To say that Cannabis and hemp/CBD accounting is like the Wild Wild West, is a bit of an understatement. High regulation, unusual tax codes and penalties, cash handling issues, lack of reliable software, merchant services availability, and complex reporting and compliance needs make Cannabis accounting ridiculously complicated. Never mind the fact that Cannabis is still federally illegal, so businesses must adhere to 280E, which stipulates deductions can’t be taken (for the most part). Because of this, the IRS and local governments want their tax dollars, and are closely watching and are planning on auditing Cannabis businesses pretty heavily. Cannabis businesses that intend to limit their tax liability as much as possible must not only understand how to do it legally, they must keep impeccable records for when their business gets audited. The saving grace and one of the biggest keys to properly preparing for an audit is the permanent audit trail.
Any new Cannabis or hemp/CBD company will inevitably be audited in their first few years of doing business, especially if they do anything that raises red flags. Banks will also be monitoring the emerging companies’ financials closely, with many financial institutions completing “mini-audits” each quarter. Additionally, it’s likely many companies will go through M&A deals, future capital raises, and/or strategic exits, so having a permanent audit trail can help all parties that are involved with investment activity.
Without an audit trail, you can’t tell the whole story about how money flows in and out of these highly scrutinized businesses. A number of companies have been shut down or fined because they were audited on the federal and/or state level, and the tax courts have ruled in a number of cases that most deductions weren’t justified and slapped those businesses with major fines or penalties. Some businesses were suspected of laundering or skimming cash and/or inventory, and even faced jail time.
These perilous outcomes can be avoided by understanding the nuances of Cannabis accounting. With a keen understanding of the importance of a permanent audit trail, and having systems in place to maintain proper records for each and every transaction, you’ll be able to more confidently approach any audit if and when it happens..
A permanent audit trail is a thorough and complete way to detail and document all the dealings of your client’s business. Every time money (or even inventory) is exchanged, gained, or lost, it is accounted for as you build your trail.
The audit trail is the key foundational piece that underlies the deliverables all owners want:
A proper audit trail begins by recording the company's transactions and events. This might be purchasing fertilizer, paying the rent, or making a sale to a customer. Each of these transactions will have some sort of source document–an invoice, a lease agreement, a PDF, and so on. Each source document must be deposited into the Perpetual Data Room, file storage, or in the accounting system. Many people record transactions without a source document, which is a huge mistake.
Including a source document, however, is not the same as building a permanent audit trail. Attaching an invoice to a transaction in the accounting system (i.e. attaching the electric bill to electric bill payment in QuickBooks) does not count as an audit trail. Yes, that is a necessary piece of any good “trail,” and it is a very good starting point, but the act of document attachment itself adds little value, as it is only one part of the story.
Once the source document is recorded, you establish the foundation of your trail by creating a chart of accounts. The chart of accounts is the appropriate “bucket” where you put each transaction. Each transaction requires proper allocation in the chart of accounts. As a Cannabis accountant, understanding how the plant is grown, processed, transported, marketed, and sold will help you correctly manage your chart of accounts and appropriately categorize each dollar earned, lost, or spent.
A general ledger and the trial balance must also be generated. The general ledger is the summary of all the sales in one “bucket” for a certain amount of time, perhaps six months or one year, whereas the trial balance is essentially the general ledger, but it’s a total sum of one account at any point in time. The trial balance leads to a month end tie out.
Everything you create through the audit trail leads to proper and accurate financials such as balance sheets and statements of cash flows to “value add” reports such as rolling cash forecasts.
An effective audit trail is built with all these different pieces of the puzzle outside the accounting system (as the accounting system and transactions are only a piece of the audit trail). Establishing a consistent audit trail process will help you find and fix errors along the way, make adjustments in accruals, and document every detail in the month end tie-out.
Here’s a look at the must-have components of your audit trail:
Yes there are many steps to the trail, but each step is appropriately connected to the step that both precedes and follows it, ensuring the auditor can confirm everything is accurate and complete. Any single piece of the “trail” must be fully documented, tied-out, and “tick-marked.”
You want to make sure your month-end system does the following:
The Perpetual Data Room must be kept up to date so that all the various monthly permanent audit trails, as well as permanent files (i.e. legal documents, loans, insurance policies, bank statements, etc.) are ready at all times.
If you have the tools and systems to build the audit trail out each month for your client, it will add huge value as they work with their management team, board, bankers, lenders, and investors. The trail provides accurate, complete, and timely data necessary to keep the business on the path of profitability and growth.
An audit trail provides:
As a Cannabis accountant, you must always be prepared for your client’s inevitable audit. We know this is a big undertaking, but thousands of companies are being licensed, and there are not enough niche-trained accountants ready to serve Cannabis companies.
Providing world-class service to these audit-prone businesses makes you highly valuable (and often highly compensated because of your value-add).