Informal Staff Advisory Opinion
This staff advisory opinion addresses the disclosure of financial statements following a corporate reorganization and change of fiscal year.
I. BACKGROUND
You represent a large franchise system with over 500 franchised outlets (“Franchisor”). The Franchisor is wholly-owned by a subsidiary of another company (“Immediate Parent”). Beginning with the Franchisor’s disclosures dated April 1, 2004, the Franchisor chose to include the financial statements of the Immediate Parent, together with the Immediate Parent’s guarantee to assume the obligations of the Franchisor under the franchise agreement.
Recently, the Immediate Parent was purchased by the American subsidiary (“U.S. Parent”) of a company organized and headquartered outside the United States (“Foreign Parent”). This acquisition closed on November 17, 2005. According to your letter, after the completion of the acquisition and other restructuring, the Immediate Parent will be owned approximately 60% by the U.S. Parent and approximately 40% by the Foreign Parent.
Prior to the acquisition, the Franchisor, the Immediate Parent, and the U.S. Parent each had a fiscal year ending December 31. The Foreign Parent has, and continues to have, a fiscal year ending March 31. The Franchisor, the Immediate Parent, and the U.S. Parent have changed their fiscal year to end on March 31, consistent with the Foreign Parent’s current fiscal year end.
You now raise a series of questions on how the Franchisor should proceed in preparing its financial statements in light of both the corporate restructuring and the change in fiscal year. You pose various possible approaches, which are explained in detail in your letter. At its core, your inquiry raises essentially three questions:
- Under what circumstances may a franchisor use the financial statements of a parent;
- How should a franchisor prepare financial statements when its fiscal year has changed, specifically going from a calendar fiscal year to a March 31 fiscal year; and
- To what extent does the Commission take into consideration approaches adopted by the states regarding the preparation and filing of financial statements.
We will address each of these issues below. We begin with an overview of the Rule’s financial statement disclosure requirements.
II. FINANCIAL STATEMENT DISCLOSURES
The Franchise Rule requires franchisors to include financial statements in their disclosure documents. Specifically, section 436.1(a)(20)(1) provides that a disclosure document must contain:
A balance sheet (statement of financial position) for the franchisor for the most recent fiscal year, and an income statement (statement of results of operations) and statement of changes in financial position for the franchisor for the most recent three fiscal years. Such statements are required to have been examined in accordance with generally accepted auditing standards by an independent certified or licensed public accountant.
In addition, the Franchise Rule requires franchisors to update their disclosures on an annual basis. Specifically, section 436.1(a)(22) provides that “[a]fter the close of each fiscal year, the franchisor shall be given a period not exceeding 90 days to prepare a revised disclosure statement and, following such 90 days, may distribute only the revised prospectus and no other.” Further, within a reasonable time after the close of each quarter of the fiscal year, franchisors must prepare revisions to their disclosure statements to reflect any material changes. To the extent that there are changes in the franchisor’s financial condition, however, the franchisor may use unaudited financial statements for any quarterly updates, provided that the “unaudited information be accompanied by a statement in immediate conjunction therewith that clearly and conspicuously discloses that such information has not been audited.” Id.
III. USE OF PARENT FINANCIAL STATEMENTS
The Interpretive Guides to the Franchise Rule state that if a franchisor is a subsidiary, it need not provide audited financial statements of its own, but may include audited financial statement of its parent under limited circumstances. The parent’s audited financial statements must be prepared on a combined or consolidated basis according to generally accepted accounting principles. In addition, the franchisor must include its own unaudited financials. Further, the parent must “absolutely and irrevocably agree to guarantee to the franchisee all obligations of the franchisor under the franchise agreement and related agreements, and as set forth in the Basic Disclosure Document,” and the guarantee must appear in conjunction with the financial statements1.
According to your letter, Franchisor has used the audited financials of its Immediate Parent, and it contemplates continuing to use the audited financials of either the Immediate Parent or the U.S. Parent in the future. Assuming the Franchisor satisfies the requirements for the use of a parent’s financials – as outlined above – there does not appear to be any Franchise Rule issue. Moreover, the Franchise Rule does not express any preference about the choice of parents in the chain of ownership. Accordingly, Franchisor could use the financial statements of either its Immediate Parent or U.S. Parent.
IV. CHANGE IN FISCAL YEAR
In your letter, you state that the Franchisor and its parents (Immediate Parent and U.S. Parent) have changed their fiscal year from a calendar fiscal year to a March 31 fiscal year, consistent with the accounting practices of the Foreign Parent. You then ask how Franchisor should report its financials, given the change in fiscal year.
We begin by noting that nothing in the Franchise Rule addresses the effect of a fiscal year change on the obligation to prepare financial statements. Nonetheless, as noted above, the Rule permits the use of unaudited financial statements during the course of a fiscal year. Accordingly, we see no policy reason why the use of unaudited financial statements should not be permitted to address financial changes occurring during the course of a franchisor’s fiscal year, as discussed below.
A. Reporting Changes in Finances During a Fiscal Year
As noted above, franchisors that have prepared audited financial statements as part of their annual disclosure document updating, need not prepare any additional audited financial statements during the course of their fiscal year. In short, the obligation to prepare audited financials is an exclusively annual reporting obligation. In the event of changes in financial circumstances during a fiscal year, franchisors may use unaudited financials, until such time as their next annual update.
Accordingly, Franchisor may use unaudited financials to report changes in its financial condition during the course of its new March 31 fiscal year. So, for example, at the time of the restructuring on November 17, 2005, Franchisor will have had fully audited financial statements in its disclosure document for the year 2004. To reflect financial changes as a result of the restructuring, Franchisor may use unaudited financials for the period January 1, 2005, through November 17, 2005, and then separate quarterly unaudited financials for the post-acquisition period November 18 until the end of its new fiscal year – March 31, 2006.
B. Reporting Changes in Finances at the End of a Fiscal Year
In this instance, the franchisor’s fiscal year has been extended from December 31 to March 31, an additional quarter. According to your letter, starting in 2006, Franchisor intends to prepare an annual update no later than 90 days after the close of its new fiscal year, thereby complying with the Rule’s annual updating requirement. This annual update will contain financial statements for the year ending March 31, 2006. The question remains, however, how should Franchisor account for the extended reporting period, January 1, 2005, through March 31, 2006 – a 15-month period.
Your letter raises several possibilities for reporting changes in the Franchisor’s financial circumstances at the end of its new fiscal year. We believe the best approach in resolving this issue would be for Franchisor to prepare audited financial statements for the 15-month period January 1, 2005, through March 31, 2006. In our view, having audited financials for a 15-month period is better than other possible alternatives. For example, one approach would be for Franchisor to have audited financials for the period April 1, 2005, through March 31, 2006. While this approach would be consistent with the Rule’s requirement of comparing 12 months of financial data for three years, it would leave the period January 1, 2005 through March 31, 2005 unreported. Another approach would be to use unaudited financials for the period January 1, 2005, through March 31, 2005, with full audited statements thereafter. This approach is also undesirable. The Commission permits the use of unaudited financial statements in preparing annual financial statements only by start-up franchise systems and, then, only if audited financials are unavailable. 16 C.F.R. § 436.1(a)(20)(ii). In the hypothetical posed above, audited financials could in fact be prepared for January 1, 2005, through March 31, 2005.
For these reasons, it would appear that the most efficient and cost-justified approach would be to have audited financials, but for the 15-month period in question2. Nonetheless, to prevent any confusion to prospective franchisees in trying to compare Franchisor’s data over a three-year period, Franchisor should include a clear caveat at the beginning of each use of the 15-month financial statement over the three-year reporting period that: (1) the financial statement covers a 15-month period instead of a 12-month period because of a change in the company’s fiscal year end from a calendar fiscal year to a March 31 fiscal year; and (2) as a result, the 15-month statement is not comparable to the other two statements presented in the disclosure document.
V. COORDINATION WITH STATES
In your letter, you note that several franchise registration states have agreed to accommodate Franchisor by extending its registration so that Franchisor’s current registration will remain valid until such time as it prepares its annual update in June to reflect its new March 31 fiscal year. You ask whether Franchisor would be in compliance with the Franchise Rule if it were to prepare its annual financial statements as permitted by these states.
As an initial matter, the Commission has long recognized that states are free to adopt various registration requirements for franchisors. The Commission has said that these registration requirements are not preempted by the Franchise Rule. E.g., Interpretive Guides, 44 Fed. Reg. at 49971. State registration requirements, however, are not necessarily tied to a franchisor’s fiscal year. For example, a franchisor may register its disclosure document with a state in the middle of its fiscal year. Where a franchisor’s fiscal year ends in the middle of its annual registration, the state may require the franchisor to update its registration by filing amended financial statements after the close of its fiscal year.
The Commission permits great latitude to franchisors in order to comply with state law. As noted in the Interpretive Guides, where a franchisor has a currently registered disclosure document in a state, the Commission “will presume the sufficiency, adequacy, and accuracy of the document.” The Commission, however, “retains the right to determine whether the UFOC requirements . . . have been met, so that this presumption should not be viewed as deferring to state law enforcement. 43 Fed. Reg. at 49970-971.
In reviewing the states’ actions, we focus not on the term of the franchisor’s registration – an issue solely within the purview of the states – but on how the states permit a franchisor to report its financial statements. As indicated in your letter, several states are accommodating Franchisor essentially by permitting Franchisor to use a 15-month fiscal year. That approach is entirely consistent with the approach outlined above and we anticipate no conflict with the Franchise Rule.
Please be advised that our opinion is based on the information furnished in your request. Please be advised further that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.
Franchise Rule Staff: April 3, 2006
1 Final Interpretive Guides, 44 Fed. Reg. 49966, 49981, (Aug. 24, 1979).
2 Our opinion is based upon the specific facts raised in your letter – that Franchisor has extended its fiscal year by three months. Had Franchisor elected to extend its fiscal year by more than three months – for example, a November 30 fiscal year – our analysis might be different.