Almost six years have passed since the Financial Accounting Standards Board (FASB) issued the standards update on “Revenue From Contracts With Customers,” replacing almost all revenue guidance under Generally Accepted Accounting Principles (GAAP). The new standard is effective for all companies, and for many auto dealers, although the changes have not had a material impact on most revenue lines. Instead, dealerships have been focusing on the modifications needed to remain compliant in recognizing revenue and on their financial statement disclosures.
In this two-part series, we will review how the new standards changed how dealerships recognize revenue with their customer contracts, as well as the new presentation and disclosure requirements.
Part 1: Recognizing Revenue with the Five-Step Model
Auto dealerships must adopt the principle of the standard, which is 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.
- Identify the contract. To be considered a contract, the agreement must meet specific criteria. The agreement must create enforceable rights and obligations between the dealership and the customer. The payment terms must be identifiable, and the dealer should be reasonably assured they will be able to collect on their payment terms. Standard contracts in a dealership include Buyer’s Orders, parts purchase orders, service invoices, or repair orders, as well as F&I products.
- Identify performance obligations. Next, you must apply judgment to identify distinct performance obligations and allocate values to each one. For example, a dealer that sells a vehicle and includes five years of free car washes has established two performance obligations. The first obligation is the sale of the vehicle (product). The second obligation is the series of car washes (service). What makes each obligation distinct is its ability to be perceived as separately delivered products or services by the customer. When the performance obligation is substantial, a portion of the transaction price should be allocated to this obligation, and the associated revenue would be recognized over the expected life of the service.Prior to ASC 606, dealerships would accrue an expense for their “free for life” programs. Under the new standard, the programs should be recorded as deferred revenue for the estimated transaction price based off future events. If someone purchases a vehicle that comes with a free car wash for x amount of times a year, the dealership should estimate how many car washes the vehicle will receive over its’ life and recognize deferred revenue at the point of sale. Similarly, to the “free for life” programs are additional consideration for significant rewards/points programs. If they are material, the dealerships should defer a portion of the revenue recognized for service work for the amount of the future free service.
- Determine the transaction price: It is crucial to accurately estimate variable pricing at this stage, including discounts, gift cards, and chargebacks.
- Allocate the transaction price to the identified performance obligations: It is relatively easy to tie transaction prices when you have only one performance obligation. When a contract has more than one performance obligation; however, it is critical to allocate the transaction price based on their separate selling price.
- Recognize revenue as each performance obligation is satisfied: The complicated part at this stage is recognizing revenue at the correct time. New GAAP rules state that obligations met over a span of time, such as maintenance contracts or repair orders, need to be recognized over the period in which the obligation to the customer is satisfied. Then complications that arise under the new rules are reconciling add-ons that are not redeemed by the customer.One area this has come into play for auto dealers is extended warranties. Previously, revenue on the sale of an extended warranty was not recognized until received. Now, all potential consideration to be received must be estimated as variable consideration and recognized at the point of sale.
If you need assistance or have questions about revenue recognition compliance, Selden Fox can help. Our team has considerable experience in this area and is here to assist. For additional information please call us at 630.954.1400 or click here to contact us.