Accounting enforcement in action, or: is being held accountable!

Here are some extracts from a settlement agreement recently entered into between the Ontario Securities Commission and Cronos Group Inc.

  • Cronos Group Inc., an Ontario-based public cannabis company, is being held accountable for improperly recognizing $7.6 million (US $5.8 million) in revenue in its Q1, Q2 and Q3 2019 interim financial statements and for subsequently overstating virtually all of its U.S. goodwill and a significant portion of its U.S. intangible assets by a collective amount of $234.9 million in its Q2 2021 interim financial statements.
  • Cronos restated its Q1, Q2 and Q3 2019 interim financial statements to correct the revenue recognition error upon determining that they had not been prepared in accordance with generally accepted accounting principles (GAAP). The Company again restated its interim financial statements, this time for Q2 2021, to correct its failure to recognize impairment charges for goodwill and intangible assets relating to the U.S. reporting unit. In both instances, Cronos reported related material weaknesses in internal control over financial reporting.

Some details on the first of the revenue errors:

  • In the three months ended March 31, 2019, the revenue recognition error was due to one wholesale transaction that was inappropriately accounted for as revenue in the Company’s originally issued interim financial statements for Q1 2019. The transaction involved the exchange of cannabis dry flower for cannabis resin, with a third party, in two simultaneous transactions entered into in contemplation of one another.
  • This transaction did not meet the criteria for revenue recognition in accordance with GAAP, in this case…IFRS. The standard applicable to revenue recognition for the transaction was IFRS 15, Revenue from Contracts with Customers. This transaction lacked commercial substance and therefore revenue should not have been recognized. As a result, Cronos had overstated revenue by approximately $2.5 million (US $1.9 million)…in the original Q1 2019 interim financial statements.

There’s a second revenue error described in similar terms, and also another one:

  • During the three months ended September 30, 2019, there was a further wholesale transaction for a sale of dried cannabis to a different third party for which revenue was improperly recognized.
  • This further wholesale transaction did not meet the criteria for revenue recognition in accordance with IFRS 15 because it was deemed to be a consignment sale and lacked commercial substance. As a result, Cronos had overstated revenue by approximately $3.0 million (US $2.3 million)… in the Q3 2019 interim financial statements.

And here’s a summary of the errors related to goodwill and intangible assets:

  • On February 18, 2022, Cronos filed restated interim financial statements and an Amended and Restated MD&A for the three and six month period ending June 30, 2021 as the previously filed financial statements had not been prepared in accordance with GAAP, in this case US GAAP. Cronos disclosed that it had performed an interim impairment test on its U.S. reporting unit and the Lord Jones brand, as of June 30, 2021, to determine whether the carrying amount of the reporting unit and indefinite-lived intangible asset, the Lord Jones brand, exceeded their respective fair values. As a result of its analyses, the Company concluded that it should have recorded an impairment charge of US $234.9 million on goodwill and indefinite-lived intangible assets related to its U.S. reporting unit.

Such cases provide a good real-life opportunity to review various aspects of accounting, including in this case the specification under IFRS that a contract only exists when, among other things, it has commercial substance, meaning that the risk, timing or amount of the entity’s future cash flows is expected to change as a result of the contract. More broadly, of course, they provide a reminder that although accounting-related enforcement cases aren’t particularly common (which we can take as a general cause for mild celebration), they do occasionally occur, and the consequences can be notable. In this instance, the company agreed to pay an administrative penalty in the amount of $1,300,000, and to submit to a review (at its own expense) by an independent consultant of practices and procedures, instituting such changes as the independent consultant recommends. These penalties might have been worse if not for various mitigating factors, including that Cronos did have mechanisms in place for employees to submit internal tips and complaints and that it promptly took steps to evaluate a complaint submitted by an employee, and the high degree of cooperation with the OSC.

The case also reminds us that enforcement actions may focus on individuals as well as entities as a whole; the former CFO agreed under a separate settlement agreement to make a payment of $70,000, including costs, and to be prohibited from acting as a director or officer of any reporting issuer for a period of one year. The OSC held back, however, on suggesting specifically how he might best spend that year…

The opinions expressed are solely those of the author

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