Marijuana sector’s accounting quirks generating ‘audited hallucinations’

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Courtesy of Globe and Mail

Marijuana plants are pictured during a tour of Canopy Growth Corp., in Smiths Falls, Ont., on Jan. 21, 2016.
SEAN KILPATRICK/THE CANADIAN PRESS

In Canada, where 84 listed marijuana stocks have surged to a value of about $36.9-billion ahead of recreational legalization in July, companies abide by International Financial Reporting Standards. The guidelines favor a fair-value model used by the agricultural industry, which requires companies to place a value on plants while they’re still in the ground.

That’s akin to counting your chickens before they’re hatched, leaving companies open to big write-offs and investors groping for financial clarity. It’s all crying out for more guidance and standardization from the country’s regulators, industry observers say.

“It’s audited hallucinations,” said Al Rosen, founder of Toronto-based Accountability Research Corp., a veteran forensic accountant and a long-time critic of IFRS and its application in the cannabis industry. “The marijuana financial statements have absolutely nothing to do with reality.”

Canada switched to IFRS in 2011, following Europe and several other countries worldwide, whereas the U.S. still uses Generally Accepted Accounting Principles, or GAAP. Where IFRS says fair value is more relevant, GAAP prefers a cost-based approach.

Under IFRS, pot producers report the unrealized, non-cash change in the fair value of their cannabis plants as they grow, relative to their theoretical selling price. This requires management to make several estimates, including growing, harvesting and selling costs; projected plant yields; and the price the drug will sell for, which for recreational pot, governments have yet to give guidance. And that’s assuming the plants don’t succumb to rot or mold.

Because the unrealized value of the plants is factored into gross profit, a company that’s adding plants faster than it’s selling inventory – which is almost every producer in the fast-growing industry – can end up reporting gross margins of more than 100 per cent. In theory, non-cash income could even be reported without selling a single gram of pot.

“We all recognize that the statements as they are are not very helpful to anyone,” said Tim Saunders, chief financial officer at Canopy.

Canopy Growth Corp., the world’s biggest cannabis company with a market value of more than $7-billion, reported an IFRS gross margin of 164 per cent in the third quarter, while Aphria Inc.’s was 129 per cent in the three months ended Aug. 31. The difference can be dramatic. Canopy’s IFRS gross margin was 186 per cent in the third quarter of 2016 but 60 per cent after removing the fair-value metrics, according to Rosen.

“Investors don’t understand IFRS,” said Carl Merton, chief financial officer at Leamington, Ontario-based Aphria. “It’s so burdensome and complex that an ordinary investor just gets lost too easily.”

Different methods

Overly rosy plant valuations can then lead to big writeoffs in an industry that’s already prone to wild price swings.

“When companies are valued at $2-billion overnight and they’re raising hundreds of millions of dollars, you don’t want to have someone that’s got an extremely biased position to tell investors what their true gross margin is,” said Jason Zandberg, analyst at PI Financial Corp. “It’s definitely a problem.”

Most of the big pot companies are taking steps to clarify their results, adding details in the management discussion and analysis (MD&A) section of their disclosure so analysts and investors can get a clearer view of the company’s profitability.

Aurora Cannabis Inc. specifies its cash cost of sales and cash cost to produce dried cannabis, while Aphria details its cost per gram, gross profit before fair-value adjustments and several other metrics. Canopy, meanwhile, began breaking out its cash gross margin, subtracting the effects of IFRS fair-value accounting.

Apples-to-apples

But problems remain. Without any industry standardization outside of IFRS rules, each company makes slightly different assumptions and breaks out slightly different numbers than its competitors.

“It’s hard to get an apples-to-apples comparison for these companies,” said Vahan Ajamian, an analyst at Toronto-based Beacon Securities Ltd who covers pot stocks.

Merton is calling on Canadian regulators to set accounting standards for the industry that go beyond IFRS. “We believe it’s going to take someone in a leadership position like that to really get the industry to change,” he said. He adds stocks currently tend to trade on excitement around growth prospects rather than company results.

Subjective assumptions

Linda Mezon, chair of Canada’s Accounting Standards Board, said the organization’s IFRS Discussion Group is considering tackling the issues around cannabis accounting at its next meeting. She acknowledged that there is some “discomfort” with the way IFRS standards are currently applied to the industry, particularly since there’s no clear pricing standard for marijuana the way there is with commodities like wheat, which trade on futures exchanges.

“People get really uncomfortable if they think those fair values are very subjective,” Mezon said. “Since you don’t have the ability to point to a commodity market and say, ‘That’s the price I use,’ then it feels like it’s a very subjective value, but over time we believe that situation will get rectified.”

As one of the first developed countries in the world to legalize recreational pot at the national level, Canada’s successes and failures will be watched by other countries that are thinking about following suit, said Cam Battley, chief corporate officer at Aurora Cannabis Inc.

“It is critical that we establish reliable, sustainable standards because we are inventing a new industry, and we’re doing it not just for Canada but for the world.”

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