Impact of the New Revenue Recognition Standard on Dealerships

In May 2014, the Financial Accounting Standards Board (FASB) issued a new revenue recognition accounting standard with Accounting Standards Update (ASU) 2014-09 (Topic 606), Revenue from Contracts with Customers, replacing nearly all existing revenue guidance under U.S. Generally Accepted Accounting Principles (GAAP). The new standard uses a five-step process to analyze revenue recognition. This memo will analyze the new standard at a high level and focus on the most common scenarios that impact dealerships. Outcomes may vary for dealers with more unique facts and circumstances.

Effective Dates

The standard is already effective for all companies with calendar year-ends. The effective date for public companies was for years beginning after Dec. 15, 2017. For private companies, the effective date was for years beginning after Dec. 15, 2018. All dealers with calendar year-ends should assess the impact of the standard in 2019.

Analysis of Impact on Dealerships:

Below are key portions of the 5-step process under the new revenue standard that have been assessed for each of a dealership’s typical key business areas:

SALES OF VEHICLES (NEW AND USED)

5-STEP PROCESS UNDER THE NEW STANDARD:

  1. Identify the contract with the customer.
    Contract is for the sale of a vehicle, and the transaction has an associated written contract (Buyer’s Order).
  2. Identify the performance obligations of the contract.
    The primary performance obligation is the delivery of the vehicle. Other obligations (customization, etc.) are typically fulfilled before the delivery of the vehicle. However, you should also determine whether there are other performance obligations beyond delivery of the vehicle, such as “for life” service components. One such example would be free “Tires for Life” on the vehicle, which typically involves free new tires at certain time or mileage intervals, if the customer owns the car and meets certain service requirements. If this is included, a portion of the transaction price would need to be allocated to this performance obligation, and the associated revenue would need to be recognized over the expected life of the free service.
  3. Determine the transaction price.
    The transaction price is determined by the fair value of consideration received (typically a combination of cash and trade-in vehicle received) and is clearly stated in the buyer’s order. Most of the transaction price is likely for the vehicle itself; however, other items can be listed (primarily for extended warranty and similar policies). See analysis of this component of the transaction price in the extended warranties section below. Also, see discussion of “for life” service components under Step 2 above and Step 5 below. Consideration of interest income would be required should the dealership finance the transaction.
  4. Allocate the transaction price to the performance obligations in the contract.
    The transaction price components are primarily split between the delivery of the vehicle and the sale of extended warranty, related products and other services, if applicable.
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.
    For the sale of the vehicle, the performance obligation is satisfied upon delivery of the unit and completion / signing of the contract. As noted in Step 2, if a dealer offers “for life” products for free as part of the sale of a vehicle, then the estimated value of that service should be allocated separately, and the dealer would need to defer that portion of the revenue on the sale.

COMPARISON TO CURRENT PRACTICE:

Dealerships reporting under GAAP are typically recognizing the revenue on the sale of new and used vehicles upon delivery of the unit and completion / signing of the associated contract, and they are recording the amount of revenue identified in the contract as the sales price of the vehicle. The new standard would typically not significantly change this current practice, unless the dealer offers a free “for life” program as noted above. Under GAAP prior to the adoption of Topic 606, dealers were required to accrue for estimated future costs under “for life” programs, however this was typically treated as an increase to expense when the accrual was booked, and not a decrease in revenue. This would represent a change to current practice.

SALES OF PARTS (STANDALONE PARTS ORDER)

5-STEP PROCESS UNDER THE NEW STANDARD:

  1. Identify the contract with the customer.
    Contract is for the sale of parts, and the transaction has an associated written contract (parts purchase order / invoice are typically in one document, or the parts line items are on a signed service order).
  2. Identify the performance obligations of the contract.
    The performance obligation is the delivery of the parts, either directly to the customer or the installation of parts as part of a service order.
  3. Determine the transaction price.
    The transaction price is stated on the parts invoice or service order.
  4. Allocate the transaction price to the performance obligations in the contract.
    The only performance obligation is the delivery or installation of the parts.
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.
    For the sale of the parts, the performance obligation is satisfied upon delivery or installation of the parts.

COMPARISON TO CURRENT PRACTICE:

Dealerships reporting under GAAP are typically recognizing the revenue on the sale of parts upon delivery of the parts, or installation of parts as part of a service order. For sales of parts directly to customers, the new standard typically would not significantly change this current practice. For parts installed as part of a service order, there are potential timing changes under the new standard. See additional guidance under the “Servicing of Vehicles” section below.

SERVICING OF VEHICLES (INCLUDING LABOR AND PARTS)

5-STEP PROCESS UNDER THE NEW STANDARD:

  1. Identify the contract with the customer.
    Contract is for the providing of repair of and / or maintenance to the vehicle, and the transaction has an associated written contract (invoice / repair order). This applies for both customer-pay repairs and warranty repairs.
  2. Identify the performance obligations of the contract.
    The performance obligation is the performance of the specified service(s) and / or parts. Some dealers may offer a rewards or points program that allows customers to earn points toward future service. The obligation of the future service earned would be considered a material right to future services, if the right is material compared to the overall contract. See “Comparison of Current Practice” section below for further discussion.
  3. Determine the transaction price.
    The transaction price is clearly stated on the final invoice. For service performed under warranty work, the transaction price is based on pre-determined standard reimbursement rates with the third-party warranty provider (manufacturer or other outside warranty company).
  4. Allocate the transaction price to the performance obligations in the contract.
    Although multiple repair services can be performed as part of one invoice / repair order, the services are typically completed within a relatively short timeframe and are all related to repair and/or maintenance of the vehicle. Dealers may consider the allocation of revenue between the labor and parts components of service orders. Concessions on service charges may be given in exchange for higher markup on parts, or vice versa. If this is done for a material amount of service orders, dealers should discuss with their CPA whether this allocation needs to be re-analyzed under ASC 606 for footnote disclosures. As noted in Step 2 above, if there is a material service “points” reward program offered, the material right to future services should be separately allocated as part of the transaction price.
  5. Recognize revenue when (or as) the entity satisfies a performance obligation.
    Historically, dealers have recognized service revenue upon completion of the service(s) and return of the vehicle to the customer. However, under the new standard, service work in process (WIP), which includes the related parts installed as part of the service order, falls under the category of revenue that should be recognized over time. The guidance in ASC 606 states that a company should recognize revenue over time if the entity’s performance “creates or enhances an asset” (e.g., work in process) that the customer controls as the asset is created or enhanced. Under the new guidance, as of the end of a reporting period, a dealership should recognize the sales and associated cost of any service order WIP as of the period-end date.

COMPARISON TO CURRENT PRACTICE:

There are two potential changes under the new standard:

  • The first relates to service order WIP. Under the new standard, this gross profit from WIP should be recognized in the income statement as of a period-end. (For most privately held dealers, this would be most relevant as of year-end for external reporting). However, dealers would need to assess whether any potential adjustment is material.
  • The second relates to service rewards or points programs. Dealerships should assess whether they have significant service rewards programs. Under the new standard, if there are significant service rewards programs in place, the right to future service work represents a material right to future service, and the dealership would be required to defer a portion of the revenue recognized for service work for the estimated amount of future free service work earned by the customer. Dealerships would need to assess whether any potential adjustment is material.
Leasing of Vehicles

Lease contracts are specifically excluded from the scope of the new revenue recognition standard. The FASB has issued a new standard on leases, which became effective as of Jan. 1, 2019, for public entities and will become effective (pending final adoption of a one-year delay) as of Jan. 1, 2021, for nonpublic entities. However, this new leasing standard does not significantly change lessor accounting from current practice.

Sales of Extended Warranties
UPDATED GUIDANCE UNDER THE NEW REVENUE RECOGNITION STANDARD:

The first key consideration for sales of extended warranty products under the new revenue recognition standard is the principal versus agent consideration. In general terms, a principal serves as the primary obligor for a performance obligation, while an agent arranges for another party to provide for goods or services.

The second key consideration for sales of extended warranty products under the new standard is the treatment of “retro” payments. These represent future payments that a dealership will receive from a third-party warranty company based on the performance of the portfolio of contracts sold by the dealership, and also represents a future bonus on current sales. Under previous guidance, dealerships typically would not recognize this income until received. Under the new guidance, because the dealership satisfies its performance obligation of selling the policy as of the date it is sold, all potential consideration to be received for that sale must be estimated as variable consideration and recognized. Dealerships participating in these types of programs will be required to estimate the likely amount that they will receive in the future related to retro payments for policies already sold and record a receivable, with a corresponding increase to revenue. This will be a highly judgmental estimate, and dealerships should consult with their CPA.

COMPARISON TO CURRENT PRACTICE:

Dealerships that sell products on behalf of outside warranty companies typically recognize the revenue, with a corresponding receivable, on the sale of extended warranty products upon delivery of the warranty contract to the customer, as the dealership serves as an agent, not the principal or primary obligor. This practice will not change under the new standard.

Dealership groups that have an extended warranty company included within their financial statements are already required under GAAP to defer and recognize the contract revenue over the life of the associated contracts. This would remain the same under the new standard. As noted above, dealerships that receive “retro” payments may have an acceleration of revenue under the new standard.

Transition Considerations

Most privately held dealerships adopting the new standard will do so effective Jan. 1, 2019, using the modified retrospective method. This means that any net impact as of Jan. 1, 2019, will be recorded directly to retained earnings. For example, if a dealership determines that it has a cumulative timing change under the new standard as of Jan. 1, 2019, and it needs to recognize a contract asset and revenue of $100,000 as of that date to comply with the new standard, the dealer would need to recognize a contract asset of $100,000 and increase retained earnings by $100,000. Dealerships should consider whether any transition adjustment is material, and if so, consult with their CPA.

Disclosure Considerations

Below are the general disclosure objectives of Topic 606 as applied to dealerships (our comments related to dealerships are in blue). Dealerships will need to refer to the specific guidance within Topic 606 in order to achieve these objectives. While these represent the general categories of disclosure objectives, Topic 606 provides detailed requirements.

ASC 606-10-50-1 The objective of the disclosure requirements in this Topic is for an entity to disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. To achieve that objective, an entity shall disclose qualitative and quantitative information about the following:

  1. Its contracts with customers: Dealerships typically disclose the nature of its contracts with customers. However, the new standard does require disclosure of the disaggregation of revenue among the significant types of revenue. Therefore, those that are not currently doing so will need to disclose its breakout of revenue by major type, beginning upon adoption of the standard.
  2. The significant judgments, and changes in those judgments, made in applying the guidance in this Topic to those contracts: Dealerships’ disclosures may already cover this requirement, but dealerships should assess whether any new judgments were made as part of adopting the new standard and should disclose these judgment items in the financial statement footnotes.
  3. Any assets recognized from the costs to obtain or fulfill a contract with a customer: Not anticipated to be applicable for dealerships.

Dealerships should work to determine the needs for required disclosures in advance of their 2019 year-end reporting deadlines to make sure they have the appropriate data and information available.

Summary of Key Points

For many dealers, the new standard may not have a significant impact. However, dealers with the following three factors are more likely to have a significant impact upon adoption:

  1. A significant service rewards or points program, with a large amount of future service obligations.
  2. An extended warranty arrangement with retro payments later in the life of warranty contracts.
  3. A material amount of service WIP in inventory as of yearend.

DHG is ready to help as you navigate the revenue recognition standard. Visit dhg.com/services/assurance/revenue-recognition for more information.