The Importance of Inventory Accounting - Part 2
In our previous article, we discussed how maintaining inventory on the accrual basis of accounting is a requirement of the IRS. In this installment we will discuss why we believe the accrual basis is best not only for inventory accounting but for overall accounting.
There are 3 main reasons why we believe using the accrual basis of accounting is the best practice for cannabis producers:
1) Accrual basis financial statements provide better understanding of financial operating results so managers can make better decisions.
2) Many states require audited financial statements which must conform to Generally Accepted Accounting Principals (GAAP) which in turn requires accrual basis financial statements.
3) Almost all corporate or institutional investors will require audited financial statements and in the fortunate circumstance of becoming a publicly traded company, that also requires audited financials.
Meaningful Financial Information
Accrual basis accounting is generally preferable over cash basis accounting because it produces more accurate financial statements that provide a better representation of actual financial circumstances than the cash basis. Since accrual basis accounting records revenues and the related expenses together in the same time periods, it produces more accurate representation of financial performance in any given time period.
A simple example in terms of a resale business would be products which are bought and paid for in one year but not sold until the next. This would result in financial statements reflecting only expense in the first year and only revenue in the second thereby distorting the actual financial performance of the business. By contrast, the use of the accrual basis would mandate that both the revenue and expense are recognized in the same year, allowing management to see what true gross profit/margin is on any particular sale. Exhibit A below depicts this. In total both methods result in a gross profit of $35 but you would not readily understand this unless you were using the accrual method.
Do You Know How Much Debt Your Business Has?
Another thing I see very frequently with cash basis operations, is that they do not know what their outstanding liabilities are. In a cash basis operation, liabilities are not recorded (and therefore not tracked) and only expensed once paid. In an accrual basis operation, liabilities are recorded as they are incurred (ie. accounts payable, accrued liabilities, payroll, etc.). By accruing (and therefore tracking) liabilities as you incur them allows you to understand how much you owe as well as your overall financial condition. Many cash basis operations believe they are doing well when in reality they owe much more than the business can afford. I've seen more than a few businesses fail from this circumstance.
State and Investor Requirements
And finally, as with any other highly regulated industry, audited financial statements are many times a state regulatory requirement and in addition, because of the significant costs of operating a cannabusiness, many look for outside capital or once established, look to sell or merge. These states, corporate parents or institutional investors require audited financial statements (and therefore accrual basis accounting) so that they can understand the true financial situation of the respective company.
Now that we've made our case for why we believe accrual basis accounting is necessary, particularly for inventory, we'll get into some specifics of inventory accounting in our next installment.