It’s important for franchisors to periodically audit individual franchisees. These routine “check-ups” are especially valuable in a store’s early years of operations or if performance starts to deteriorate. They can be used to detect symptoms of unhealthy performance and treat problems before they spiral out of control.
The importance of royalty payments
Royalties are typically a franchisor’s primary source of income. Because royalties are typically based on a percentage of revenue, auditors pay close attention to the franchisee’s revenue reporting process.
To test whether revenue has been accurately reported, auditors trace transactions from the point-of-sale to:
- The franchisee’s financial records,
- Revenue reported to the franchisor, and
- Tax returns submitted to the state and federal government.
If the revenue trail doesn’t hold up, further investigation may be required. In addition to vouching a representative sample of randomly selected sales transactions, auditors use analytical techniques to compare key metrics for an individual franchisee against benchmarks for franchises of a similar size and others in your franchise system. Any discrepancies from these benchmarks raise a red flag that the franchisee may have underreported revenue to minimize royalty payments.
Compliance with franchise agreements
Beyond testing revenue, auditors spend extensive time examining whether the franchisee has complied with the franchise agreement. They consider such questions as:
- Is the franchisee spending the required amount on advertising?
- Does its signage comply with brand standards?
- Is the franchisee purchasing materials and supplies from approved vendors?
- Is the HR manager conducting appropriate employee background checks?
Failure to comply with such terms compromises future revenue and the reputation of your brand.
Analyzing a franchisee’s books and records can only reveal so much. There’s no substitute for meeting face-to-face with the owner-operator.
Site visits give the auditor an opportunity to assess business operations from the customer’s perspective, evaluate the condition of equipment and the morale of workers, and interview the management team. These inquiries help the auditor understand how the business operates and investigate any anomalies unearthed during testing and analytical procedures.
Hiring an outside auditor to enforce the audit provisions of your franchise agreement brings objectivity and financial expertise to the process. In addition to auditing a franchisee’s financial statements, a financial advisor can follow up on any compliance issues unearthed by the audit.