How to Survive a Cannabis Accounting Audit: A Look at the Permanent Audit Trail

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..

What is a permanent audit trail?

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:

1. Robust reporting on top of basic financials.
   
2. Methods to track and improve cash flow (which also prevents theft and skimming).
   
3. Timely and appropriate tax planning to correctly minimize taxes.
   
4. Transparency to “user groups” including management, board, investors, banking, and lenders.

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. 

What are the key features of a permanent audit trail?

Here’s a look at the must-have components of your audit trail:

• A “trail of crumbs” – As an accountant for a Cannabis company, you must build out a trail that any auditor can easily trace, either backward or forward, for any transaction in any prior month from company inception to current month. For example, if the auditor wants to look at the cash balance in March of 2016, they should be able to trace cash transactions from March 2016 to supporting document/source files to general ledger to trial balance to trial balance tie out (including bank records and bank statements) to any adjusting entries to base financials.

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.”

• A robust “month-end tie-out system” – Reporting isn’t just about tracking numbers. Reporting is about documenting the actions and transactions of the business so that every number is justified and accurate. Documenting the processes of the business, whether it’s how inventory is managed or who collects the cash and where it is stored, provides a holistic view of the business’s practices and streamlines accounting. This ensures nothing was overlooked in the month-end reports. A “month-end tie-out system” is a repeatable and accurate way to make sure all records match across the endless spreadsheets required to document the many transactions and movements of your Cannabis clients.

          You want to make sure your month-end system does the following:

1. Finds and fixes monthly errors each month
2. Fully ties out all balance sheet accounts to supporting schedules and transactional support
3. Shows all monthly Adjusting Journal Entries, or AJEs
4. Shows tie-out to financials from trial balance
5. Has a clear “tick marked trail of crumbs” that goes backward and forward from financials to transaction level

• A Perpetual Data Room – This must be scrupulously maintained and it must be owned by the client. You want to make sure it is housed on their servers and networks and that they own all rights to the software associated with the data room. Cannabis business owners like having access to, and control of, their data.

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.

How does an audit trail add value?

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: 

1. Worry-free audits – When auditors show up for a “surprise” visit, there will be no issues for business owners who have their “permanent audit trail” as the audit will be smooth sailing. If you are being audited, the government is there to collect tax revenue they think is owed. Your job is to prove why you don’t owe that money. Relying on receipts isn’t enough. A comprehensive and complete audit trail allows you to easily plead your case and explain your rationale behind every expense, deduction, and allocation.  
2. Compliance check-ins – Proper cost accounting and allocation is crucial, so you aren’t avoiding taxes, rather you’re being taxed fairly and claiming legal deductions. As a Cannabis accountant, you are charged with telling the story of how each transaction came about and how each event or expense goes into the production of your goods (in accordance with Section 471).
3. Reduced risk of theft and fraud – Cannabis companies are dealing in large amounts of cash, so it is essential you are tracking every penny. In the audit trail you account for all movements of the cash, in and out. You can even showcase how you track the cash. For example, showcasing your client counts cash everyday at 12noon and 8PM.
4. Trust from lenders, investors, and partners – Anyone looking to partner with or support the company financially will do their due diligence. By presenting them with accurate records that are quickly and seamlessly verifiable, you demonstrate effective internal controls, which speaks to the integrity of the business and adds immense value for your clients.

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).

To learn more about how the Cannabis Accounting 5.0 program can add massive value to your business, click here.