Are Your Books and Records Audit Ready?

Are Your Books and Records Audit Ready?

by Ken Teasdale
April 29, 2021

As your cannabis company begins to scale nationally or when you begin thinking about positioning for future M&A, you may be subject to a more complex audit that includes your inventory, internal controls, equity/debt structures, etc.

There is nothing more frustrating (and time consuming) for auditors than finding surprises, so having your books and records as clean as possible before the auditor dives in is critical. This will drive down the costs and time involved in your audit, help you avoid disruption to your daily business and make you look more attractive to a potential acquirer.

Why You May Need an Audit

Why would you do an audit if you’re not public and/or it’s not required? In today’s market, it’s a key part of positioning for a future transaction.

While most cannabis businesses don’t have traditional bank loans, which at times require audited financial statements as a condition of the loan, what we’re seeing lately in the industry is a lot of movement in the M&A markets with larger cannabis companies looking to gain additional market share with strategic acquisitions. COVID has also triggered consolidations as opportunistic buyers have been looking for deals. Some of the larger entities, especially in the Canadian market, are looking south for acquisition targets and asking for audits, either as a condition of the transaction or because they are a reporting entity on a Canadian exchange already.

Equity raises based on new investors are another driver of the need for an audit. As more sophisticated and larger investors, including cannabis industry specific private equity funds, are getting into the cannabis space, they traditionally will want to see audit results before they commit to an investment.

What Is the Biggest Pain Point With Audit Readiness?

Your books need to be reconciled and supportable to be audit ready, and a lot of companies don't realize what this entails. Many cannabis companies assume that part of what an audit consists of is the audit firm cleaning up the books and records as part of the audit firm’s procedures. But that is rarely the case.

As an independent third party, auditors can only give an opinion on the financials, so the books and records must be created by the client and supportable (underlying documentation and evidence). Part of that process entails using the necessary technology solutions available, specifically to the cannabis industry, to accurately account for the activity in the company (seed-to-sale solutions, new ERP system, accounting and GL packages, etc.). This is crucial to the audit effort because poorly kept books only creates more work for the auditor, less confidence in the numbers, which ultimately increases audit costs.

Believe it or not, an audit can be relatively painless if the client is ready and organized. Therefore, getting everything in order beforehand is well worth the short-term investment of time and resources. Your audit won’t take as long and your business will look more attractive to a potential acquirer.

If your organization is knee-deep in due diligence with a potential buyer who asks for one- or two-years’ worth of audited financials, you will be left scrambling if you aren’t prepared, causing major disruption.

Common Problem Areas for Audits

The following are some typical stumbling blocks where cannabis companies run into problems in preparing for an audit:

  • Inventory – Beginning and ending inventory quantities have not been observed by an auditor and therefore an inventory rollback must be prepared. Because this is a requirement specific to audited financial statements, this may not be on a cannabis company’s radar initially. An inventory observation must be done as soon as possible, and then a rollback schedule must be prepared reconciling to both the year end, and the previous year end inventory quantities and values. This can be incredibly challenging for businesses due to poor internal inventory reporting, complexity of inventory movement and lack of technical staff.
  • Complicated Equity Structures – Many cannabis companies have complex organization charts containing multiple entities (many times for tax purposes). Based on percentage ownership, stock/equity awards or intercompany transactions, there is specific accounting based on these transactions that can contain some complexity. Some examples include minority interest calculations and presentations and stock-based compensation accounting.
  • Cash Revenue – Early stage cannabis companies have been susceptible to poor recordkeeping when it comes to cash-only sales. A detailed log should be kept showing all the additions to or subtractions from physical cash, arriving at a final balance. Those amounts should then be supported by sales invoices or expense invoices evidencing the transactions. Many times, cannabis companies are not able to deposit cash in a traditional bank, and therefore large amounts of currency must be kept in a vault. It’s imperative to have sound internal controls around the handling of cash, which includes a supportable cash log.
  • Convertible Debt or More Complex Equity/Debt Structures – Cannabis companies have been extremely creative with their initial or continual financing absent traditional bank lending. As a result, there can be complex debt agreements with equity “kickers” involved. This triggers specialized accounting analysis and accounting that contains particular financial statement disclosures.
  • Remote Inventory Counts –Due to the restrictions of COVID, physical inventory counts have been switched to a remote environment. Auditors will need to do their counts through a remote session (e.g., Zoom or Microsoft Teams) with the help of the warehouse personnel. The auditors will watch the client’s personnel counting or weighing their selected sample items and must visually see the whole process.
  • Documentation of Internal Controls – We know you worked hard to strategize, create and implement internal controls to safeguard your business and mitigate various risks. Those controls include proper segregation of duties as well as basic standard operating procedures. Now you need to document them and provide evidence that they are functioning. Part of the audit process is to understand the control environment and actually walk through key internal controls identified. Documenting these controls ahead of the audit will save time and energy during the audit.

Which Type of Audit Will You Need?

Believe it or not, audits don’t come in just one flavor, as there are several different types to consider based on your ultimate goals and needs. Therefore, it’s important to understand the different reporting standards available and what best fits your organization at the time of audit:

  • United States Generally Accepted Accounting Standards (U.S. GAAP) – This is the type of audit most privately held companies in the United States use. This is relevant if you are not listed on an exchange or aren’t planning on it soon.
  • Public Company Accounting Oversight Board Standards (PCAOB) – This type of audit is for publicly held companies who are filers on a United States exchange, such as the Over the Counter, or “OTC”, NASDAQ or the NYSE. However, you can (and sometimes must) have this type of audit performed when you are contemplating a transaction that will create an exchange filing need (through a merger/acquisition of a public company or going public yourself). A PCAOB audit includes more specific accounting standards for areas such as revenue and leases.
  • International Financial Reporting Standards (IFRS) – This type of audit would be applicable should you want to list on one of the Canadian exchanges, either through a merger transaction or your own listing. There are differences in these reporting standards to a traditional U.S. GAAP or PCAOB audit including fair market value accounting and more accelerated accounting standards.

Each of these types of audits will have different ramifications on the time and effort on you and your accounting staff to report your financial statements appropriately. For instance, with either a PCAOB or and IFRS audit, the audit firm cannot prepare the financial statements for you. Independence rules are much stricter in those audit environments, so you must either have staff that has the technical abilities to draft the full financial statements, or you must consider outsourcing this function to a separate firm.

How Long Does an Audit Take?

Like everything else, how long an audit will take, will depend. However, any timetable will be directly affected by your team’s readiness and technical capabilities. For example, a first year (never been audited before), single-year presentation, which would have to include audit procedures on the opening balance sheet accounts, will generally take 45-60 days from the start of fieldwork. For a first year, two-year audit presentation, which would again require audit procedures on the opening balance sheet accounts, will generally take 60-90 days from the start of fieldwork, depending on the complexity.

All of this demonstrates the importance of getting your books and records in order now, which will save time, money and disruption when the audit team arrives.

If you have questions or need help preparing for your U.S. or Canadian audit, contact our cannabis experts.

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