by Jim Marasco and Andrew Zappia.

The success of any franchised business depends largely on the ability of the franchise system and the franchisees to each meet the important responsibilities placed on them.  For the system, those responsibilities include perfecting the concept, running the system, and promoting concept growth.

Franchisee responsibilities include effectively operating their businesses within the concept and satisfying their other obligations to the franchisor, including monetary obligations.  A franchise system will be endangered if either party fails to meet its part of the bargain.

There is no doubt that franchisees typically keep a close eye on how their franchisor runs the system, to ensure that proper investments are being made into the concept and that the concept is being properly run and promoted.  Likewise, franchise systems need to be able to monitor their franchisees for system compliance to ensure brand protection.  However, compliance with operational and store appearance standards are only part of what the system must monitor.  Equally important are franchisee monetary obligations, because it is the flow of funds (in the form of royalties and advertising fees) from franchisee to franchisor that provides the resources to enhance and grow the system.

Audits are one way to monitor franchisee compliance.   However, for most franchise systems, putting a franchisee on notice that it will be subject to an audit is a difficult step.  Some franchisors see it as contrary to building and developing a cooperative business relationship.  Most systems are trying to add locations, not scrutinize the locations they already have for compliance.  Yet, an audit initiative that is properly planned, communicated and executed can dispel these apprehensions.

The honest and compliant franchisees will support such an initiative, because the objective is to ensure a level playing field.  The non-compliant franchisees are a threat to the system, by hurting the concept’s financial footing.  Non-compliant franchisees are also avoiding the obligations that honest franchisees are meeting, so basic notions of fairness support audits.  It is in everyone’s interest that no one be allowed to cheat the system.  Moreover, even the compliant franchisee will get direct benefits from an audit because auditors can pass along information that can assist the franchisee in improving its operations, including issues such as internal theft, weak internal controls, and out-of-line operational costs.

Purpose of Audit Program

Most audit programs are designed to evaluate sales underreporting and should address the various methods by which franchisee compliance with reporting requirements can be tested. For example, in an audit:

• Franchisee financial records can be checked against various government filings;
• Point-of-sale reporting or invoice/work order can be traced on a daily basis to the organization’s banking and credit card records;
• In situations where sales verification procedures have limitations, product usage or similar correlations can be created to measure actual sales volume.

Audit programs do not have to be limited to underreporting issues. Some concepts mandate the franchisee spend a certain percentage of gross revenues on local advertising expenses, purchase from authorized suppliers or operate within a defined geographic region. A simple review of key records can also reveal the opening and closing times, compliance with wage regulations and banking requirements, etc.

Developing the Audit Program

As with most initiatives, a well-designed plan and approach are a necessity for any audit program to be successful. There are three distinct steps with any audit program.  First, creating a detailed outline of the procedures that will be followed from candidate selection to the physical audit of the selected franchisees.  Second, the actual performance of an examination.  Third, documenting the audit and enforcing its findings.  Under most franchise agreements, sales reporting and royalty and advertising remittances are by and large the responsibility of the franchisees.  Most franchise agreements establish controls to govern these obligations, but in the end there is always a heavy dependence on a good faith understanding that the franchisee will faithfully comply with its agreement to pay these fees.  However, in certain circumstances, a franchisor needs to be able to ensure that the parties’ good faith understanding is being met.

Most agreements give the franchisor the right to audit franchisee compliance. A well-conceived audit process can foster compliance with these agreements, without creating any animosity or tension.  An audit program should be created in a methodical step-by-step process to ensure consistency in application.  The program should also be tailored to address the unique needs and characteristics of a concept.  Whether your concept is built on retail sales or providing a specialized service, the audit steps should address your needs.

Most audit programs are designed to evaluate sales under-reporting.  The outline of the audit program should address the various methods by which franchisee compliance with reporting requirements can be tested.  For example in an audit: franchisee financial records can be checked against various government filings; point-of-sale reporting or invoice or work orders can be traced on a daily basis to the organization’s banking records; in situations where sales verification procedures have limitations, product usage or similar correlations can be created to measure actual sales volume.  A written outline of the audit program should be created detailing these approaches as a tool for the auditor to use, but should remain flexible for potential modifications as the audit process develops.

Likewise, alternative procedures can be developed for situations where records are not available or full-cooperation is not being received.  Audit programs do not have to be limited to under-reporting issues. For example, some concepts mandate that the franchisee spend a certain percentage of gross revenues on local advertising expenses.  An on-site audit can validate these expenditures.  Other systems insist that certain products offered for sale by the franchisee be purchased from authorized distributors.  While analyzing the books and records, improper product purchases can be discovered.  A simple review of key records can also reveal the opening and closing times, compliance with wage regulations and banking requirements, and other important items.

These areas can all be addressed within an audit program. The level of detail that is built into an audit program must take into account a cost-benefit analysis of the consequences of franchisee non-compliance.  Developing an audit program will involve some expense and the franchisor needs to ensure that the benefits will outweigh the costs and the program needs to be tailored to ensure that.  The scope and duration of the review must be established.  For instance, most franchise agreements insist that three years of records be made available upon request, but reviewing three years of records can be time-consuming and expensive.  Alternatively, a shortened period within this three-year span can be considered.  Likewise, if a multi-unit franchisee is selected for audit, consideration should be given to reviewing only certain locations in detail.  In applying any limited scope procedures, if instances of abuse are discovered, the review can then be expanded to cover more years or all locations.

Concerning the cost-benefit, many franchise agreements have clauses, which provide that if franchisee noncompliance reaches a certain threshold, the audit costs must be borne by the franchisee.  Thus, franchisors can recoup the costs of an audit program in many ways.  Including the increased revenues generated by better franchisee compliance and the opportunity to charge non-compliant franchisees for audit costs.  To garner support for the initiative, it is important to emphasize how the results of an audit can actually help a franchisee.  An audit will examine expected gross profits, payroll percentages, operating expense relationships, and such.  Not all franchisees properly monitor or control these financial performance indicators.  By providing information to franchisees on the operational results of their businesses, an audit program can help them understand areas that need improvement to enhance profitability.

Thus, an audit program can serve the interests of both the franchisor and the franchisee by ensuring system compliance, while at the same time providing insight into areas where the franchisee could improve its operations.

Whom to Audit

Any franchisor can probably point to some in their system who would be good candidates for an audit.  Unfortunately, without proper planning and documented procedures, simply selecting the “problem” franchisees for audit can have serious consequences.  First, a method for choosing audit candidates should be created that selects a fair cross-section of franchisees.  That way, the selection process can withstand scrutiny for fairness.  Second, notification should be made to the franchisees in a formal manner: the selected franchisees and their officers, owners or operators should be contacted officially by certified mail. Individual franchise agreements may dictate the amount of lead time that must be given before an audit and those time periods must be followed strictly.  If the audit clause does not set forth a time period, we recommend no more than two or three weeks’ advanced notice.  Third, the same types of records should he requested from all audit candidates, by means of the notification letter or in a follow-up correspondence.  Fourth, all audit procedures and notices should follow the standards established in the audit clause of the franchise agreement.

Conducting the Audit

After the audit program has been designed, the candidates selected, and the notices sent, a franchisee should be given a limited amount of time to gather the records for the audit.  While the franchisee is collecting its documentation, the auditors should be in contact with the franchisee to discuss any questions or concerns regarding the scope of the review, when the review will take place, and the records that will need to be available.  From the time a franchisee is notified of an intended audit to the actual performance of the review by the audit team, much can be learned.

The franchisee’s initial reaction will typically determine the cooperation that will be received and the level of concern the auditors will carry with them.  A franchise system should be prepared for destroyed records, difficulty in scheduling, challenges to the right-to audit, challenges to the records being sought to review and a host of other concerns.  Once the logistics are worked through, the auditor should communicate the scope and objective at the initial introduction meeting.  Any questions or concerns can again be addressed, but at this point, the audit process should commence.

The records of the franchisee can be reviewed on-site or remote, if practical.  Audit teams usually number one to four individuals, depending on the size of the project, and audits will typically last one day to a week, depending on the scope, size and volume of the records under review.  Different auditors have different approaches.  The most successful method to conduct an audit is to obtain the necessary records in the least amount of time and with as little disruption to the franchisee as possible and then to quickly and accurately apply the procedures to validate compliance or accurately substantiate levels of noncompliance.

The audit team should ensure that prior to completing, all necessary information is obtained.  

After the Audit

After the audit is completed and the results analyzed, any suspected underreporting or instances of noncompliance with the franchise agreement should be dealt with promptly.  To support enforcement, adequate documentation must be maintained regarding all aspects of the audit.  If a dispute arises, such as a termination proceeding or a collection action, the documentation will likely be subject to intense scrutiny.

Weak or unsubstantiated allegations by the franchisor could prove embarrassing and costly.  A uniform and detailed written report should be generated from each audit and distributed to the applicable parties within a reasonable time period after the audit was performed.  Any serious noncompliance or underreporting should be quantified and then a demand for compliance and cure should be made to the franchisee.

In the absence of a cure by the franchisee, other appropriate action should be taken, including termination or litigation.  However, actions taken against franchisees should be consistent and uniformly applied.  Exceptions that are granted to some may be challenged by others in similar situations seeking similar treatment.  A tough, no tolerance attitude evidenced by your actions will do more to spark added compliance by your system than any other program or procedure you could implement.

Today, more than ever, franchise systems are being challenged. They are being challenged to grow their systems, expand their concept, add new product or service offerings, manage through greater governmental regulation, and monitor their members.  What cannot become lost is the need for honest cooperation between franchisees and the franchisor.  Franchisees have been entrusted to represent the brand to the public and to properly pay the franchisor for the right to use the brand. The financial strength and well-being of the system depends on compliance and integrity.  Franchisors owe it to themselves, their investors and all their franchisees to ensure full compliance.  Periodic compliance audits can be a valuable tool in achieving that goal.

James I. Marasco, CPA/CFF, CFE, CIA Jim is a partner at EFPR Group. He brings more than 18 years of public accounting and auditing experience.

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