Internal Fraud and Theft Risk in the Cannabis Industry

Boom-to-bust cycle leaves dispensaries little margin for preventable losses

Some of us can recall back in 2014, Colorado’s grand scheme to become the center of the legal, recreational marijuana industry, a virtual Napa Valley of Cannabis. Tax revenue from retail sales was going to solve every municipal problem for the town of 112,000. The streets would be paved with Gold, and the schools would be the finest in the land. Early returns were promising; The Wall Street Journal reported, “The day after legal recreational use arrived in Pueblo, Colorado, in 2014, fifty people were camped out in front of one of the first dispensaries, waiting for the doors to open.” The two shops licensed at the time “rang up a combined $1 million in sales the first month, sending $56,000 in taxes to the county.” Pueblo was on its way to becoming not just the national center of cannabis commerce but a tourist destination for connoisseurs of recreational marijuana.

Yet, a decade later, legalized marijuana has spread across the country, and Pueblo has gone from bong to bust. Pueblo County’s once-thriving industry, which numbered more than 200 retailers, growers, and cannabis-oil extractors in 2017, has dispersed like so much smoke. Only 45 cannabis-related entities remain, and county tax revenue from cannabis enterprises has shrunk from more than $7.1 million in 2021 to $4.8 million in 2023.

It’s not that the public has abandoned recreational marijuana use. But Colorado no longer has a monopoly on distribution. Today 46 states have legalized some use of cannabis products, ranging from recreational to CBD products only. There are just four states where cannabis products are totally illegal. Thus, out-of-staters don’t have to go to Colorado, and the tourist angle has never come to fruition.

But it’s not just competition among licensed vendors that has blunted the marijuana trade. Licensing was supposed to draw the contraband dealers out of the shadows, allowing the government to tax their sales. But many of these dealers have preferred to remain unlicensed, and since they are not paying fees or taxes, they can offer their product at a substantially lower price. In California, as NPR has reported, The Department of Cannabis Control openly admits that the tax-free underground economy is” definitely larger” than the legal market.

All of this has led to the current situation, in which only 27 percent of legal cannabis businesses in the United States are profitable, down from 42 percent in 2022. Retailers hoping to stay out of the weeds are dealing with narrower margins. That means their businesses have less tolerance for preventable losses, such as the subject of today’s blog: internal fraud.

Common types of internal fraud and theft in cannabis businesses

The cannabis industry is particularly vulnerable to internal fraud and theft due to its cash-heavy operations and high-value inventory. Cash purchases might not make their way into your register and products might walk out the door, producing inexplicable inventory shrinkage. Business owners must be aware that their trusted employees, managers, and even their partners can exploit weaknesses in the company’s financial controls and inventory tracking to perpetrate fraud.

Here are a few of the ways insiders might commit fraud against your business, how you can spot these schemes, and how you can prevent them.

Theft and embezzlement takes several forms:

• Cash skimming — Employees pocket cash from sales without recording it in the point-of-sale system.
• Inventory theft — Workers steal cannabis products from inventory for personal use to divert them for resale.
• Payroll fraud — Employees inflate real workers’ hours/pay.

Warning signs:

• Cash register shortages or unexplained revenue drops
• Discrepancies in perpetual inventory vs. actual product on hand
• Suspicious employee behaviors, such as a reluctance to take time off, or sudden changes in lifestyle

Mitigation tactics:

• Implement strong cash reconciliation procedures with frequent audits
• Enforce strict perpetual inventory tracking with frequent reconciliations (regular on-hand counts)
• Require two-person approvals for any significant financial activities including payroll changes and adjustments

Then there is transaction fraud, whichinserts a dishonest wrinkle into a real purchase:

• Vendor fraud — Employees collude with vendors to overcharge or provide lower value product substitutions in exchange for cash.
• Fake or unauthorized discounts — Front-line staff process or give unauthorized discounts to certain customers.

Warning signs:

• Unusually high purchase orders or a sudden change in purchases with a specific supplier
• Suspicious or increased discounted purchases

Mitigation tactics:

• Implement multi-level approval for major purchases.
• Conduct frequent vendor audits and cross-check invoices.
• Monitor discount activity/trends in the point-of-sale system.

If you suspect that some type of illegal activity must be going on within your shop, you should consult a forensic accountant with fraud investigation experience.

Proven strategies to reduce your risk of internal fraud

There are numerous ways to strengthen the internal controls on your business processes to reduce the likelihood that an employee might commit fraud:

• Enforce segregation of duties and rotate employee responsibilities like inventory reconciliation/on-hand counts.
• Implement surveillance and security systems in all cash-handling and inventory areas with regular monitoring.
• Require dual approvals for financial transactions and inventory adjustments.
• Implement strong employee screening and monitoring processes
• Conduct background checks on employees and key business partners.
• Use behavioral monitoring to flag unusual employee activities.

Because of the nature of its transactions, the cannabis industry is highly vulnerable to fraud. But even more importantly, due to intense industry competition and high taxation, most businesses cannot absorb the financial losses fraud can inflict. So, unless you rid your business of internal fraud, you are at risk of closure.

The good news is that by implementing strong financial controls, inventory tracking systems, and security and surveillance systems, you can detect and deter employee misconduct. A skilled cannabis industry forensic accountant can provide invaluable assistance by reviewing internal controls and investigating revenue losses or inventory discrepancies to safeguard your business.