Do’s and Dont's of Cannabis Cost of Goods Sold Accounting and IRC 471-11
Jul 23, 2019
Cannabis cost accounting tools
To be able to do effective cost accounting for your clients you will need some very important tools, if you plan to take advantage of the maximum tax benefit. For starters, a very good cannabis Chart of Accounts that is QBB/Xero/ready (specific for grow, processing, edibles, and retail operations). You will also need a client inventory template to accumulate monthly/quarterly counts, weights, estimated yields and estimated percent complete, and finally cost accounting templates to perform the calculations.
We have all of this in our program, which was developed after 2-3 years of working with other CPAs, cannabis farm personnel, cannabis tax attorneys, and bookkeepers.
Diving in to Cost Accounting for 280E
- To effectively do cost accounting you will need to allocate some of the P&L costs out of expenses and into Inventory/COGS. Use the Trial Balance at any ending reporting period to determine which costs to allocate, and how much of each, using allocation percentages determined once or twice a year. Always allocate total YTD amounts. Allocations for items related to labor (ie direct labor, indirect labor, payroll taxes, etc.) use hours, and for allocations related to facility (ie rent, utilities, etc.), use square footage percentages.
- Next, determine the quantity of Inventory, and quantity of Sales at the reporting date, to determine how much costs (per groupings listed in 471-11) to allocate to inventory, and how much to COGS.
- We then take the total allocated cost and make an AJE considering opening inventory balances.
- Finally, you must consider Inventory Valuation which for GAAP (and usually for tax) is lower of cost or market.
- Have a great Chart of Accounts tailored for cannabis cultivation, extract, and manufacturing (ie. Edibles)
- Have cost accounting templates in excel that are tailored to do 471-11 and GAAP cost accounting correctly and easily each month
- Have operational templates that capture client data easily each month, such as stage of completion of each strain, estimated yields per strain, direct and indirect labor allocations, and facility allocations
- Read 471-11 top to bottom MANY times so you completely understand and apply it correctly. Read the entire IRC 471 as well
- Don’t use 263a, as it’s not allowed (see Harborside case)
- Don’t put too much expense into non-cannabis divisions
- Don’t play games with complex legal entity structures
- Don’t put so much in COGS that it’s not believable
Useful Links to review:
Read and re-read these closely. It will be a very quick way to become an expert in this space. It’s not rocket science, but it is complex so read it until you understand all these links and workpapers.
IRC 471 gives an overview and applies to all cannabis companies. This link states that the method used for inventory must "most clearly reflect the income". Also, it must conform to how the client accounts for inventory in the financials, which is usually going to be GAAP and Lower of Cost or Market (LCM).
Irc 471-2 applies to all cannabis companies, as well, and states how you must value inventory. It again says that the inventory must clearly reflect income and be consistent (usually going to be LCM which is also GAAP).
Irc 471-3 is for retailers/dispensaries.
Irc 471-11 is for cultivators, edible producers, and extract/processors. It requires GAAP if you want to maximize what is included in COGS. Also, 471-11 lists applicable ways to allocate costs via Burden Rate, Standard Cost, or Practical Capacity. We use a Practical Capacity approach in our program.
To learn more about 471 and COGS for cannabis companies register to view the on-demand webinar here!