overhead view of a red bowl containing a pile of marijuana leaves

(Nathan Cyprys photo)

Analysis | From Pivot Magazine

A bucketload of trouble

A huge global cannabis market awaits. Canadian producers are world leaders. There’s just one (accounting) problem...

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At first glance it’s preposterous that an industry with less than half a billion dollars in sales last year should have had a market capitalization of $37 billion. Even assuming the legalization of recreational marijuana proceeds as planned over the second half of 2018, and all the sales migrate over from the incumbent black market, we’re talking about a $5.8-billion business, tops, according to estimates from Statistics Canada and the Parliamentary Budget Officer. It only makes sense when you consider the global opportunity out there.

The worldwide market is estimated to hit US$31-billion by 2021, and Canadian companies have it virtually all to themselves—for now. By dint of being the largest country to legalize medical and soon recreational marijuana at the federal level—the other early movers being the Netherlands and Israel—Canada has a unique opportunity for global domination. Countries like Germany and Italy, at earlier stages of legalization, have welcomed well-regulated, transparent operators from Canada to supply their nascent medical marijuana markets. International competition with superior scale, talent and access to capital—the usual obstacle to Canadian companies’ global ambitions—does not exist.

Only there’s a problem: an accounting problem. It’s been raised by equity analysts, commentators and even the chief financial officers of some of the largest players. “I came into the industry a year ago and the first thing I saw was gross profits that were higher than revenues,” says Glen Ibbott, a CPA with 25 years’ experience under his belt who serves as CFO of Vancouver-based Aurora Cannabis Inc. “And I say ‘Okay, there’s something crazy going on with the accounting here.’ ”

31: The number of publicly traded pot companies on the TSX and TSXV

Basically, pot producers are booking gross profits and gross margins based on unsold inventory. That’s in line with International Financial Reporting Standards (IFRS), which require agricultural businesses to record the fair value of their biological assets, as they grow, as a negative adjustment against cost of sales. But critics consider this estimate speculative, seeing as the recreational market for cannabis has not even been legalized yet. Not to mention the crop could rot, or prices could tank. Some companies are reporting gross profits far in excess of their actual revenues (which are all, to date, from the smaller medical market), and investors are confused, if not deluded.

Producers, meanwhile, feel shackled to a reporting standard they say does not apply very well to their burgeoning industry. Some are proactively including their own additional, non-IFRS metrics to their financial statements in a bid for greater transparency. But as yet there is no agreed methodology or industry-specific guidelines for doing so, whereby investors could compare these line items between different companies.

$5.8 billion: Estimated cannabis sales in Canada

Some industry CFOs think it’s time for a regulatory authority to step in. Linda Mezon, chair of the Accounting Standards Board (AcSB), says that once the fuss over legalization and the volatility in the market settles down, the question over whether the standard is appropriate will be clearer. The AcSB is actively monitoring the situation and, in June, its IFRS Discussion Group will have its first meeting on cannabis. Mezon is also planning talks with the standard setters in the Netherlands. If the AcSB does decide a change is needed, it will go to the International Board in London.

“It’s a two-prong issue,” says Mezon. “One, it’s early days now. We’re keeping an eye on events to see what needs to be done. The second prong is that, once we work with the industry, if we identify things that need to be done, the AcSB will move forward to have the right discussions and support the industry in asking for changes as needed.”

US$31 billion: Estimated sales worldwide by 2021

To understand how we got here, you have to go back to 2011, when Canada adopted the IFRS for publicly listed companies. IFRS was meant to create a global standard that would allow investors to compare the results of public companies across borders. Before Tweed Marijuana Inc., now known as Canopy Growth Corp.—the first, and still the largest, publicly traded pot company in Canada went public in 2014, it received an expert opinion from its auditor, Deloitte, on how to report its biological assets per IFRS. That determination hewed to IFRS rules for agricultural companies, which included booking the value of unsold plants as a fair value adjustment on the balance sheet, which then triggered reporting on the profit and loss statement as a debit or credit under cost of sales.

Rival companies now feel bound by that precedent even though some question its applicability. (Canopy Growth did not respond to questions for this story.) The fair value adjustment, critics argue, was intended for companies with relatively long-lived assets such as hogs or trees. This way, they could demonstrate the value they were creating in the very long lead time before they sold these biological assets. Marijuana, by contrast, is grown in a six- to 20-week cycle. Importantly too, there exist futures markets for hogs and trees and many other agricultural commodities, meaning a farmer with a three-year-old hog can sell it today for delivery in a year’s time. This is not yet true of cannabis. Growers currently have no opportunity to pre-sell their inventory and no one knows what the market these plants will be sold into will look like.

$37 billion: Market cap reached by cannabis producers

Lumping them in with farmers also misinterprets how pot producers create value, argues Igor Gimelshtein, CFO of Markham, Ont.-based MedReleaf Corp. “Farming is just one component of our business. We harvest, process, manufacture, package and brand our product. Why should I be recognizing gross profit on just the farming part?” He compares pot companies to wineries: how much they charge for their product has more to do with what happens after the harvest than before.

MedReleaf modifies its income statement in an effort to clarify things for investors, and Aphria Inc. and even Canopy Growth itself have followed suit. They insert a gross profit line that does not factor in the fair value adjustment ahead of the IFRS-defined gross profit line. “Is that going to become a common convention? I’m almost sure of it,” Gimelshtein says.

Given the unprecedented opportunity for Canadian operators, it’s worth getting this part right. Industry CFOs know only too well what a shame it would be for this situation to let one or two less scrupulous players soil Canada’s reputation with stock-promotion shenanigans just as a global market is set to take off.