What are Generally Accepted Accounting Principles ("GAAP")

Generally accepted accounting principles (GAAP) are a common set of accounting principles, standards and procedures that companies must follow when they compile their financial statements. GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP improves the clarity of the communication of financial information. GAAP is meant to ensure a minimum level of consistency in a company's financial statements, which makes it easier for investors to analyze and extract useful information. GAAP also facilitates the cross comparison of financial information across different companies. GAAP must be followed when a company distributes its financial statements outside of the company. If a corporation's stock is publicly traded, the financial statements must also adhere to rules established by the U.S. Securities and Exchange Commission (SEC). GAAP covers such things as revenue recognition, balance sheet item classification and outstanding share measurements. If a financial statement is not prepared using GAAP, investors should be cautious. Also, some companies may use both GAAP and non-GAAP compliant measures when reporting financial results. GAAP regulations require that non-GAAP measures are identified in financial statements and other public disclosures, such as press releases.

Be ready for an audit and for dealing with very aggressive revenue agents. Even though federal law enforcement is easing up on enforcement, the IRS has not adopted that view – marijuana businesses have a huge target on their back and the IRS is holding marijuana businesses to a very high standard.  Cash-based businesses are closely scrutinized by the IRS and other taxing authorities. Having robust internal control procedures, in writing, which are strictly enforced, will go a long way in establishing credibility with taxing authorities. Hire a reputable Certified Public Accountant to assist you in ensuring GAAP and IRC 280E is being followed. Having an independent review and an outside CPA to work with your accounting staff will allow you to sleep better at night. 
 
What is the Difference Between GAAP and Cash Accounting

The main difference between the accrual and cash basis of accounting relates to the timing of expenses and revenue. In the cash basis of accounting, revenue is recognized when money is received while expenses are recognized when money has been paid out. Accounts receivables and accounts payables are not recognized by the cash basis. For instance, it is only when a bill is paid is an expense recognized. Revenues are usually recognized when earned in the accrual basis of accounting. This means that revenue is recorded by the company when earned even though the customer has not yet made the payment. Expenses are also similarly treated; upon their occurrence as opposed to when payment is made. The main advantage of the cash basis is that it is not only simple but also flexible and cash flows are also taken into consideration. Unless received, income is never taxed. The main advantage of the system of accrual is that it gives an ideal picture of real expenses and income within a certain time period. Unlike the cash basis of accounting, the accrual method offers a long term business picture. The main disadvantage is that accrual accounting basis is more complex compared to cash method. Financial statements and other reports can be prepared using the cash basis or accrual basis. A Balance Sheet made on accrual basis will show the accounts payables and accounts receivables and may also present the prepaid expenses and deferred revenue. None of these accounts will be shown in a report of cash basis; rather, it will only show the equity and cash.

Why is GAAP Important to the Cannabis Industry

In 2014 the IRS released Chief Counsel Advice (“CCA”) 201504011. This CCA finally shed light on which cannabis-related expenses can be assigned to COGS. The CCA states a taxpayer may deduct wages, rents, and repair expenses attributable to its production activities, but would not be permitted to deduct wages, rents, or repair expenses attributable to its G&A or its marketing activities. IRS regulations state that if a business produces GAAP basis financial statements, it may include in inventory additional costs that are properly allocated under GAAP. Examples of these additional expenses are:

  • Insurance,
  • Depreciation,
  • Employee benefits, and
  • Administrative expenses.

​The CCA also addresses Section 263A as it applies to cannabis businesses.  Section 263A requires “resellers and producers of merchandise to treat as inventoriable costs a proper share of those indirect costs that are allocable (in whole or in part) to that property.” Cannabis businesses would be inclined to capitalize their expenses into inventory under Section 263A, thereby converting previously nondeductible G&A expenses into deductible COGS expenses. However, the CCA clearly states Section 263A doesn’t apply to businesses that fall under the classification of Section 280E and therefore cannabis business cannot capitalize expenses under Section 263A. The IRS is relying on Section 263A(a)(2) which states “any cost which could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described.” Essentially the IRS is allowing a taxpayer to only include in its COGS costs required by Section 471 determined at the time Section 280E was enacted in 1982 (not 1986 when Section 263A was added to the Code).

A cash basis cannabis business would, by definition, have no inventorial costs. When Section 280E is applied, the cash basis producer’s taxable income for each year would be significantly higher than it would have been on the accrual basis under an allowable inventory method. The accrual basis business could have recouped its production costs through COGS. Therefore in this situation, the cash basis business is at a disadvantage as compared to an accrual basis business. The IRS does provide some relief in CCA 201504011, which states “when examining a cash basis cannabis business, it has the authority to permit the taxpayer to deduct from gross income its costs that would have been inventoriable had the taxpayer been on the accrual method.” Accordingly the IRS has discretion to allow cash basis cannabis businesses to deduct additional expenses as if it had been on the accrual method.​ While these regulations outline the general categories of deductions that are permitted for cannabis businesses, they do not detail what specific items cannabis businesses can deduct. Below are some examples of the types of expenses that may be capitalized. 


COGS for Cannabis


Resellers

According to §1.471-3(b), the IRS has interpreted this section of the IRC to mean that cannabis businesses are permitted to deduct expenses related to inventory as COGS only. As result, cannabis resellers can claim deductions for (i) he invoice price for cannabis, less trade or other discounts, (ii) Electric bills for designated inventory areas (electricity used in sales areas are not eligible to be deducted as COGS) and (iii) Transportation (the cost of travel to purchase cannabis, transportation and shipping costs of the cannabis). Cannabis resellers are permitted to take these deductions only as long as these charges are strictly related to the acquisition of cannabis for resale and the storage and handling of inventory. The best way to mitigate the IRS’ challenge of these deductions is by creating an inventory space that is closed off from the sales area of your cannabis business.



COGS for Cannabis

Producers

For cannabis producers, §1.471-3(c) and § 1.471-11 of the IRC define how these businesses should treat cannabis production costs and define which expenses they are permitted to deduct as COGS. The IRC advises the use of the “full absorption” method of computing COGS which takes into account both direct and indirect production costs. Direct production costs are considered those costs which are necessary for the production of cannabis and the materials that are consumed as a part of the production process. Per the IRC, the direct production costs that cannabis producers can deduct are the costs of (i) Raw materials and supplies (seeds, soil, clones, fertilizer), (ii) Expenditures for direct labor (hiring workers to clean, trim, cure, package and inventory the cannabis and (iii) the associated wages, payroll taxes, and insurance).

Examples of indirect production costs that can be deducted as COGS include:

  • Repairs to production and storage facilities
  • Maintenance costs for your production and storage facilities
  • Utilities (water and electricity used to grow cannabis)
  • Rent for your production facility
  • Indirect materials and supplies (grow supplies and packaging)
  • Indirect labor (supervisory wages)
  • Costs of quality control and inspection

These indirect production costs are deductible if they can be related to the production of cannabis. In addition, if the cannabis production business prepares financial statements that are in accordance with GAAP, some additional expenses can be deducted.  Cultivators and manufacturers do not have to go through the same tax complications as dispensaries. They are producing the cannabis from seed to flower and most expenses under GAAP are deductible.  The depletion of the land, the seeds, the labor to work the land (even for owners), the depreciation on the equipment used to cultivate the land, transportation to the dispensary, depreciation on the trucks that are used to transport the cannabis - are all COGS under GAAP.  Those expenses make up most of the costs entailed in growing cannabis.