Go To Search
Click to Home
California Cannabis: Is the Smoke Clearing on Regulations?
By Jay Siegel

THE 2018 U.S. FDA APPROVAL CHANGED EVERYTHING

On June 25, 2018, The United States Food and Drug Administration (USFDA) approved Epidiolex, a prescription medicine developed by GW Pharmaceuticals that contains a purified drug, CBD (cannabidiol), which is chemically extracted from the Cannabis sativa plant.1 Epidiolex will be used for the treatment of severe seizures associated with two rare and catastrophic forms of epilepsy: Lennox-Gastaut syndrome and Dravet Syndrome. Approximately 20 percent of patients with these diseases pass away before they are 20 years old.2 This approval is a significant milestone for the following reasons: first, the USFDA has never approved a key component extracted from the Cannabis sativa plant. Second, the CBD component of Epidiolex does not create the high associated with THC. Third, this approval puts an end to the contention that cannabis has no legitimate medical purpose as asserted by the federal Controlled Substances Act of 1970.3 Consequently, this puts a whole new light on the federal legality and perceived value of cannabis.  

shutterstock_1063143638_350_px.jpg 
Having CBD extracted and purified from the Cannabis sativa plant directly means this component of Epidiolex can be grown, manufactured, distributed and prescribed in all of the 33 states and the District of Columbia that have approved the use of medical marijuana. This also means that American citizens will not have to travel to Canada, Europe, or other parts of the world to treat these forms of epilepsy, dramatically lowering the total cost of treatment, the impact of the disease on affected patients, and lives lost. The implication is that the remaining 17 states that have not approved medical marijuana could soon be under pressure to do so. It also could open the way for the USFDA to approve the use of other medications derived from the 60 pharmacologically active cannabinoids in cannabis.4 Finally, it could be an important step in persuading Congress to approve medical cannabis nationally which could allow the distribution of life saving medications across state lines, as well as financial support for banking, future research, and further innovation. Canada recently became the second country after Uruguay to legalize the production, manufacturing, distribution, and sale of cannabis products which could influence other nations to expand legalization of cannabis.5 Also notable is the very recent $4 billion investment by Constellation Brands, which owns Corona Beer and Robert Mondavi wines, in the cannabis company Canopy.6
       
THE GOVERNMENT AUDITOR WILL BE HEAVILY TASKED

Meanwhile, in the trenches of this new era of the legitimate birth of medical marijuana, local government auditors are becoming overwhelmed in examining the myriad layers of conflicting cannabis laws and regulations simultaneously being proposed and enacted by federal, state, and local regulators. Fueling the complexity are strong unfolding interests by a host of countries, regions, and government entities, such as states, counties, and cities, seeking to protect human safety, public interests, and the environment while generating tax revenue. Beyond that, industries, investors, and entrepreneurs are seeking to develop consumer products, make new medical discoveries, and boost profits.

Having so many interests at play all at once creates chaos as the various players struggle to keep up with the rapid pace of change. At this time, 10 states and the District of Columbia have now legalized recreational cannabis in addition to the two-thirds of the states that have legalized medical cannabis.7 Thirteen states have decriminalized but not legalized marijuana, which means they allow the possession of small amounts of cannabis for medical and recreational use without risk of imprisonment, but possession of larger amounts and trafficking remains criminally illegal. Canada recently became the second country in the world to legalize cannabis for recreational use nationwide and the first major economy to do so signifying a major cultural, social, and economic change comparable to the ending of alcohol prohibition in the United States.8 Despite all of these changes, the U.S. Federal government still considers cannabis a Schedule One Controlled Substance, on par with health-threatening narcotics such as opioids.9  
       
CHANGE IS THE ONLY CERTAINTY

With all this monumental change, auditors should consider the following key regulatory areas of concern. First, where should ordinance-required internal or external auditing of retail establishment revenues and self-reported grower and manufacturing revenues occur? Second, are there enough auditors on call to test key risk areas? Third, are there enough internal accountants working with new pronouncements and proposals from the Governmental Standards Board under the Dodd-Frank Act to deal with direct and indirect accounting related to cannabis?

An example of a typical problem spinning out of control is the following: In 2018 the California legislature killed a bill that could have enabled state-chartered banks to accommodate finances for the cannabis industry.10 The bill could have worked around federal money laundering and other laws applicable to federally chartered banks that currently do not allow use of a federal bank to handle financing of prohibited controlled substances. This rejected option has forced the cannabis industry to use cash for all financial operations having to do with marijuana, subjecting the industry to high risks in potential robberies, embezzlement, fraud, and tax avoidance, as well as inefficiencies in payroll, armed shipment of cash, vendor payment, tax collection, and auditing. Consider the difficulties following an audit trail when cash is being employed in the long chain of cannabis production steps from agriculture to manufacturing, and from sales to use.

Lack of regulations is what is most problematic at present. The federal government taxes all income unless otherwise excluded by law. State laws follow suit, and cannabis regulation currently incurs a laundry list of other government fees, charges, and paperwork. To be able to do a decent job of tracking cannabis business, a state should have robust regulations that give regulators the authority to tightly control and govern the cannabis industry. Problematically, not all states are created equal. In Washington, Oregon, and Colorado, chartered non-cash banking exists because there are strict regulations ranging from financial and criminal background checks on all cannabis business owners so that every single dollar that comes into a given operation and its source can be closely tracked. On the other side of the coin, in unregulated medical cannabis states such as New Mexico and Arizona, banking is non-existent. Cannabis is also relatively unregulated in California which has resulted in extensive criticism.11 For example, there are no spousal vetting requirements for owners of cannabis businesses, and this is just one reason why it is still nearly impossible for a cannabis business to get a bank account. There were 30 new laws passed in the 2018 by the California legislature over a broad range of issues.12 However, comprehensive regulation is far from complete. The reality is there are many incomplete or proposed regulations in the state and localities, such as regulations relating to medical cannabis businesses in Palm Springs.13

This brings up matters for current and future auditors. How can self-reported cash-based revenue be audited effectively? If there is an audit provision written into laws, such as the Palm Springs ordinance,14  what will happen if shortfalls are noted in cash self-reporting and internal control weaknesses are identified? Federal return audits are supposed to be shared with states for similar investigation and recovery. Will these city, county and state taxing authorities share sales tax information and vice versa? Additionally, how will results relating to permitting, clean water, clean air, and other compliance matters be shared? The answers to these questions impact auditor risk assessments, work levels, compliance, revenue auditing, and reporting. It is well within the realm of auditing to consider tight cash controls to control cash businesses, such as those imposed by gaming regulators.

Whether or not financial institutions begin to bank cannabis entities, where will the money come from? Equity and debt lenders are deeply interested in cannabis from the local to the international level. How far can the money chain be tracked and checked? Add to this, will cryptocurrency gain acceptance in what all indicators say will be a huge new frontier of opportunity in the cannabis commodity futures market?

Because cannabis is federally illegal, getting a bank account has been very difficult for cannabis businesses—even though the 2014 Financial Crimes Enforcement Network (FinCEN) guidelines allow financial institutions to provide banking services to cannabis businesses under certain circumstances. In these circumstances, FinCEN makes clear in its guidelines that banks should make these services available but will they actually do so in the future?15

Cities and counties are in the process of establishing additional standards in addition to the State of California for health and safety, environmental protection, security, food and safety, and work protections. These standards can be more stringent than State of California standards.16 Governmental auditors and accountants also wonder if all of the many factors are being computed in the total regulatory cost of Cannabis? Conversely, when cash is received by government agencies, are accounts set up which separate all cannabis revenue sources?


A NEW INDUSTRY IS BORN

In 2018, the U.S. Bureau of Economic Analysis listed California as world’s fifth largest economy with $2.746 trillion gross state product.17 Cannabis is expected to reach $3.7 billion in revenue by the end of 2018 and to increase to $5 billion in 2019, making it more valuable than beer.18 The cannabis industry could very well move through the cycles of all capitalist industries to the top echelon of growth and development. Auditors will be accompanying this growth to preserve and assist in the grass roots revenue and other compliance needs of government, but the pathway could be challenging.


ABOUT THE AUTHOR

Jay Siegel, C.P.A., M.S.T., CFE, is a Supervisor in an Internal Audit Group for a county in California. Jay’s more than four decades of experience has mainly been with local governmental counties, working with single audits, special districts, not for profits and a large federal agency. Jay is licensed as a C.P.A. in California, Texas and Washington, D. C. He also holds a J.D. from Chapman College University of Law.



NOTES

1 FDA, “FDA approves first drug comprised of an active ingredient derived from marijuana to treat rare severe forms of epilepsy,” Washington, D.C. U.S. Department of Health and Human Services, U.S. Food & Drug Administration (2018). https://www.fda.gov/newsevents/newsroom/pressannouncements/ ucm611046.htm.

Andrew Joseph, “Panel recommends FDA approval of epilepsy drug derived from marijuana,” STATnews.com (April 29, 2018). https://www.statnews.com/2018/04/19/fda-epilepsy-drug-marijuana/

Federal Controlled Substances Act, 21 USC 801 et seq. (1970). https://www.deadiversion.usdoj. gov/21cfr/21usc/

4 John C. M. Brust, Dominic Fee, Pushpa Narayanaswami, Anup Patel, Sarah Song, Sarah Youssof, & Amber Stock, “Use of medical marijuana for neurologic disorders,” American Academy of Neurology Position Statement (2014). https://www.aan. com/siteassets/home-page/policy-and-guidelines/policy/position-statements/medical-marijuana/medical_marijuana_2018.pdf

Dan Bilefsky, “Legalizing Recreational Marijuana, Canada Begins a National Experiment,” New York Times (October 17, 2018). http://www.nytimes.com.

CNBC, “Corona beer maker Constellation ups bet on cannabis with $4 billion investment in Canopy Growth,” CNBC (August 15, 2018). https://www.cnbc.com/ 2018/08/15/corona-maker-constellation-ups-bet-on-cannabis-with-4-billion-investm.html.

Governing, “State marijuana laws in 2018 Map,” Governing the States and Localities Magazine (2018). http://www. governing.com/gov-data/safety-justice/state-marijuana-laws-map-medical-recreational.html.

8 Dan Bilefsky, “Legalizing Recreational Marijuana, Canada Begins a National Experiment,”

9 Virgil Van Dusen, & Alan R. Spies, “An overview and update of the controlled substances Act of 1970,” PharmacyTimes.com (2007). https://www.pharmacytimes.com/ publications/issue/ 2007/2007-02/2007-02-6309.

10 Nick Kovacevich, “California Kills a Cannabis Banking Plan,” Forbes (August 21, 2018). https://www.forbes.com/sites/nickkovacevich/2018/08/21/california-kills-a-cannabis-banking-plan/#4af934810a68

11 H. C. at The Economist, “Is pot legal through California?”, The Economist (January 9, 2018). https://www.economist.com/the-economist-explains/2018/01/09/is-pot-legal-throughout-california.

12 Jennifer McGrath, “2018 California Cannabis Law Legislative Update,” Law Offices of Jennifer McGrath (November 2, 2018). https://www.jennifermcgrath.com/california-cannabis-law-legislative-update/

13 Ordinance of the City of Palm Springs, “An Ordinance of the City of Palm Springs, California…. Related to Medical Cannabis Businesses in the City of Palm Springs.,” Palm Springs (January 9, 2018). https://www.economist.com/the-economist-explains/2018/01/09/is-pot-legal-throughout-california.

14 Ibid

15 Financial Crimes Enforcement Network, “Guidance, BSA Expectations Regarding Marijuana-Related Businesses,” U.S. Department of the Treasury Financial Crimes Enforcement Network (2014). https://www.fincen.gov/sites/default/files/shared/FIN-2014-G001.pdf

16 Ordinance of the City of Palm Springs, “An Ordinance of the City of Palm Springs, California…. Related to Medical Cannabis Businesses in the City of Palm Springs.,”

17 U. S. Bureau of Economic Analysis, “Regional Data – GDP & Personal Income,” BEA (2018). https://apps.bea.gov/iTable/iTable.cfm?0=1200&isuri=1&reqid= 70&step=10&1=1&2= 200&3= sic&4=1&5=xx&6=-1&7=-1&8=-1&9=70&10=levels#reqid=70&step=10&isuri=1&7003= 200&7004=naics&7035=-1&7005=1&7006=xx&7001=1200&7036=-1&7002=1&7090= 70&7007=-1&7093=levels.

18 Los Angeles Times, “California is now the world’s fifth-largest economy, surpassing United Kingdom” Associated Press (May 4, 2018). http://www.latimes.com/ business/la-fi-california-economy-gdp-20180504-story.html.