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:: New Vehicle Dealership Audit Technique Guide 2004 - Chapter 3 - Balance Sheet (12-2004)   Chapter 3 - Table of Contents Introduction Balance Sheet Items Cash   Accounts Receivable   Inventory   Loans to/from Shareholders   Fixed Assets - Real Estate-Building & Equipment   Accounts Payable, Other Current Liabilities and Other Liabilities   Capital Stock/Capital Account   Retained Earnings Conclusion Generally, Balance Sheets are necessary where a corporation or partnership is the business organization of choice. Most new vehicle auto dealerships are corporations or partnerships. Balance sheet examinations can save time and ensure a thorough examination. Entries made to many, if not most, balance sheet accounts have corresponding entries to the income statement. Audit planning which considers this duplication of entries will save time and effort. Remember that partnership return balance sheets entries shown on Form 1065 are sometimes, but not always reported at Fair Market Value. Balance sheet accounts are "real" accounts. These accounts represent things the dealership owns or owes. Their balances are carried forward from year to year. This differs from income statement accounts, which are closed out at yearend and only reflect business operations within a specified cycle. These operating accounts are closed to retained earnings and result in net income or loss to the business. Material fluctuations or changes to these real accounts may signify activities requiring examination. These fluctuations and changes signify a change to things the dealership owns or owes. These differences require effort on the part of the dealer when assets or liabilities are accumulated or dispersed. If these changes are not correctly accounted for in the books and records, assets or liabilities may be accumulated or disbursed without ever being reflected in income. As a general statement, income is taxable, unless a proper Schedule M-1 adjustment is made. The propriety of Schedule M-1 adjustments is addressed later. A 3-year comparative analysis at the beginning of an auto dealership examination allows us to identify such changes and fluctuations that may require examination in the audit planning stages. Tax classification of balance sheet accounts, performed when the books are reconciled to the return, is paramount to a successful balance sheet audit. This classification gives us the ability to spot curious relationships that may occur with these accounts. As an example, loans to shareholders are often grouped in the other current liability account. If the balance sheet does not specifically list this loan, its existence may never be discovered. This audit tool assists in the determination of the examination scope. Frequently, adjustments to balance sheet accounts result in an increase to taxable income. Remember that all income statement accounts are run through the balance sheet, but not all balance sheet accounts are run through the income statement. An example of entries in balance sheet accounts not affecting the income statement could be a loan to the shareholder eliminated through retained earnings. An example of an entry involving a corporation is: Debit Retained Earnings         Credit Loan to Shareholder Retained Earnings is an Equity account and Loans to Shareholder is an Asset account. If the Loan to Shareholder account is being increased as a result of a loan being made to shareholder, the account should be debited rather than credited to reflect an increase in the account's balance. The cash account should be credited to reflect the decrease or payment of cash in that situation. If an examiner observes the above entry, further inquiry is necessary.  The manufacturer's statement should be secured in order to establish confidence in the taxpayer's balance sheet accounts. Schedules M-1 and M-2 have definite balance sheet implications and should be reconciled and looked to for help in identifying what the taxpayer is doing. Differences between book and tax treatment of items should be questioned and taxpayers should be asked to submit their authority for any differences that do not appear to be compatible with generally accepted accounting or tax principles. This is also where deviations from reliable manufacturer statements may occur.  1.  Cash One of the objectives in analyzing the cash account is to determine if cash equivalents and balances are properly classified on the balance sheet. Dealerships may put an asset into the cash portion of the balance sheet in order to make financial statements look more attractive. Contracts in Transit are one example of this. Although much like a receivable, some auto dealerships may treat these as a cash item. A Contract in Transit is the amount of the automobile's sale price, which is going to come from the financing company that has not yet arrived. The dealer justifies a cash treatment of these contracts as they typically deal with one or two institutions on an ongoing basis, collection is close to certain, and turn around is fast (about a week). The financing institution "makes the loan," the proceeds are forwarded to the dealer who then acts on the note executed by the buyer. The entries that should be made are: DR Contracts in Transit (a receivable)                 CR Sales (When the sale is made) DR Cash in Bank                 CR Contracts in Transit (When cash is received) Sources of cash verification and substantiation items include: Bank Statements General Ledger and subsidiary journals Statement of Cash Flows Financial statement footnotes Loan applications and credit line and flooring limits Non-trade in used car acquisitions Non-inventoried durable goods purchases Other entities Issues Is all income reported? Has Form 8300 been filed as required? Audit Techniques - Cash These techniques can be utilized to determine potential areas of non-compliance affecting the tax return by: Tracing the outstanding checks at yearend to determine payment of a liability in the next period. Accounting for and questioning all material related to company transfers. Reviewing Adjusting Journal Entries, standard entries, and Journal Vouchers affecting the cash accounts. Form 8300 - Documents to Request Form 8300 for currency transactions over $10,000 should be requested. The review of these forms should be conducted in conjunction with the audit of the cash accounts. Ask taxpayer to provide an analysis of cash receipts and copies of the Forms 8300¡¦s that were filed. Request to review cash receipts vouchers (generally maintained by the dealers in bundles in numerical sequence) and make a determination as to whether or not there are any delinquent Form 8300¡¦s outstanding. 2.  Accounts Receivable Receivables for an Auto dealer are typically divided into: New Vehicle Sales Used Vehicle Sales Warranty Repairs Other Repairs Extended Service Contracts (ESC) Holdbacks Finance Receivables Other Driver education receivables (paid by Mfg.) Manufacturer rebates (paid by Mfg.) Other claims *    Non-Trade Receivables a.    Sales Only portions of these receivables actually deal with vehicle sales. Extended Service Contracts (ESC's) are usually receivables from auto buyers, but since most dealers sell to individuals, and most individuals either pay cash or obtain their own financing, sales receivables only occur when the dealership chooses to finance an arrangement.        Potential Issues Unreported sales and proper year of inclusion. In addition, a related party, or series of related party transactions could be occurring which may raise an arm's length transaction question under IRC section 482.        Audit Techniques Test sales recorded in opening days of subsequent year to determine whether said sales are includible in year under examination. Confirm tested sales against Car Jackets, Sales Journal and the Car Stock Book, etc. b.    Dealership financing If the dealer is financing the customer, there must be a note, which should be booked at face value. As payments are earned by the dealership, the note is reduced by the amount of the principal payment and interest income is recorded.        Audit Techniques The terms of the note must be reasonable. In this category of the balance sheet, the note should call for payback to occur within a 1 to 5 year window. If the principal balance remains unchanged for a long period of time or if the stated or (unstated) interest rate is not at least equal to the Applicable Federal Rate (AFR). IRC §483, look to see if it is an arm-length transaction. c.    Note Transfers Scrutinize any trend of dispositions of notes, either gains or losses, as related or unreported transactions could be occurring.  The note carried by the dealership is sold to a financial institution, the terms of sale become important. The note is sold either "without recourse" or "with recourse." A note is sold "without recourse" when the dealership is in financial duress or when the prospects of collecting are poor. If the customer defaults the bank CAN NOT look to the dealer for payment. Notes sold "without recourse" can be discounted to a significant degree. A note sold "with recourse" means that if the customer defaults, the bank CAN force the dealership to pay. Receivables transferred "without recourse" should be recorded as a sale because (1) ownership risks and benefits are transferred and (2) the net cash flow effect of the transfer is known at the date of the transfer. When receivables are transferred "with recourse," the transferor agrees to make good any receivables that are not collectible. Even though ownership risks and benefits are not shifted completely, the transfer should be recorded as a sale if the net cash flow effect of the transfer can be reasonably estimated; otherwise the transfer of receivables is a borrowing and a liability should be recorded. FASB Statement of Financial Accounting Standards No. 125 (superceding FASB No. 77) sets forth conditions, all of which must be met, in order for the transferor to record a sale. These include: The transferred assets have been isolated from the transfer or put beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Either (1) each transferee obtains the right--free of conditions that restrict it from taking advantage of that right--to pledge or exchange the transferred assets or (2) the transferee is a qualifying special-purpose entity and the holders of beneficial interests in that entity have the right--free of conditions that constrain them from taking advantage of that right--to pledge or exchange those interests. The transferor does not maintain effective control over the transferred assets through (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) an agreement that entitles the transferor to repurchase or redeem transferred assets that are not readily obtainable. For additional information, refer to the Chapter 16, Related Financing Companies.  d.    Financing A Finance Receivable occurs when the dealership negotiates a customer's loan for them. The amount of finance income is dependent on two factors: the interest rate on the contract and the market rate. The dealership may earn a commission on the market rate and the entire difference between the market rate and the rate on the contract. This should be booked to Finance Sales when the customer signs the note. When a dealership has a significant amount of "recourse" notes, the main financing institution will often establish a reserve, which corresponds to a chargeback account on the dealership's books (contra-asset receivable). Audit Techniques - Finance Receivable It is recommended that these credits be reviewed to determine the correctness of any connected write-offs through a Bad Debts account.   (In order to take a bad debts expense, the direct write off method must be used). See the Finance Reserves section in Chapter 14. e.    Leased Car Receivables FASB Statement of Financial Accounting Standards No. 13 provides classification criteria to account for a lease as either a capital lease (sale) or as an operating lease (rental). Most dealerships involved with leasing have operating leases. Vehicles placed in the leasing business within the dealership operation should be transferred at inventory value, excluding holdback, and not recorded as vehicle sales. The vehicle remains on the books of the dealership as property leased to a lessee and is depreciated over its useful life. The dealership records the lease payments as lease income. Units  retired from leasing service should be transferred to the used vehicle inventory for disposal. It is at this time that a valuation issue may exist, whether the vehicle should be transferred at its net book value or at wholesale value, less estimated reconditioning charges. Remember, for tax purposes, the adjusted basis and resulting gain or loss, and treatment of reconditioning expenses differs from how it is recorded on the books. If under the terms of the lease, the ownership risk and benefits are transferred to the lessee, the lessee has purchased the vehicle and the dealer is merely financing the purchase for the lessee. Also, vehicles sold to a separate leasing entity, independent or owned, should be recorded as sales. f.    Dealer Reserves Dealers sell the majority of new vehicles under some form of note that includes the unpaid balance of the vehicle, plus finance charges. These contracts are sold or endorsed to a finance company. This transaction normally creates the "dealer's reserve." See Financing above. If the note is transferred in a non-recourse transaction (the note is not always non-recourse), the finance company owns any cars, which are repossessed. The dealer receives the purchase price of the automobile and a finance commission. Obligations of purchasers for deferred payments on installment sales are discounted or sold by dealers to finance companies. These finance companies pay the dealers most of the amounts in cash, but credit to each dealer, in a "reserve account," a small percentage thereof, which is retained by the finance company to secure performance of the dealer's obligations under his guarantees or endorsements. The amounts thus credited to the dealers in "reserve accounts" on the books of the finance companies must be reported as income accrued during the tax years in which they are credited to such reserve accounts. Law: In Commissioner vs. Hansen, 360 U.S. 446 (1959), the Supreme Court held that amounts credited to an automobile dealership in a reserve account on the books of the finance company must be reported as income during the tax year in which the amounts are credited to the reserve accounts. Dealers must include in income all amounts placed in the reserve account and all deposits into the account regardless of use. Resale Mobile Homes, Inc., 965 F.2d 818 (10th Circuit, 1992)  g.    Related Party Receivables Non-trade receivables should be examined for possible related party issues.  Accounts receivable that are due from related individuals should be closely scrutinized. Issue: Constructive dividend to shareholder Documents to Request: Secure analysis of items comprising other receivables and segregate between related and non-related trade receivables. Audit Techniques: Review and analyze non-trade receivables Review all substantial credit balances and trace to source. Analyze the composition of the account balance. Trace the source of repayments Determine whether or not a loan was made and if a bona fide debtor-creditor relationship exists. If there is a loan, secure copies of notes or evidence of indebtedness. Determine that the terms of note are being followed such as interest is being accrued as income. 3. Inventory Inventory includes items that are used to produce income and are not period expenses, such as: New vehicles Used vehicles Remanufactured core Parts and Accessories IRC section 263A LIFO reserve Demonstrators Body shop materials Sublet repairs Labor-in-process Taken on an individual basis, these sectors of the inventory account can be analyzed by looking at the LIFO calculations, the accountant's work papers on the 263A allocation, and the used vehicle valuation sheets. See LIFO, 263A chapters. a.    New Vehicles Many dealerships use LIFO to value new car and truck inventories. LIFO is discussed in a separate chapter due to its complexity. b.    Used Vehicles Effective for tax years after December 31, 2000 an Alternative LIFO method for Used Cars is available as prescribed by Revenue Procedure 2001-23. . Taxpayers must follow the automatic consent procedures of Revenue Procedure 2002-9, (Revenue Procedure 99-49 superceded) to use this method. Upon election, all previous write-down or parts inventory (if LIFO is elected for Parts Inventory) must be recaptured. Refer to the Used Car LIFO chapter. Dealers are to value the automobiles based on the lower of: Cost: What the dealer actually pays for a vehicle (cash outlay) in an arm's length transaction or its actual cash value. Or  Market: Treas. Reg. section 1.471-4(a) provides that for normal goods, market is the aggregate of the current bid prices prevailing at the date of inventory. Thor Power Tools, 439 U.S.  522 (1979) defines current bid price as replacement cost based on the normal quantity and quality of the inventory item in the market in which the taxpayer normally purchases its goods.  Subsequent selling price does not necessarily equate to replacement cost. Reconditioning expenses are inventoriable and added to the cost of the applicable vehicle. Rev. Rul. 67-107 recognized industry practice of carrying into inventory the cost figure until the end of the year. The inventory value is then adjusted to conform to the average wholesale price at that time. The ruling then refers to Section 471 of the Code as well as the above regulations so inventory valuation methodology is one that clearly reflects income. Accordingly, it allows only used vehicles taken in trade to be valued using an official used car guide. It does not require the use of a specific publisher, but the regulations do require consistent treatment. To any used vehicle valuation guide, additions and/or subtractions may be necessary according to options and mileage, and according to the condition of each vehicle. Certain vehicles, such as antiques or classics, may have a value that cannot be ascertained from the usual official guides. c.    Remanufactured Cores If your dealer is engaged in servicing vehicles for repairs and/or warranty work and even reconditioning, he or she may purchase remanufactured parts (for example, carburetor, alternator). Generally, the price of the remanufactured part includes a charge for the "core." This is an amount that will be refunded to the dealer once the old part is returned. If the dealer has any cores on hand at yearend, they should be inventoried. For example, a part may cost $100 divided into two costs: $70 for the cost of rebuilding the part and a $30 core charge. The $70 may be an inventoriable cost if part of reconditioning a vehicle or a current expense for repairs or warranty work. The $30 is inventoriable separately with other parts until the core is returned for credit.  Although it is improper, the dealer may expense the entire $100 when the part is purchased and include the $30 core charge as income only when the core is returned. Remanufactured Cores and Revenue Procedure 2003-20 Beginning with taxable years ending on or after December 31, 2002, Revenue Procedure 2003-20 allows a safe harbor method of accounting (the "Core Alternative Valuation" (CAV) for remanufacturers and rebuilders of motor vehicle parts ("remanufacturers"¨) and resellers of remanufactured and rebuilt motor vehicle parts ("resellers") that use the lower of cost or market (LCM) inventory valuation method to value their inventory of cores held for remanufacturing or sale. This revenue procedure also provides a procedure for qualifying remanufacturers and resellers currently using the LCM method to obtain automatic consent of the Commissioner to change to the CAV method.  Moreover, this revenue procedure provides a procedure for qualifying remanufactures and resellers not currently using an LCM method to obtain automatic consent to change to an LCM method in conjunction with a change to the CAV method. Section 2 Background: .01 In General. (1) Remanufacturers acquire inventories of used motor vehicle parts (e.g., wiper motors, engines, transmissions, and alternators for automobiles, trucks, buses, etc.) for use in remanufacturing. These used parts are frequently referred to within the remanufacturing industry as "cores" Remanufacturers rebuild motor vehicle parts from cores through use of new and used component parts and sell the resulting products as remanufactured replacement parts. Resellers acquire cores in conjunction with their resale activity and sell the cores to a remanufacturer or another reseller in the distribution chain. (2) Remanufacturers and resellers acquire cores from customers ("customer cores") who purchase remanufactured replacement parts. To encourage a customer to return the core, remanufacturers and resellers generally offer the customer a credit (offset against the purchase price). Remanufacturers and resellers also acquire cores from third-party suppliers of cores (businesses that specialize in supplying cores to meet specific needs, referred to within the industry as "core suppliers" or "core brokers") and occasionally acquire cores directly from other sources. (3) Controversy exists as to the proper market valuation of cores under the LCM method. See Consolidated Manufacturing, Inc. v. Commissioner, 249 F.3d 1231 (10th Cir. 2001), rev'g in part, 111 T.C. 1 (1998). In order to reduce controversy and minimize disputes, the Service has determined that it is appropriate to provide a safe harbor procedure for the LCM valuation of cores in inventory. .02 Law: §471: treatment of inventories: it must conform as nearly as may be to the best accounting practice in the trade or business; and it must clearly reflect income. Regs. §1.471-2(c) provides that the bases of valuation most commonly used by business concerns and which meet the requirements of §471 are (1) cost and (2) cost or market, whichever is lower. Section 1.471-2(c) also provides that any goods in an inventory that are unsalable at normal prices or unusable in the normal way because of damage, imperfections, but in no case shall such value be less than the scrap value. .03 Section 1.471-3(b) defines the cost of merchandise purchased since the beginning of the taxable year as the invoice price less trade or other discounts, §1.471-3(c) defines cost as (1) the cost of raw materials and supplies entering into or consumed in connection with the product, (2) expenditures for direct labor, and (3) indirect production costs incident to, and necessary for, the production of the particular article, including in such indirect production costs an appropriate portion of management expenses, but not including any cost of selling or return on capital, whether by way of interest or profit. 04 Section 1.471-4(a) provides "market" means the aggregate of the current bid prices prevailing at the date of the inventory of the basic elements of cost reflected in inventories of goods purchased and on hand, goods in process of manufacturer, and finished manufactured goods on hand. 05 Section 1.471-4(c) provides inventory valuation for market value of each article when using cost or market. 06 Section 1.471-2(f) provides deducting from inventory a reserve for price changes is not in accord with regulations underlying §471. 07 Section 472(b) and §1.472-2 require taxpayers using the last-in, first-out (LIFO) method to inventory their goods at cost. 08 Section 446(e) and §1.446-1(e)(2)(i) require that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for income tax purposes. Section 3. Scope .01 Applicability: This revenue procedure applies to remanufacturers and resellers that want to change to the CAV method described in section 4 of this revenue procedure to value inventories of cores. For purposes of this "cores" include electrical, mechanical, hydraulic, and other operating motor vehicle parts, including parts of automobiles, trucks, buses, motorcycles, boats, construction equipment, farm machinery, and other on- and off-road motorized equipment. The CAV method applies only to cores held in inventory for remanufacturing or, in the case of a reseller, held for sale to a remanufacturer or another entity in the distribution chain. The CAV method only applies to cores valued under the LCM method. 02 Inapplicability. This revenue procedure does not apply to a taxpayer that values its inventory of cores at cost (including a taxpayer using the LIFO method) unless the taxpayer concurrently changes (under section 6.02 of this revenue procedure) from cost to the LCM method for its cores (including labor and overhead related to the cores in raw materials, work-in-process and finished goods). A taxpayer that wants to concurrently change from cost to the LCM method must: (a) not be otherwise prohibited from using the LCM  method; (b) comply with the general rules relating to inventories under § 471 and the regulations thereunder; and (c) in the case of taxpayers using the LIFO method, use the LCM method and a permitted method for identification as determined and defined in section 10.01(1)(b) of the APPENDIX of Rev. Proc. 2002-9, 2002-3 I.R.B. 327, 368-69. SECTION 4. THE CORE ALTERNATIVE VALUATION METHOD .01 In General. (1) A taxpayer using the CAV method values its inventory of cores at LCM, determines cost in accordance with section 4.02 of this revenue procedure, and determines market in accordance with section 4.03 of this revenue procedure. (2) The CAV method will be a permissible method of accounting provided the taxpayer follows the rules and computational methodology described in sections 4.02 through 4.05 of this revenue procedure and, if the taxpayer is changing from another method to the CAV method, the provisions of section 6 of this revenue procedure regarding changes in method of accounting. All computations under the CAV method, however, are subject to verification upon examination of the taxpayer's income tax returns. .02 Determination of Cost. (1) In general. Under the CAV method, the taxpayer is required to use as the cost of each core in ending inventory the invoice price adjusted, as appropriate, for discounts, freight costs, and other direct and indirect costs properly allocable to the cores as described in §§ 1.471-3 and 1.263A-1. If the core was acquired from a core supplier or broker, the invoice price is the amount paid to the core supplier or broker. If the core was acquired from a customer, the invoice price is the sum of any credit allowed to the customer and any amount paid to the customer. (2) Service may redetermine appropriate cost. As a general rule, the taxpayer must follow the form that the taxpayer used for the transaction. See, for example, In re Steen, 509 F.2d 1398, 1402 n. 4 (9th Cir. 1975) and Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967). If the Service determines, however, that the taxpayer's use of the credit amount as the invoice price does not clearly reflect income (for example, because the taxpayer artificially inflated both the price of the remanufactured core and the credit amount solely to manipulate gross receipts for tax avoidance), the Service may examine the substance of the transaction to determine the appropriate cost for a core. See, for example, Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935). .03 Determination of Market Value. (1) In general. Under the CAV method, the market value under § 1.471-4 of each core in ending inventory is the "allowable supplier price" adjusted, as appropriate, for other direct and indirect costs properly allocable to the core as described in §§ 1.471-4 and 1.263A-1. The allowable supplier price will be considered to be the replacement cost for purposes of §§ 1.471-4 and 1.263A-1. (2) Allowable supplier price. For purposes of this revenue procedure the "allowable supplier price"¨ is the amount the taxpayer would pay in an arm's length transaction to acquire a particular core from a core supplier or core broker, plus the related transportation cost that would be incurred to acquire possession of the core from the core broker or supplier at year-end. If the taxpayer has purchased a particular type of core from several core suppliers or core brokers during the tax year, the allowable supplier price for that core type will be deemed to be the weighted-average price, including transportation cost, the taxpayer would have to pay in an arm's length transaction to acquire the particular core type at year-end from the core suppliers or core brokers from whom the cores were purchased during the tax year. If the taxpayer has not purchased a particular core type from a core supplier or core broker during the tax year, the taxpayer must identify its largest (in dollar terms) supplier of cores during the current tax year that also sells the particular core type in the ordinary course of its business; the allowable supplier price will be the arm's length price from that supplier for the core type at year-end plus the transportation cost that would be incurred to acquire the core type from that supplier. If none of the taxpayer's suppliers sell the particular core type, the taxpayer must reasonably determine the allowable supplier price based on the arm' s length price for the core type at year-end, plus the transportation cost, in the geographical area or market in which the taxpayer regularly participates. In any case, no further adjustments will be allowed in determination of allowable supplier price. (3) Example of allowable supplier price calculation using weighted-average price. Taxpayer, a remanufacturer, had 4 units of Part X customer cores in inventory at year-end. Taxpayer acquired these customer cores from customers in transactions in which taxpayer sold to the customers remanufactured parts and received cores from the customers in exchange for credits toward the purchase price of the remanufactured parts. During the tax year, Taxpayer purchased 8 units of Part X cores from suppliers (2 units of Part X from Core Supplier A and 6 units of Part X from Core Supplier B). Therefore, Taxpayer purchased 25% (2 of 8 units) of the total number of Part X acquired for the year from Core Supplier A and 75% (6 of 8 units) of the total number of Part X acquired for the year from Core Supplier B. At the end of the taxable year, the price Taxpayer would have to pay in an arm's length transaction to acquire Part X, including transportation cost, was $20 from Core Supplier A and $16 from Core Supplier B. Taxpayer would determine the allowable supplier price for Part X customer cores under the CAV method as follows:         # of Units Purchased During Year % of Total Units Purchased During Year End of Year  Price Core Supplier A 2 25% $20 Core Supplier B 6 75% $16 Total 8                 CAV Core Supplier Price for Part X Customer Cores = (25% x $20) + (75% x 16) =$17. .04 Comparison of Cost and Market. Under the CAV method, the market value of each core in ending inventory, as determined under section 4.03 of this revenue procedure, shall be compared with the cost of each core in ending inventory, as determined under section 4.02 of this revenue procedure, and the lower of such values shall be the inventory value of the core. This analysis must be performed on a part-by-part basis.  .05 Write-down of Defective Cores. Under the CAV method, a taxpayer may not reduce the value of a defective core under § 1.471-2(c) until the taxpayer discovers that the core is subnormal and scraps the core or offers the core for sale at a bona fide selling price that is less than cost. In no case may a taxpayer value a core at less than the scrap value. A taxpayer may not reduce the value of cores based on anticipated defect percentages or historical defect experience rates. If a taxpayer complies with the requirements of this revenue procedure, the Service will not disallow a write-down of a defective core in the year it is scrapped on the grounds that the decline in the value of the core actually occurred in a preceding taxable year.  SECTION 5. AUDIT PROTECTION FOR TAXPAYERS CURRENTLY USING THE SAFE HARBOR METHOD If a taxpayer within the scope of this revenue procedure was consistently using the CAV method provided in section 4 of this revenue procedure before February 10, 2003, the taxpayer's use of the CAV method will not be raised by the Service as an issue in a taxable year that ends before February 10, 2003. Moreover, if such taxpayer's use of the CAV method has already been raised as an issue in examination, appeals, or before the Tax Court in a taxable year that ends before February 10, 2003, the issue will not be further pursued by the Service. SECTION 6. CHANGES IN METHOD OF ACCOUNTING .01 In General. A change in the treatment of customer cores in inventory to the CAV method provided by this revenue procedure is a change in method of accounting to which the provisions of §§ 446 and 481 and the regulations thereunder apply. Therefore, a taxpayer within the scope of this revenue procedure that wishes to change to the CAV method for a taxable year ending on or after December 31, 2002, must file a Form 3115, Application for Change in Accounting Method. .02 Automatic Change for Taxpayers Within the Scope of this Revenue Procedure.  (1) Automatic change to the CAV method. A taxpayer within the scope of this revenue procedure that wants to change to the CAV method must follow the automatic change in accounting method provisions of Rev. Proc. 2002-9, as modified by Rev. Proc. 2002-19, 2002-13 I.R.B. 696, Announcement 2002-17, 2002-8 I.R.B. 561, and Rev. Proc. 2002-54, 2002-35 I.R.B. 432, with the following modifications:  (a) The scope limitations in section 4.02 of Rev. Proc. 2002-9 do not apply to a taxpayer that wants to change to the CAV method for its first taxable year ending on or after December 31, 2002, provided the taxpayer's method of accounting for cores is not an issue under consideration in examination (within the meaning of section 3.09 of Rev. Proc. 2002-9) at the time the Form 3115 is filed with the national office; (b) In lieu of the label required by section 6.02(4) of Rev. Proc. 2002-9, taxpayers are instructed to write "Filed under Rev. Proc. 2003-20"¨ at the top of the form; and (c) Taxpayers making concurrent changes under subsections (2) or (3) of this section should include the concurrent change with the change to the CAV method in a single application. (2) Change from cost to LCM. An automatic change in method of accounting to the CAV method under this revenue procedure also includes, where applicable, a concurrent change from the cost method to the LCM method. (3) Change from LIFO. An automatic change in method of accounting to the CAV method under this revenue procedure also includes a concurrent change from the LIFO method to a permitted method for identification as determined and defined in section 10.01(1)(b) of the APPENDIX of Rev. Proc. 2002-9. A taxpayer that desires to discontinue LIFO to use the CAV method must make a concurrent change from its cost method to the LCM method. SECTION 7. RECORD KEEPING Section 6001 provides that every person liable for any tax imposed by the Code, or for the collection thereof, must keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary may from time to time prescribe. The books or records required by § 6001 must be kept at all times available for inspection by authorized internal revenue officers or employees, and must be retained so long as the contents thereof may become material in the administration of any internal revenue law. § 1.6001-1(e). In order to satisfy the record keeping requirements of § 6001 and the regulations thereunder, a taxpayer that uses the CAV method should maintain records supporting all aspects of its inventory valuation including but not limited to cost of supplier cores. SECTION 8. EFFECT ON OTHER DOCUMENTS Rev. Proc. 2002-9 is modified and amplified to include this automatic change in section 9 of the APPENDIX. d.    Parts Inventory Revenue Procedure 2002-17 describes a safe harbor method of accounting for vehicle parts inventory that allows automobile dealers to approximate the cost of their parts inventory using the replacement cost of the parts. The revenue procedure also includes procedures for dealers to receive automatic consent to change to the replacement cost method. Discussion Automobile dealerships normally carry a significant inventory of parts for use in the dealership service department and for retail sales. Dealers are generally required by their franchiser manufacturer/distributor) to value their parts inventory at replacement cost rather than at the historical purchase cost of each part. To assist dealers in valuing parts at replacement cost, the manufacturer or other parts supplier provides the dealer with periodic price updates. Once the dealership processes the price updates, the historical purchase price of the parts is not maintained by the computer system. The method described in Revenue Procedure 2002-17 applies to a specific group of taxpayers. To qualify, a taxpayer must be engaged in the trade or business of selling vehicle parts at retail and must be authorized by one or more manufacturers or distributors to sell new automobiles or light, medium or heavy trucks. The replacement cost method may be used in conjunction with either the First-in, First-out (FIFO) inventory method or the Last-in, First-out (LIFO) method. The method authorizes a qualifying taxpayer to "determine the cost of vehicle parts in inventory by reference to the replacement cost of the part[s]" Replacement cost is defined as the amount provided in a "standard price list" on the date of the dealer's inventory. The price list must be one that is widely recognized, used for business purposes in the industry, and used by the dealer to purchase vehicle parts. In addition, a dealership that elects the Replacement Cost Method must satisfy the conformity requirement and use the method for financial reports and tax. Changing to the Method Qualifying dealers that are using the replacement cost method described in Revenue Procedure 2002-17 on March 12, 2002 may continue to use the safe harbor method without filing a Form 3115, Application for Change in Method of Accounting. The revenue procedure also provides audit protection for years ending before December 31, 2001. If the dealer is under examination and the issue is currently under consideration, the revenue procedure mandates that the issue will not be pursued. Dealers that are not using the replacement cost method on March 12, 2002 must follow the automatic change provisions of Revenue Procedure 2002-9 with certain modifications. Modifications include making the change on a cut-off basis, i.e. without a §481(a) adjustment. Dealers that comply with the election requirements will receive audit protection, with respect to the method of determining the cost of parts, for any tax year prior to the year of change. In addition to normal recordkeeping requirements supporting all aspects of its inventory valuation, dealers electing the Replacement Cost Method must maintain copies of the price lists used in the applying the method. Conclusion The Replacement Cost Method provided in Revenue Procedure 2002-17 provides clear guidance for franchised automobile dealers and resolves a long-standing issue in the industry without imposing significant additional burden on the dealerships.  Parts inventory should include properly valued cores and "obsolete" parts in which the taxpayer retains dominion and control, but has written down or written off. If the dealership writes down used car or parts inventories year after year, a further examination of the yearend inventory sheet is required. Yearend write-downs are subject to compliance with Treas. Reg. sections 1.471-2 and 1.471-4 and the Thor Power Tool case. Issue: Valuation of Parts, Valuation of CORES inventory Documents to Request: Form 3115 Parts Price List Schedule of Obsolete and Cores inventory Request Supplier List of CORES  Invoice price adjusted, as appropriate, for discounts, freight costs, and other direct and indirect costs properly allocable to the cores.  If the core was acquired from a core supplier or broker, the invoice price is the amount paid to the core supplier or broker. If the core was acquired from a customer, the invoice price is the sum of any credit allowed to the customer and any amount paid to the customer. Audit Techniques Review Form 3115 for conformity to Rev. Proc. 2002-17 Review the procedures for Coordinated Issue on CORES Review Form 3115 for conformity to Revenue Proc 2003-10 (item #3 is effective for tax years after 12/31/2002). 4. Loans to and from Shareholders Refer to the MSSP Guide Shareholder Loans on the website address: http://ftp.fedworld.gov/pub/irs-mssp/a8shloan.pdf The corporate balance sheet should be reviewed for the existence of loan accounts either to or from the shareholder. However, when balance sheet for shareholder loan accounts has no entry this does not mean there are no outstanding loan balances. In several cases, it was noted the shareholder loans were included in asset and liability (primarily other current liabilities) accounts other then the normal loans to and from shareholder account. This is why tax classification is so important. Thus, during the initial interview the agent should inquire as to the existence of loans and the taxpayer's policies with respect to the loan, repayments, interest rates, and collateral. Once the existence of a shareholder loan is established, the concern is whether the loans are arms length transactions (i.e. length of loan, interest rate, etc.). The shareholder could be receiving an interest free loan or they may be taking money out of the company tax free, through forgiveness of the loans by the corporation at a later date. Therefore, the agent should request copies of the loan documents. If loan documents exist, they will show the terms, which the agent can then validate. If loan documents are not available, the agent should review the corporate minutes for a possible mention of and the details of the loans.  In regard to interest generated by a loan from shareholder, the agent must inspect the payables accounts and interest expense account for a possible deduction of the interest owed by the corporation of which the shareholder has not been paid. IRC section 267(a)(2) states the corporation and the shareholder (who holds a greater than 50 percent interest in the company either directly or by attribution) will be put on the same basis of accounting, usually cash basis, to determine when a deduction is allowed, even though one is an accrual basis taxpayer and the other is cash basis. In simpler terms, the corporation will be allowed a deduction when the interest is paid, not when it is accrued. However if the corporation has accrued the expense, inspect the Schedule M-1 to determine whether the amount has been backed out for tax purposes. To illustrate this point consider the following example: A corporate taxpayer has a tax year ending in June.  The corporation accrued and deducted $125,000 as interest expense, which was related to a shareholder loan. The corporation had only paid $75,000 before its yearend and paid the remaining $50,000 in December.  Even though the shareholder is required to include the full $125,000 in his calendar tax year, the corporation is not allowed a deduction for the accrual of $50,000 until such time as it is paid. Timing adjustments, such as this, should be considered and made. a. Demand Loans Often times, the loans between the taxpayer and its shareholder will be demand loans in lieu of formal loans with a stated rate of interest and repayment period. In the case of demand loans, special rules apply under IRC section 7872.  IRC section 7872(f)(5) defines a demand loan as "any loan which is payable in full at any time on the demand of the lender" and is not necessarily "in lieu of formal loans." The foregone interest on such below-market interest rate loans is treated as transferred from the lender to the borrower as of the last day of the calendar year and re-transferred immediately from the borrower to the lender as interest.  There is a $10,000 de minimis exception for compensation-related and corporate-shareholder loans that do not have tax avoidance as one of the principal purposes. See IRC section 7872(c)(3). When a corporation makes interest free (or low interest) loans to its shareholders, the shareholders' family members, or other related parties the constructive ownership rules of IRC section 267(c) apply per Treas. Reg. section 1.7872-4(d)(2)(ii). The shareholder has received a constructive dividend in the amount of the foregone interest to the extent of earnings and profits. The corporation is treated as having received a like amount of interest income. After the 1990 year, the shareholder will be allowed a deduction for the interest deemed paid to the corporation only if the shareholder can demonstrate the expense is other than a personal expense. If the corporate loan is made to an employee, who is unrelated to the shareholder as discussed in IRC section 267(c), the scenario is similar except: (a) The foregone interest is characterized as additional compensation to the employee. (b) The corporation has deemed interest income in a like amount. (c) The corporation can deduct the amount as compensation, subject to reasonable compensation limits. IRC section 7872(f)(9) specifically states that the amount of additional compensation flowing to an employee from a compensation-related below-market loan is not subject to income tax withholding. Such compensation is subject to FICA and FUTA employment taxes (Conference Committee Report on P.L. 98-369). Even though income tax withholding is not required, payments must be reported under the appropriate information provision. (d) After the 1990 year, the employee will only be allowed a deduction ii. for the interest deemed paid to the corporation if the employee can demonstrate the expense is not a personal expense. Although the transfer of taxable income between parties may appear to be offsetting, there can be significant tax impact in the reallocation, depending on the relative tax brackets of the borrower and lender and the deductibility of the interest deemed paid.  The regulations contain detailed instructions for computing the interest imputed on interest free and below-market rate loans using published federal rates. A simplified method is available for use in imputing interest on loans of $250,000 or less. Rev. Rul. 86-17 provides for the use of a "blended annual rate" to simplify the computation of the amount of foregone interest. There is no threshold dollar amount. Despite the fact the computation may seem somewhat tedious at first, adjustments can be substantial and are required by law. 5. Fixed Assets and Real Estate (Building & Equipment) In an auto dealership, it is common for the dealership to rent the land and building from a related entity. When this occurs, building and equipment will not be one of the larger balance sheet accounts. The main issue is if the amount of the rent paid for the property by the dealership to the related entity is at arms-length. Fair Rental Value must be considered to determine excessive rent on a potential constructive dividend issue. Subsequent to a reconciliation of the building and equipment items, the agent may wish to further look at: Large, unusual, or questionable items Like-kind exchanges Potentially personal items "Imaging Payments" Manufacturers may reimburse dealers for a portion of the costs to renovate and/or relocate their stores. Taxpayers may be excluding these "imaging payments" from income as a contribution to capital. In John B. White, Inc., 458 F.2d 989 (1972), aff'g 55 T.C. 729 (1971), the court ruled that the payment was includable in income. consider §469 when the dealership leases the building and land from the shareholder. The rent is recharacterized as Nonpassive, Regs. 1.469-2(f)(6). 6. Accounts Payable, Other Current Liabilities and Other Liabilities When auditing a payable account, the agent may wish to focus on the year-end balances. By doing so, the agent will be able to verify that the taxpayer has not expensed items not meeting the conditions of IRC section 461(h), Treas. Reg. section 1.461-1(a)(2), or IRC section 162: The liability must exist The liability can be reasonably determined Economic performance has occurred The expense is ordinary and necessary Expense is directly related to business. Audit Techniques: Review balances due to officer's and shareholder's; ascertain business purpose, trace to the corporate minutes, if material. Look for liability amounts owed to other related entities. Customer deposits is one liability account that dealerships may show as either a contra account receivable or a payable. It represents cash advances received for sales where delivery of the vehicle(s) has not yet occurred. Reserves: A dealership may establish reserves for many contingent and uncertain losses. These should be expensed for tax purposes only when economic performance occurs and not when estimated. For book purposes however, reserves may be proper for such things as service contract losses, repossession losses, and potential bad debts. Transfer of funds. These are which the dealership collects but must send to governmental agencies such as sales tax, luxury tax, and Department of Motor Vehicle (DMV) fees. 7. Capital Stock/Capital Account It is common for auto dealerships to be controlled by family members. They tend to be family ventures that may pass from generation to generation and may expand to incorporate several dealerships in different areas. Possible issues include the transfer of ownership between family members. These transfers should be examined to ensure that gift tax or capital gain tax was properly reported. Flow through entities should be analyzed with their related Forms 1040 to determine that Forms K-1 match ownership percentages and those individuals are not mistakenly considering active income as passive or visa versa. Although a stock certificate book and corporate minutes are helpful in developing capital issues, the most important facts come from the related returns and interviews of the taxpayers involved. 8. Retained Earnings Auto dealerships tend to expand and therefore issues such as Accumulated Earnings Tax (IRC section 531) are not usually applicable. If the balance sheet of the corporation leads an agent to consider this issue the agent should gather the information necessary for using the Bardahl formula early in the examination including: Planned expansion Operating ratios Amount of liquid assets and retained earnings. 9. Conclusion A balance sheet audit is valuable and necessary, as it not only provides information for many possible issues, but also familiarizes the agent with the structure and nature of the taxpayer's books and records, which although somewhat standardized in the auto industry, always tends to differ from one taxpayer to the next. Reconciliation and scrutinization of large, unusual or questionable items is the key to an effective and efficient balance sheet audit.