You have probably heard how important proper accounting is to the cannabis industry but why is that the case? What is 280E and what are GAAP and COGS? Here we provide an introduction to those subjects.
Why Proper Accounting is Important to the Cannabis Industry
Cannabis companies are being audited regularly, and noncompliant businesses face years of litigation, significant legal fees and back taxes. In extreme cases, significant penalties have been handed out for lack of accuracy, such as in the Alterman-Gibson court case, with a $78,000 accuracy penalty, and the Northern California Small Business Assistants case, with a $250,000-plus accuracy penalty.
Every number in the books should be supported and properly recorded. Organized books not only reduce risk but can result in cost savings during an audit. It should be as easy as handing over a folder with all this support to the auditors.
Cannabis companies must think about the following long-term goals:
- Are you building a legacy to be passed down from generation to generation?
- Do you want to show as much growth as possible to take advantage of buyouts and acquisitions that will occur once this industry goes federally legal?
If it’s the latter, executives must think about how the company will be able to get the highest valuations in the event of a merger or acquisition. Buyers will be looking for cannabis companies that:
- Maintain clean books and records.
- Comply with Section 280E of the IRS tax code.
- Have a reputable brand and market share.
- Can grow and vertically integrate.
Recent headlines report a number of companies being sued by investors. As this news surfaces, it’s going to get increasingly more difficult for cannabis companies to secure funding if they don’t have a clean set of books. Cannabis business owners should not only consider their long-term goals for valuations but also their short-term goals for bringing on new lenders and investors.
Since cannabis remains classified as a Schedule 1 drug, its illegal status makes banking a challenge. It is not easy to pay wages, insurance and taxes when you are working with an all-cash business. Having massive amounts of cash on your premises also puts your business at an extremely high risk of internal and external theft, so more security is necessary to protect personal and professional interests.
The good news for cannabis businesses is that there are banks that will take your money. Most of the banks that will do business with cannabis businesses tend to have a lengthy application process, including documentation such as financial statements. Many of these banks also perform quarterly reviews of these financial statements, so marijuana companies need a cannabis-trained accountant to keep their books and records up-to-date for submission to the bank. The banks do not just look at the quarter in total, they also look at each month leading into the quarter. So monthly financial records must be prepared and ready to go. If a bank sees huge fluctuations month-over-month, the account will be flagged and the banker will ask about those discrepancies. If your company does not have a solid reason for such inconsistencies – other than not having great accounting systems in place – your account might be shut down.
With all the federal and state regulations to navigate, accounting for cannabis is very complex. Section 280E is one sentence in the tax code with major implications when it comes to accounting. To account for 280E expenses properly, your accountant must understand:
- Cost accounting. (COGS)
- Accrual accounting.
- Generally accepted accounting principles (GAAP).
- Absorption accounting.
Cannabis business owners will find it difficult to locate a generalist accountant who understands all of these concepts, largely because an understanding of GAAP and cost-based accounting is not required for most small- to medium-sized businesses. GAAP is actually required for publicly traded companies overseen by the U.S. Securities and Exchange Commission, so it requires an extra skill set beyond everyday small business accounting.
What is “GAAP”?
“GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.” In other words, generally accepted accounting principles (GAAP) are a common set of accounting principles, standards and procedures that companies must follow when they compile their financial statements to be distributed outside of the company. It covers such things as revenue recognition, balance sheet item classification and outstanding share measurements.
What it boils down to is that GAAP is meant to ensure a minimum level of consistency in a company’s financial statements. This makes it easier for investors to analyze and extract useful information. Investors should be cautious of a financial statement that is not prepared using GAAP. It also makes the cross comparison of financial information across different companies easier.
What are “COGS”?
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs.
Marijuana companies need an experienced cannabis accountant trained in keeping sound books and records. Include an accountant in your budget from inception. Maintaining meticulous records will help ensure you are able to maintain your license, banking and funding. It also will keep you out of hot water with the IRS.
We can help!
Did you know that Adilas is a full ERP that can help you properly track COGS? We even have a training course to help you get started. Contact us today to find out more and get a free demonstration. Let us show you what Adilas Seed-To-Sale can do for you!