Valuing a Franchisee

In a previous post, I examined some of the key issues involved in valuing a franchise system. In this post, I take a look at valuing a franchisee.

Like any business, the value of a franchised business is ultimately a function of a) the level of future cash flows the business is expected to generate, b) the duration of those cash flows, and c) the risk associated with those cash flows. But franchised businesses come with a number of wrinkles, as we discuss below:

A. Level of Cash Flows

With respect to projected cash flows, every business will be different in terms of its operating and investment cash flows. The valuator will need to project sales and operating expenses based on the historic results of the business and any forecasted changes. There are, however, a few twists when it comes to assessing a franchise.

Royalties

Most systems charge a royalty that varies in line with sales. Royalty percentages will vary on a system by system basis, and may change over time. It is important to review the franchise agreement to understand how the royalty system works.

It is also important to note that royalties can come in different forms. For instance, in some systems a significant portion of the franchisor’s revenue comes from markups charged on the sale of inventory rather than from royalties as such.

Some franchisors charge a fixed monthly royalty that does not fluctuate at all. This type of arrangement can be beneficial to successful franchises, but can be a severe burden when sales do not perform as expected.


Capital Investments

When valuing a business, it is always necessary to consider the need for capital investments, and to deduct any planned expenditures from the value.

Franchise agreements often give franchisors the right to require franchisees to carry out capital upgrades. The costs associated with these can often be significant; in the case of McDonalds, for example, the costs can run into the millions. The valuator needs to gain an understanding of any requirements for capital expenditures: when they will be required, how much they will cost, and how they will be financed. 

Financial performance of franchisees is often dramatically affected by these renovations. A franchise that has already done its capital expenditures will likely exhibit a spike in sales during the period when other, nearby franchises are closed for their renovations. It is important to understand the reason for these spikes and to normalize results on a go-forward basis.

B. Duration of Cash Flows

Renewal Rights

In many business valuations, the valuator will assume that the business will carry on into the indefinite future. When we apply a multiple of 5 times after-tax cash flows (for example), that multiplier may be assuming that the discount rate is 22% and the growth rate is 2% into perpetuity.[1]

Franchise agreements typically have a finite term, often consisting of 5 to 10 years. While many agreements contain renewal options, those are normally not automatic.

Now, that does not mean that, in valuing the business, we should project cash flows only over the remaining term of the franchise agreement. But it does mean that a realistic assessment of a) the probability of renewal, and b) the impact of non-renewal on cash flows need to be undertaken. Thus:

• Is the franchisee compliant with the franchise agreement? Is it current with all of its payments? Have discussions occurred with the franchisor concerning renewal?
• If the agreement is not renewed, will the franchisee be able to “de-brand” and carry on business under a new name? If so, how will the business perform? If not, what is the liquidation value of its assets?

Restrictions on Resale
 Franchisors will generally have the right to veto any potential sale of the franchise if the proposed purchaser is deemed unsuitable. While this right cannot be exercised unreasonably, this right can sometimes be a burden to franchisees.
In addition, unlike most businesses, owners of franchises are sometimes restricted in their ability to sell their businesses for an amount equal to their fair market value.  In some systems, the franchisor sets the selling price. In those situations, the impact on "fair market value" may depend on why the business is being valued. Is the plan to sell the business, or to hold it indefinitely?

For example, in Cooke v. Cooke, 2011 BCCA 44, a family law case, the divorcing couple owned two Tim Horton’s franchises in separate companies. They jointly retained a business valuator to value the two companies. The valuator arrived at a value of $850,000 for the more profitable company, and $295,000 for the less profitable company.

Unbeknownst to the valuator, Tim Horton’s had placed restrictions on the resale value of the franchises, stipulating a resale value of only $440,000 for the more profitable of the locations.

Nonetheless, the trial judge ruled that since the husband had no plans to dispose of the business, the limitation on its resale value was largely theoretical, and the value of the business to him as an ongoing investment was $850,000, equal to the present value of projected future cash flows. This finding was upheld on appeal.

C. Risk

Management Expertise

Let’s begin with some positives. One of the reasons franchised businesses are so popular is because one is buying into a business model that is tried and true. There is an operating manual, and the franchisor takes responsibility for many decisions such as what vendors to source supplies from, how and where to advertise, and how the business should appear. All of these factors ought to result in a lower level of riskiness than for a comparable, non-franchised business.

Concentration Risk

The flip side of this is that franchised businesses are typically restricted in a variety of ways. Their rights are typically limited to a particular territory and to the sale of particular products at particular prices. Non-franchised businesses have more flexibility in terms of mobility and the ability to try new product offerings.

Other Issues: The Market Approach

One method by which valuators will sometimes appraise a business is through the use of market comparables. Use of the market approach by a business valuator as a primary approach is relatively rare. It is usually difficult to find sufficient data involving truly comparable transactions.

Franchised businesses would seem to present a rare exception to this. Ostensibly, franchise systems impose a level of homogeneity on their franchisees such that, in theory, the valuation metrics for a group of franchisees should be a good predictor of what a subject franchisee will sell for.

Yet even within the context of franchised businesses, the application of this approach is not easy. This was recognized in C.V.D. v. I.D., 2003 MBQB 274, where the Manitoba Court of Queen’s Bench rejected the application of a rule of thumb approach to valuing a McDonalds’ franchise at 50% of sales.

First of all, even within a franchise system, sales and profitability levels can vary dramatically. Below, I present information from 22 transactions involving Dairy Queen restaurants, based on data from the Pratts Stats database. The chart shows that the vast majority of these restaurants sold for an asset value equal to 0.2 to 0.6x sales. That might seem like a fairly narrow range, until you realize that it simply means that a restaurant with sales of $800,000 will sell for anywhere from $160,000 to $480,000.

Second of all, within any franchise system there will be a wide range of revenue levels, profit margins and other metrics. Every franchise is still, in many ways unique.

At the end of the day, valuing a franchisee is similar to valuing any other business. Buyers want to know the answer to two questions: how much they will make, and how risky the business is. Hopefully, this article has provided them with some useful tools for finding answers to these questions.

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[1] Using the Gordon Growth Model, 1/(22%-2%) = 5.

Valuing a Franchise System

Valuing a franchise system, or “franchisor”, is in many ways very similar to the valuation of any other type of business; it is a function of the forecasted levels of cash flows that the business will generate, and the risk associated with those cash flows. Yet there are some particular factors that make valuing franchisors very tricky. This brief article touches on some of them.

Franchisors – Who are they?

The first point we need to clarify is what we mean when we speak of “franchisors”.  Broadly speaking, a franchisor is a business that earns its income by granting the privilege to one or more franchisees to do business and offers some form of ongoing assistance and oversight in return for ongoing monetary consideration.

Franchisors operate in a variety of industries. The largest industry sector is in the food services; these businesses made up around 40% of the membership in the Canadian Franchise Association in 2017.[1] Tim Hortons’, McDonalds, Swiss Chalet – you get the picture. But there are many other types of franchisors in the retail and service industries. Most hotel chains are franchised, as are most automobile dealerships and the guys who promise to remove junk from your house at all hours of the day. These different industries obviously have different valuation characteristics.

There are also different types of business structures for franchisors. Thus:

• Some franchisors are what one might call “pure plays” (i.e. their income derives almost solely from the sale of franchises and the receipt of royalties). On example of this type of franchisor is Dine Brands Global Inc., the franchisor for the “Applebee’s” and “IHOP”.
• Other franchisors have structured their publicly traded shares as “royalty income funds”, which receive a portion of the royalties from the franchisees, while many of the expenses of operating the system are incurred in a separate company. Examples include Keg Royalties Income Fund and Boston Pizza Royalties Income Fund.
• Still other franchisor companies are hybrids, with a significant chunk of their revenue (though not necessarily their profit) coming from corporate-owned stores or from the sale of inventory to franchisees.

In a similar vein, while some franchisors hold a lot of real estate (e.g. McDonalds, Canadian Tire (until recently)), others do not.

What this means is that it is very important to understand the business of the franchisor you are valuing. It may hold several different sources of value: a stream of royalties, one or more actual operating businesses, and real estate. In order to gain a true grasp of the value of the business, you need to disaggregate and understand the different sources of value.

Valuation Approaches

There are three main approaches to valuing a business or asset: the income approach, market approach and asset approach. Of these, only the first two have any real relevance to valuing franchisors.[2] Stated very briefly:

• Under the income approach, the business valuator quantifies the present value of future cash flows associated with share ownership. The calculated future cash flows are discounted at a rate of return appropriate for the risks associated with those cash flows.
• Under the market approach, the business valuator determines the fair market value of the company based on comparable public companies and/or transactions involving comparable companies. 

Income Approach

The three main drivers of value under the income approach are a) the current level of cash flows, b) projected growth and associated reinvestment, and c) risk. Let’s take a look at each one.

Cash Flows

For “pure play” franchisors, this issue can be relatively simple. Operating margins for franchisors are generally high; there is also typically fairly little in the way of capital expenditures. Furthermore, franchisors as a whole tend to carry fairly little debt relative to their equity values (unless they have made acquisitions). They also tend to carry fairly low working capital balances. All of this means that in general, after-tax net income can serve as a reasonable proxy for cash flows.

For franchisors who also earn revenue from other sources (e.g. sale of inventory, operation of corporate stores), the analysis can become more complicated, and it will be necessary to consider things like capital expenditures to upgrade stores, changes in minimum wage legislation and commodity prices, and all of the other complicating factors that go into valuations of businesses in other industries.

Growth

For franchisors, growth can come from two main sources: a) growth in the number of franchisees and b) growth in income per franchisee. In addition, growth can also come from acquisitions.

Growth in the number of franchisees can lead to multiple sources of revenue growth. In additional to new royalty streams, franchisors also typically charge an initial franchise fee that is payable upfront; this can often be substantial and can be a significant source of revenue. Some franchisors also serve as suppliers to their franchisees and earn income from markups on the supplies they sell. Franchisors can also assist their new franchisees manage the build-out of their locations, charging a management fee.

In many businesses, growth is accompanied by significant cash outflows as companies are required to carry additional inventory, carry more accounts receivable and build larger facilities. Franchisors do not have to deal with these issues to nearly the same degree.
That said, franchisors face other issues when it comes to growth. There is a cost associated with finding new franchisees in new territories, and for that reason many franchisors outsource that function to master franchisees. The master franchisee will assist the franchisor in developing franchisees in a given territory, but only in exchange for a significant cut of the new franchisees’ franchise fees and royalties.

Moreover, growth within a territory can result in friction with existing franchisees. The addition of a new location within proximity to a franchisee can lead to great overall system sales (and thus more royalties and other payments to the franchisor); but this comes at a cost to the existing franchisee, who in some sense becomes a competitor to the newcomer and will likely see a reduction in income. If the reduction is too great, the existing franchisee may go out of business.

Risk

Established franchisors are relatively immune from macro-level trends. To understand why this is the case, consider the difference between a franchisor and a franchisee of a restaurant chain. Assume that each of a chain’s 100 franchisees earns an average of $500,000 in revenue per year, that the costs of sales equals 30% of sales, the royalty is 5%, and fixed costs (labour, rent, utilities) equals 55% of sales, giving it a profit margin of 10%, or $50,000 per year. The franchisor makes $25,000 in royalties (5% of $500,000) per franchisee, and $2.5M overall from the 100 franchisees.

If the market shifts and the franchisees sales decline by 15%, the franchisor’s profit from the restaurant will also drop by around 21%;[3] however, the franchisees’ profits will drop by almost 98%.

The fact that a franchisor’s profits are less subject to large swings based on small changes in revenue is an advantage and lowers the riskiness of an investment in a franchisor.
On the other hand, there are also risk factors that are significantly higher for franchisors than for other businesses. Many of these are legal in nature. Franchisors can be susceptible to class actions of various types, although the success rate for these so far in Canada has been poor.[4] Franchisors are also subject to a rigorous disclosure regime in many Canadian provinces; the failure to provide a proper Franchise Disclosure Document (“FDD”) can be severe, with franchisees potentially eligible to rescind their agreements and recover all of their costs and losses within the first two years of signing the franchise agreement. In my experience dealing with quantifying such claims, the average bill to a franchisor is somewhere in the $300,000 to $500,000 range, plus legal costs.

Market Approach

As we discussed above, franchise systems derive their value from many different sources. That can make the market approach difficult to apply; it is difficult to speak of a standard valuation multiple based on revenue in the franchising industry.  Thus:

• While royalty income funds (e.g. Boston Pizza Royalties Income Fund, Keg Royalties Income Fund) have tended to trade at multiples of over 10 times revenue, other hybrid franchisor public companies (e.g. Imvescor Restaurant Group Inc.) have traded at around five times revenue.  Multiples of revenue are therefore generally not a good approach to use.
• As described above, franchisors who derive most of their revenue from franchising (as opposed to corporate stores) generally are less subject to volatile changes in their profits. Royalty income funds are even less volatile, since their costs are minimal.
• Differences in growth rates can also affect multipliers; firms that are expected to grow rapidly will attract higher multipliers.

In summary, the market approach is a difficult approach to apply for franchisors.

Conclusion

Conceptually, valuing a franchise system is in many ways no different than valuing any other business: it requires an understanding of the industry and the business, and the assessment of cash flows and risk. Executing on these concepts can pose a challenge.

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[1] 2018 CFA Accomplishment Report

[2] The asset approach is generally one that is more applicable to companies whose main value derives from their individual asset holdings (e.g. real estate holding companies).

[3] I have assumed a level of fixed costs for the franchisor similar to Dine Equity, a “pure play” franchisor.

[4] Several notable examples include:

-          Fairview Donut Inc. v. The TDL Group Corp., 2012 ONSC 1252 (brought by Tim Horton’s franchisees over the introduction of a breakfast menu). Certification denied.

-          1250264 Ontario Inc. v. Pet Valu Canada Inc., 2016 ONCA 24 (brought by Pet Valu franchisees over the alleged failure of the franchisor to share volume rebates with franchisees). Certification denied.

-          2038724 Ontario Ltd. v. Quizno’s Canada Restaurant Corporation, 2014 ONSC 5812 (brought by Quizno’s franchisees over allegations of price fixing). Certification granted, but later settled for a small amount.

The Award in an Alberta Franchise Rescission Case - Essa v Mediterranean Franchise Inc.

Introduction

Reported decisions dealing with the quantification of the rescission remedy under the various provincial franchise disclosure acts are rare. Of the few reported cases, most have come out of Ontario. The trial decision in Essa v. Mediterranean Franchise Inc 2016 ABQB 178 provides a welcome opportunity to see the rescission remedy of the Alberta Franchises Act (“AFA”) in action. In this article, I analyze the financial concepts behind the different categories of expenditures that comprised the trial judge’s award.

Background

Mr. Essa and his business partner purchased a “Taste of Mediterranean” franchise in Edmonton in 2010. The business was not successful, and closed after nine months of operation.

The trial judge found that the disclosure document provided was deficient in several respects, including:

• Failing to disclose telephone numbers of existing franchisees
• Failing to disclose a list of all unit closures within the past three years
• Failing to comply with disclosure requirements regarding earnings claims
• Failing to comply with disclosure requirements regarding financing arrangements

For these reasons, statutory rescission was granted under section 13 of the AFA.

Unlike all of the other provincial franchise disclosure legislation, the AFA does not break down the rescission remedy into four separate components or "buckets". Section 14(2) of the AFA states simply that in the event of a rescission due to non-disclosure:

 “The franchisor or its associate, as the case may be, must, within 30 days after receiving a notice of cancellation under section 13, compensate the franchisee for any net losses that the franchisee has incurred in acquiring, setting up and operating the franchised business" (emphasis added)

In Essa, while the evidence was that the plaintiff lost money operating the business, the plaintiff did not present a calculation based on the overall results of the business; though not stated in the decision, this may be because detailed accounting records were not kept. Instead, Mr. Essa presented the following claims for losses:

  

 These amounts were all accepted by the trial judge.

Analysis

Do the above amounts overcompensate or undercompensate the franchisee? It is not possible to say, based on the information contained in the decision. However, we can offer the following conceptual commentary:

In general, businesses spend money to either a) buy assets or b) fund operating losses. In a franchise rescission, assuming the assets are no longer of any value, the franchisee is entitled to receive an amount equal to what it paid to fund its assets and operating losses. Broadly speaking, this is how Ontario's Arthur Wishart Act works, and there is no reason the AFA would not work the same way. The only difference is that under the AFA, these two categories can be offset against one another; thus, if a franchisee paid $100,000 for the assets of her business and made a $30,000 profit, the rescission remedy in Alberta would be $70,000, whereas in Ontario it would be $100,000.

With that introduction, we can now analyze the rescission award in Essa.

• The franchise fee and store purchase amounts are moneys paid for assets that are of no value following a rescission. Given that it was established that the plaintiff did not make any money running the business (i.e. there is no offsetting profit), the amounts awarded under these categories make ample sense.
• In Ontario, a separate claim for royalties and ad fund payments would be uncontroversial; there is a separate subsection (6(6)(a)) for amounts paid to the franchisor. In Alberta, however, the only reason to include these as separate heads of claim would be if it were established that the business broke even (or lost money) prior to considering these amounts. This may have been the evidence before the court; it is difficult to tell.
• The claims for capital infusions are amounts paid into the business, not out of the business. These infusions would be used to either buy assets or fund losses. Strictly speaking, if a franchisee is already claiming for amounts paid for a) assets and b) operating losses, it cannot also claim for the cost of funding those cash outflows; to do so would likely result in double-counting. That is, if the business incurred $100,000 in operating losses and borrowed $100,000 to fund those losses, it can only claim a rescission remedy of $100,000, not $200,000. This is an error I have seen in many rescission claims.
• That said, in cases where it is very difficult to quantify the amounts spent based on the accounting records, it may be possible to arrive at a reasonable estimate of the franchisee’s losses by looking at how much money the franchisee invested (both debt and equity) in the business; that is, if you can't measure the money going out of the business, you can measure the money going in. It appears that in this case the cash infusions were being used by the trial judge in precisely that manner, as a proxy for operating losses.
• Finally, the claim of $36,000 for unpaid owner/manager labour was based on an hourly wage of $10. Based on 9 months of operating the business, this works out to around 50 hours per week for each of Mr. Essa and his wife. The court noted that Mr. Essa’s hourly rate as an engineer was $300, and concluded that the claim for unpaid wages was “properly compensable as part of their net loss just as much as actual payments to employees would have been compensable had they any other employees” (para. 230).

All in all, the overall rescission remedy appears reasonable.

Ontario's New Minimum Wage - Impact on Profits of the Restaurant Industry

Introduction

On January 1, 2018, the minimum wage in Ontario government changed from $11.60 to $14.00. It is scheduled to rise to $15.00 in 2019.

The move has provoked negative reactions from business groups. For example, according to Restaurants Canada:

“These aggressive changes to labour legislation will have severe and immediate consequences for the foodservice industry and the customers they serve every day. Prices for consumers will go up. Jobs will be lost, it’s as simple as that." A recent story in the Globe and Mail contains different reactions from restaurant owners; some are unfazed, others somewhat less so.

This issue is also of interest to business valuators such as myself. Valuations of established businesses are often based on the future anticipated profits or cash flows of a business. These are typically projected based on an analysis of the business's historical results, adjusted for forecasted changes. Valuators need to understand how the change to the minimum wage will impact profitability going forward.

The Data

Somewhat surprisingly, when we look at average labour costs for limited service restaurants (as a percentage of revenue) for the period 2001 to 2012, we see surprisingly little change:

The chart (which is based on data from Statistics Canada, CANSIM Table 355-0005) includes several periods where the minimum wage stayed constant in nominal dollars.

For example, in BC the rate was stagnant at $8.00 per hour from November 2001 until May 2011.  During that period, the CPI for restaurant food grew by 35%. Assuming that the average restaurant has 75% of its employees making the minimum wage, one would have expected the average cost of labour at BC restaurants to fall to 23% of revenue. Yet that did not happen.

The chart also includes periods in which the minimum wage grew very quickly. Again looking at BC, the minimum wage in 2010 was $8.00; in 2012, the average was approximately $10, an increase of 25% (slightly higher than the proposed Ontario change). A restaurant with 75% of its employees making the minimum wage would expect to see its cost of labour rise from 29% to 33%. Yet that did not happen.

Some (Tentative) Theories

What should one make of the data?

One theory might be that restaurants are able to pass along wage increases to consumers in the form of higher prices; the Globe and Mail article gives some examples of restaurants that are planning to do precisely this. Unlike, say, a manufacturing plant, restaurants cannot really be moved to other jurisdictions with more favorable labour laws. A change affecting all restaurants will therefore result in higher prices for consumers.

Another possibility is that the aggregate data shown above masks significant changes.

Imagine for a moment that there are two types of restaurants: prosperous ones who have an average wage cost of 25%, and less efficient ones whose average cost is 35%. The former have profit margins of 15%, the latter have profit margins of 5%. A rapid hike in wage costs equal to 5% of revenue will mean that the less prosperous firms will no longer be viable; they will be forced to close.  The more prosperous firms, meanwhile, will see an increase in their labour cost, such that the industry average will remain 30%.

A third possibility is that the increase in third-party wage costs results in owners (many of whom pay themselves via a salary) being forced to reduce their own wages.

Financial Statements, Disclosure and the Arthur Wishart Act

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 brief post 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).

Background

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”)[1]) 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 which accounting 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 and identical 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.

Conclusion

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.

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[1] IFRS are the financial reported standards currently in place for Canadian public companies, having replaced Canadian GAAP several years ago.