Cash sounds better, we like cash. Everyone likes cash but as a marijuana accountant, I invite you to consider the differences when it comes to the basis for reporting your financial operations.
Nerds like me spent many years studying the difference between cash and accrual based financial statements. We spent a lot more time on accrual because it is more complicated than cash. And yes, here it comes, I am going to recommend that you use accrual, not because it’s more complicated but because it paints a truer picture of your financial results. Remember that financial story I mentioned in previous blogs? Accrual based accounting tells a more accurate story.
First let’s talk about what we mean by basis for accounting. Your basis for accounting is the premise upon which you report your financial activity. Simply put, it the set of rules that govern the preparation of your financial statements. There are other bases of accounting besides these two, such as modified cash, modified accrual and income tax basis, but cash and accrual are the basics.
Cash basis of accounting is reporting sales when they are collected, and reporting expenses when they are paid. For most of you in the cannabis business, your income statement under the cash basis would report all of your sales (because you collect all your sales when the sale is made) but report only the expenses you actually paid in the given month.
Accrual basis of accounting is often called the matching principle, because it matches and reports revenues AND the expenses attributable to those revenues on the same financial statement. It’s easier to understand this with examples.
Example 1: Whole Earth Dispensary had $82,000 in sales for the month of July and paid out $40,000 in expenses for the same month. On the cash basis of accounting, they would show a profit of $42,000. Sales minus expenses paid equals $42,000.
Example 2: In that same month, Whole Earth Dispensary paid their July rent on July 3 and paid their August rent on July 30, both in the amount of $3,000. So, included in the $40,000 of expenses paid in the month was an extra month’s rent of $3,000. On the accrual basis, the August rent that was paid in July would not be reported on the financials until August, even though it was paid in July, because we want to match the August rent, to August sales. The cash basis net profit is $42,000 but the accrual basis net profit is $45,000.
So why do we marijuana accountants recommend the accrual method? First of all, if your sales are at a certain level and you maintain a substantial inventory, the IRS requires that you file your tax returns on accrual. But more importantly, the accrual basis gives you a truer reflection of your financial performance. In the examples above, which is a truer reflection of the actual performance of the dispensary for July, the cash basis or accrual? The answer is accrual because otherwise we are counting an expense (rent), twice in one month and understating our net income for that month.
Those examples are ultra-simple and in fact, it is more complicated than that to capture all expenses in the proper accounting period. And you might say to yourself, “I know I paid the rent twice in July so I know my bottom line is actually better”, but what if you looked at these financials a year from now to compare performance to the current? Would you remember then? What if you presented these to a potential investor?
The language of accounting in the business world is accrual. There are a few businesses that keep their books on a cash basis but bankers, investors and others with a financial interest in your business expect accrual. Accrual provides you with the most useful tool to manage your cannabis business so if you’re smart, you’ll do the hard thing and use the accrual basis to report your financial results.