Whether a cannabis company reports a profitable quarter or not can sometimes have a lot to do with nonoperating-related items. Impairment losses, fair-value gains, and income related to investments can easily pull a company's bottom line into many different directions. Trying to suss out if a company had a good quarter becomes a challenge, to say the least. And although you can just use adjusted EBITDA, that is a non-GAAP number that can contain a lot of subjectivity.
It may not be an interesting topic to discuss whether a company uses U.S. GAAP or International Financial Reporting Standards (IFRS) when preparing its financials, but it's something investors shouldn't ignore, because it can play a significant role in both the predictability and quality of earnings results.
Here's why it matters
The difference in financial statements is easy to spot when you know what you are looking for. My favorite example is Trulieve's (TCNNF 0.04%) financial results from 2019. During that year, the company reported revenue of $253 million. And its operating income was $286 million. That's right -- the company's operating profit was more than its revenue. The reason is simple: Trulieve added back roughly $200 million worth of fair-value adjustments related to its inventory and biological assets. If you see the words "fair-value adjustment" come before operating expenses on the income statement, you are looking at a company that uses IFRS to prepare its reports.
Under IFRS, a cannabis company will carry its biological assets at fair value minus the costs to sell them. And there is generally more room for fair values to be used when reporting assets under IFRS than there is with U.S. GAAP (which focuses more on historical costs). Using fair value is a problem, because it involves making estimates. Accounting firm BDO says there are many factors companies will consider in fair-value measurement models, including expected yields, the stage of growth that a plant is in, the market price, waste, and costs. That means there can be a great deal of subjectivity involved when estimating those values.
And while fair-value gains can be great and make a company's otherwise-underwhelming results look amazing, losses can have the reverse effect. When Trulieve reported its quarterly results for the three-month period ending Sept. 30, 2020, fair-value adjustments related to inventory and biological assets were a net negative $17 million, and the company's profit of $5 million paled in comparison to more than $60 million it reported in net income in the prior-year period (its fair value gains then totaled a positive $66 million).
More companies are moving toward U.S. GAAP
Trulieve has since moved to U.S. GAAP for its financial reporting. The reason is that as of June 30, 2020, the majority of its shareholders were based in the U.S., and under securities laws that meant the company was no longer considered a "foreign private issuer." Without that classification, the company no longer had the choice to use IFRS, and had to adopt U.S. GAAP.
As more U.S. investors buy shares of multistate operators, there will be fewer cannabis companies reporting under IFRS. Cresco Labs announced in May that it would be switching to U.S. GAAP. However, in its announcement the company didn't mention having to do so because of a change in where the majority of its shareholders are located, only that it was making the move to align with the reporting standards that U.S. investors are used to. Canadian-based Canopy Growth also reports using U.S. GAAP, likely for the same reason.
What does this mean for cannabis investors?
The key takeaway here is that, on average, cannabis companies that switch to U.S. GAAP will post much more consistent and less volatile earnings reports than those that still report under IFRS. That doesn't mean there won't be other noise to deal with, including impairment losses or other income and expenses, but it does take away some of the volatility. It should strengthen the quality of earnings reports, making it easier for investors to compare one period against another and be less dependent on adjusted EBITDA numbers to make informed decisions.
Overall, the change in accounting standards is a positive move for companies like Trulieve and Cresco and could make them more investable in the long run, especially for investors who may not want to deal with complicated earnings reports. And that could help make both pot stocks better buys today.