Recent financial reporting by HEXO Corp. raises pertinent questions

On Dec. 13, HEXO Corp. released the results of its impressive quarter ending on Oct. 31, and highlighted in its press release that the company had generated “gross revenue”, from an investor’s standpoint, a term the company had never used before, of $6.67 million.

“HEXO hit tremendous milestones in the weeks following the legalization of adult-use cannabis. The Company continues to honour its commitment to executing on its plans, which has led to a significant portion of our first quarter’s $6.7 million in revenue generated in just two weeks and represents more than a 500 percent increase over last quarter,” HEXO’s CEO and co-founder Sebastien St-Louis was quoted as saying.

In the same release, the company also reported “net revenue”, another term it had never used before, of $5.66 million for the period.

In all of HEXO’s previous financial statements, the company had used the relatively straightforward term “revenue” on its income statement; so why did HEXO break with its previous reporting and adopt these new terms that their investors had never seen before?

While it is true the terms gross revenue and net revenue are new to HEXO’s financials, they align the company with the standard in other public industries that, as of Oct. 17, share a common feature with Canada’s cannabis industry: excise taxes.

HEXO Corp.’s fiscal 2018-FY v. fiscal 2019-Q1 statements of loss

With great backlash, especially among the patient community, the Canadian government introduced excise taxes on a broad array of medical and recreational cannabis products, with limited exceptions such as low-THC products. The tax was introduced upon the legalization of adult-use cannabis and, in a nutshell, is to be paid by the producer and calculated as the greater of a flat fee or a percentage of the sale price, depending on the price and the type of product being sold (i.e. flower and trim have different rates).

With HEXO’s quarter-end of Oct. 31, 2018, the company’s financials included a considerable amount of adult-use sales as well as excise taxes that were incurred and payable to the government.

Of HEXO’s $6.67 million in gross revenue, $1.01 million, or just over 15 percent, is attributable to paying excise taxes. If one were to do the math, HEXO’s net revenue of $5.66 million is just its gross revenue less than the excise taxes that were incurred. This leads to the question: Why has HEXO included the excise taxes owed in its top-line gross revenue? Why didn’t the company omit these taxes entirely as one would do with a tax like Canada’s Harmonized Sales Tax (HST), which is never included in a company’s revenue?

It is understandable in this era of aggressive competition for both capital and customers why a company would want to augment its revenues. However, HEXO’s decision is not a matter of bad faith, but rather a product of the accounting standards and the specific nature of Canada’s excise tax on cannabis, which requires the company to do so.

On Jan. 1, 2018, the new accounting standard that detailed how companies reporting their financials under International Financial Reporting Standards (IFRS) should recognize and present revenues came into mandatory effect. This new standard, IFRS 15–Revenue from Contracts with Customers–which replaced and superseded a number of previous standards and interpretations–would have a direct impact on the way companies accounted for and presented certain excise taxes on their financial statements. IFRS 15 identifies when and how an IFRS reporter “will recognize revenue as well as requiring such entities to provide users of financial statements with more informative, relevant disclosures,” as pointed out on IAS Plus, a resource for international accounting and auditing developments.

Prior to the mandatory introduction of IFRS 15, companies had a degree of latitude when it came to how they presented excise taxes and whether to include them in their top-line revenues or just omit them entirely. While companies such as alcoholic beverages giant Diageo chose to include certain excise taxes in top-line revenue and, subsequently, expense them on the income statement – other companies such as competitor Heineken N.V. chose to omit all excise taxes from its income statement.

Understandably, this lack of uniformity created a slight issue for comparability across the alcoholic beverage industry, especially given the sheer size of the excise taxes incurred. In Diageo’s 2018 Annual Report, for example, the company paid more than £6.269 billion in excise taxes alone, making up more than 34 percent of its gross revenue.

Diageo’s fiscal 2018-FY consolidated income statement

Under IFRS 15, companies no longer have the same latitude as they did and will have to include certain excise taxes on the income statement, depending on a number of factors.

In the simplest sense under IFRS 15, when excise taxes are effectively a tax on an entity’s production, the excise tax should be included in top-line revenue and flow through the income statement.

This is the standard for many of the excise taxes imposed on alcoholic beverage companies and why Heineken was required to adjust its financial statements to include certain excise taxes in its top-line revenue.

Alternatively, in the case where the excise taxes are imposed directly on the customer and are collected by the entity as an agent on behalf of the government, they will not be included on the income statement. Value-added tax (VAT) of sales such as Canada’s HST clearly would belong in the latter category, and is why companies don’t include that amount in their reported top-line revenues (or at least, they aren’t supposed to). So, what about Canada’s excise tax on cannabis?

Heineken Corporate Presentation Commenting on Changes Required by IFRS 15, February 20, 2018

To determine whether a tax should be considered on production and, in turn, be included on the income statement, companies assess several key elements of the imposed tax. Key questions to address include, but are not limited to, whether or not the tax is calculated based on the quantities produced, what triggers the payment of the tax to authorities, and whether or not the entity is on the hook for the tax even if they never receive payment.

For Canada’s cannabis excise tax, the tax is primarily based on the total quantities produced, triggered and made payable to the government by the delivery of the product to the purchaser, and requires the producer to pay the government regardless of whether or not the buyer actually pays them in the end. This distinction between a production tax versus one directly levied against the customer based on the sales value can admittedly appear rather academic; however, for financial reporting and analysis purposes, the distinction is critical given its potential to dramatically influence key figures and ratios on which every industry in Canada relies.

In HEXO’s most recent Management Discussion and Analysis (MD&A), the company made it clear that it interpreted the cannabis excise tax as a production tax by including it on the income statement and introducing the terms gross revenue and net revenue. The use of both gross revenue (or simply revenue) and net revenue separated by excise taxes has been the standard for public alcoholic beverage companies reporting under both IFRS as well as U.S. GAAP (Generally Accepted Accounting Principles), e.g. Molson Coors, which puts HEXO’s accounting treatment in line with other industries subject to significant excise taxes.

For investors in these companies, what does this shift mean for their own interpretation and analysis? For the major beverage companies, many have tied their key performance indicators (KPI) to figures derived from net revenue, such as organic net revenue growth, as opposed to those derived from gross revenue. Key reasons for this shift include how net revenue better reflects a company’s performance in participating markets and its ability to increase price and market share.

Focusing solely on growth in gross revenue could lead someone to erroneously conclude that a company’s performance was improving, and that it was capturing market share, when, in fact, the jurisdiction in which it operates may have instituted an increase in the excise tax that was simply passed on to consumers.

As the cannabis industry continues its global expansion, the rise of complexity and the imposition of excise taxes in new markets are likely to continue. Investors should recognize that simply because a tax on cannabis products in a country in which an entity operates or exports to is referred to as an excise tax, it doesn’t necessarily mean that, by default, that tax will find its way onto the income statement. As always, it is best to check the accounting notes.

Michael Miller is the director of finance at White Sheep Corp.