Financial Reporting in the Cannabis Industry: Impact of 'Biological Asset' Rules

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By: Zach S. Ramey, CPA

In the world of mergers and acquisitions, private equity and venture capital, words like “high-growth potential” and “new markets” are music to the ears of analysts and investors. Companies that operate in the unchartered waters of new industries are poised to disrupt the status quo and can change the marketplace as we know it. Companies that exhibit these factors show promise and stand as some of the most sought-after investments.

Enter: The Cannabis Industry.

The cannabis industry exemplifies these factors and is already disrupting the global market with countries across the globe taking a new approach to marijuana. Just this year, Canada became the first G7 country to fully legalize marijuana. Other countries are beginning to follow suit, with over 30 countries legalizing medical marijuana and many more moving to decriminalize personal use of the plant. In the United States, nine states and Washington, D.C. have legalized it for recreational use and 30 states have legalized it for medical use. The shift stems from new research regarding the drug’s use for medical purposes, the desire to undermine the black market for illegal cannabis, and the ability to generate millions of dollars in tax revenue. Colorado has generated over $900 million in marijuana-related tax revenue since legalization in 2014. IBISWorld notes that total U.S. marijuana revenues have increased from $3.72 billion in 2014 to $8.12 billion in 2017 and projects the industry to continue this supernormal growth trend, potentially reaching total U.S. revenues of $35.85 billion by 2023.

Enforcement of the marijuana industry started to change during the Obama administration by means of the Cole Memorandum (see detail here). President Trump has recently signaled a “hands-off” approach by allowing states to regulate the cannabis industry and has stated he supports some sort of federal resolution. The current regulatory environment makes it difficult for marijuana-related businesses (MRBs) to operate due to banking and tax laws. In general, banks are reluctant to provide banking services to any MRBs because doing so would violate money-laundering provisions of federal law. Additionally, MRBs are governed by IRC § 280E, which prohibits them from deducting normal business expenses from gross income in the calculation of taxable income. MRBs are only allowed to deduct costs of goods sold and are taxed on gross income rather than net income, creating significant financial burdens for legitimate cannabis companies. Resolution of these issues would give the industry an even more optimistic outlook.

These favorable global and national trends foreshadow a day when cannabis will be legal across the U.S. and many other countries. Investors and companies are presented with a rare opportunity to capitalize on this ‘budding’ – soon-to-be ‘blooming’ – market. With such extreme growth potential, the M&A opportunities and activity will likely heat up as investors make their bets. A vital part of M&A is pre-acquisition due diligence and “quality of earnings” (QoE) – the extent to which a business’ economic performance is faithfully represented by its reported earnings and can be sustained into the future (see detail here). In addition to the regulation and credibility issues, there are financial reporting and valuation issues that present additional problems for the industry. Therefore, it is paramount that professionals performing QoE analyses in this space are aware of and properly adjust for these accounting rules. It is equally important that buyers and investors be informed because the accounting rules can present a more flattering picture than reality.

Current guidance under IFRS and GAAP steers towards agricultural accounting for the cannabis industry (IAS 41 (IFRS) and ASC 905 (GAAP). IFRS accounts for “biological assets” (i.e. living animal or plant assets) differently than other assets by using a fair value model, which requires companies to measure their biological assets at fair value less costs to sell (FVLCS). Further, these assets must be measured at the end of each reporting period and any changes in FVLCS must be recognized on the income statement, near the top (i.e. after revenues but before expenses).

For cannabis companies, this means they are required to value their plants while they are still growing or recently harvested and recognize the gross profit of the planted or stored cannabis on the income statement before they sell it or even line up a buyer. Valuation issues can also be problematic because different types and maturities of plants – clones, bearer plants, flowering plants, harvested cannabis, etc. – must be assigned different fair values which are under constant threat of change as the plant goes through its life cycle. Valuing marijuana plants like this requires management to make estimates including costs to grow, harvesting and selling costs, sales price and expected yields. These estimates assume that the plants will produce, be harvested and sold – but what if these pre-recorded profits never materialize? Crops could be the victim of fire, mold, drought, or theft. In addition to misleading financials, the fair value model exposes cannabis companies to the risk of significant write-downs or write-offs if the valuation is misstated, if the price per gram drops, or if the marijuana is never sold.

A simple example of this accounting practice was presented by a user (GoBlueCDN) on StockHouse and has been summarized below:

Dad: Hey son. How’s the lemonade business?

Son: Pretty good, Dad. I sold $9,752 worth of lemonade.

Dad: Wow! That is good. How much did you make?

Son: Well, the lemons, sugar, water and other production costs (i.e. COGS) were $10,950.

Dad: So you lost $1,198?

Son: Well no…. you see I picked some more lemons (i.e. harvest).

Dad: How does that make any difference?

Son: My accountant says I get to add back the value of what I grew during the period after harvest (i.e. non-cash gain on biologicals) even though I didn’t sell it.

Dad: How much did you grow and not sell?

Son: $18,141.

Dad: So how much does the accountant say you made?

Son: $16,493 (i.e. gross profit), crazy right? Especially given my sales were only $9,752.

Dad: How much inventory do you have?

Son: $50,958.

Dad: *Opens the garage and is confronted with boxes of lemons from the floor to the ceiling* Son, how many lemons are in here?

Son: If I sell at the same pace as last quarter, then 15 months. If I double my sales, then 7.5 months. But don’t worry I have a HUGE harvest tomorrow too.

As illustrated above, the biological asset rule artificially inflates gross profit through the recognition of fair value adjustments. If everything goes as planned indefinitely, there won’t be any problems. However, if anything happens to the plants or product before it’s ready for sale, there is a cascading effect where a company needs to cover significant operating costs but is unable to recognize any profit because that profit has already been accounted for through gains on biological assets.

These rules were originally intended for farmers growing highly cyclical crops, allowing them to be able to smooth out their revenues throughout the growing cycle of their plants; however, they are not well-tailored for the cannabis industry. This accounting can be misleading and create issues for cannabis companies seeking access to external capital. Three of the most common reasons that M&A deals are unsuccessful include:

  1. Failure to properly prepare for and plan a transaction;
  2. Failure to perform proper due diligence; and
  3. Failure to anticipate and execute on economies of scale.

Each of these reasons should receive proper consideration, either directly by management (items #1 and #3), or through professionals hired to perform due diligence and earnings quality analysis (item #2). Therefore, accounting and finance professionals performing M&A due diligence in this industry must understand, analyze and adjust for these rules and advise their clients about these issues in this new, uncertain, highly regulated and scrutinized industry.

Many cannabis companies are taking it upon themselves to be provide alternative financial metrics that more accurately display the current financial condition. Some of these metrics include:

  • Cash cost of sales per gram of cannabis sold;
  • Cash cost to produce per gram of cannabis sold;
  • Gross profit on cannabis before fair value adjustments; and
  • Gross margin on cannabis before fair value adjustments.

Unfortunately, there are no standard calculations or disclosures of these metrics, so it is up to management to determine how to calculate and disclose, making it difficult for investors and analysts to compare apples-to-apples. Despite all the issues that vex the cannabis industry, the U.S. and many other countries are trending towards a more progressive attitude of cannabis which is expected to spur a wave of new MRBs entering the industry, likely causing a spike in M&A activity. Therefore, it is crucial for M&A due diligence professionals to adapt and provide relevant guidance and advice to their clients, so they too can capitalize on this ‘budding’ industry.