What other industries can learn from cannabis companies

By Al and Mark Rosen | November 15, 2018 | Last updated on November 15, 2018
4 min read

The CSA recently issued a comprehensive review of marijuana producers’ financial disclosures and found that all licensed producers needed to improve how they value their assets.

The review hit on many issues we have identified as problematic in the past, not only with regard to the cannabis sector, but for other industries as well. Aside from valuing assets, the major areas highlighted as potentially confusing for investors included capitalizing versus expensing of costs, non-GAAP metrics, cost per gram metrics, the level of detail used in describing future production plans, and the risks related to U.S.-based assets.

While the CSA provided cannabis companies with much to improve upon, we found the review most interesting for the implied deficiencies in financial disclosures from industries outside the cannabis space.

The real test of accounting rules

Proof of substance in Canadian accounting rules only ever gets tested in litigation settings, where the vague wording of specific rules are contrasted against overarching requirements that imply a higher standard. The CSA highlighted such a conflict in its review: “International Financial Reporting Standards (IFRS) require issuers to record growing cannabis plants at their fair value [less cost to sell]. [All] of the [licensed producers] we reviewed needed to improve their fair value and fair value related disclosures.”

In other words, the companies’ audited financial statements followed the specific IFRS rules related to agriculture, yet 100% of the companies provided deficient financial reporting.

The takeaway for advisors is to understand how accounting rules can fail in practice, and why strong gatekeepers are essential to strong capital markets. While securities regulators have stepped up their game recently, remember that the auditors approved financial statements that were found to be deficient, seemingly dropping the ball from an investor protection standpoint.

Regulators turning up the heat?

While we can’t argue with the CSA’s effort in addressing the cannabis space, we wonder why the same critique has not yet been extended to other industries. We see similar disclosure problems in the retail, real estate, infrastructure and utilities sectors, to name a few.

An issue plaguing financial statements in the cannabis sector is the reporting of gross margin. The CSA confirmed our previous observation that companies are approaching the calculation in different ways, especially when determining expenses. The regulator noted that the IFRS accounting rules don’t “prescribe an accounting policy for determining what costs are directly or indirectly attributable to biological assets, nor whether those costs should be capitalized to biological assets or expensed as incurred.”

With such a wide allowance, it’s no surprise the sector’s financial reporting is such a free-for-all and that gross margin figures are incomparable, frustrating investor analysis.

With the CSA trying to fix financial reporting in the cannabis sector, it’s opened a can of worms by implying reporting in other industries is deficient.

The regulator noted that labelling a figure as gross margin can be misleading to investors unless all the included and excluded costs are itemized—including, but not limited to, depreciation of production equipment and overhead costs such as labour, rent and utilities.

While this is beneficial for investors in the cannabis sector, companies in other industries are allowed to escape with vague disclosures like “All costs incurred in bringing the inventories to their present location and condition are included in the cost of warehouse and retail inventories.”

Similarly, the CSA takes the marijuana sector to task for its reporting disclosure related to calculating the fair value of their assets (mostly growing plants). The regulators suggest companies provide extensive disclosure, including a sensitivity table for potential variation in major inputs, such as the impact of a 10% change in plant yield.

A similar level of disclosure would be welcome in other industries, especially where the valuation of major investment assets are left to the whim of management.

In some cases, companies are allowed to escape with limited statements like “an increase in the capitalization rate would lead to a decrease in the fair value of investment property, with the opposite impact for a decrease in the capitalization rate.” Requiring disclosure in all industries equal to that suggested for the cannabis sector would be a major improvement for investors.

Advisors should know that deficient financial reporting can extend beyond nascent industries, such as cannabis, and into established large-cap Canadian firms. The vague IFRS accounting rules, and the subsequent audits of those rules, can offer little protection in key areas where management possesses significant judgment to sway financial reporting and valuation by investors.

Read: Finding value amid the cannabis confusion

Al and Mark Rosen

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.