Accounting rules are supposed to give investors uniform rules of the road by which to analyze companies. Sometimes, however, rules that attempt to “fix” industries with quirky or lumpy revenues introduce undue complications, missing the original goal and actually making things more convoluted. An example of this happened to Warren Buffett’s Berkshire Hathaway last year. New rules state that Berkshire must record unrealized capital gains on its stock holdings as earnings, meaning Berkshire’s earnings will fluctuate wildly with the market’s moves each quarter, as it’s essentially a holding company of other publicly-traded companies.
Another example has unfortunately happened to the cannabis industry. I say “unfortunately” because cannabis is currently a very “hot” industry that may lure excited, yet inexperienced, investors. And yet, this accounting rule could very well lead to a big trap, not only for novice investors, but even the companies within the industry. Here’s what the rule is, and why it’s so absurd.
The vast majority of cannabis stocks and growers are public in Canada, which adheres to International Accounting Standards (IAS). Companies that cultivate marijuana are subject to IAS Rule 41, which applies not only to cannabis growers but also growers of any agricultural asset such as corn or livestock.
The gist is this: As one grows an agricultural asset — in this case, cannabis — the plants must be recorded not just as inventory, but as profit at the end of each reporting period — even before they’re sold. As the cannabis plant grows and flowers, companies must record the profit it could fetch at that particular moment, based on the current market price, minus costs to sell. So even though the plant is still really inventory, it’s recorded as profit in the income statement.
Of course, what happens when one “actually” sells the marijuana? Well, you can only record profit once, so the company will only be able to record revenue and profit above and beyond what has already been recorded. Basically, some of your past profit now becomes a cost of goods sold.