Cannabis Industry Holds Unique Challenges for CPAs

Jun 24, 2020

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The federal Controlled Substances Act (CSA) regulates the manufacture and distribution of controlled substances, such as narcotics, depressants, and others. Under the CSA, drugs are categorized into five classifications (schedules) based on their potential for abuse and status in international treaties. It also considers any medical benefits from such drugs. The CSA provides examples of drugs and their classifications:

  • Schedule 1: Ecstasy, LSD, heroin, and marijuana
  • Schedule 2: Cocaine and methamphetamine
  • Schedule 3: Anabolic steroids, ketamine, and testosterone
  • Schedule 4: Ambien, Xanax, and Valium
  • Schedule 5: Lyrica and cough suppressants

The inclusion of marijuana in Schedule 1 is widely debated, particularly because studies have found it to have medical uses. Accordingly, 33 states (and the District of Columbia) have enacted laws making medical marijuana legal, and 11 (plus the District of Columbia) have legalized its sale for recreational use. In Pennsylvania, it is currently legal for medical use but not for recreation.

The Cannabis Industry

According to the National Cannabis Industry Association, Pennsylvania had medical cannabis sales totaling $116 million in 2018, with projected sales increasing to $363 million by 2022.1

Despite booming sales, banking is a real problem for businesses operating in the cannabis industry because of its Schedule 1 classification. Any bank that provides services to a cannabis business, even one operating legally within a state, faces the possibility of federal criminal prosecution (i.e., money laundering). Therefore, few banks will provide services to cannabis businesses.

According to Forbes,2 there are more than 10,000 banks and credit unions in the United States, but as of March 2019 only about 633 depository institutions3 provided services to the cannabis industry. The Financial Crimes Enforcement Network (FinCEN) has guidelines for financial institutions considering services for cannabis businesses. According to FinCEN, it is up to each financial institution whether “… to open, close, or refuse any particular account or relationship.”4 This means a bank can close a cannabis business’s account without warning and for no reason, just because they decided they no longer would like them as a customer.

FinCEN further suggests that financial institutions conduct customer due diligence:

  • Verify with state authorities whether the business is duly licensed and registered.
  • Review the license application (and related documentation) submitted by the business for obtaining a state license.
  • Request information from state licensing and enforcement authorities about the business and related parties.
  • Develop an understanding of the normal and expected activity for the business, including the products to be sold and the customers to be served.
  • Monitor public sources for adverse information about the business and related parties.
  • Monitor for suspicious activity, watching for red flags described in the guidance.
  • Refresh information obtained as part of customer due diligence on a periodic basis.5

Because of banking difficulties, many cannabis businesses operate solely in cash, which is not only a safety concern, but also an unrealistic way to operate a business. Some companies have opted for cryptocurrencies to operate their businesses, such as PotCoin and CannabisCoin.6 These allow businesses to buy and sell products without transferring physical cash and provide an opportunity to operate without running up against the regulations of a traditional bank. This is an effective work-around, but it cannot provide all of the business services that traditional banks offer.

To start closing the gap between the federal and state issues regarding cannabis business regulations, the U.S. House of Representatives passed the Secure and Fair Enforcement (SAFE) Banking Act on Sept. 25, 2019. This bill guarantees that banks and credit unions would not be penalized by federal regulators solely for conducting business with cannabis clients in states where cannabis has been legalized.7 It would inhibit federal banking regulators and other depository institutions from limiting or terminating banking services to cannabis-related businesses.8 The bill still requires approval in the U.S. Senate and the signature of the president before becoming law.

The Risks for CPAs

Directives provided by state boards of accountancy have helped guide CPAs regarding the ethical implications of providing services to cannabis businesses, but the reality is medical marijuana is still classified as a Schedule 1 drug. Therefore, technically, it is subject to prosecution in accordance with the CSA. CPAs could expose themselves to federal racketeering and other federal laws as a result of merely collecting fees for services rendered since marijuana businesses are considered illegal under federal law.

This raises the question of professional liability insurance and how it applies regarding claims involving a marijuana client. While professional liability insurance does provide protection for claims of negligence in connection with services provided within a professional practice, most policies do not cover criminal investigations and their accompanying penalties. However, services rendered by a CPA in the normal course of business to these clients may be covered within professional liability insurance limitations. It should be noted there are restrictions. Practitioners need to be very familiar with their policy terms and conditions, as well as applicable laws, regulations, and professional standards. Consult with your insurance carrier prior to commencement of services.

For additional information and review, the AICPA has a white paper, An Issue Brief on State Marijuana Laws and the CPA Profession,9 that can be used by CPAs considering marijuana business engagements and their effects within the CPA industry.

Getting to Know the Cannabis Industry

Before doing anything within the cannabis industry, CPAs need to be well-educated regarding the proper accounting procedures for these companies. It will ensure that they can offer appropriate support and guidance on best industry practices. CPAs also must do their due diligence and become competent through education, research, and networking.

CPAs considering work in the cannabis industry should research and understand multiple areas, from farming, to retail, to the potential problems that can arise. Other important areas of research include case law: Alterman v. Commissioner,10 for instance, concluded that marijuana businesses are not entitled to any business-expense deductions. These are all aspects that can significantly affect a business, and are areas of which CPAs need to be aware. Through frequent research, CPAs can stay well-informed of changes within the industry.

Another great tool that can be invaluable is networking. Developing connections is a great opportunity to acquire information and resources for a mutually beneficial relationship. You can start connecting with others by joining and following LinkedIn and Facebook groups regarding the cannabis industry. Find out who the CEOs are, engage them, ask questions, and participate in discussions. Attend seminars and conferences to learn more about the industry, and be sure to connect with others in attendance.

Business Valuation Challenges

How do you value a cannabis business? Many cannabis businesses use the fair-value model, which is the same model utilized by the agricultural industry. While the agricultural industry seems like it could be a comparable business model, it is not. Fair-value accounting places a value on an asset for what it could be sold for based on current market values. This essentially places a value on the marijuana plant while it is still being grown before it can be sold. As a result, the unrealized value of these plants can significantly increase the gross margin of a company without ever selling one plant. Consequently, valuing marijuana plants using this method does not take into consideration influences that could affect the ultimate sale of the product, such as economic factors, weather conditions, insects or other pathogens, and the law. Ultimately, federal and state legislation will have the final word with respect to the legality and continuity of the business across state lines, which have an impact on business value.

With no clear guidance regarding valuing a cannabis business, these valuations are highly subjective. Therefore, CPAs must evaluate these businesses based on more than just the fair value of the plants. They need to look at adjusted net assets and projected cash flows, among other things. Furthermore, it would be appropriate for the businesses that do use fair-value accounting to explain their results in their annual reports.

Fraud and Other Risks

Because most traditional banks will not be involved with the cannabis industry, this has led to alternative markets for financing and the handling of cash. This inherently brings increased risks of potential fraud and misuse.

In September 2018, the Securities and Exchange Commission (SEC) issued an “Investor Alert: Marijuana Investments and Fraud.”11 This alert was intended to warn investors about the risks of investment fraud and market manipulation. The warnings are akin to the red flags we see in potentially suspect investment schemes: look out for unlicensed or unregistered sellers, beware of guaranteed returns, and look out for unsolicited offers (via social media, email, or phone calls).

The SEC further advises caution when a company has had its stock suspended, changes have been made in the company name, or false press releases have been generated. Again, these are not dissimilar to traditional scams, but investors often get caught up in a new trend (see the dot-com boom of 1994 to 2000).

Many businesses that are new to the cannabis industry are also new to, well, just doing business. They may be novices at how to keep books and records, how to safeguard their money, and, at the most basic level, how to maintain internal controls. As observed throughout this article, this is an industry where cash remains paramount. Assisting with safeguarding that cash is, therefore, critical.

When cash is a key element of a business, the risk of traditional fraud schemes such as skimming is high. These companies will need help to reduce such risk. Similarly, reliance on cash also can lead to complicit behavior and the risk of collusion with outsiders.

The traditional rules of safeguarding assets apply to this industry as much as to any other. Internal controls, counting of cash (especially surprise cash counts), and review of journal entries are all nonnegotiable. The red flags of fraud all apply in this industry as they do elsewhere. Whether instituting mandatory vacation for accounting personnel or making sure management understands what each person does within the accounting function, these can be simple steps to reduce the risk of loss.

Conclusion

What follows are a few practice tips for CPAs considering work in or with cannabis companies:

  • Education, education, and more education. This is an ever-changing industry. There are many industry publications to which you can subscribe, including Cannabis Industry Journal and Marijuana Business Magazine. Also, be up to date with the position of your state board of accountancy.
  • Understand the law. Similar to state board pronouncements, you should know what the law is within your state. Talk to lawyers who are working with clients in this industry, and attend local chamber of commerce and other events that focus on the state of the industry.
  • Connect through social media sites such as LinkedIn. You will get to know who the players are in the industry and find out directly from them what the latest issues are.
  • Reach out to your professional liability insurance carrier and understand what services you may perform.
  • Identify potential clients who may have a need for fraud-prevention services, training for cash-intense businesses, among other specialty support services.
  • Do background checks on all workers in the business.

The cannabis industry provides entrepreneurs and CPAs alike with an incredible opportunity, but it also holds many risks at this time. Significant developments at the state and federal level have been made in the past few years, yet more work needs to be done before this industry can become a more “main street” business with “normal use” accounting, banking, and business practices. Until then, CPAs may be even more valuable as a source of support to help mitigate the risks faced by those in the cannabis industry. 

1 https://thecannabisindustry.org/ncia-news-resources/state-by-state-policies/
2 www.forbes.com/sites/kurtbadenhausen/2019/06/25/the-top-banks-and-credit-unions-in-every-state-2019/#36e40df07f78
3 www.fincen.gov/sites/default/files/shared/285053%202Q%20FY2019%20Marijuana%20Banking%20Update_Public_final.pdf
4 www.fincen.gov/resources/statutes-regulations/guidance/bsa-expectations-regarding-marijuana-related-businesses
5 Ibid.
6 www.potcoin.com and cannabiscoin.net
7 www.investopedia.com/safe-banking-act-4587773
8 www.congress.gov/bill/116th-congress/house-bill/1595/text
9 www.aicpa.org/Advocacy/State/DownloadableDocuments/MarijuanaCPAsIssueBrief.pdf
10 www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11671
11 www.sec.gov/oiea/investor-alerts-and-bulletins/ia_marijuana

 


Howard M. Silverstone, MBE, CPA, CFF, is a managing director at Forensic Resolutions Inc. He can be reached at hsilverstone@forensicresolutions.com.

 

Marion Wickersham, CFE, is a senior associate at Forensic Resolutions Inc. She can be reached at mwickersham@forensicresolutions.com.

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