The Audit Dilemma | are current regulations meeting the needs of investors?
By: James Dahl
Securities legislation currently requires exempt issuers to include audited financial statements, prepared in accordance with International Financial Reporting Standards (IFRS), with their initial and ongoing offering memorandum (OM). Although there may be very little or no financial activity in the initial stages of operations, the requirement for an audit remains unchanged. Contrastingly, there is currently no securities regulation which requires an exempt issuer to provide ongoing financial reporting results subsequent to closing their OM even though significant financial transactions may continue to occur.
Legislation within the Alberta, British Columbia, and Saskatchewan Business Corporations Acts provides the right to investors to dispense with the audit which is otherwise required annually. Within the Alberta, British Columbia, and Saskatchewan Partnership Acts, investors have the right to make inquiries into the books and records of the issuer. However, irrespective of this legislation all too often issuers do not provide annual financial reporting as securities regulators are not requesting it nor is it required to be made publicly available on SEDAR.
initial or opening balance sheet financial statements
Often a new issuer will include financial statements as at the date of the inception of the entity with its initial OM. In most cases a new issuer’s initial financial statements include an opening balance sheet which discloses the issuance of the initial share capital, the cash received for same and notes to the statements describing accounting policies.
Arguably, the information provided in the initial financial statements provides little, if any, value to a potential investor. However, having these statements audited may result in fees ranging from $5,000 to $10,000. In addition to monetary cost, there may also be costs associated with the delay of bringing the issuer to market because of the time it takes to perform audit procedures and issue the audit opinion. In cases where the opening balance sheet provides a minimum amount of information (i.e. share capital and cash) the cost of having the information audited is inconsistent with the value provided to a potential investor.
It is understood that regulators require the initial audit in order to provide assurance over and disclosure of the capital structure, loans outstanding, contingent liabilities, material commitments and related party transactions. However, this information should be disclosed in the body of the OM itself. One potential benefit of the initial audit would be to uncover undisclosed or concealed information related to these disclosures; however, auditing these areas relies fundamentally on the integrity of management. In cases where management is intentionally obfuscating commitments or contingent liabilities, and not disclosing the same in its OM, it is unlikely that the audit would uncover the necessary information to complete the required disclosure.
In order to align audit costs and benefits for both issuers and investors, it would be beneficial for the regulators to implement a financial threshold, such as a total asset test, which would differentiate the level of assurance required to be performed on the financial statements. The asset threshold test could relieve the issuer from providing financial statements and allow full disclosure within the body of the OM.
provision of financial information subsequent to the closing of an offering memorandum
There is currently no requirement by the provincial securities commissions for the provision of audited statements to investors at such time as the issuer is no longer issuing securities under an OM. Once the entity ceases offering its securities to investors it effectively falls outside of the oversight of securities regulators. Currently there appears to be a wide spectrum of post OM financial disclosure provided to investors ranging from the continued provision of audited statements to the provision of internally generated financial statements. Having said that, all too often, issuers, without the consent of their investors, stop providing continuous financial disclosure of any form to their investors.
In practice, post OM disclosure is often the most important. It is at this point in the life cycle of an issuer that there is the greatest opportunity for mismanagement and misappropriation of the assets of the entity. Examples of this include the use of the resources of the issuer for investments and expenses not contemplated in the OM, lending funds to other related issuers or the inappropriate removal of resources by management. It is important for investors to have confidence that the financial resources of the entity are being expended appropriately and within the guidelines described in the OM.
In practice, the currently regulated disclosure requirements do not appear to best meet an investor’s needs. It is counterintuitive that regulations require the audit of the initial financial statements, which arguably provide little, if any, useful information to investors, when investors would receive considerably more benefit from the assurance and disclosures that accompany audited financial statements issued subsequent to the closure of the OM. Audited financial statements should provide investors much needed insight into how their investment is performing. This information is fundamental for investors in the exempt market where stock performance and financial results are not readily available.
Each of the Alberta Business Corporations Act, British Columbia Business Corporations Act and Saskatchewan Business Corporations Act require an annual unanimous shareholder resolution to dispense with the audit. Many issuers in the exempt market, including partnership and trusts, are not formed under a provincial business corporations act. Other corporate issuers are making the decision to waive the audit without meeting the requirement under the applicable business corporations act to acquire unanimous shareholder consent. However, it appears many investors are unaware of this right. The quantity of issuers in the exempt market would make enforcement difficult, if not impossible.
The Alberta, British Columbia and Saskatchewan Partnership Acts do not contain provisions requiring the presentation of audited financial statements to unit holders. They do, however, provide a partner the right to inspect and take extracts from the partnership’s books, and to demand full information of all things affecting the partnership. Where reasonable, the limited partner has the right to a formal account of the partnership’s affairs.
Issuers are required to disclose within the OM their reporting obligations, as required by corporate legislation or their organization documents. If no on-going reporting is required, this fact is to be disclosed to potential investors in bold print. It appears as the industry matures, several exempt market dealers are requiring the issuers they work with to provide annual disclosures to investors in the form of audited or reviewed financial statements. It should be considered best practice that continuous financial disclosure is provided in the absence of a regulatory requirement to provide same.
There are various levels of assurance available to issuers subsequent to the OM closing. The level of assurance which should be considered best practice will very much depend on the operations of the entity and the provisions, if they apply, of the ABCA (or similar).
The lowest level of assurance is a compilation (or Notice to Reader) engagement which provides no assurance to users. The financial results are compiled into financial statements with limited or no note disclosure. This would most often not be an appropriate level of accountant involvement as there is no additional assurance provided to investors. This engagement is most useful when the users of the statements are limited or when statements are being generated solely for tax reporting purposes.
A review engagement requires that procedures are performed consisting primarily of inquiry, analytical procedures and discussion regarding the financial accounts and other information provided by the issuer. This is the middle level of assurance which may be considerably more economical than an audit. The accountant will not express an audit opinion but instead reports that nothing has come to their attention that would lead them to believe the financial statements are not in all material respects in accordance with Canadian generally accepted accounting principles (“GAAP”) utilizing the appropriate accounting framework. This level of assurance may be appropriate in the case where the operations of the entity are consistent from year to year, such as an entity which holds land for future development opportunities. It is considerably less financially onerous than an audit but still may provide an appropriate level of assurance to the users of the financial statements.
The highest level of assurance is an audit engagement, in which the independent auditors’ procedures involve tests of details in addition to inquiry and analysis. An audit opinion indicates that the financial statements present fairly, in all material respects, the financial position, results of operations and cash flows in accordance with Canadian GAAP utilizing the appropriate accounting framework. Audits would be considered best practice in the case where the entity has significant operations, where the results vary from year to year or where the entity is undertaking large transactions such as the acquisition or disposition of assets.
The regulations currently require that financial statements be prepared in accordance with IFRS. These standards were implemented with the expectation that the international business community, especially those entities listed on exchanges, would benefit from conformity across financial markets and that investors would benefit from substantially increased disclosure. These standards require a considerable amount of additional disclosure which may be onerous for a small issuer.
The Canadian Accounting Standards Board recognized that these standards may be onerous for non-publically traded entities and has given those entities the option to elect to use a more simplified version of the standards called Accounting Standards for Private Entities (“ASPE”). Unfortunately as the regulations currently require reporting under the IFRS framework smaller issuers cannot elect to implement the ASPE framework.
Within the exempt market, there is currently little consistency in the provision of ongoing financial disclosure from one investment opportunity to the next. The decision to provide ongoing financial reporting is subject to differing factors such as type of entity, decisions made during formation, requirements put in place by the exempt market dealer, and decisions made by the principals of the entity, with or without input from investors. In the absence of regulations continuous financial disclosure with an appropriate level of assurance should be considered a best practice by the industry.
To protect investor needs and provide more transparency within the exempt market space, it is important that the regulators revisit the current financial reporting requirements. They should consider implementing an asset test for new issuers allowing them to include the applicable financial information inside the OM to avoid the cost of an initial balance sheet audit. Regulations should require ongoing financial disclosure with a minimum of a review level of assurance. Regulators should also contemplate whether IFRS is meeting the needs of the issuers and investors as an accounting framework.