Cannabis Bookkeeping in 2020
Feb 17, 2020
The Cannabis industry is booming, and trained and knowledgeable accounting professionals are in extremely high demand. Although federally illegal (for the time being), Cannabis is now legal for medical use in 33 states and 11 states recreationally, and is responsible for some $20 billion of revenue in the legal market. With around $70 billion still lurking in the illegal Cannabis market, business owners in the industry are constantly searching for ways to turn those who still purchase on the illegal market into repeat customers. Constant legislative changes and increased auditing keep accounting professionals (and attorneys, for that matter) in the Cannabis industry on their toes, and business owners need help.
There are major accounting issues surrounding Cannabis businesses related to taxation, software, banking, and merchant services. Accounting for Cannabis is also complicated, as you often have several verticals, even in small “mom and pop” operations: cultivation, chemical processing, food manufacture, retail, and labs. Each of these verticals have their own unique accounting issues. On top of all of that, you will likely have both consolidated and combined financials to worry about!
Accountants aren’t the only ones getting in on the action, however. Cannabis accounting poses plenty of challenges for bookkeepers, as well:
- Many vendors will not service Cannabis (accounting, POS, merchant services, payroll).
- Lack of accounting tools, workpapers, industry guides, GAAP guidance, COAs.
- New software on the market full of bugs, significant periods of downtime, features that don’t work, and poor customer service.
- There is state-mandated “Seed to Sale” tracking software, which is difficult to use and doesn’t integrate well with accounting software.
- Much of the software suited for use in the Cannabis industry isn’t integrated and doesn’t talk to each other (requiring a lot of manual work).
- Strict monthly, quarterly, and yearly reporting requirements (specialized accounting, highly regulated).
- Workarounds are required, as are daily reconciliations of cash and inventory.
Since Cannabis is a Schedule 1 drug, IRC 280e says that a Cannabis company can’t take advantage of any sort of deduction or credit on their tax return. Cannabis businesses are, however, allowed Cost of Goods Sold (COGS), as COGS is a return of capital and not a deduction or credit.
That brings Section 471 into the equation, which is also complex cost accounting that MUST be done at least quarterly to maximize the allowable COGS on the company’s tax return, which will save them money.
Here is a quick Summary of IRC 471, but you should read carefully the entire code section:
- 471-2: Valuation of Inventories. Usually lower of Cost or Market, or Cost.
- 471-3: Retailers/Dispensaries. Inventory is invoice price, plus transportation and necessary costs to acquire goods. If any “production” is done to the product, you can allocate more cost. There must be an essential “change” to the nature of the product for this to qualify, so making a “joint” from a bag of flower, for example, doesn’t count.
- 471-11: For Cultivators, Processors, Manufacturers of Edibles: There are many more allowable costs in this category. Accrual and absorption costing is absolutely required. All direct costs, plus determination of three categories of indirect costs : 1) costs which must be included, 2) costs which can never be included (ie advertising), and 3) costs which can be included if they are consistent with taxpayer recurring financials and in accordance with GAAP.
Since cost accounting is required in accounting for Cannabis businesses, you must have the right tools and information, or you will be lost from the start. Here are some important things that are needed for cost accounting for Cannabis companies:
- Cannabis tailored charts of accounts for each vertical.
- Perpetual data room for document and data storage.
- PBC: A list of needed documents that are “Prepared by Client,” which includes legal documents, leases, notes, invoices, bank statements, etc.
- Operational templates that capture strain data, yields, and estimated percent complete (must have to do the cost accounting).
- Accurate monthly counts.
- Month-end “tie out” system that will find and fix errors, add accruals, do the cost accounting, and create an audit trial.
- Cost accounting workpaper templates that work with your charts of accounts.
Before you can start the “day to day” accounting or bookkeeping for a new Cannabis client, you must make sure to do a thorough and meticulous cleanup, as 99% of Cannabis companies have messy books that are not in compliance.
Things to consider:
- First, get an engagement letter signed and a collect a retainer. Bill the cleanup piece at high hour rate as you don't know how long it will take (I suggest $100 or more) and this is ON TOP of your normal monthly fixed fee.
- Deliver PBC list (“Prepared by Client”), including due dates for each item.
- Create an action plan with the client, including expectations of what the client is expected to deliver and when, and the “penalty” if deadlines are not met.
- Accounting always follows legal documents, so make sure to get all legal documents in your PBCs before beginning the cleanup process. These documents include signed corporate docs, stock option plans, leases, notes, and debts.
- If the cleanup needs to start at the inception of the company (for example Aug 1, 2014), you want all prior years’ tax returns, and always start off with adjusting journal entry #1 at the date of inception, which will be the capital contribution on the formation of the company (amounts are found in the corporate legal documents).
- Opening entry is often something like this: Cash $150, Common Stock ($150).
- If the books are a complete mess, we often will download transactions into Excel and start with our COA (not the client’s) at day one/inception, then journal entry in the income and expenses into our COA, by year, based on that Excel file (and you’ll make sure to get supporting documents for each material transaction).
The number one issue that bookkeepers face in the cleanup process is NOT getting access to, or delivery of, the client’s supporting documents!
Month End Steps
The month-end closeout period can be a hectic time for Cannabis accounting professionals.
These steps below, along with utilizing the proper tools and workpapers, will help make sure that accounts are reconciled, tied out, errors are fixed, accruals are made, and that the cost accounting is done properly:
- Cash and inventory counts (last day of the month)
- State Seed-to-Sale and POS reports (first day of the month)
- Client operations data, flower calendar, yields by strain, % Complete, WIP (work in process)
- Build your “Month-End Tie Out” file
- Reconcile, reconcile, reconcile: counts to POS, POS to Seed-to-Sale and accounting system, bank requirements, etc.
- Build financials, consolidations, rolling cash forecasts, KPIs, dashboards
- Tax Planning and other value-add services
The Cannabis industry is booming, and CEOs are willing to pay top dollar for these services, as most bookkeepers simply don’t have the skillset or the tools in place to get the job done. Cannabis companies need knowledgeable bookkeepers with the proper tools to keep them compliant and out of trouble. Add major value to your Cannabis clients by getting it right!
Check out our on-demand webinar on “Cannabis Bookkeeping in 2020: How to do it right, add client value, and earn higher fees“ with DOPE CFO co-founders Naomi Granger, MBA, CPA and Andrew Hunzicker, CPA. We dive deeper on the topics covered here, plus much more!
Check out the replay now by clicking here.