One year ago, it looked as if the cannabis industry would not be stopped. Canada had just become the first industrialized country in the modern era to legalize recreational marijuana, derivative products were expected to be launched by no later than October 2019, and a number of states in the U.S. were newly legalizing marijuana in some capacity.

And yet, the wheels fell off the wagon. Regulatory and procedural problems in Canada have combined to keep legal product from reaching dispensaries. Health Canada has been overwhelmed with cultivation and sales license applications, while certain provinces (ahem, Ontario) have been slow to license physical dispensaries. Meanwhile, high tax rates in U.S. markets have encouraged consumers to stick with considerably cheaper black-market growers.

The end result has been a sea of losses throughout much of the marijuana industry, with Canadian pot stocks being especially susceptible to early-stage red ink.

However, a few growers to our north have managed to buck this trend and generate quarterly profits. Unfortunately, as you'll see, these profits are nothing more than fool's gold.

A magnifying glass is held over a potted cannabis plant.

Image source: Getty Images.

Canadian pot stocks are (legally) fooling you

It's easy for investors to read a headline number (such as sales, or earnings per share) and take it as fact. But Canadian cannabis stocks are a different breed of company that require more sleuthing from investors to uncover the facts. That's because publicly traded Canadian cannabis companies report their operating results using International Financial Reporting Standards (IFRS), which has a few marked differences from the generally accepted accounting principles (GAAP) that we're used to in the United States.

Canadian cannabis stocks are classified as "agricultural companies" under IFRS accounting, and as such are required to make a handful of estimations and reconciliations on their income statements, some of which can seriously alter their operating results.

These are known as "fair-value adjustments." Canadian marijuana growers are required to:

  • Estimate the value of their crops on a quarter-by-quarter basis. How, you ask? Growers offer their best guesses on fair value based on the stage of plant propagation. In other words, flowering cannabis plants are going to be "worth more" than plants that haven't flowered yet, and growers are required to recognize this on their income statement as an "unrealized change in fair value of biological assets."
  • Reconcile fair-value adjustments on product sold during a given quarter. Not only are Canadian cannabis companies estimating the value of their crops every quarter, but they're also being required to guess how much it'll cost to sell those crops, often many months before the sales actually occur. When the sales do occur, these pot growers have to go back and reconcile any differences between the actual costs and the estimate. This is referred to as the "realized fair value adjustments on inventory sold."

Fair-value adjustments are an above-the-line metric, meaning they either add to or subtract from gross profit before expenses are factored in.

An accountant chews on a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

These two "profits" aren't really profits

The thing to understand here is that these fair-value adjustments have no bearing on the operational performance of Canadian cannabis stocks. All they wind up doing is confusing investors, especially if the fair-value adjustment results in a considerable upward adjustment in gross profit, which has happened twice over the past month.

For example, on Tuesday, Nov. 12, medical-clinic operator and marijuana grower Aleafia Health (OTC:ALEAF) reported its third-quarter operating results. This was a particularly anticipated event, given that Aleafia provided guidance on Sept. 24 that it would be achieving positive net income for the quarter. But all is not as it appears.

For the quarter, Aleafia Health recorded 4.96 million Canadian dollars in net revenue, after excise taxes, and recognized CA$2.93 million in cost of goods sold. That's a gross profit of CA$2.03 million before fair-value adjustments. However, Aleafia wound up recognizing an unrealized gain on the fair value of its biological assets of CA$10.37 million, vaulting its gross profit to CA$12.4 million. After operating expenses and other items, the company netted CA$1.86 million in net income. But without this fair-value adjustment, Aleafia's CA$2.03 million gross profit would have been dwarfed by CA$8.46 million in operating expenses and CA$2.41 million in interest expenses.

A magnifying glass is held over a company's balance sheet.

Image source: Getty Images.

It's the same story for Aphria (NASDAQ:APHA), which reported its fiscal first-quarter operating results last month. In that report, Aphria generated CA$126.1 million in sales, but CA$95.3 million came from its pharmaceutical distribution business, which has virtually nothing to do with cannabis. After subtracting cost of goods sold or purchased, Aphria was left with a gross profit of CA$27.6 million.

The thing is, Aphria realized a negative CA$7.3 million adjustment on product sold from inventory, but was graced with a positive CA$25.2 million bump from fair value on its biological assets. In short, that CA$27.6 million gross margin jumped to CA$45.4 million with a click of an accountant's pen. But in Q1 2020, Aphria's CA$27.6 million in gross margin before fair-value adjustments would have paled in comparison to its CA$41.4 million in normal operating expenses. Just like Aleafia Health, it would not have made money without this perfectly legal, but entirely confusing, adjustment.

Suffice it to say that investors should take IFRS-based pot-stock profits with a grain of salt, until they've done some digging into the true nature of the profit.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.