In every industry, bad debts can happen for a variety of reasons: fraud, bankruptcy, and other financial problems make some debts uncollectible. The COVID-19 pandemic and ensuing economic chaos have increased the likelihood that cannabis entrepreneurs will have to deal with bad debt.
In some cases, you may encounter bad debt on the customer side: rising unemployment has meant many people are going bankrupt. As a cannabis venture, you may even have some debt you aren’t able to repay. Here’s what you need to know about bad debt in the cannabis industry, and what to do if you’re trying to pay or collect.
What is bad debt?
Investopedia defines bad debt as “an expense that a business incurs once the repayment of credit previously extended to a customer is estimated to be uncollectible.” Any time you offer a partner or customer the option to do business on credit, you run the risk of incurring bad debt – meaning you won’t be able to recoup the expense.
Personal, or non-business bad debt, is recorded slightly differently than business bad debt. The IRS is trying to make sure you don’t write off gifts as “bad debt” on your personal tax return. Read this guide for more on personal bad debt.
What is bad debt expense?
Bad debt gets recognized as a business expense when an account receivable is no longer collectible. In accounting, there are two main ways you can record a bad debt expense: the direct write-off method and the matching principle.
The direct write-off method means that you write off accounts as they are directly identified as being uncollectible. This is the method that is most common for income tax purposes. However, cannabis accountants should note that the direct write-off method does not meet GAAP standards; it records precise figures of accounts that have been deemed uncollectible, thereby failing to adhere to the matching principle.
The matching principle requires that an expense be matched to related revenues in the same accounting period in which the revenue transaction occurs. A bad debt expense must be estimated using the allowance method in which the credit sale occurs. For instance, if your cannabis business records a transaction in January that is later deemed to be uncollectible, the way you account for that bad debt expense must match the revenue recording process used in January (not the month in which that expense is deemed uncollectible).
Essentially, what this means for your cannabis business is that you should be using historic sales records to estimate a certain percentage of bad debt you can expect to face each quarter.
Estimating bad debts
How can you predict how much accounts receivable will turn into bad debt expense? There are two primary methods for estimating bad debt expenses.
The first is known as the accounts receivable aging method. To use this calculation, group all outstanding accounts receivable by age. Then apply specific percentages to each group. The resulting aggregate of the groups’ results gives you the estimated uncollectible amount.
For instance, pretend your cannabis business has $7,000 accounts receivable that less than 30 days outstanding; $2,000 of accounts receivable is more than 30 days outstanding. By looking at your historic data, you see that 1% of accounts receivable less than 30 days is not uncollectible; 4% of accounts receivable more than 30 days old are uncollectible. (($7,000 x 1%) + ($2,000 x 4%)) gives you $150 in estimated bad debts.
The second option for estimating bad debt is to use the percentage of sales method. Using this option, you would apply a flat percentage to the total dollar amount of sales over a certain period.
For instance, you may know that roughly 3% of sales over six months result in bad debt. If you record $50,000 in sales, you would account for $1,500 in bad debt.
Bad Debt in the Cannabis Industry
Bad debt can show up in your personal life and in your business life. In cannabis, a common example is when a dispensary does not pay a distributor for your brand’s product that you offered on consignment. More recently, looting as an offshoot of the social justice protests has resulted in some dispensaries getting robbed (of product). This can also be considered bad debt. Packaging vendors not getting paid on the packaging that they gave to brands with terms such as Net30 are also an instance of bad debt. You may encounter a brand that’s gone out of business or is avoiding calls after 90 or 120 days of non-payment. These cases are becoming more common as the economy struggles to reopen.
How to Mitigate Bad Debts
First, in the cannabis industry, you should never, ever extend credit. With how new the market is and the high turnover of companies, extending credit could cripple your business growth. Always collect your money, cash on delivery. If you must extend credit to be competitive in your market, then create some type of qualifying process and potentially start extending terms on portions of payments instead of the full amount. For example, collect 25-50% on sale to help cover costs and expenses. Then, when you do collect the balance of their bill, that is your profit.
Second, NEVER, EVER extend credit on taxes, especially cultivation and excise tax. In most states, distributors are the tax collectors and remitters for the state and cities which means they are open to the most opportunities of losing cash due to non-payment of taxes. With every delivery or pickup, we suggest that cannabis distributors collect all of the applicable cannabis taxes upfront so you don’t get caught holding someone else’s tax bag. Also, make sure that you separate the tax money from your revenue so you don’t use it as working capital.
For advice on what to do in these instances, and guidance on writing off bad debt, get in touch with our cannabis finance experts.