Public companies traded on any stock exchange have higher demands for financial reporting. International Financial Reporting Standards (IFRS) are required to be followed in most countries, including Canada.
These standards guide accountants how to present the financial information of the company, and have caused some controversy recently with the rise of cannabis companies in Canada.
Cannabis Company Controversy
Several articles have been published outlining the risk of investors being misled by how cannabis companies value their plants; namely, that a company can ‘front-load’ earnings. This is where a company, that has had no sales in a reporting period, can report the changes in the fair-value of growing or harvested cannabis as a reduction of their cost of sales, boosting their net income, as per the accounting standard IAS 41, (explained further below).
Some argue there is currently not an established market for legal, recreational marijuana in Canada, so the fair value adjustments have little information to go on as prices haven’t been firmly established, unlike most other agricultural products.
Cannabis companies have responded by saying they aren’t trying to dupe anyone, and that because of the need to follow these accounting standards, they are careful to be conservative in their estimates. It wouldn’t bode well for these companies to overvalue their products and post big earnings, only to have to backpedal when, for example, they harvest their crop, and have to sharply revalue their buds in the opposite direction.
Fear not! We have provided a handy guide to help accountants and investors better understand how accounting in a cannabis business works.
Properly accounting for weed depends on exactly what you are producing and selling, and involves categorizing your products between biological assets, agricultural produce, and products for sale.
If your company grows marijuana you likely have a beautiful warehouse full of plants. Those plants shall be recognized as biological assets. The assets will be measured at fair value less costs to sell unless no fair value can be determined, in which case you can recognize as inventory valued at cost less any depreciation.
If your company has marijuana buds harvested and ready for sale, the buds are classified as agricultural produce, and should be measured at fair value at the reporting date less costs to sell.
Products for Sale
If your company has taken those buds and made them into a sellable good other than the buds themselves (like oil, gummies, baked goods – which of course you aren’t selling until October 2019 – those items are classified as products available for sale and should be measured at the lower of cost and net realizable value.
For the Accounting Nerds
Want the nerdy version? Here is the IFRS accounting brief:
For plants and produce, we look to IAS 41 Agriculture, which deals with agricultural produce to the point of harvest. For product we look to IAS 2 Inventories.
According to IAS 41, a biological asset is a living animal or plant and agricultural produce is the harvested product of the entity’s biological assets. This table is a partial reference from IAS 41, and shows examples of biological assets and their related agricultural produce for consideration:
The recognition criteria are similar for plants, produce and product. An entity shall recognize these inventories when, and only when:
- The entity controls the assets as a result of past events,
- It is probable that future economic benefits associated with the asset will flow to the entity; and
- The fair value or cost of the asset can be measured reliably.
When applying these criteria to marijuana plants, produce and product, we need to consider if the plants, buds, and product are owned and controlled by the entity is a matter of fact.
If your business has taken reasonable measures to ensure the physical safety of your inventory, and you have a license to grow and/or sell (mitigating the risk of seizure of your assets), you are deemed to control the assets.
Future economic benefits associated with the plants, bud and product are probable because they can be sold in exchange for cash.
The fair value of the plants and buds can be measured reliably as discussed in the following paragraph on measurement.
Plants and Produce:
IFRS guidance states that plants should be measured on initial recognition and at the end of each reporting period at their fair value less costs to sell. Buds shall be measured at their fair value less costs to sell at the point of harvest. The guidance further instructs that it may be useful for plants or buds to be grouped according to significant attributes, for example, by age or quality.
In practice, we have grouped together plants based on a combination of age and quality, and buds on quality (strain) alone.
Our guidance assumes that a fair value can be established as the supply of cannabis plants could surely facilitate a sale, and that buds have easily attainable market prices.
For plants, we recommend that they are grouped by age and quality and valued at the market-selling price less incremental costs directly attributable to the disposal of the plant (excluding finance costs and income taxes).
For buds, we recommend that they are grouped by quality and valued at the market selling rate per gram per group of similar buds less incremental costs directly attributable to the sale of the buds (excluding finance costs and income taxes).
For product, we look to IAS 2 Inventories for guidance on measurement. It states that product should be valued at the lesser of cost (including cost of the product, taxes, transport, handling and all costs to reasonably bring the inventory to its present location and condition), and net realizable value (selling price less costs to sell).
For Cannabis Investors
If all that accounting jargon left you dazed, don’t fret. Most of you are savvy enough to get the gist of it, but it should be pointed out that if you want to dig deep on fundamental analysis, it would be unwise to ignore the notes section of the financial statements.
The disclosure requirements of IAS 41 state that the entity must provide a “description of the nature of an entity’s activities with each group of biological assets and non-financial measures or estimates of physical quantities of output during the period and assets on hand at the end of the period”.
If you look to the notes section of Aurora Cannabis’ 2017 financial statements, you’ll find this excerpt: “As of June 30, 2017, it is expected that the Company’s biological assets will yield approximately 599,245 grams (2016 – 227,449 grams) of medical cannabis when harvested.” Now, by simply dividing the estimated value of their biological assets by their expected yield in grams, you can arrive at an expected value per gram. Does this value gel with the information on price we can glean so far? It’s a good way to suss out and compare multiple companies valuations of their biological assets.
Are some companies being ultra-conservatives in their estimates? This leaves room for a company to be possibly undervalued.
The MD&A should spell out some of this information for you, but it is important to understand how biological assets are accounted for under IFRS. The accounting standards are designed to provide information to users of the financial statements in a way that is fair and unbiased. The MD&A may use metrics that may be completely true, but may not be comparable to other companies, and use non-GAAP measures that can tell a biased story.
Until the market for recreational cannabis is fully established, valuations of plants, buds, and other cannabis products are not as reliable as established other agricultural products in Canada; but, it isn’t uninformed guess-work. The current grey market gives us valuable insight on what is to come.
As with any new industry, professionals and investors need to pay close attention to developments as they rapidly occur. We at Metrics Chartered Professional Accounting are excited to help the trailblazers in this space set up for success, and will continue to help educate our clients and followers about this thrilling new industry.