The Necessity of Proper Internal Controls
Good internal controls and compliance programs are critical to every company. Internal controls facilitate the implementation of proper accounting standards and controls as well as the maintenance of appropriate records. Properly installed compliance programs aid avoiding errors that can turn out to be prohibited transactions. Yet many young firms fail to invest in the installation of properly functioning internal controls and policies and procedures for a variety of reasons. The Commission’s latest case in this area is a good example. There a small cannabis company discovered three error in its financial reports for three different quarters. The result, a restatement of the firm’s financial statements for three quarters. In the Matter of Cronos Group Inc., Adm. Proc. File No. 3-21215 (October 24, 2022).
In 2019 Cronos, a small Canadian company in its first years of operating as a U.S. publicly traded issuer, embarked on a significant business expansion. The firm sought to enter the nascent cannabis vaporizer market. It lacked not just expertise but “familiarity” with the requisite accounting requirements and internal controls, according to the Order Instituting Proceedings. This resulted in three material errors in three different quarters over a three year period beginning in 2019.
In 2019 there were two material errors. One occurred in the first quarter of 2019 while the second was in the third quarter of that year. During those periods the company improperly recognized revenue in connection with transactions involving the same counter party. Each transaction involved the sale of cannabis raw materials (or cannabis flower) by Cronos. Each occurred simultaneously with the purchase by Cronos of processed cannabis product. Separately, a now departed firm executive entered into an undisclosed oral agreement with a different counter-party to sell cannabis raw material to the counter-party but then repurchased the cannabis product, either as a derivative product or in another form the next quarter. The oral purchase agreement made it inappropriate for Cronos to recognize revenue in connection with the sale transaction.
In the second quarter of 2021 a third error occurred. During that period Cronos failed to timely record impairment charges tied to goodwill and intangible assets associated with U.S. reporting.
Following the discovery of the errors Cronos filed restated financial statements for the relevant quarters. For the first and third quarter of 2019 the company had overstated revenue by $5.8 million. In the third quarter of 2021 the firm disclosed that it should have recorded about $234.9 million in impairment charges for the U.S. reporting unit. For each quarter the firm disclosed that it had identified material weaknesses in its internal control over financial reporting.
The Commission considered the cooperation of the firm in resolving the matter and agreed to implement certain undertakings which included the retention at its expense of a consultant on internal accounting controls and internal controls over financial reporting.
The Order alleges violations of Securities Act Section 17(a) and Exchange Act Sections (10)(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). Respondent Cronos consented to the entry of a cease-and-desist order based on the Sections cited above. The firm acknowledged that the Commission was not imposing a penalty based on its cooperation. See also In the Matter of William Hilson, CPA, CA, Adm. Proc. File No. 3-21216 (October 24, 2022)(proceeding naming firm’s CFO from 2016 to April 2019 and CCO from October 2016 to April 2019; action is based on facts above; resolved with a cease-and-desist order based on same Sections as above; Respondent also denied the right to appear before the Commission as an accountant with the right to apply for re-entry after 3 years).