Why IRS Cannabis Audits Are Likely to Increase and How You Can Prepare

Why IRS Cannabis Audits Are Likely to Increase and How You Can Prepare

by Mike Goral
May 04, 2021

Updated June 28, 2023

In 2021 the cannabis industry gained insight into the IRS’s internal thought process toward cannabis company audits. A Freedom of Information Act request initiated by MJBiz Daily provided new visibility into the agency’s perspective, and while the documents primarily discuss old audits conducted between 2012 and 2019, they help explain why the IRS may target the cannabis industry for future audits.

Cannabis Audits Are More Lucrative

It’s fairly common knowledge that the IRS has been conducting audits in the cannabis industry for several years. However, the documents revealed the significant financial incentives that the IRS benefits from by auditing cannabis companies compared to other industry groups. For instance, the report discloses that a 2012 cannabis audit generated an average of $945 per hour in a tax assessment versus $544 an hour from a non-cannabis business.

This disparity continued to deepen, despite expanded legalization. As several states, including California, changed their policies to permit adult cannabis use by 2019, the average hourly assessment rate increased to $2,752 from marijuana industry audits versus $1,065 from mainstream businesses. With the average hourly audit assessment rate almost tripling within the cannabis sector and when compared to non-cannabis industries over this period, the IRS’s financial incentives are apparent.

Additionally, the report showed only 3% of cannabis returns had no errors or adjustments, as opposed to 21% in other business areas. These documents also revealed that cannabis reviews took one-third the time of other industry groups. While an IRS representative denied that it targets marijuana businesses over other companies, given these figures, there are clear justifications for the agency dedicating more resources to reviews of cannabis companies.

The IRS found that marijuana returns in the “Western Area” resulted in the highest average per hour assessment in unpaid taxes — with IRC 280E being the main audit issue. As a result, government auditors can concentrate their efforts surrounding cost of goods sold (COGS) deductions rather than spending time on a wide variety of code sections that come into play in other industry groups.

Prepare Your Organization for Increased Scrutiny

Those that had expected the Biden administration to take a less aggressive approach toward cannabis companies may find the above information disappointing news. Based on the recent cannabis audit cases that have been made public, it’s clear that taking aggressive tax positions could be costly for taxpayers. If your organization has been taking this kind of approach, it may be time to rethink your strategy and get your financials aligned to stand up to more rigorous scrutiny by the IRS.

Having good records and supporting documents to justify the company’s IRC Sec. 280E deductions is critical to defend your position throughout the audit process. You should also consider adding additional reserves based on any uncertain tax positions, as it is clear we can expect the IRS to continue targeting cannabis companies.

Are Your Books and Records Audit Ready?

Good record-keeping and preparation are key to helping you defend your position in the face of IRS scrutiny, but that’s not the only type of audit that should be on your radar. As your cannabis company begins to scale nationally or when you begin thinking about positioning for future M&A, you may need a more complex independent audit that includes your inventory, internal controls, equity/debt structures and more.

Prior to scheduling your first independent audit, you should evaluate and document the internal controls your business has in place. Internal controls are processes designed to ensure the reliability of a company's financial reports, the effectiveness and efficiency of its operations and its compliance with applicable laws and regulations. They also allow more accurate measurement of the organization’s financial health.

Developing and implementing a robust system of internal controls is a must for every organization and that’s especially so for cannabis companies. Demonstrating that the company is adhering consistently to a documented system of internal controls provides auditors and investors with a benchmark that can establish credibility for your business in four key areas:

  1. Safeguarding assets
  2. Ensuring financial statement reliability
  3. Promoting operational efficiency
  4. Encouraging compliance with management's directives

Improving Internal Controls for Your Cannabis Business

Maintaining rigorous internal controls contributes to the long-term profitability of your company by limiting errors and fraud, which is particularly challenging for cannabis companies.

Despite being designated as essential businesses during the pandemic, cannabis organizations still face banking issues due to marijuana’s illegal status at the federal level. The industry's forced reliance on cash transactions raises fraud and theft risks that include skimming, customer collusion and unauthorized spending. This makes protecting revenues and profits more difficult — and more critical — as your sales increase. You can help mitigate risk exposure arising from a cash-centric business environment by consistently enforcing these internal controls:

  • Monitor employees with cash access

    Even a strong vetting process and thorough background check before hire doesn't guarantee an employee's honesty. Typically, a staff member doesn't engage in criminal activities until several years after being on-boarded. You should track employees' schedules and monitor their behavior to uncover warning signs such as a sudden change in their working hours; strong objections to making procedural changes in transaction processing, inventory or vendor management; and their refusal to take vacations.

  • Control cash receipts and payments

    Using serially pre-numbered sales slips and conducting weekly audits will uncover missing slips that indicate discrepancies. Comparisons of daily sales and cash receipts will also expose whether cash is being pocketed. Video surveillance and segregation of duties (discussed below) will also reduce the opportunities for skimming.

    Limit access to the safe and always make sure it's locked. Consistently use a key and combination access log, with keys numbered and assigned to designated employees.

    Using serially pre-numbered purchase orders and verifying incoming orders before payment is authorized will help prevent fictitious and unauthorized purchases. Missing documents or gaps in transaction numbers could mean documents are being used for fraudulent transactions. A sudden increase in slow payments may also indicate an employee is stealing money.

    Carefully monitor all disbursements from the register. An unusual increase in customer refunds, voided sales or discounts are all potential indicators of suspicious activity.

  • Enforce segregation of duties

    Segregation of duties and responsibilities is key to maintaining strong internal controls across operations, accounting and custody of assets. Adequate segregation of duties helps ensure that cash-related activities are monitored and cross-checked, and it reduces the chance of collusion between staff and vendors.

    It’s especially important to make different employees responsible for purchasing, receipts of cash and making cash payments. The physical handling of cash should always be separated from its recording.

    Achieving segregation of duties can be difficult in a small organization. These businesses may need to adopt compensating controls to ensure that at least two people are responsible for any task.

  • Focus on system security

    Having a robust accounting system with an experienced team of accountants and segregation of duties should result in solid recordkeeping. Employees will lose the ability to hide transactions; any backlog in recording them would signal an attempt to delay the detection of fraud.

    It's imperative to invest in your accounting, accounts payable and inventory software. You will want to keep it updated and restrict access to the financial system. Understand how your system can allow money to be diverted and inventory to be manipulated to determine how an employee might be able to commit fraud. Finally, change passwords often in your systems.

    The ancillary benefit of having a strong accounting system is that it facilitates data analysis to detect buying trends, set pricing and mine data, as well as monitor cash activities. It will also organize your data to support and guide you in daily decision-making.

  • Conduct internal and external audits

    You should conduct periodic unannounced internal audits to uncover malfeasance and determine areas for control improvements.

    It’s also important for cannabis companies to have a yearly audit performed by an outside firm. The independent auditor will test your internal controls, identify vulnerabilities and make suggestions to remedy them and strengthen the overall control environment.

Why You May Need an Independent Audit

Why would you undergo an audit if you’re not public and/or it’s not required? In today’s market, it’s a key part of positioning for a future transaction.

While most cannabis businesses don’t have traditional bank loans, which at times require audited financial statements as a condition of the loan, the industry is consolidating, with increased M&A activity as opportunistic buyers look for deals. Some of the larger entities, especially in the Canadian market, are looking south for acquisition targets and asking for audits, either as a condition of the transaction or because they are a reporting entity on a Canadian exchange already.

Equity raises based on new investors are also driving increased audit needs for cannabis companies. As more sophisticated and larger investors, including cannabis industry-specific private equity funds, are getting into the cannabis space, they typically want to see audit results before committing to an investment.

What Is the Biggest Pain Point for Independent Audit Readiness?

Your books need to be reconciled and supportable to be audit-ready, and a lot of companies don't realize what this entails. Many cannabis companies assume that the audit firm cleans up the books and records as part of the audit itself, but that is rarely the case.

As an independent third party, auditors can only give an opinion on your company’s financials; the books and records must be created by the client (your business) and fully supportable by the underlying documentation and evidence you provide to auditors.

Part of that process entails using the appropriate technology solutions, available specifically to the cannabis industry, to accurately account for the activity in the company (seed-to-sale solutions, new ERP system, accounting and GL packages, etc.). This is crucial to the audit effort because poor book-keeping only create more work for the auditor and less confidence in the numbers, which ultimately increases audit costs.

An audit can be relatively painless if your business is ready and organized. Getting everything in order beforehand is well worth the short-term investment of time and resources. Besides the convenience and cost savings of having your audit completed more quickly, ensuring a smooth audit process makes your business will look more attractive to a potential acquirer. If your organization is knee-deep in due diligence with a potential buyer who asks to see a year or two of audited financials, you will be left scrambling if you aren’t prepared, causing major disruption and potentially derailing the transaction.

Common Problem Areas for Independent Audits

Being aware of typical stumbling blocks can help your cannabis company prepare for an audit. Some of the most common pitfalls include:

  • Inventory – Beginning and ending inventory quantities have not been observed by an auditor and therefore an inventory rollback must be prepared. Because this is a requirement specific to audited financial statements, it may not be on a cannabis company’s radar initially. An inventory observation must be done as soon as possible, and then a rollback schedule must be prepared reconciling to both the year-end and the previous year-end inventory quantities and values. This can be incredibly challenging for businesses due to poor internal inventory reporting, complexity of inventory movement and lack of technical staff.
  • Complicated equity structures – Many cannabis companies have complex organization charts containing multiple entities (many times for tax purposes). Based on percentage ownership, stock/equity awards or intercompany transactions, there is specific accounting based on these transactions that can contain some complexity. Some examples include minority interest calculations and presentations and stock-based compensation accounting.
  • Cash revenue – Early-stage cannabis companies have often been susceptible to poor recordkeeping when it comes to cash-only sales. Best practices include keeping a detailed log showing all the additions to or subtractions from physical cash, arriving at a final balance. Those amounts should then be supported by sales invoices or expense invoices evidencing the transactions. It’s imperative to have sound internal controls around the handling of cash, including a supportable cash log. (See previous section on Improving Internal Controls for Your Cannabis Business.)
  • Convertible debt or more complex equity/debt structures – Cannabis companies have been extremely creative with their initial or continual financing absent traditional bank lending. As a result, complex debt agreements that involve equity “kickers” are common. This arrangement triggers specialized accounting analysis and accounting that contains particular financial statement disclosures.
  • Remote inventory counts – Many cannabis companies shifted their physical inventory counts to a remote environment due to COVID restrictions. If this is still the case, auditors will need to perform their counts through a remote session (e.g., Zoom or Microsoft Teams) with the help of the warehouse personnel. The auditors will watch the client’s personnel counting or weighing their selected sample items and must visually see the whole process.
  • Documentation of internal controls – You worked hard to safeguard your business and mitigate various risks by strategizing, creating and implementing internal controls that include proper segregation of duties and standard operating procedures. Now you need to document your controls and provide evidence that they are functioning. Part of the audit process is to understand the control environment and actually walk through key internal controls identified. Documenting these controls ahead of the audit will save time and energy during the audit.

Which Type of Independent Audit Will You Need?

Audits come in various flavors, with several different types to consider based on your ultimate goals and needs. Therefore, it’s important to understand the different reporting standards and select the one that best fits your organization at the time of audit:

  • United States Generally Accepted Accounting Standards (U.S. GAAP) – This is the type of audit most privately held companies in the United States use. This is relevant if you are not listed on an exchange and aren’t planning on it soon.
  • Public Company Accounting Oversight Board Standards (PCAOB) – This type of audit is for publicly held companies that are filers on a United States exchange, such as the Over the Counter, or “OTC”, NASDAQ or NYSE. However, you can (and sometimes must) have this type of audit performed when you are contemplating a transaction that will create an exchange filing need (through a merger/acquisition of a public company or going public yourself). A PCAOB audit includes more specific accounting standards for areas such as revenue and leases.
  • International Financial Reporting Standards (IFRS) – This type of audit would be applicable should you want to list on one of the Canadian exchanges, either through a merger transaction or your own listing. In an IRFS audit, certain reporting standards differ from those of a traditional U.S. GAAP or PCAOB audit, including fair market value accounting and more accelerated accounting standards.

Each of these types of audits will have different ramifications on the time and effort demands on you and your accounting staff to report your financial statements appropriately. For instance, with either a PCAOB or and IFRS audit, the audit firm cannot prepare the financial statements for you. Independence rules are much stricter in those audit environments, so you must either have staff that has the technical abilities to draft the full financial statements, or you must consider outsourcing this function to a separate firm.

How Long Does an Independent Audit Take?

Many different factors will influence the time it takes to complete your audit. However, any timetable will be directly affected by your team’s readiness and technical capabilities. For example, a first year (never been audited before), single-year presentation, which would have to include audit procedures on the opening balance sheet accounts, will generally take 45-60 days from the start of fieldwork. A first year, two-year audit presentation, which would again require audit procedures on the opening balance sheet accounts, will generally take 60-90 days from the start of fieldwork, depending on the complexity.

How can you reap the most value from your independent audit? The same answer applies no matter which type of audit you need or how big or small your cannabis company may be: Getting your books and records in order now will save time, money and disruption when the audit team arrives.

How Audit-Ready Is Your Cannabis Company?

Without strong internal controls your company faces financial and regulatory risk — and is less appealing to investors. Contact our veteran Cannabis Industry consultants for help with an independent audit, cannabis-specific internal control guidance, assistance during IRS audits or inquiries and other specialized expertise to help your company thrive.

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