchise fees will be recognized.

In our experience initial fees are generally treated in the following manner:

  1. Initial Franchise Fees:  Initial franchise fees from franchisees that are open for business are fully recognizable.  To the extent single unit franchisees are signed but not yet open, the initial franchise fees collected may be deemed deferred revenue, and the entire initial franchise fee cannot be recognized as revenue until the franchisee is open for business. Therefore, to the extent you can open franchisees before December 31, you should.
  1. Multi Unit Options Fees:  Multi unit option feesmay be immediately recognizable because, once you actually grant someone an option, your obligations towards the option holder are fully satisfied.
  1. Area Development Fees: In our experience, the entire area development fee collected from a developer is recognizable once the area developer has opened their first franchise.   I am only aware of one instance in which a franchisor’s auditor apportioned initial area development fees over the life of the area development agreement.

Treatment of initial fees may vary, depending on the terms set forth in your individual franchise contracts and changes to applicable financial reporting rules.  We strongly recommend that you consult with your auditor regarding the treatment of initial fees taking into account your particular circumstances.

In the meantime, do not hesitate to contact one of the attorneys at FisherZucker to discuss your particular situation.