Impossible to Compare Cannabis Stocks Apples to Apples in Canada Due to Accounting Practices

How much is that cannabis producer’s stock really worth? In Canada, it is difficult to tell, based on accepted – and legal – accounting principles.

In a Globe and Mail report, a Canadian Securities Administrators (CSA) investigation revealed that “100 per cent” of licensed producers needed to improve how they disclose fair value on their cannabis plants. However, that isn’t the only accounting issue. For example, a Canadian cannabis company can legally post millions of dollar in sales without actually selling anything. It’s an accepted accounting practice for agriculture-based companies using International Financial Reporting Standards (IFRS). This globally-used accounting practice allows companies to report sales based on estimated future sales minus estimated future costs for “biological assets”. Changes in value of inventory that is unsold also muddies the financial statement waters.

Some analysts say that Canadian cannabis companies are being too aggressive in estimating profits. Others question whether the accounting standard should apply to the cannabis industry in the first place. Still others are against the accounting practice altogether, calling it “voodoo”. Further, there are no strict rules as to how things are valued, when to expense costs, or whether costs should be expensed in a lump sum or reported over time. In other words, it is very difficult to do an “apples to apples” comparison of cannabis producers when there is uncertainty about how one financial statement compares to another. One forensic accountant called the sector “a bloody mess”.

Another concern is that most Canadian cannabis companies with operations in the United States “fell short” in warning their investors about the risks of operating in a country where cannabis use and production is illegal federally.

Novice Investors in New Cannabis Industry Complicates Matters

These debates about accounting practices might normally be academic. However in case of cannabis stocks, there are two other factors that intensify the problem: the fact that the cannabis market in Canada is relatively young and the inexperience of many cannabis stock investors.

Because the market is new, there is a higher likelihood to be large fluctuations in prices from one day to the next. Accounting practices that estimate high sales numbers would obviously have an impact on stock prices. It can also cause overvaluation – a problem that has already been flagged in cannabis stocks, leading to sell-offs. So, variations in accounting practices that would have likely had a small impact on stock price in a mature market can contribute to volatility in a newer market.

The cannabis industry has attracted many new investors hoping to cash in big – and few investors are drilling down or are doing their due diligence when it comes to the financials. Whether it’s inexperience or simply a “gold rush fever” effect driving investors, there is a good case to be made for a lot of speculation going on right now with cannabis stocks.

The good news is that the Licensed Producer system is one of the most stringently regulated systems in Canada – and the world. Further, the CSA announced that licensed producers were responsive when the issue was raised, with companies recalculating their value. Health Canada continually reviews record keeping, and in fact will not issue a licence to a company until it demonstrates how it will keep its records. That puts the investor at a lot less risk than some other stocks. For example, a situation like Enron’s before its collapse where it essentially hid its debt would be less likely to happen to a Licensed Producer.

When It Comes to Cannabis Stocks, Do Your Due Diligence

Many financial advisers say that the best way to protect yourself is to do your due diligence by ensuring you understand the financials, no matter how they are reported. One investment adviser suggested evaluating the financials of a cannabis producer (or indeed any stock) based on non-IFRS measures such as EBITDA (earnings before interest, taxes, depreciation, and amortization).

Just like any stock investment, it’s important to do your due diligence – including talking to a professional investment adviser. But it’s reassuring to know that thanks to the Licensed Producer system, these companies are among the most scrutinized in the world.