Rules add haze to pot accounting
MARIJUANA PRODUCERS MUST USE PRACTICE THAT PRE-BOOKS INCOME FOR CROPS AS THEY GROW
If the accounting regime that governs Canada’s burgeoning marijuana i ndustry seems a little hazy to you, you’re not alone: Some publiclytraded cannabis companies aren’t entirely sure what to make of it either.
Under International Financial Reporting Standards ( IFRS), marijuana producers must use an accounting practice unique to the agricultural sector that pre-books income for crops as they grow.
The “biological asset” rule credits the value of product that is growing at fair value minus selling costs and reports that figure on the income statement.
The changes in fair value are not counted as revenue, but as a reduction in the cost of sales, which as a result boosts the bottom line.
That means a company can report net income in a quarter in which they grew or harvested marijuana, but had no sales to speak of.
“If you polled the LPs almost every single one would say they prefer not to do it,” says Maruf Raza, national director of public companies at accounting firm MNP, who gave a presentation on how to navigate the complex agricultural accounting standards to some 30 licensed producers last month.
“A lot of these rules are actually creating an accounting burden on these LPs because they have to spend time to value (the crops), to hire experts.”
But the potential for confusion, especially for retail investors — not to mention the danger that booked net income may never actually materialize, resulting in a future loss — has some calling on marijuana companies to take it upon themselves to be more transparent.
Three of Canada’s largest medical marijuana companies — Canopy Growth Corp., Aphria Inc. and Aurora Cannabis Inc. — neglected to point out the impact of biological assets in their press release highlights of their most recent quarters, though they did elaborate on those impacts in their management discussion and analysis document.
In Canopy Growth Corp.’s most recent quarter, unrealized gain on the changes in the fair value of the company’s biological assets amounted to $18.2 million, double its actual revenue of $9.8 million. That gain helped the company record its first- ever quarterly net income, of $3 million, in the three months ended Dec. 31, 2016.
Canopy CEO Bruce Linton said there’s no benefit for a company in overstating the value of its biological assets because being too liberal with assumptions could lead to a future period with nonmatching inventory — and markets don’t take kindly to that.
“I thought IFRS was the craziest thing I had to learn about in great detail but it actually is sensible — it creates a motive to be careful as hell not to overstate,” he said.
“You’re incentivized as any reasonable party to try and be as conservative as you can because if all the value you’re reporting in your biological assets — the things growing — if it doesn’t turn up in your inventory, you actually now have to do reverse accounting and say: ‘ Oh, we didn’t have all that’.”
Another producer, Aphria, highlighted in its most recent MD & A that biological assets were worth $ 533,402 while the net effect of unrealized changes in the fair value of those assets amounted to $74,268 in the quarter ended Nov. 30, 2016.
It explained that determining the fair value of those assets requires management to make a number of estimates including the expected cost required to grow the cannabis up to the point of harvest, harvesting and selling costs, sales price and expected yields for the plants.
Aurora touched on the impact of biological assets in its discussion of gross margin, where it explains how during the year ago period, the company didn’t generate any revenue from sales because they had not started, but recorded changes on the fair value of biological assets of $2.2 million on the inventory it had amassed.
That’s why it recorded a net loss of $2.7 million in the second quarter of 2017, when it was selling product, but a $ 600,000 gain in the year ago period, it explained in its management discussion.
Biological assets amount to tens of millions of dollars per quarter for a large, expansion- mode company like Canopy because they have so many plants growing, says Vahan Ajamian, an analyst at Beacon Securities.
“Eventually that’s going to settle down but for the next probably several years, everybody is in expansion mode and you’ll probably see a lot of gains from there.”
The accounting practice carries a risk of having to write- down inventory if the price per gram were to fall or if the inventory was never sold at all. But given the Canadian government’s plan to introduce legislation to legalize recreational marijuana in the near future, Ajamian sees little risk that demand could suddenly dry up.
“Everyone’s going to have to increase by multiple fold and it won’t be enough by 2020 or 2019 and that’s why they’re all kind of in an arms race trying to gain capacity to get ready.”
Maruf Raza, the MNP accountant, said he is working with producers to develop an industrywide non-IFRS metric that would help investors compare apples to apples. He points to other sectors such as real estate investment trusts that have created similar industry- specific gauges to address situations when traditional accounting metrics paint an incomplete picture.
Part of the problem is that legal marijuana is new industry that operates differently than the farmers the rules were intended to help. Raza said many feel trapped because they know they have to report according to international standards but also realize there are criticisms levied at them for “front-loading” income.
As for marijuana investors, who might not be in the know about different types of reporting standards, Raza says there is only one solution: reading the companies’ financial statements in their entirety — as much as that might sound like a buzzkill.