The Importance of Inventory Accounting - Part 1
Is your cannabusiness accounting for inventory appropriately? And if so, do you know how to efficiently convert costs for cultivation items such as nutrients, employee wages, electricity and rent, into finished goods inventory? In this article we'll tell you why inventory accounting is probably the most crucial and complex accounting topic for the cannabis industry as well as providing some suggestions to make your business more efficient.
[For the purposes of this article we will focus on production operations as they are the most complex and have the best opportunity to deduct a significant portion of total expenses relative to a retail environment that is mainly limited to deducting the purchase price of products sold.]
We all know that in a cannabusiness, many normally deductible expenses become non-deductible for tax purposes due to Internal Revenue Code Section 280E ("IRC 280E"). Not taking IRC 280E into consideration could result in a tax rate of 90% rather than 45% or even put your business into the red, paying more to the IRS than you actually made in net income.
So what is deductible and how can such expenses can be deducted? IRC 280E basically dictates that only Cost of Goods Sold (COGS) may be deducted; but what exactly is COGS?
Cost of Goods Sold (COGS)
COGS is the accumulated total of all costs used to create a product or service, which has been sold. Costs include all costs of purchase, costs of conversion and other costs that are incurred in bringing the inventories to their present location and condition and generally include material, labor, and allocated overhead. This basically dictates that inventory be calculated and accounted for until such time that it is sold when expensing (deducting) those costs are allowable. By definition, this necessitates the accrual basis of accounting.
In fact, the IRS states that "When the production, purchase, or sale of merchandise is an income-producing factor in your business, you must generally take inventories into account at the beginning and the end of your tax year. If you must account for an inventory, you must generally use an accrual method of accounting for your purchases and sales". There are a few exceptions to the rule but most cannabusinesses will not meet the criteria.
This all means that cannabusinesses need to appropriately determine COGS which in turn requires the accounting for inventory and therefore the accrual basis accounting (at least for inventory).
Accrual Basis Accounting
So while it seems pretty clear that at least for inventory the accrual basis of accounting is required, what about all other non-inventory transactions? In this young industry there is much confusion as to whether accrual basis accounting is required. Many IRC sections including 447 and 448 also provide some guidance but there is still confusion and there doesn't seem to be any consensus among industry accountants.
With the accrual basis of accounting, income and expenses are recognized/recorded as they are incurred rather than when cash changes hands. As example, revenue would be recognized when an invoice is issued, not when the customer makes payment (if at a later date) or wages paid to employees are recorded as an expense at the end of a day's shift, not when they receive their paycheck which may be a week later.
We believe, regardless of the disparity of how one cannabusiness may use cash basis accounting while another across the street uses accrual basis, the best practice is to use accrual method of accounting.
In our next installment we will discuss why we believe the accrual method is the better option.