Given the high-speed development of the cannabis industry in Canada, companies need to consider all the factors that work towards setting them up for success. When it comes to financial reporting, public companies in particular need to know where to focus their attention.
What defines biological assets? Plants that undergo physical transformation and are cultivated for the purpose of sale must be treated as biological assets for accounting purposes, as defined under International Accounting Standard 41 – Agriculture (“IAS 41”). At the point of harvest (the cessation of biological transformation), the harvested buds are classified as inventory, and within the scope of International Accounting Standard 2 – Inventory (“IAS 2”). In examining how biological assets are assessed under fair value, we will explore the guidance of IAS 41 and its application to the cannabis industry.
IAS 41 is not a new standard. However, it's attracting a lot of attention within the cannabis industry because of the short growth cycle of the cannabis plant, as well as the challenges of measurement those preparing financial statements are experiencing. Accounting for cannabis plants in accordance with IAS 41 can get complicated because of the numerous inputs that are considered in a fair value measurement model. This issue is further complicated as most cannabis producers and investors are interested in the cash cost to produce, which exclude the fair value adjustments.
Moreover, under IAS 41, financial statement note disclosure requirements are not simple to prepare, often taking substantial amounts of time and effort on a quarterly basis.
The biggest challenge lies in the amount of judgement required in measuring asset values during their growth stage. To add to the complexity, the number of cannabis growth cycles and grow rooms, yield rates per plant, costs per gram, cost to compete, and market selling prices can have considerable variations. In turn, the fair value of biological assets and the related adjustments often have a significant effect on net income determined in accordance with International Financial reporting Standards (“IFRS”).
There is not an active market for partially-grown cannabis plants. Therefore, the biological asset value of growing plants prior to harvest is often determined using a cash flow model to establish fair value less cost to sell (“FVLCS”) under IFRS — before it reaches the point of harvest.
The recording and tracking of cannabis plants at fair value requires a significant amount of time and attention. Further, it's a challenge to standardize systems and processes to track the data and produce the reports necessary to determine fair values and comply with the disclosure requirements.
Many cannabis companies are in a growth stage and lack stabilized data, therefore there is significant estimation uncertainty in the fair value measurements of the cannabis plants. This is particularly relevant considering many investment analysts that cover the cannabis industry remove the impact of fair value adjustments for biological assets in order to understand cash costs.
When estimating fair value, IFRS 13 – Fair Value Measurement (“IFRS 13”) requires companies to maximize the use of relevant observable inputs and minimize the use of unobservable ones1. Given the nascent stage of the cannabis industry in Canada, most inputs used to determine the fair value of biological assets are unobservable, resulting in Level 3 fair value. However, as the industry matures, we expect certain inputs to become observable, which will reduce some of the estimation uncertainty in the fair value measurements.
Conceptually, the value of biological assets provides a notional market seller with a return for cultivation efforts incurred up to the measurement date. The notional market buyer also requires a fair return for purchase, assumed risk, and return for the further development into a finished product.
As such, fair value measurement models often consider:
- Expected yields for dried flower, shake, and trim
- Stage of growth
- Market price of finished goods
- Selling costs
- Cost per gram
- Cost to complete
- Survivorship and wastage
It's expected that the variations in yield and other similar sensitive inputs will be factored into fair value measurement models, and more importantly, disclosed within the notes of the financial statements.
IAS 41 permits departure from fair value when there is an inability to reliably measure it. However, this departure is rarely applicable. In our view, this departure is not applicable within the cannabis industry as there is an ability to make reliable measurements.
Cost may be used as a proxy for fair value when:
- Little biological transformation has taken place; or
- The impact of biological transformation is not expected to be material (particularly, early in the biological transformation lifecycle)
Cannabis plants go through a series of stages as they grow and mature. Moreover, the growth (and fair value) of plants is not linear. Therefore, this poses an interesting question for fair value measurement:
- Is the passage of time a proxy to use as a basis for fair value accretion?
- Or, does the particular stage of the plant development suggest the fair value may exceed its cost?
IAS 41 is not a prescriptive standard; it does not prescribe how the FVLCS should be presented in the Statement of Comprehensive Income. It requires the disclosure of “the aggregate gain or loss arising during the current period on initial recognition of biological assets […] and from the change in FVLCS of biological assets.”
IFRS also provides additional guidance, viewed as best practice to adopt when biological assets are harvested, become inventory, and are subsequently sold. IFRS recommends presenting additional line items in the Statement of Comprehensive Income, when such presentation is relevant, to understand financial performance. Additionally, IFRS requires that when items of income or expense are material, you're required to disclose their nature and amount separately.
Consequently, unrealized gains or losses resulting from fair value changes of biological assets is now typically presented as a separate financial statement line item from the fair value adjustment included for sold inventory. By disclosing both financial statement line items on the face of the Statement of Comprehensive Income, this helps the reader better understand the true cash cost on inventory produced and sold. Additionally, it helps to readily reconcile non-IFRS measures disclosed in the Management Discussion and Analysis (such as, cash cost per gram) to the financial statements.
How does BDO provide peace of mind?
BDO has deep knowledge and understanding required to prepare, review, and provide practical coaching on the fair value measurement of biological assets, like those of cannabis, as well as any related financial reporting and disclosures. We're equipped to help determine reasonable estimates, however frequently they're required.
We understand the cultivation processes and that timelines vary among clients. So, we tailor our approach based on each client's unique considerations, along with our deep industry experience.
To discuss further, please reach out to us here.
1) The fair value hierarchy can be summarized as follows:
- Level 1: Observable market prices for identical assets and liabilities that are actively traded.
- Level 2: Observable market prices for similar assets or liabilities, or identical assets and liabilities with inactive trading or derived from inputs that are observable for most of the period.
- Level 3: Entity-derived or unobservable inputs, which should reflect the reporting entity's own assumptions about how market participants would price the assets. These include inputs that are not corroborated by observable market data.
2) Extract, IFRS Discussion Group Report on Meeting – June 21, 2018