Recreational marijuana is a new industry, which can lead to financial oddities. One of the most strange is that pot companies can claim profit based on little more than a guess about how much their cannabis is actually worth.
International accounting rules followed by the top Canadian pot producers require companies to report the value of a biological asset — such as marijuana — at various stages of the production cycle. For pot companies, this means a seed or a clone worth little will turn into a full-grown plant worth much more, and the difference will be reflected in the company’s quarterly earnings. That rule makes it possible for a cannabis company to turn a profit without selling a gram of pot, a feat companies have already accomplished.
For established industries, the International Financial Reporting Standards, or IFRS, rule is not much of an issue — meat companies have a good idea how much their livestock will be worth once sold, and tequila companies know how to value their agave plants. Legal cannabis, though, is a new industry with few benchmarks, which can make it a challenge to establish how much a weed company should expect to collect when it sells marijuana. So they are left to guess for now, after an October crackdown by Canadian regulators not satisfied with the level of transparency when companies valued their pot.
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Organigram Holdings Inc. OGRMF, -6.27% has already shown how this works, when it reported profit that exceeded revenue last month. Organigram reported earnings of C$29.5 million ($18.8 million) on sales of C$12.4 million, but disclosed a loss of C$623,000 after stripping away the gains from biological assets, as well as a tax charge.
Aside from Tilray Inc. TLRY, -0.94% , all the largest pot companies operating in Canada — such as Canopy Growth Corp. CGC, -3.11% WEED, -3.40% Aurora Cannabis Inc. ACB, -2.32% ACB, -3.40% and Aphria Inc. APHA, -1.46% APHA, -2.68% — have had to offer investors more transparency about how they value cannabis during the growing cycle. Tilray does not follow IFRS rules because it elected to go public in the U.S., which allows it to report by U.S. Generally Accepted Accounting Principles, or GAAP, rules. It chose a U.S. listing, in part, because of the complexity of valuing its pot under IFRS, according to spokesman Zack Hutson.
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The assumptions used to value marijuana are crucial for investors to understand as they track the cannabis sector in Canada, White Sheep Corp. finance director Michael Miller said. Miller and University of Cambridge professor Alan Jagolinzer wrote a curriculum for business schools that helps students understand the accounting issues around weed companies and the IFRS rules about cannabis.
Where accounting for pot can get tricky is with companies that haven’t yet recorded actual revenue. Pot companies have managed to claim a profit before even receiving a license to sell pot, including Indiva Ltd NDVAF, +1.82% NDVA, +3.51% and Supreme Cannabis Co. Inc. SPRWF, -11.52% FIRE, -16.74% .
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Miller brought up Green Organic Dutchman Holdings Ltd. TGODF, -1.45% TGOD, +0.00% in a telephone interview, revealing that Dutchman has valued its pot at $13.75 a gram, the highest number Miller has seen from any public producer. That number could lead to huge paper gains for Dutchman even though the company has yet to sell any recreational pot.
“It’s an example of how a company with zero revenue still has to come up with key assumptions even before they’ve sold anything,” Miller said.
A spokesman for Dutchman says the per-gram price of $13.75 is one of “several inputs” into its model determining the value of its pot. Vice president of investor relations Danny Brody said the company is producing pot for a small group of medical marijuana patients and that it is a “premium” product not available for wholesale purchase — hence the lofty assumption for its cannabis value. When Dutchman finally does produce pot at the massive scale promised to investors, it will likely modify some of the assumptions it made, Brody said.
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Modifications have a big potential downside, however. If a company claimed its pot was worth $13.75 a gram, then eventually sells it for $8 a gram, it would have to restate previous financial statements. Frequent, large corrections are a red flag in any industry, and could become common for cannabis companies as they learn the art of proper valuation.
“[A restatement] implies that management was excessively rosy in their assumptions of what the product would sell for,” Miller said. “There are some companies historically that were very obviously inflating their financial performance in previous years. You can do it for a while, but eventually there will be a reckoning.”