Operating a cannabis or hemp cultivation and processing facility comes with significant challenges, including maintaining compliance with local, state, and federal laws. Due to the complex nature of the cannabis industry, operators also face many accounting and cash flow management challenges.
Lack of Historical Industry Data
Legacy accounts do not exist in the cannabis or hemp industries,. There is a lack of legacy accounting software that operators can use to track inventory costs year-over-year. Currently, most states mandate the use of seed to sale software specifically designed to comply with state regulations. Although this industry-specific software serves a critical purpose, it is not intended to support cash flow management. As an example, typically seed to sale software does not track production activity and determine plant growing costs, the price related to the yield, or the cost of the yield converted into a gram of oil. It also does not help with supply chain management, which is crucial for any manufacturer.
IRS 280E Tax Code Hurdles
Until the Federal government removes cannabis as a Schedule I drug from the Controlled Substances Act, cannabis cultivators and processors remain subject to 280E, which prohibits deductions of anything otherwise ordinary and necessary. 280E only allows cannabis businesses to deduct the costs of goods, according to Section 471(c). However, Generally Accepted Accounting Principles (GAAP) will allow cultivators and processors to allocate more costs into production costs, thus making up the costs of goods sold (COGS). Unfortunately, this is difficult due to the absence of legacy accountants to help determine what meets the definition of 471(c) and GAAP.
Setting Up Your Cannabis Business for Financial Success
With the guidance of a skilled cannabis tax advisor, cultivators and processors can mitigate the pitfalls of 280E through GAAP accounting and meet the IRS requirements. It is critical to work with an advisor who has industry expertise and insight into the Federal and State’s interpretation of 280E and 471(c). To increase cash flow while mitigating the risk of noncompliance, it is essential to correctly set-up your accounting system from the beginning with the best chart of accounts and determine your departments. This initial step helps you understand the flow of inventory costs throughout the accounting system. The next step is to understand each business transaction clearly and determine the type of expense, i.e., if it is a manufacturing expense and which department incurred the costs. Cannabis business owners and operators must decide how to allocate expenses to each department, and examples are rent, utilities, and insurance. In addition, it is vital to set-up your payroll to track labor by department.
Tracking Production Information to Develop Accurate Reports
Although most seed to sale software can collect some production information, the most reliable data is typically stored by department managers for cultivation, processing, and packaging. This is because most seed to sale software is designed to keep cannabis businesses compliant. Most departments will track their own production information and accounting departments should work closely with department managers to obtain critical production information. Developing meaningful production reports is challenging and requires communication across various areas of the business. Obtaining accurate data for each aspect of your business is critical for accounting to review the cost of each department in relation to the product production. This information helps department managers and the accountants understand the costs at each stage.
Due to a lack of solid accounting systems that provide management with inventory reports, it is common to see significant growth in inventory levels, especially in yield and stock/bulk oil. In a given year, a higher level of production will result in a better margin, but will not increase cash flow. When gross profits are higher, cannabis operations must pay more Federal and State income taxes.
For cultivators and processors to increase cash flow, management, department managers, and internal accountants must understand the annual costs by department, the sales by product type, and the current inventory levels. On a quarterly basis, if not more frequently, accounting departments should review production data to ensure it is accurate and consistent. Bridge West works closely with owners and operators to mitigate compliance risks and increase cash flow. Our deep industry experience allows us to make the process more manageable for department managers, internal accounting personnel, and management. Reach out, we’d love to talk.