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The traditional automobile dealership recognizes revenue from new and used vehicle sales, new and used vehicle leases, vehicle servicing, and financing contracts. The discussion below examines proper revenue recognition policy for each of these areas.
New and Used Vehicle Sales
Revenue Recognition for sales of new or used vehicles follows generally accepted accounting principles as discussed in Part I of this Guide, specifically, FASB Concepts Statement (CON) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises. The passing of title ordinarily is evidence of change in ownership, with the dealership rendering to the customer “temporary” title until the Department of Motor Vehicles remits the actual title. The revenue is realized and earned when the product (vehicle) is sold and delivered to the customer, accompanied by legal evidence of ownership (temporary title). (See also the discussion of Article 2 of the Uniform Commercial Code in Part IV of this Guide.)
Tangible personal propertytaxes can impede year-end sales. So the dealership may close the sale on December 31 but pass title to the vehicle in January, thereby saving the consumer any personal property tax liability. Aside from the obvious ethical question, the dealership may overstate both earnings and assets in this case, since the vehicle is reflected in both revenue and ending inventory. To ensure that such a situation does not occur, sound revenue policy requires revenue cutoff procedures to establish that vehicles sold at year end are not included in ending inventory.
For dealerships, one of the most common areas of confusion about revenue recognition is around the question of how to treat sales incentives such as cash, products, or services offered to customers. The FASB’s EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” provides the following revenue rules that should be incorporated into the dealership revenue policy.
Cash Incentives: These are treated as direct revenue reductions upon revenue recognition.
Dealership gives a $2,000 cash incentive on its new luxury vehicles that list at $42,000. Upon sale, Dealership recognizes $40,000 (the $42,000 selling price less the $2,000 cash incentive) as revenue.
Product or Service Incentives: These are treated as cost of revenue or expenses (Issue 01-9 allows the dealer to select the treatment). Accordingly, the dealership recognizes revenue equal to the selling price.
The facts are the same as in Example 1, above, except that Dealership also offers, as a product incentive, a $3,000 plasma TV. Dealership still recognizes the $40,000 in revenue upon sale and treats the $3,000 product incentive as an advertising expense.
In 2005, 01-9 was clarified to identify product or service incentives redeemable at a future date, absent any exchange transaction with the dealership, as a “separate deliverable.” This means that EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” is applicable. (For an in-depth discussion of Issue 00-21, see Chapter IND-II N, “Software,” below.)
The customer in Example 1 also receives “tires for life” upon purchase of the luxury vehicle. This is not a product or service incentive under Issue 01-9 but, rather, is treated as a separate deliverable under Issue 00-21.
Other Incentives: Issue 01-9 addresses other forms of incentives, such as coupons, and their impact on revenue. This EITF issue should be consulted in reviewing and formulating revenue policy. Copies of EITF issues can be ordered from the FASB at its website www.fasb.org.
New and Used Vehicle Leases
Long-term lease arrangements have allowed dealerships to recognize more revenue from those customers inclined to lease rather than purchase. Of course, this is not the case when the dealer acts as a lease broker, whereby it sells vehicles to leasing companies that, as buyer-lessors, take legal title. Lease arrangements can be offered for both new and used vehicles, although the used vehicles are ordinarily limited to more high-end or luxury models.
In the vast majority of dealerships, the dealers do their own leasing of new and used vehicles. They finance the lease “paper” through a manufacturer’s financing arm or a commercial bank. Revenue recognition is controlled by FASB Statement No. 13, Accounting for Leases.
Under Statement 13, leases are treated as either operating or capital (sale-type) leases. Operating leases are non-sale, time-delimited arrangements. A lease is an operating lease whenever it is cancelable or, if non-cancellable, whenever the lease specifies the value at the lease end (the purchase option) to be equivalent to the fair value of the vehicle. Operating leases are never interpreted as sales, so the rent revenue is recognized upon its receipt.
If a lease is non-cancellable with a guaranteed residual (salvage) value at lease end, it is a sales-type lease. Under Statement 13, this common type of vehicle lease is treated, in substance, as a sale. Typically, at lease end, the customer-lessee must ante up to the dealership the difference between the residual value prescribed in the lease and the vehicle’s fair value. Under this type of lease, the cumulative minimum lease payments include the guaranteed residual value and allow the dealership to obtain a reasonable rate of return above the vehicle’s cost.
This type of lease is referred to as a sales-type transaction because it is equivalent to an actual sale of the vehicle. The dealership must recognize gross profit on the sale and record a receivable at the time the lease is executed. Interest income will be recognized over the lease term. This means that rental payments are allocated between reduction of the lease investment and interest income. The “selling price” of the vehicle under the lease is computed by calculating the present value of the minimum lease payments. The full text of Statement 13, including a sample computation can be reviewed at the FASB website www.fasb.org.
Another form of “capital” lease under Statement 13 is referred to as a direct financing lease, which is the sale of a vehicle acquired for the lessee. Unlike the sales-type capital lease, where the gross profit is recognized on the putative sale, there is no gross profit recognition in the direct financing lease. Rather, a receivable is recorded and interest income is recognized.
There are two main types of vehicle servicing: warranty and non-warranty. Practically all new vehicles come with a manufacturer’s warranty, and luxury “pre-owned” vehicles will carry a dealer’s warranty.
In all non-warranty cases, or when a vehicle’s warranty has expired, revenue is recognized simply upon the satisfactory completion of the vehicle service.
It is the extended warranty cases that present the most revenue recognition challenges. Usually, the manufacturer is the warrantor and the dealership is the intermediary or broker between the customer and the manufacturer (as is the situation for new vehicles). The dealership collects the premium from the customer and remits it to the manufacturer. Upon collection of the premium by the dealership, the broker fee should be retained and recognized as revenue. The rate of contract cancellations, if significant, should be estimated.
On the other hand, if the dealership is the warrantor for the extended warranty (as is often the case for used vehicles), then the premium received from the customer is recognized as deferred revenue and amortized to income over the warranty period, as provided by FASB Technical Bulletin (FTB) No. 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts (full text available for review at the FASB website www.fasb.org).
The FASB and IASB have undertaken a joint project to develop a common conceptual framework for developing future accounting standards. The two boards are conducting the project over eight phases, which may extend into 2007 and beyond.
Of concern to dealership revenue recognition, however, is the measurement and allocation of items within a revenue contract. The FASB and IASB are presently in agreement that performance obligations should be separated using the customer’s viewpoint and based on whether a deliverable has utility. In the case of any warranty that accompanies the sales contract, therefore, an allocation will be deemed necessary. Keep in mind that such a revenue allocation approach is several years downstream but is eventually certain to take hold.
Dealer sells customer a new vehicle with a sales price of $40,000. The vehicle carries a five-year, 100,000-mile warranty. At present, Dealer recognizes revenue of $40,000 and treats the warranty as described in the discussion above.
Under the joint project of the FASB and IASB, Dealer recognizes as revenue upon the sale only a portion of the $40,000 as customer consideration, and the balance is allocated to be recognized as revenue over the life of the warranty, that is, over five years.
The automobile financing contract is an installment contract between the customer and the dealership. As a practical matter, however, dealerships are not banks. Generally, either a commercial bank or the manufacturer’s financing subsidiary (usually for subprime credit risks) “buys” the installment note on a nonrecourse or partial recourse basis.
The dealership recognizes financing income in the period of the vehicle sale.
Dealership sells a vehicle for $30,000 under a five-year installment note with a face of $24,000 (Customer paid $6,000 cash down). A dealer reserve (reported as a dealer receivable classified generally as a current asset) of 1% of the $24,000 or $240 is deemed reasonable.
The dealership will recognize sales revenue of $30,000 and financing income of $240.
Special rules apply to the transfer and servicing of installment obligations for many businesses, including dealerships. These rules treat some installment contracts with recourse as a sale or, failing certain tests, as a secured borrowing. The rules are set out in FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, which is available for review at the FASB website www.fasb.org. Statement 140, however, has no impact on recognition of revenue from the vehicle sale.
Finally, as part of the financing contract, the dealership offers (and in some cases may require) insurance that satisfies the customer’s installment obligation in the event of death or disability. Such an arrangement is merely a third party beneficiary contract, in which an insurer (independent insurance company), a beneficiary (dealership), and an insured (customer) agree that, in the event of the customer’s death or disability, the contract is satisfied.
The risk of loss is squarely on the insurer, and the commission income received by the dealership for selling the policy is recognized at the time of sale. Such a one-time premium is usually part of the financing proceeds.
Excerpted by permission. Copyright 2007, Specialty Technical Publishers.