Growth in All the Wrong Places: Navigating Fraud Challenges in the Emerging Marijuana Industry

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“Welcome to campus, for those of you attending this session,” said Justin Breidenbach, CFE, CPA, Associate Professor of Accounting at Ohio Wesleyan University during his Wednesday morning session. Breidenbach streamed his presentation from his office on the empty Ohio campus on the last day of the virtual 31st Annual ACFE Global Fraud Conference.

Also an accounting consultant with his own firm, Breidenbach Consulting Services LLC, he wasn’t tasked to actually speak about accounting. “So, how does a CFE, CPA and full-time professor get into something like this?” The “this” he was referring to is marijuana fraud. “There’s a lot of stigma and curiosity about this topic,” he said.

A black market gets clean … in some places
There is quite a bit of regulatory conflict as it relates to the legalized marijuana industry and ethical concerns when servicing the industry, Breidenbach explained. In the U.S., some states have completely legalized marijuana, while others have only legalized it for medical reasons, prohibited it completely or decriminalized it. And we’re seeing shades of legalization change rapidly all over the globe.

However, on a federal level, marijuana and high-THC products are considered a Schedule I federally illegal drug under the Controlled Substances Act. “So, states are legalizing a federally illegal product,” Breidenbach said. “This creates a lot of issues when dealing in business from state to state.”

He cited a case from a few years back in which executives transported product across state lines. They had a license for medical in one state and had an overstock of inventory, so they decided to moved it to a second state where they also had a license. However, they were arrested anyway. They couldn’t understand why they weren’t allowed to transport their product when they had legal licenses in both states. But, federally, authorities said their product had to stay within state lines. “Some people think they can go into other states to do business,” Briedenbach said, “but they just can’t.”

He explained that marijuana legalization has also created a unique business environment in which there is strong pressure, opportunity and rationalization, the three legs of the Fraud Triangle.

There are extreme financial pressures. “A lot of [marijuana] companies are actually under water and playing the long game,” said Breidenbach. Taxes in the industry are complicated and costly. U.S. internal revenue code §280e doesn’t allow for deductions or credits for a Schedule I substance. Marijuana companies are being taxed on their gross profits. “So, someone might have positive gross profit, so their tax bill is expensive — but net income is zero or negative,” he said. “They don’t have the money to pay that tax bill. So, they might try to cook the books a little or hide some revenue.”

It’s also a cash-heavy market with limited supply and distribution chains. “From an operational standpoint, it’s costly to go to a regulated market,” he said. “If you have a history of growing marijuana in a shed, garage or basement, scaling the business can be costly. There’s a lot of pressure to get it right, because there’s millions of dollars being pumped into the industry and owners are expecting a return.”

Other risks and regulatory compliance include:

  • Other taxes: sales/use, activity taxes, employer withholding, etc.

  • Financial reporting and bookkeeping

  • Inventory records: “Individually, these [marijuana plants] are very small items,” Breidenbach said. “It’s very easy for small amounts to walk out the front door in someone’s pocket.” He recommended keeping cameras and software on the plants to keep track of product at all times. “But this, too, is costly. There is a premium for these kinds of tools.”

  • Ethics considerations and licensing

  • Complex industry: “In my opinion, this is not an industry to dabble in,” he said. “It’s a complex industry. You have to stay on top of all operational issues.” Because the industry is new, rules change constantly. Breidenbach encouraged attendees to do their research. “This is not your normal type of client or normal type of industry.”

Breidenbach finished with a final word of advice for CFEs: find your niche. “Do a lot of networking,” he said. “Fall into a specific location — mistakes happen when you try to work nationwide. Every state is different in its regulation, so you have to find your niche.”