July 2018 Revenue Recognition for Dealerships: Preparing for the New GAAP Rules An article by James C. Bianchi, CPA, and Kelly L. Faehr, CPA Audit / Tax / Advisory / Risk / Performance Smart decisions. Lasting value.
Revenue Recognition for Dealerships: Preparing for the New GAAP Rules With the long-anticipated new accounting standard on revenue recognition becoming fully effective over the coming months, dealerships should be taking steps now to determine how they will be affected and what they must do to remain compliant with generally accepted accounting principles (GAAP). In the four years since it first issued Accounting Standards Update (ASU) 2014-19, Revenue From Contracts With Customers (Topic 606), the Financial Accounting Standards Board (FASB) has published five additional updates to change or clarify the original guidance. The fact that the FASB has taken the unusual step of issuing amendments to the standard prior to its effective date could be interpreted as a confirmation of the sweeping, far-reaching nature of the new standard, which replaces almost all previous revenue recognition guidance for nearly every type of organization that must comply with GAAP. 2 July 2018 Crowe LLP
For publicly traded companies and other organizations that meet the FASB definition of a public business entity, the new standard went into effect for calendar year entities beginning Jan. 1, 2018. For all other entities that are required to maintain GAAP-compliant financial statements, the new standard goes into effect for reporting periods beginning after Dec. 15, 2018. Fortunately, for most dealerships, the changes are not expected to have a material impact on most revenue lines. Nevertheless, financial executives should review all of their dealerships revenue lines and the contracts they have with customers and determine if they need to make any modifications to how they recognize revenue. In addition, the new standard changes some disclosure requirements for all companies as the FASB expands the information to be provided to users of the financial statements. To be ready when the new guidance goes into effect, financial executives need to understand the potential effects of the coming changes and determine the best way to implement the new guidance. crowe.com 3
Revenue Recognition for Dealerships: Preparing for the New GAAP Rules The Five Steps of Revenue Recognition The new standard uses a principles-based approach, designed to establish more consistency in how revenue is recognized across various industries, as compared to the previous rules-based approach with industry-specific guidance. In addition, the new standard is based on the core principle that a company should recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration the company expects to be entitled to in exchange for the goods or services. To achieve that principle, the new guidance spells out a five-step revenue recognition model that applies to all customer contracts: 1. Identify the contract. An entity must first identify the contract, or contracts, to provide goods and services to customers. Any contracts that create enforceable rights and obligations fall within the scope of the new guidance. It is important to note that an agreement does not have to be written to be considered a contract. Contracts that are not formally documented but are implied by the organization s customary business practices are still contracts. 2. Identify the performance obligations within the contract. A performance obligation is a promise within a contract to transfer a good or service to the customer. The focus in this step is to identify the promised goods and services and then determine which of those are distinct. This determination can involve significant management judgment to correctly reflect the economic substance of the transaction. For example, in a typical retail automobile sale, a customer s contract is likely to contain several promised goods or services. In addition to vehicle delivery, other distinct performance obligations could include a separate dealership warranty beyond the manufacturer coverage; after-sale services such as free oil changes, car washes, or other maintenance offerings; dealer accessories such as paint treatments or undercoating; title and license transfers; and other we owes that are either spelled out in the contract or given verbally. Note that the materiality of the performance obligation should be considered. If a performance obligation is identified but is determined to be immaterial to the customer, then it need not be separately considered in the next steps. For example, if a customer is promised a free oil change with the purchase of a new car, management may conclude the free oil change is not material to the customer and did not affect his or her decision to buy the car. As such, the performance obligation to complete that oil change would not need to be separated from the obligation to provide a new vehicle to the customer. 4 July 2018 Crowe LLP
3. Determine the transaction price. The transaction price is the amount of consideration that the organization expects to be entitled to in exchange for transferring the promised goods or services to the customer. This can be relatively straightforward to estimate for contract items with consideration fixed on a buyer s order. However, complexities may arise if the promised consideration includes variable amounts, including discounts or chargebacks. 4. Allocate the transaction price to the identified performance obligations. When a contract has only one performance obligation selling a vehicle, performing an oil change, or selling a part to a retail parts department customer, for example the entire transaction price is attributed to that performance obligation. If the contract has more than one performance obligation, the transaction price must be allocated among the individual performance obligations based on a relative stand-alone selling price. The prices of features such as extended warranties, added services, and accessories usually are relatively easy to estimate, based on how much the dealership would charge to sell these items separately. 5. Recognize revenue as each performance obligation is satisfied. The final step in the model is to recognize revenue. Recognition occurs when each performance obligation is satisfied by transferring the promised good or service to the customer. That transfer occurs when the customer obtains control of the good or service. Depending on the nature of the performance obligation, revenue may be recognized at a point in time (for example, delivery of a vehicle) or over time (for example, performance of body work). For example, when a car is sold, the bulk of the revenue may be recognized immediately. But under the new GAAP rules, the revenue associated with dealerprovided add-ons such as extended warranties, free maintenance contracts, service and repair work performed over multiple reporting periods, or other longterm items would need to be deferred until those items are actually delivered to the customer. The situation is further complicated when customers do not take full advantage of certain enticements such as free oil changes. crowe.com 5
Revenue Recognition for Dealerships: Preparing for the New GAAP Rules Major Contract Types and Revenue Lines As mentioned earlier, the new revenue recognition standard might have little effect on the timing and nature of how some dealership transactions are recorded. Nevertheless, financial executives should review all customer contracts (explicit and implicit) under the new standards to identify the proper method of revenue recognition. The main revenue lines of many dealerships and some key considerations are as follows: New, used, and wholesale vehicle sales. The first step in the revenue recognition process identifying the contract with the customer is fairly obvious in most vehicle sales, even though there could be times when wholesale transactions are not documented with a signed agreement for each individual car. Even in such sales, the implied contract typically is clear. On the other hand, the next steps of the process identifying the various performance obligations and allocating transaction prices in the contracts can be more complicated, particularly when extended warranties and the deferred delivery of services are involved. The underlying principle is that the revenue should be recognized when the customer gains control of the asset or service. Externally sourced lending, insurance, maintenance, and other services. A critical question to be determined for such transactions is whether the dealership is simply an agent selling the service or is actually a principal involved in providing the financing, insurance, or maintenance service to the customer. The new revenue standard changes the focus of this analysis to whether an entity controls the promised good or service before delivery to the customer. Given the change in focus to control versus risks and rewards, dealerships should reassess their previous principal versus agent conclusions. Internally performed lending, insurance, leasing, maintenance, and other services. If a dealer provides lending, leasing, or insurance services directly to customers rather than through a separate company, such transactions generally are considered outside the scope of Topic 606 and are governed by other FASB standards. Maintenance services, on the other hand, are not excluded from Topic 606. A dealership providing service under its own long-term maintenance contracts will need to identify the specific performance obligations, determine transaction prices based on what the dealership would normally charge for such maintenance, allocate the transaction price, and then recognize the appropriate prorated amount of revenue as each performance obligation is completed. 6 July 2018 Crowe LLP
Parts. When parts are sold over the counter or shipped directly to a customer, applying the revenue framework generally is a simple and straightforward process. Revenue is recognized when the buyer takes control of the part which in most cases means at the time of sale. Repairs, services, and body shop work. When a repair or service work is completed and the car is returned to the customer the same day, all revenue is recognized that day. But large power train or body shop projects or work that requires special-order parts can extend over a longer period. In some cases, this work could be considered to involve performance obligations that are satisfied over time rather than satisfied at a point in time. This distinction means that the dealership may need to record revenue over time using a measure of progress such as actual labor hours incurred to recognize its satisfaction of its overall performance obligation. If a dealership concludes under the new revenue standard that certain of its body work contracts should be recognized over time, the dealership should ensure it has an appropriate process at period end to record revenue based on its progress on such over time performance obligations. crowe.com 7
Revenue Recognition for Dealerships: Preparing for the New GAAP Rules Presentation and Disclosure Requirements The new standard also offers guidance about how assets and liabilities resulting from transactions with customers are to be presented on the balance sheet. The balance sheet must distinguish between traditional receivables and a new term, contract assets. The distinction revolves around whether a dealership s right to be paid is unconditional or conditional. A dealership has an unconditional right to receive consideration from a customer once it has completed its performance obligation and nothing else is required. Such a right is recorded on the balance sheet as a receivable, consistent with previous GAAP rules. On the other hand, a dealership has a conditional right to receive consideration when payment for one performance obligation cannot be received until other performance obligations (or other promises within a single performance obligation) are completed. For example, if a dealership has completed body shop work but has not yet finished with other repairs and therefore cannot yet bill the customer or insurer, the right to receive payment is shown as a contract asset. Making the distinction between a contract asset and a receivable is important because it provides users of financial statements with information about the relevant risks associated with a contract. For example, although receivables and contract assets are both subject to credit risk, a contract asset also is subject to other risks, such as performance risk. The new guidance also uses another term, contract liability, which refers to a dealership s obligation to provide goods or services to a customer for which it already has been paid (that is, deferred revenue under legacy GAAP). The new revenue recognition standard also spells out new annual disclosure requirements, which include qualitative and quantitative information about all of an entity s contracts with customers along with significant judgments and changes in judgments that it made in applying the new guidance. Companies also must disclose any assets that were recognized from the costs to obtain or fulfill a contract, but these costs generally do not apply to auto dealerships. Most dealerships already have granular data available from their manufacturer statements, so compiling the required information is less difficult than it would be in some other industries. 8 July 2018 Crowe LLP
Making the Transition In addition to the specific accounting and financial reporting requirements stemming from the GAAP revenue recognition guidance, dealerships also should consider other issues they might face in applying the new rules. For example, they should consider internal controls. As dealerships gather and apply performance and accounting information, they must consider and update controls around this process to make sure the information is complete and accurate. Any changes in operations and financial reporting also will be subject to audit and review procedures. Management should plan early to be able to provide the appropriate level of support and documentation to its external auditors. Dealerships also should consider how the revenue recognition changes will affect compensation and commission arrangements and how the new balance sheet presentation might affect other contracts such as debt covenants. In addition, income tax issues can arise with any change in revenue recognition methods, so dealers should be discussing these changes with their tax providers. For most dealerships, the first step in preparing for the new standard is to fully identify and list each of the dealership s revenue streams and then drill down into the various customer contracts and gather needed data. Financial executives should be sensitive to the many possibilities for errors and oversights in the implementation efforts, asking their implementation teams some probing questions such as: Do we fully understand all our contracts with customers? Did we miss any, and are we grouping contracts that are materially different? Did we identify the performance obligations correctly? Have we determined the transaction prices correctly? Are the assumptions used when applying the new standard reasonable? Did we consider ultimate collectability? Do we have complete and accurate data? Do we have the right processes and controls in place to be sure we are in compliance? crowe.com 9
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Although the industry is still in various stages of implementation, many dealerships are struggling with the new revenue standard, due either to a lack of time and resources or to the assumption that the new standard will not have a material effect on their financial statements. Even if that assumption proves to be true, the new disclosure requirements still are likely to require that dealers change internal processes to gather the newly required data appropriately. With the implementation dates upon us, dealership groups should be taking proactive steps to understand the potential effects of the coming changes and determine what they must do to implement the new guidance. crowe.com 11
Learn More James Bianchi +1 630 586 5283 james.bianchi@crowe.com Kelly Faehr Managing Director +1 317 706 2737 kelly.faehr@crowe.com crowe.com Crowe is the brand name under which the member firms of Crowe Global operate and provide professional services, and those firms together form the Crowe Global network of independent audit, tax, and consulting firms. Crowe may be used to refer to individual firms, to several such firms, or to all firms within the Crowe Global network. The Crowe Horwath Global Risk Consulting entities, Crowe Healthcare Risk Consulting LLC, and our affiliate in Grand Cayman are subsidiaries of Crowe LLP. Crowe LLP is an Indiana limited liability partnership and the U.S. member firm of Crowe Global. Services to clients are provided by the individual member firms of Crowe Global, but Crowe Global itself is a Swiss entity that does not provide services to clients. Each member firm is a separate legal entity responsible only for its own acts and omissions and not those of any other Crowe Global network firm or other party. Visit www.crowe.com/disclosure for more information about Crowe LLP, its subsidiaries, and Crowe Global. The information in this document is not and is not intended to be audit, tax, accounting, advisory, risk, performance, consulting, business, financial, investment, legal, or other professional advice. Some firm services may not be available to attest clients. The information is general in nature, based on existing authorities, and is subject to change. The information is not a substitute for professional advice or services, and you should consult a qualified professional adviser before taking any action based on the information. Crowe is not responsible for any loss incurred by any person who relies on the information discussed in this document. 2018 Crowe LLP. RD-19003-013A