Key challenges for cannabis auditing and accounting arise from the conflict between state-level legalization and federal-level prohibition, which complicates tax laws, limits access to traditional banking, and increases the risk of IRS audits. Inadequate financial controls and reporting also pose significant hurdles for businesses in this industry.
Challenges Pursuant to Cannabis Company AUDITING:
Heightened regulatory and audit risk
- Increased scrutiny: Due to the complex and often cash-based nature of the industry, cannabis businesses are at a significantly higher risk of being audited by the IRS.
- Severe consequences: Non-compliance can result in not only financial penalties and fines, but also potential loss of licenses or criminal charges in extreme cases.
- Preparation for IRS audits: Auditors must be experts in Section 280E and state-specific tax laws to ensure clients can properly document and defend their COGS deductions.
Inconsistent financial standards
- Lack of standardized guidance: The rapid growth and unique constraints of the industry mean there is little standardized literature or formal guidance on best practices for internal controls.
- Audit readiness: Clients are required to build robust, audit-ready financial reporting and internal control systems from the ground up, as many novice companies lack these processes.
- Vendor and people risks: The influx of personnel with limited experience in large corporate environments increases the need for robust internal controls over vendors and staff.
Verification of financial data
- Complex inventory: The seed-to-sale tracking systems are crucial, but auditors must verify that the inventory records reconcile with the company's financial books. Discrepancies can affect COGS and tax filings.
- Cash flow validation: Auditing a cash-heavy business requires meticulous documentation to ensure all transactions are properly accounted for, which is a major red flag for auditors if not handled correctly.
- Valuation of assets: Merger and acquisition activity is increasing, but inconsistencies in accounting policies and the complex valuation of intangible assets like licenses can create significant financial impacts for the combined entity.
Difficulty securing professional services
- Lack of expertise: Many accounting firms and auditors are hesitant to work with the cannabis industry due to its federal legal status and complexity.
- Specialized knowledge required: Finding qualified accountants and auditors with specific knowledge of cannabis regulations, including Section 280E, is a major challenge for many businesses.
Challenges Pursuant to Cannabis Company ACCOUNTING:
Federal tax restrictions under IRC Section 280E
- Limited deductions: Due to cannabis' status as a Schedule I controlled substance under federal law, the IRS prohibits cannabis businesses from deducting most ordinary business expenses from their federal taxable income.
- Higher tax burden: Cannabis businesses can only deduct the Cost of Goods Sold (COGS), not expenses like rent, payroll, marketing, or utilities. This results in an exceptionally high effective tax rate that strains cash flow and limits opportunities for reinvestment.
- Complex COGS calculations: Determining which costs can be allocated to COGS is a complex process that requires expertise. Errors can lead to significant issues during an audit.
Cash-intensive operations
- Limited banking access: Most major financial institutions avoid providing services to cannabis businesses due to federal regulations, forcing many companies to operate on a cash-only basis.
- Increased risks: Heavy cash operations make accurate bookkeeping, financial tracking, and cash flow management difficult. This also increases the risk of theft and fraud.
- Mandatory reporting: Businesses must file IRS Form 8300 for cash payments over $10,000, adding another layer of compliance.
Complex regulatory framework
- Conflicting laws: Businesses must navigate a patchwork of conflicting and frequently changing regulations across federal, state, and local jurisdictions.
- Seed-to-sale tracking: States require strict, meticulous tracking of cannabis inventory from cultivation to sale, often using proprietary software like Metrc. Errors in this system can impact financial reports and tax filings.
- High compliance costs: Licensing, renewal fees, and maintaining compliance with evolving rules are expensive and must be factored into financial planning.
Immature financial processes
- Unseasoned management: Many cannabis startups lack experienced finance professionals, leading to poor bookkeeping, inadequate budgeting, and inconsistent financial controls.
- Weak internal controls: The cash-heavy nature of the business and immature internal processes leave companies vulnerable to employee theft and financial mismanagement.
- Inadequate software: Generic accounting software often doesn't meet the industry's complex inventory and regulatory reporting needs, and specialized software may still require manual oversight.
Ravi Ramnarain, CPA, LLC is well versed in Cannabis Auditing and Accounting; since FY 2018, we have assisted cannabis clients directly and via subcontracting for an extended period of time for a larger Cannabis-focused CPA firm. Our team, aside from being US GAAP and International Financial Reporting Standards (IFRS) experts, are extremely well versed in Internal Revenue Code Section 280E and have directly participated in public filings for Cannabis companies who file with the SEC, the Canadian Securities Exchange, the Tel Aviv Stock Exchange, and others.
Drop us a line at Admin@RaviRamCPA.com to learn how we can help you on either the Cannabis Auditing side or the Cannabis Accounting side!