Inspection affection

Andrew Hayward outlines the value of regular franchisee audits.

While it would be unfair to tarnish the reputation of the majority of franchisees who operate their businesses in accordance with the system and rules laid down by their franchisor, most franchise businesses will at one time or another have experience a franchisee who doesn’t. Franchisee ‘misbehaviour’ comes in a number of forms but a common complaint relates to jobs done ‘on the side’ for a customer, often for cash, where the income is neither recorded in the franchisee’s books nor declared in its returns to the franchisor for the purpose of calculating management services fees or royalties.

Not only does this reduce the franchisor’s revenues, but also probably constitutes illegal tax evasion on the part of the franchisee that, if exposed, presents a risk to the reputation of the franchised brand. The media do not instinctively tend to advise their readership of the distinction between a franchisee’s misconduct and the brand and franchisor. It usually remains for the franchisor to attempt to highlight the distinction, usually after the initial bad publicity and sometimes to little or no effect. How, then, can such situations be avoided? 

Ultimately, the answer is that it is impossible to eliminate altogether the chances of a franchisee ‘cooking the books’.

There is, however – or should be – a weapon in the franchisor’s armoury that can significantly reduce the risk and at the same time recover what would otherwise be lost income for the franchisor.

Somewhere in any well-drafted franchise agreement there should be a provision entitling the franchisor to undertake an audit of the franchisee’s business and accounting records whenever they wish to do so.

Some franchise agreements enable the right to be exercised without notice and entitle the franchisor to enter into any premises, showroom or even the franchisee’s home, to investigate their accounting records, take copies and make enquiries of the franchisee.

The franchise agreement should go on to provide that any attempt to obstruct the audit or refusal to cooperate with the franchisor’s investigation will constitute a serious breach of the agreement, entitling the franchisor to terminate it.

The agreement can also provide that if any financial discrepancy is discovered in excess of a specified amount then all of the costs of the audit are to be paid by the franchisee.

While such provisions could appear draconian or punitive, a sensible franchisor will ensure that they are not viewed in this way by carrying out regular audits throughout its network on franchisees selected at random.

Obviously, if a particular franchise outlet is causing concern or is consistently slow in producing accounting information, it may be seen as a signal that an audit should be undertaken to discover what is causing the accounting issue, whether the franchisee’s books and records are being properly maintained, and to ensure that full financial disclosure has been given to the franchisor.

Another positive purpose of an audit is, of course, to identify any areas where the franchisee could improve its accounting function or business practices generally to make it more efficient and increase productivity and profitability.

Audits should always be undertaken by someone with suitable accounting qualifications, otherwise they risk lacking credibility. There are many firms offering investigative accountancy services by suitably qualified professionals; see the bfa website for a list of affiliated providers.

The audit is a tool capable of providing useful information to both franchisor and franchisee and, if a franchisor wants to look at it this way, to keep all the franchisees in its network ‘on their toes’. Utilised properly, audits can be of enormous assistance in maintaining the integrity, reputation and financial wellbeing of a franchise network.

Andrew Hayward is a director in the franchise team at Owen White Solicitors.