Identifying Business and Financial Risks in the Cannabis Industry

The Case Andys Medicinal Chemicals and Botanicals

In October 2018 the Cannabis Act was adopted in Canada and regulated by Health Canada, an oversight and regulatory body, under the authority of the Cannabis Regulations (CR). The legislation permits individuals over the age of 18 to purchase, possess, and cultivate limited amounts of cannabis. Andys Medicinal Chemicals and Botanicals (Andys), one of the initial licensed dealers of cannabis in Canada, supplies high-quality cannabis products to adult consumers in twelve countries and Canada. Andys is a U.S. based corporation (Delaware) with principal executive offices in Vancouver, B.C. On April 15, 20X3, Andys completed an Initial Public Offering (IPO) on the NASDAQ exchange and in December sold $410 million of bonds. The primary purpose of the IPO and debt issuance is to increase liquidity and raise capital to further develop their cultivation and processing facilities and future acquisitions. With the legalization of cannabis in Canada and many parts of the United States, the cannabis industry is rapidly expanding. Andys operations are currently indoors but they have plans to expand cultivation outdoors. Andys has experienced significant growth that they attribute to their global expansion strategy, their multinational supply chain and distribution network, and commitment to innovative research, product quality, and operational excellence. Andys has developed a reputation for producing pure and predictable medical-grade products. Despite their rapid growth, premium product quality and pristine reputation, Andys has generated net losses over the past three years. Andys has operations located in Canada, Australia, and Germany. Their operations comply with the CGMP (Current Good Manufacturing Process) regulations. The CGMP regulations for drugs contain minimum requirements for the methods, facilities, and controls used in manufacturing, processing, and packing of a drug product. The regulations make sure that the product is safe for use, along with the appropriate ingredients with the intended strength of the drug. Andys has plans to expand into the U.S. market. Initially, Andys plans to expand into the United States setting up cultivation and recreational dispensary facilities in the state of Massachusetts. Cannabis Industry While cannabis is legal in Canada, authorities still have regulators limiting the amount of medical marijuana inventory a medical marijuana center may cultivate and have on hand (typically based on reasonable factors including sales history and number of patients registered). First movers in this industry are visionary entrepreneurs with a high tolerance for risk. As the industry develops and consolidation businesses are better capitalized, there are better systems and operations, more experienced personnel and overall improved developed the legitimacy of the industry. While early ERP systems were overwritten from other industries, there are current systems specifically built for the challenges of the cannabis industry. This has helped internal controls around inventory as sales employee turnover is very high. 2 In Germany cannabis is medically legalized and recreational decriminalized. In early 2018 Germany began importing medical marijuana from Canada as part of an extended program. Potential cultivators are vying for government licenses. The legalization of marijuana for medicinal purposes is continually developing in the United States therefore laws and regulations vary greatly by state. In addition to legalization, agricultural and health regulations are still developing slowly in the U.S. as the business is currently illegally federally. Auditors need to also review the design and operation effectiveness of agriculture regulatory processes (IIIA whitepaper). While U.S. federal banks refuse to work with the industry, local credit unions have embraced the industry. These banking issues are not relevant in internal businesses that have legalized cannabis for medical (and/or recreational) purposes. Management team and employees As of September 30, 20X3, Andys employed 702 total employees, 688 are full-time employees located in Canada, Australia, and Germany. Four hundred and seventy-five employees are engaged in research, product development (horticulture and culinary), engineering, and logistics, 80 employees in general and administrative, and 135 employees in sales and marketing, and 12 employees in the accounting department. The core leadership team consists of individuals with degrees in mathematics, international law, medicine, engineering, economics, and finance. The average age of the leadership team is 42 years old. The Board of Directors is comprised of four directors including Andys CEO/President. See Appendix B for the organizational chart and Board of Directors. Understanding obtained from discussions with management In order to determine the availability and relevance of audit evidence and identify risks we have performed the following planning procedures: Discussion with Jeff Gnomes (CEO/President) (10/3), Annie Rice, CFO (10/3), and Joanne Smith, Sales Manager (10/7). Read minutes of quarterly board of director meetings, including quarterly financial statements, annual budget, and sales project reports. Based on management discussions and documents reviewed we have noted the following: Banking continues to be no concern at the time for international operations. The company can transact using all currencies including credit and debit cards. Company management uses the following measures to monitor the Companys financial performance: Cash on hand, receivables and payables. This gives management a quick assessment of liquidity. Sales, gross margins, inventory turnover. This is a typical measure of company performance. 3 Inventory balances fluctuate with sales and regulations. Sales and inventory balances are monitored to estimate demands. A full inventory count is performed every month on the last business day of the month at all locations. As an international company domiciled in the United States, each international subsidiary is set up to comply with international and U.S. tax standards so that no U.S. taxes are incurred on foreign operations. U.S. taxes (280E) will become important when operations begin locally but will be immaterial for 20X3. Andies U.S. expansion plans involving beginning operations in Massachusetts state planned for opening in December, 20X3. Recent industry developments in Canada involve consolidation. In addition average market returns have been declining as the industry develops, but sales have been increasing. In discussions with sales manager she noted the sales and marketing team has had a problem with turnover as operations continue to grow. Financial Statements and Related Information See Appendix A for the Budget and Actual financial statement information. Cash and cash equivalents: are comprised of cash and highly liquid investments that are readily convertible into cash with original maturities of three months or less. Investments: Investments consist of equity securities. The equity securities represent ownership interests in entities which do not have significant influence or controlling interests. The securities are recorded at fair value through net income. Inventory: consists of raw materials, finished goods, and work-in-process. Work-in-process includes pre-harvested cannabis plants and by-products to be extracted. Labor, utilities, nutrition, and irrigation costs are capitalized into inventory until the time of harvest. Inventory is stated at the lower of cost or net realizable value, determined using weightedaverage cost. Costs include raw materials, packaging, direct labor, overhead, shipping and the depreciation of manufacturing equipment and production facilities determined at normal capacity. Manufacturing overhead and related expenses include salaries, wages, employee benefits, utilities, maintenance, and property taxes. Recently, Andys discovered a material misstatement of Inventory. Andys process for inventory cost calculations is a manual process using complex spreadsheet-based models. Property and equipment: are recorded at cost net of accumulated depreciation. Assets held under capital leases are capitalized at the beginning of the lease term at the lower of the present value of the minimum lease payments or fair value. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The estimated useful life of the building is 4 20 years and the estimated useful life of property and equipment ranges from three to seven years. Bonds payable: On October 1, 20X3 Andys issued $410 of bonds at an effective interest rate of 12% paid semi-annually to mature in 20 years. Revenue: is generated from the following channels: 1. Sales to patients through the medical program under the Cannabis Regulations. 2. Wholesale of bulk and finished product to other Licensed Producers under the Cannabis Regulations. 3. Wholesale of finished product to provinces and provincially regulated distributors under the Cannabis Act and applicable provincial legislation. 4. Export sales to third-party distributors. Revenue is recognized based on contractual agreement, which can be upon shipment or delivery to the customer. Andys products include whole flower, ground flower, broad spectrum cannabis oils and capsules, and purified cannabis oils and capsules. Andys plan is to launch beverage and edible products in the future. Performance-based Stock Compensation and Cash Awards: Performance goals are based on company-wide performance. Stock-based compensation is comprised of non-cash costs for the fair value of compensation charges related to stock options and restricted stock units (RSUs) that are issued to employees and directors. The costs are amortized over the expected life of the options and RSUs. The weighted average expected life of the options and RSUs is 8.2 years.

Assignment Your firm recently retained Andys Medicinal Chemicals and Botanicals (Andys) as an audit client and as part of the audit strategy and planning process you have been tasked with writing an Audit Strategy Memorandum that will be included in the audit working papers.

PART1: Business and operations risk assessment.

Prepare an Audit Strategy memorandum to the audit files; you are to identify Andys business and economic environment incorporating risks of material misstatement. At a minimum you should include in your memorandum

1. Identify and document Andies Medicinal Chemicals and Botanicals (Andies) audit strategy along with an overview of the business and economic environmental risks of material misstatement due to:

External business factors

Nature of the client (operations and organizational structure)

Business risks related to Andies stated objectives and strategies

Managements financial performance measures

2. Identify factors that affect Andies control risk.

3. Differentiate an emerging growth company as defined in Section 2(a) of the Securities Act of 1933, modified by the Jumpstart Our Business Start-ups Act of 2012 (the JOBS Act), section 5 107 with a company compliant with public company effective dates for new or revised accounting standards.

4. Identify additional financial reporting risks encountered by an emerging growth company.

5. Identify the risks that an audit firm must consider when it auditing a company with foreign operations.