The topic of what types of financial statements must be included in a disclosure document in order to comply with the disclosure requirements of the Arthur Wishart Act (“AWA”) was discussed at a recent dinner put on by the OBA’s Franchise Law section. This article attempts to clarify a number of the issues relating to this topic, some of which were raised during the course of one of the presentations. (The analysis presented here is my own, and not necessarily that of the presenters at the dinner).
Section 5(4)(b) of the AWA requires that the disclosure document include “financial statements as prescribed”. Section 3 of the Regulations defines these financial statements as follows:
3. (1) Every disclosure document shall include,
(a) an audited financial statement for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with generally accepted auditing standards that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants Handbook;
(b) a financial statement for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with generally accepted accounting principles that are at least equivalent to the review and reporting standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants Handbook;
The Regulations then go on to identify certain exceptional circumstances in which such financial statements are not required to be disclosed.
Two types of standards
There are two types of standards that apply to financial statements.
The first are accounting standards, which govern how various transactions should be recorded in a company’s books and reported on its financial statements. For example, should an expenditure be capitalized (i.e. recorded as the purchase of an asset on the balance sheet), or should it be expensed (i.e. shown as a deduction on the income statement)? Different sets of accounting rules (e.g. Canadian generally accepted accounting principles (“GAAP”), US GAAP, International Financial Reporting Standards (“IFRS”)) will have different standards or rules for how various transactions should be recorded.
The second are auditing standards, or (more properly) assurance standards. These speak not of the content of the financial statements, but rather of the degree of investigation undertaken by the external accountants in verifying and providing assurance that the financial statements are not materially misstated. The highest level of assurance is an audit, which provides a positive level of assurance that the financial statements are not materially misstated. Below the level of an audit is a review engagement, which provides only negative assurance (“nothing has come to our attention that causes us to believe that the financial statements are not prepared, in all material aspects, in accordance with (insert name of applicable financial reporting framework…”). Review engagements consist only of inquiries and discussion with management and analytical procedures.
Section 3(a) of the Regulations
The phrasing of section 3(a) is unclear.
The regulation begins by speaking of how the franchisor’s financial statements are “prepared”. However, financial statements are “prepared” by its management, not its external auditors. When section 3(a) therefore speaks of how the financial statements were “prepared”, it is presumably a reference to the content of the financial statements, and in particular the accounting rules that were followed in presenting items on the statements. But section 3(a) does not tell us whichaccounting standard must be used. For example, Canadian GAAP? US GAAP? IFRS? Section 3(a) does not say.
What section 3(a) does say is that the financial statements must be “in accordance with generally accepted auditing standards that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants Handbook”. “Auditing” standards, not “accounting” standards. There is no reference to Canadian GAAP in section 3(a).
Therefore, one possible reading of section 3(a) might therefore be that if financial statements were prepared based on some foreign set of accounting standards – even if they are completely different from Canadian accounting standards – but were audited to a degree of assurance equivalent to a Canadian audit engagement, those financial statements would be acceptable.
Section 3(b) of the Regulations
Section 3(b) is also imprecise, but for a different reason. It speaks of statements “prepared in accordance with generally accepted accounting principles that are at least equivalent to the review and reporting standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants Handbook”.
Breaking this down, this section begins by describing GAAP – accounting principles – but then goes on to refer to those standards as being equivalent to the “review and reporting standards” (i.e. assurance standards) that apply to review engagements. Again, it mixes apples and oranges in comparing accounting standards to assurance standards. But there is – if one applies some syntactical reengineering – at least more of a suggestion here that we are concerned with the accounting standards being used in the financial statements as well as the level of assurance being provided, and that if the accounting standards are radically different from those used in Canada, the disclosure may be deemed insufficient.
Towards an Interpretation (?)
What is one to make of this terminological hodge-podge? It may make sense to step back to examine the issue from first principles.
It makes ample sense to speak of equivalency between assurance standards. Assurance standards will be universally applicable, regardless of the particular accounting standards to which they are applied. One can apply Canadian audit standards to a US GAAP financial statement, an IFRS financial statement, or any other type of financial statement.
However, what does it mean for one accounting standard to be “at least equivalent” to another? Does it mean that the treatment of the franchisor’s financial transactions must be equivalent andidentical under US and Canadian accounting standards, and therefore that a US and Canadian financial statement will look exactly the same before the US financial statement can be included in an Ontario disclosure document? This seems unlikely because, if so, what does the phrase “at least” mean? Either the two statements are equivalent or they are not; there are no degrees of equivalency under this definition. To say something must be “at least equivalent” implies that it can also be “more than equivalent” (which has an Orwellian ring to it), or “better”. How can one financial statement be “better” than the other?
Perhaps we can suggest an alternate explanation. Suppose that a certain expenditure is deemed to be an expense under US GAAP but a capital purchase (i.e. an asset) under Canadian accounting standards. Assuming all other transactions are treated identically, the US financial statement will show the franchisor to be in a worse financial position than the Canadian statement; they will show the franchisor as having fewer assets and less net income.
Suppose the franchisor is shown the US financial statement and proceeds, nonetheless, to purchase the franchise. It would be illogical for the franchisee to argue that, had it been provided with the Canadian statement it would not have bought the franchise, because the Canadian statements would show a rosier financial picture than their US counterparts. If the situation were reversed, however, such an argument might be plausible. Possibly, the degree of difference between the two versions might dictate whether a rescission remedy would be available under 6(1) or 6(2) of the Arthur Wishart Act, although what the relevant degree of difference would be is, to say the least, unclear.
Section 3 of the Regulations to the Arthur Wishart Act uses inconsistent terminology, and its intent is – at least in my layman’s reading – murky. It is clear that the financial statements contained in a disclosure document must be either audited or reviewed, and the US and Canadian standards in this regard are essentially the same. As for whether US GAAP is an acceptable basis on which to present the financial statements – I honestly don’t know.
IFRS are the financial reported standards currently in place for Canadian public companies, having replaced Canadian GAAP several years ago.