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Cannabis Accounting Principles 101

cannabis accounting principles

Cannabis may be legal in your state, but in the eyes of federal law, cannabis businesses in the US are running an illegal operation. This is due to the Controlled Substances Act which classifies cannabis as a Schedule I drug. Additionally, IRS Section 280E prevents cannabis business owners from including most of their ordinary business expenses (e.g. rent and salaries) in their federal tax deductions, leading to significantly higher taxes than other businesses.


To manage these tax implications and properly go about the more complex legal processes associated with cannabis companies and cannabis-related businesses, it's important to be aware of the cannabis industry accounting principles. Whether you've experienced significant growth in your cannabis business or you're aiming for one, you'll have to be knowledgeable of accounting principles beyond those of everyday small business accounting.


Redbud Advisors consists of accounting professionals and entrepreneurs who know the complicated ins and outs of the cannabis industry. In this article, we'll help you go over everything you need to know about cannabis accounting to ensure not only legal compliance but also help you make informed decisions on these matters.


Importance of Mastering Cannabis Accounting Principles for Licensed Cannabis Businesses


person using a calculator and writing on paperwork

Practicing key accounting principles ensures accurate financial reporting, compliance with tax regulations, and an efficient accounting system. Federal and state laws have separate specifications for cannabis companies, so it's best to gain an in-depth understanding of both areas for regulatory compliance and tax compliance. A cannabis company that fails to implement key accounting principles can incur compliance violations, tax liabilities, financial mismanagement, legal risks, and security concerns.


Cannabis Industry Taxation


close-up of cannabis plant

Cannabis businesses have unique tax regulations like the Internal Revenue Code (IRC) which is a tax code that disallows the deductions of ordinary business expenses for companies dealing with controlled substances like recreational and medical marijuana (IRC Section 280E).


Every accounting professional in the cannabis industry should be well-informed on each complex tax law and regulation. Particularly, they can legally lower taxable income by allotting business expenses to the cost of goods sold (COGS), as decreed by IRC 471. Keep in mind that there are other tax requirements to be met by cannabis businesses aside from the IRC 280E.


Federal Tax vs. State Tax


Federal taxes are imposed by the US federal government. This includes taxes on business income, profits, and other financial transactions. On the federal level, cannabis counts as a Schedule I controlled substance, which poses more strict regulatory requirements and tax laws. One significant example is the IRS Section 280E which limits tax deductions that cannabis businesses can claim, leading to a higher tax liability. For cannabis businesses, the cost of goods sold (COGS) is the only allowable reduction of income.


State taxes, on the other hand, are imposed by separate states of the US where cannabis has been legalized for both medical and recreational use. They have the power to impose taxes on the cannabis industry, such as sales taxes, excise taxes, and cultivation taxes. Depending on your state, tax regulations may vary.


Ultimately, as a cannabis business owner, you want to stay on top of things by being well-versed and updated on both federal and state regulations. These specifications will influence various accounting processes for your cannabis business such as tax reporting, financial planning, compliance audits, and financial statement preparation.


Chart of Accounts


The chart of accounts compiles and categorizes the financial activities of cannabis businesses. It's essential for financial management as it groups various financial activities into accounts like liabilities, assets, revenues, and expenses. This is especially important for cannabis companies because it helps you accurately track their business expenses and activities and, in turn, comply with strict regulatory requirements.


Numerous cannabis businesses streamline their operations and optimize tax strategies under IRS Section 280E by integrating their chart of accounts with their accounting software. Additionally, the chart of accounts also helps cannabis businesses keep track of their financial performance.


Cost Accounting


Cost accounting refers to the practice of tracking and analyzing expenses such as cultivation, processing, distribution, and cannabis production costs. Essentially, it keeps track of the operational costs associated with creating and selling products. Cost accounting helps marijuana companies determine the true cost of goods sold (COGS), which gives them a deeper insight into their profitability.


Specifically, in the cannabis industry, cost accounting helps cannabis businesses navigate the restrictions of IRS Section 280E by helping them determine allowable costs that can be deducted from their taxable income. This can be done by categorizing expenses such as raw materials, direct materials, overhead costs, labor expenses, and compliance-related expenditures. Simply put, cost accounting practices help cannabis businesses improve their tax planning strategies to keep their tax liability as low as legally possible.


Cannabis Bookkeeping


Cannabis bookkeeping involves keeping proper accounting records of money coming in and going out of a cannabis business. It tracks sales, direct costs, indirect costs, growing costs, and other financial information.


Good bookkeeping in the cannabis sector ensures that the company's cash flow is properly managed, cannabis laws are followed, and that money and resources are wisely spent or allocated. Additionally, proper cannabis bookkeeping reduces risks of financial discrepancies and errors and has accurate monthly financial records available for regulatory compliance.


Cash Flow Management


Many cannabis businesses have a cannabis accountant who facilitates the business' cash flow. This involves monitoring the date cash is received from sales and when it's used for expenses for business operations like employee salaries, property rent, production costs, and cannabis inventory.


It's important to manage cash flow so the company has enough resources to cover daily operating expenses and monthly bills while also planning for future expenses such as tax law compliance. Proper cash flow management can also help cannabis businesses achieve financial stability, secure funding for expansion, and put aside money for long-term investments and overall financial health.


Cannabis Inventory Accounting


Part of cannabis accounting is cannabis inventory accounting, which refers to the process of accurately managing, keeping track, and reporting the inventory of cannabis products from the moment each item is bought all the way to its sale. It's important to take into account cannabis industry regulations during the process.


Cannabis industry regulations are particularly complex and strict, involving requirements like seed-to-sale tracking (more on that later). So it's essential to keep an accurate record of everything, such as exact inventory levels and product types.


Financial Reporting and Compliance for Cannabis Businesses


person working on a computer

Accounting for cannabis businesses involves presenting accurate financial statements. This includes documents like balance sheets, income statements, and cash flow statements. Financial reporting benefits cannabis businesses as it helps owners understand how well their company is doing in terms of sales and financial health.


It's also essential to comply with regulations in the cannabis industry—both federal and state regulations. So, you should know the specific guidelines on cannabis taxation, licensing, inventory tracking, sales reporting, and so on.


Audits


In the cannabis industry, auditing is done to verify financial records and transactions and ensure regulatory compliance. This includes checking and assessing expenses like direct costs, indirect costs, operation expenses, and overhead costs. Audits are conducted by both internal auditors and external auditors. Audits contribute to financial transparency while also building credibility with investors and regulators.


Internal Controls


Internal controls are policies made to protect assets and prevent fraud. Additionally, internal controls help ensure the accuracy of financial reporting. Internal controls often include duty segregation, regular reconciliations, employee training and ethics, and inventory accounting or management. Effective internal controls can reduce risks of internal and external theft and catch any errors or fraudulent activities early on.


Generally Accepted Accounting Principles (GAAP)


In the US, the Generally Accepted Accounting Principles (GAAP) refers to standard accounting practices that explain how financial statements should be presented. It presents accounting principles that produce consistent and transparent financial reporting. The GAAP encompasses several industries in the US, including the cannabis industry.

While cannabis businesses are under more strict and unique regulations like the Internal Revenue Code (IRC), the GAAP can still provide these companies with a standardized framework of financial reporting as part of their accounting system. However, a tailored and adjusted process may be required when applying GAAP to cannabis businesses.


Accrual Accounting


Accrual accounting refers to the method of recording financial transactions as they happen, instead of when the funds are exchanged between partners as payment for products or services. In simple terms, it means recording income as soon as it's earned (e.g. when products are sold) even if the payment hasn't been received yet. In the same vein, accountants record the company's expenses as soon as it's incurred, regardless of whether the payment has been completed.


Absorption Accounting


Also known as absorption costing or full costing, absorption accounting refers to the allocation of all manufacturing costs (variable and fixed) to products. This method includes direct costs like labor and materials as well as indirect costs such as utilities and overhead. Basically, this process is done so all expenses associated with production are included (absorbed) in the inventory cost.


For cannabis businesses, this helps pinpoint the true cost of producing cannabis products. Having this information helps cannabis businesses make the right pricing decisions, analyze their profitability, and comply with regulations for the cannabis industry.


Anti-Money Laundering (AML) in the Cannabis Industry


stacks of dollar bills

Anti-money laundering (AML) prevents the illegal financial activity of money laundering, which is the process of making money obtained from criminal activities appear legitimate—making criminal money appear "clean." AML procedures are especially important in the cannabis industry because marijuana is not federally legal and is recognized as a Schedule I controlled substance.


Due to the illegality of cannabis under federal law, many financial institutions aren't very eager to provide a business bank account for cannabis businesses. This leaves most cannabis companies with no choice but to operate in cash, and businesses that are largely cash-dependent pose significant risks of money laundering.


To prevent any potential money laundering issues, cannabis businesses must implement AML programs. This helps ensure that these business operations are protected from suspicious activities. AML programs include closely monitoring activities, implementing strict financial management processes, and reporting potential illegal transactions to the authorities.


Seed-to-Sale Tracking


person using software on computer

Seed-to-sale tracking is a regulatory requirement that monitors the entire lifecycle of cannabis plants and products. The processes are closely tracked from the moment the seeds are planted to the moment they're sold off to customers, including every step of the supply chain: cultivation, harvesting, processing, packaging, distribution, and sale. Most cannabis businesses use their own seed-to-sale software that makes the process quicker, more convenient, and less prone to errors.


Banking Services for Cannabis Businesses


As cannabis is illegal on a federal level, it's harder for cannabis businesses to access banking services. Financial institutions are governed by federal laws, so banks are often hesitant to offer cannabis businesses basic services that businesses in other industries would have no issues accessing. Consequently, businesses in the cannabis industry operate on cash, which has a long list of disadvantages and risks.


To name a few, handling large sums of cash poses security risks such as theft, and it makes the process of paying employees, vendors, and bills more challenging and less efficient than if they had access to basic banking services.


How to Choose the Best Accounting Software


Accounting for cannabis businesses is far from a walk in the park. There are a lot of regulations and rules to keep track of and comply with, so even the most competent accountants in the cannabis industry would need accounting software for effective cannabis accounting.


How big is your cannabis business? What specific features do you need in your cannabis accounting software? What is your budget for this software? These are some of the questions you should ask yourself as you choose your accounting software.

Generally, though, you want accounting software that offers basic features like invoicing, expense tracking, cost accounting, and bank reconciliation. Additionally, you should make sure your software complies with cannabis regulations such as seed-to-sale tracking and IRC Section 280E for tax deductions.


You'll also want software that can integrate with other tools you're using (e.g. payroll systems, inventory management software, and seed-to-sale software). Aside from this, it's important to consider if your software can grow with your business and take on the additional transaction volumes that will come with your company's significant growth.


When to Hire a Professional Accountant


professional accountant sitting at a desk on her computer

For tax compliance and tax code observance, it's important to hire a professional accountant well-versed in the cannabis industry. Certified public accountants or private accountants can help your company achieve financial stability, ensure tax compliance, and efficiently manage cannabis accounting.


You can never be too careful in the cannabis industry, so hiring a cannabis accounting professional should be a no-brainer. Certified public accountants and private accountants well-versed in the cannabis industry and tax regulations can handle processes including cost accounting, tax compliance, and audit preparation.


Final Notes from Redbud Avisors LLC


cannabis plant

Looking for cannabis accounting professionals? At Redbud Advisors LLC, we specialize in providing expert accounting services tailored to the unique needs of the cannabis industry. With years of experience working with small business owners, we've mastered the strategies for reducing tax liabilities, providing bookkeeping services, and advising business owners on the best financial decisions.


You may schedule a call with us or contact us at 866-830-5144 or hi@redbudadvisors.com.


FAQs


What is the Chart of Accountants for Cannabis?

In the context of cannabis accounting, the chart of accounts is a structured comprehensive list of the accounts used in a company's general ledger. Tailored to the cannabis industry, these accounts often include assets, equity, liabilities, revenue, and costs.

What is Cost Accounting for Cannabis?

Does QuickBooks Work With The Cannabis Industry?

Why Are Cannabis Accountants Important?

Is Medical Marijuana or Medical Cannabis Legal in hte US?



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