A: The franchisor’s financial statement is a required component of the franchise disclosure document (FDD), in such provinces with disclosure legislation. The first step in a franchisee’s review is to determine whether the financial statement provided meets the minimum statutory requirements by asking the five Ws.
Who?
The financial statement must be that of the franchisor company. The franchisor company is the entity that will enter into the franchise agreement with the prospective franchisee and should be identified in the FDD. A financial statement of the parent company, an affiliate, a subsidiary, the owner of a corporate store, or the trademark owner is non-compliant.
Keep in mind that certain large franchisors may be exempt from disclosing their financial statement if the prescribed criteria are met.
What?
The financial statement must meet the prescribed review standards, which differ slightly across the varying provincial legislation. Generally speaking, the financial statement must be prepared in accordance with audit or the review engagement standards, as set out in the CPA Canada Handbook – Accounting or an equivalent standard. Moreover, the financial statements must contain all the information necessary for disclosure. A recent Ontario case confirmed that failure to disclose the notes to the financial statement rendered the financial statement incomplete and thus, this omission was a material deficiency of the FDD.
There is one exception to the application of the prescribed standard available to newly established franchisors. Franchisors that have been in operation for less than one fiscal year may disclose a balance sheet that is not subject to such review standards (unless the franchise is to be located in British Columbia).
When?
The financial statement must address the most recently completed fiscal year, provided the financial statement of the penultimate fiscal year may be used into the earlier of:
- the date the most recent financial statement is available; and
- 180 days from the franchisor’s fiscal year end.
For example, if the franchisor’s fiscal year end is December 31st, then the financial statements for the previous fiscal year can be used, at the latest, until June 28th of the immediately following year. If the franchisor discloses the financial statement of the previous fiscal year as of June 29th, then the financial statement and thus the FDD is non-compliant.
Where?
The financial statement must be disclosed as part of the FDD, “as one document at one time.” There is one exception to this: if the most recent financial statements are made available between the time an FDD is delivered and any agreement or compensation is paid, then the franchisor may deliver such updated financial statement by way of a statement of material change. For example, if the franchisor emails a standalone copy of the financial statement before or after the FDD is delivered, then this delivery is non-compliant.
Why?
Financial statements are a formal record of the financial activities of a corporation which informs the operations and financial health of a franchisor. Prior to investing in a franchise, a franchisee should confirm they have received a legally compliant FDD and carefully review the financial statement of the franchisor.
Why does it matter if the financial statements meet the regulatory requirements?
The Court of Appeal for Ontario recently described the gravity of failing to provide a statutorily compliant financial statement, stating:
The failure to comply with the requirement to include the prescribed financial statements in a disclosure document has been characterized by the courts as “fundamentally important,” a “foundational part of disclosure,” “by itself constitutes a material deficiency” and therefore rising to the level of non-delivery of a meaningful disclosure statement. This conclusion flows from the prime importance to all franchisees of knowing the complete financial picture of the franchisor’s business in making an informed…investment decision.
At the heart of disclosure obligations is the desire to ensure franchisees can make informed investment decisions. Where a franchisee is deprived of a “foundational part of disclosure,” such as the financial statement, the entire FDD is rendered null and void, which means the franchisee can avail itself to the statutory right of rescission.
Why should I review the franchisor’s financial statement?
Understanding the statutory framework and a franchisee’s statutory rights, as well as the key components of the financial statement, like the balance sheet and notes, will provide valuable insight into the franchisor’s ability to meet its financial obligations.
In reviewing the financial statement, the franchisee should pay particular attention to the franchisor’s balance sheet. It’s important to ensure the franchisor has sufficient cash and assets to meet its financial obligations, such as the satisfaction of a rescission claim. If a franchisee wishes to exercise its right of rescission, but the franchisor has insufficient assets to respond to the claim, the franchisee will be left in a difficult and perilous position. Furthermore, franchisees should review the current assets and liabilities sections to understand the franchisor’s liquidity position.
The franchisor’s amount of working capital speaks to the franchisor’s ability to respond to any claim, such as trademark infringement, creditor claims, and other disputes, as well as effectively manage the day-to-day operations of the system.
Don’t skip over the notes! Reading the notes of a financial statement can provide additional valuable information beyond the numbers presented in the balance sheet, income statement, and cash flow statement. For example, the notes may disclose potential liabilities that the company may face in the future, such as lawsuits, warranty claims, guaranteed contractual obligations, etc. This information can clarify the potential risks and uncertainties facing the franchisor that may impact the franchisor’s financial position.
Cassandra Da Re
Partner
Dale & Lessmann LLP
cdare@dalelessmann.com