A first-of-its-kind study focusing on the marijuana industry raises questions about financial reporting and accounting practices in the marijuana industry.
The study looks to untangle certain aspects of the financial reporting process “that are fundamentally confusing to a retail investor,” making it hard to identify good companies, said Michael Miller, co-author and director of finance at White Sheep Corp, a commercial operator and strategic investor in cannabis assets.
The findings were presented to students recently at Cambridge University’s Judge Business School.
The analysis will be released to the public after being presented a second time in the coming weeks.
Alan Jagolinzer, a Cambridge professor of financial accounting, and Steven Looi, White Sheep’s director of origination, were the other co-authors.
The study ultimately focuses on how the “fair value” of cannabis crops are reflected in financial statements and the level of discretion that management has in dictating what the fair value is.
“If you look at the financial statements of some of the publicly traded cannabis companies,” Miller said, “it is possible to have no revenue whatsoever, no sales, but you can also tell your investors you made millions of dollars in profit over the same period.”
That’s because all Canadian publicly traded companies must report under International Financial Reporting Standards (IFRS), which classifies biological assets like plants differently than other assets.
“It lets you recognize the fair value, less cost, to sell off your biological assets on your income statement before you actually sell them, and that is the heart of the problem,” Miller said.
That can cause gross margins to soar in excess of 100% because cannabis production facilities are expanding rapidly, thus growing more biological assets. And recreational sales haven’t started yet.
“The issue will be less acute over time as the market matures, but while the cannabis industry is in expansion mode, it’s pretty chaotic,” Miller said.
“You could fill a room full of cannabis plants, management could decide those plants have a value of millions of dollars, then you could tell investors you made all this money on your income statement just because you’re growing a room full of stuff,” Miller said, adding that these companies aren’t breaking any rules.
Investors should pay less attention to gross profit and focus more on revenue, he suggested.
Canadian and Australian public companies comply with IFRS, but American businesses report with US Generally Accepted Accounting Principles, which doesn’t have the same issue with “fair value” recognition of biological assets.
Matt Lamers can be reached at email@example.com