On October 10, 2018, the Canadian Securities Administrators (“CSA”) published Staff Notice 51-357 Staff Review of Reporting Issuers in the Cannabis Industry. The purpose of the notice is to provide further guidance for issuers in the cannabis industry to ensure that these issuers maintain proper disclosure practices.
The notice is based on the information provided by the securities regulators in Alberta, British Columbia, Ontario, and Quebec (the “Regulators”). The Regulators reviewed the disclosure practices of 70 reporting issuers in the cannabis industry. The review had a broad scope and included issuers with any type of involvement in the cannabis industry, including licensed cannabis producers (“LPs”), issuers who plan to be involved in the industry but have not begun operations, issuers who do not directly sell or produce cannabis, and issuers with cannabis operations in the United States.
The LPs all had similar disclosure issues that were broken into five categories:
The CSA notes that issuers who have agricultural activities must disclose the fair market value of any living plants or biological assets under IFRS. This results in LPs profit and loss statements (“P&L”) often including unrealized gains related to the growth of biological assets that have not been sold. The CSA found that most LPs (71%) did not separately disclose all fair value amounts in their P&L.
According to the CSA the following items should be separately disclosed:
The CSA found that most LPs did not properly disclose their “production costs” or “costs of goods sold”. The LPs generally did not state whether the indirect and direct costs related to biological assets and/or inventory sold were included in their production costs. The CSA states that they expect issuers to clearly disclose:
The following is a model disclosure with respect to biological asset accounting policies provided by the CSA:
Enhanced disclosure of biological asset accounting policies
While the Company’s biological assets are within the scope of IAS 41 Agriculture, the direct and indirect costs of biological assets are determined using an approach similar to the capitalization criteria outlined in IAS 2 Inventories. They include the direct cost of seeds and growing materials as well as other indirect costs such as utilities and supplies used in the growing process. Indirect labour for individuals involved in the growing and quality control process is also included, as well as depreciation on production equipment and overhead costs such as rent to the extent it is associated with the growing space. All direct and indirect costs of biological assets are capitalized as they are incurred and they are all subsequently recorded within the line item ‘cost of goods sold’ on the P&L in the period that the related product is sold. Unrealized fair value gains/losses on growth of biological assets are recorded in a separate line on the face of the P&L. Biological assets are measured at their fair value less costs to sell on the balance sheet.
The direct and indirect costs of inventory initially include the fair value of the biological asset at the time of harvest. They also include subsequent costs such as materials, labour and depreciation expense on equipment involved in packaging, labeling and inspection. All direct and indirect costs related to inventory are capitalized as they are incurred and they are subsequently recorded within ‘cost of goods sold’ on the P&L at the time cannabis is sold, except for realized fair value amounts included in inventory sold which are recorded as a separate line on the face of the P&L. Inventory is measured at lower of cost or net realizable value on the balance sheet.”
LPs either capitalize or expense (as incurred) all direct and indirect costs related to biological assets. The LPs that elected to expense these costs are likely to include costs related to cannabis that has not yet been sold in their P&L. This has the potential to mislead investors as it will be difficult to determine which costs relate to cannabis that has been sold, as opposed to those which relate to the unsold cannabis in the period covered by the P&L. The CSA suggests that issuers who choose to expense the costs related to biological assets provide supplemental information in their MD&A that highlights the potential impact that the capitalization of these costs would have had on the P&L.
The CSA also notes that the presentation of a gross profit subtotal can be impacted by the decision to expense all costs related to biological assets. “Gross profit” can be understood to capture all the costs of cannabis sold during the relevant period. Since expensing the costs often results in the P&L including the costs of cannabis that has not been sold, the CSA states that issuers that expense these costs need to be aware that the gross profit on their P&L could be misleading.
Although the CSA acknowledges that the determination of the fair market value of biological assets is a subjective process, investors still need to be aware of the process by which these assets are valued and should understand what judgement(s) LPs employ when determining the fair market value. In order to accomplish this, the CSA suggests that LPs disclose the following:
In many cases, LPs included a non-GAAP financial measure that was used to calculate cost per gram. The CSA observed that in some instances the composition of the non-GAAP financial measure was unclear because of the issues discussed above, but in other cases, the confusion stemmed from the fact that the non-GAAP financial measure was insufficiently explained. Issuers need to ensure that any non-GAAP financial measure used is sufficiently explained and that any reasoning or judgement behind the use of the measure in question should be disclosed.
The CSA found that many issuers in the cannabis industry had disclosure deficiencies related to forward looking information. Issuers who make announcements about anticipated production should disclose all material factors and assumptions that are behind such projections. The CSA provided the following model of disclosure with respect to production estimates:
Enhanced disclosure about production estimates
The Company is in the process of building a second greenhouse directly adjacent to its current facility. While construction has commenced, it is still at an early stage, with only the foundation having been poured. The second greenhouse, once constructed and approved/licensed by Health Canada, will be able to produce approximately 100,000 kilograms of dried cannabis per year. This forward looking estimate is based on the following material factors and assumptions:
- The facility size will be approximately 800,000 square feet, with all of that space being used for cultivation.
- The ratio of dried cannabis cultivated per square foot of facility space will be consistent with historical output in our existing facility.
- Costs to construct the facility will be approximately $100 million, where only a deminimis amount has been incurred to date.
- The second greenhouse facility is expected to be fully constructed and ready for final inspection by Health Canada by December 1, 20X9(1).
These statements constitute forward-looking information related to possible events, conditions or financial performance based on future economic conditions and courses of action. These statements involve known and unknown risks, assumptions, uncertainties and other factors that may cause actual results or events to differ materially. The Company believes there is a reasonable basis for the expectations reflected in the forward-looking statements, however these expectations may not prove to be correct.”
The CSA went on to remind Issuers that all forward looking information must be kept up to date in accordance with Section 5.8 Disclosure Relating to Previously Disclosed Material Forward-Looking Information of National Instrument 51-102 Continuous Disclosure Obligations.
In addition, the CSA suggests the following as proper disclosure practices:
Enhanced disclosure about plans to enter the cannabis industry
On July 5, 20X8 the Company entered in to a binding arrangement to acquire Cannabis Co., an entity that has applied for a recreational marijuana dispensary licence in the U.S. state of Colorado. Other than the license application, Cannabis Co. has no other material assets. The expected purchase price of $50 million will be paid in cash.
The acquisition is subject to a number of contingencies which must be satisfied prior to closing, including that Cannabis Co. must obtain regulatory approval for its dispensary license on or before December 1, 20X8. If the dispensary licence application is not approved by the state regulator on or prior to December 1, 20X8 then the binding acquisition arrangement may be terminated by either party without penalty.”
- Issuers with material cannabis-related assets should implement impairment testing.
- Issuers who are reliant on licenses to produce or sell cannabis should consider filing these licenses as material contracts.
- Issuers with cannabis-related operations outside North America should disclose information about the foreign regulatory frameworks that apply to their business.
CSA staff published CSA Staff Notice 51-352 (Revised) Issuers with US Marijuana-Related Activities on February 8, 2018, for commentary see “CSA Announces Enhanced Disclosure Obligations on Issuers with U.S. Marijuana – Related Activities”. The CSA review found that most US issuers provided inadequate disclosure, but the vast majority have taken steps to improve their disclosure practices since the review and some have refiled their most recent MD&A.
The CSA will continue to monitor the disclosure practices of all reporting issuers in the cannabis industry and any issuer who does not maintain acceptable disclosure practices may face regulatory action.
Full CSA Staff Notice can be viewed here.