Why Pursue a Franchisee Compliance Audit Program?

June 2016

Is your company leaving money on the table? Do you know everything about what your business partner is doing and how they are doing it? Anytime there is a contract between two parties that requires some form of self-reporting and payment, underreporting can occur. While approximately 20-30 percent of underreporting is a result of fraud, about 40-50 percent is due to interpretation issues and a large proportion of it stems from human error.

As a franchisor, a franchisee compliance audit program can help you avoid the fate of leaving money on the table and determine whether the underlying data reported by franchisees is correct. Such a program also ensures that both parties fully understand the franchisee contract and can identify and address misunderstandings that often exist.

What other benefits are there to implementing a franchisee compliance audit program?
  • Best practice – Whenever reporting is conducted on an honor system, it is a best practice to have a formal program in place to test that the reporting parties are doing so correctly, without errors or underreporting. The volume of contract compliance audits varies, but franchisors should have a program in place at all times, either internally or externally, or a combination of both. For example, a franchisor could have a program to perform 10 audits per year, selected randomly, or a routine program, or on an as-needed basis should a whistleblower or other event arise.
  • Manageable with limited resources – Many companies may not be at a size where they can conduct their own audits internally, whether it be because existing employees have limited bandwidth or lack of funds to hire dedicated personnel that can focus on such audits. For companies in these positions, it can be cost beneficial to have an independent auditor conducting these engagements. In some situations, a franchising agreement may stipulate that audits may be conducted by a third party only, usually a CPA.
  • Provides a valuable learning experience – While the amount of money that will be collected from an audit cannot be predicted with any certainty, the fact that the franchisor will learn something valuable about the reporting party and its operations can be guaranteed. The franchisee can also learn how to improve their processes, receive clarity around any misinterpretations and/or correct any errors that are uncovered, as well as develop strategies for preventing them from occurring in the future.
  • Eliminates temptation to underreport – Due to the self-reporting aspect of franchise systems, there is often great temptation for the reporting party to underreport funds. This is the case not only for franchisee relationships, but also in any situation where there is an agreement between two parties. Having a third party conduct an audit can help identify where this underreporting has occurred and an ongoing audit program can help eliminate this temptation.
  • Potential financial benefits – Franchisors typically receive a measurable return on the investment from an audit program through the identified underreportings. On average, franchisees underreport by about 10 percent. Therefore, if a franchisee has paid $$500,000, they may be underreporting by $50,000 – not an insignificant amount.
  • Can lead to improved operations – An audit program may help identify how franchisors can improve on their processes and operations, such as implementing certain internal controls when a report comes in, altering the form of the reports they receive or even rewriting terms of their agreements.
  • Sends a message to your network – Initiating an audit program sends a message through a franchise system that franchisors are serious about checking on their reporting and ensuring compliance with all aspects of the franchise agreement. This can help drive franchisees to improve compliance when it comes to reporting and be more diligent about following established processes.
While royalty audit programs require persistence (audits should be conducted regularly and involve commitment on the part of the franchisor) they present significant opportunities to identify additional royalties due to underreporting and improved franchise agreement compliance. Even if the increase in royalties reported across a franchise network amounts to just 10 percent following the implementation of a comprehensive audit program, the results go straight to the bottom line of the income statement, resulting in a positive impact to EBIDTA.