Get your financial house in order: financial disclosure and the Code

Under the new Franchising Code of Conduct (“the Code”) which came into effect on 1 January 2015, there is greater obligation and cost to franchisors to provide financial information and there are various ways to do so as set out in the Code.

Decisions need to be made early on and franchisors now more than ever, need to get their financial houses in order.

Annual disclosure documents

Franchisors have four months from the end of each financial year to review and update their disclosure documents (by 31 October of each year), and must provide these to the franchisee.

The updated disclosure document must incorporate any material changes, including changes to the number of existing franchisees and key events, such as terminations and defaults.

In addition, franchisors  must provide a statement of financial solvency and include their financial reports for the last two trading years prepared in accordance with the Corporations Act,  or an audit report as well as financial statements for marketing funds (if applicable).

Marketing fund

The marketing fund financial statement must be prepared within four months after the end of the financial year (31 October) together with a marketing fund audit report unless clause 15 (2) of the Code applies. That is, if 75 percent  of franchisees agree not to have the fund audited for that financial year. (Not the three years as was formerly the case under the previous Code).

There are pecuniary penalties under the Code for a failure by a franchisor to comply with these requirements.

The impact of the Code changes on new franchisors

1. Where a franchisor has not existed for the previous two years

The franchisor must supply the following:

  • a statutory declaration of solvency by a director
  • an independent audit report by a registered company auditor of the business’ solvency that matches the date of the declaration by the director (“solvency statement audit”).

This is a mandatory requirement and cannot be avoided by franchisors.

Practical issues

This requirement has raised a number of interesting practical issues for new franchisors in our experience:

There is neither a definition nor guidance in the explanatory memorandum leading to the changes to the Code as to what “existing” for the previous two years means. Does this mean from the date of registration of the franchisor entity? Or from when the franchisor began operations as a franchisor?

The logical view is that it is two  years from the date of registration of the company.

In practice the franchise company may be established at an early stage in franchise planning. It may then take six  to 12 months before the franchise model, business plan and agreements are actually in place. In that period the franchisor is not trading, nor of course offering franchises, so the provision of their financials will be of little value to a prospective franchisee.

Another practical difficulty we have encountered, is that the audit certificate must be provided by a registered company auditor. Often the client may be dealing with their accountant who is familiar with their affairs but who is not a registered company auditor. Auditors have professional conduct rules and will not issue a certificate overnight. To support the directors’ solvency statement the auditor will be required to audit the financial records of the company, the cost of which ranges from $2,000 to $5,000 depending on the auditor and the complexity of the business.

In discussing this issue with Tim Kilham of Lanyon Partners, a well recognised franchise accountant,  he confirms that many new franchisors and their consultants are unaware of these new Code requirements and the time and cost it takes to get these steps in place can be significant.

Many new franchisors have no financial statements at all and this will delay their entry in to the market and ability to sign up prospective franchisees.

We have also found that the cost to new franchisors to establish their system has substantially increased due to these requirements.

There may also be issues if the auditor is not prepared to provide the solvency audit certificate.

So what is solvency?

The Corporations Act 2001 under Section 95A defines a person (which includes a company) who is not solvent as insolvent.

Section 95A provides that a person is solvent if and only if they are able to pay  their debts as and when they become due and payable.

So the question arises – how is it, that a new franchisor recently registered but not having engaged in any actual trading activity and therefore not yet receiving revenue, would be considered to be solvent?

2. Franchisor in existence for more than two years

A  franchisor’s director must provide a statement of solvency for the last financial year giving the director’s opinion as to whether they have reasonable grounds to believe the franchisor will be able to pay its debts as and when they fall due (the definition of solvency).

If the franchisor did not exist as at the end of the last financial year the director’s statement must be given as at the date of the statement.

The franchisor must provide the financial reports of the franchisor for each of the last two completed financial years (or foreign equivalent financial reports) prepared by the franchisor pursuant to Section 295 and 297 of the Corporations Act 2001.

Consolidated entities

If a franchisor is part of a business which provides audited financial reports (or the foreign equivalent) and the franchisee requests them, the franchisor must provide financial reports for each of the last two completed financial years..

Alternatively, the franchisor may provide a director’s statement of solvency supported by a registered company audit or foreign equivalent within four months after the end of the financial year.

Franchisors may be reluctant to provide copies of their financial reports for a variety of reasons as they may contain confidential and/or commercially sensitive information.

In this case the franchisor will need to provide the auditor’s solvency certificate supporting the director’s declaration under Item 21.1 of the disclosure document.

In cases where the franchisor (and/or business) was insolvent in either of the last two financial years

The franchisor must provide:

  • a statement by its director of the period during which it was insolvent in those two years
  • a statutory declaration by the director of its current solvency
  • supported by an audit solvency certificate.

Continuing disclosure

The Code also requires franchisors to provide continuing disclosure to franchisees if there have been any changes to the company’s solvency between the date of the disclosure document and the date it is actually provided to a franchisee.

What does this mean to new franchisors?

  • Make sure your financial statements and accounts are up-to-date and completed at the earliest opportunity after the expiry of each financial year.
  • The days when a company could delay the completion of their financial accounts until March the following year are now long gone!
  • Franchisors need to engage their accountants early and ensure their financial reports and audit statements are prepared and finalised well before  31 October
  • Franchisors need to ensure they are on top of their management accounts, their CFOs and internal book keeper are aware of these added compliance requirements, and systems are in place to meet the compliance regime.

A failure to do so can put a franchisor at risk of financial penalties under the Code but also delay their ability to roll out new franchises.