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:: New Vehicle Dealership Audit Technique Guide 2004 - Chapter 4
- Inventory (12-2004)
Chapter 4 - Table of Content
Automobile dealerships have a
great deal of discretion in what
accounting methods they will
employ for various classes of
their inventoried items.
Whatever method the taxpayer
chooses, it must clearly reflect
income. If there is confidence
in the taxpayer's books and
records, the scope of the
inquiry into inventory can be
narrowed, allowing the agent to
dedicate audit resources to
specific examination techniques:
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Make sure everything that
should be inventoried is
included in an inventory
account.
-
Verify that an allowable
method is being used.
-
Scrutinize any adjustments
made to inventory accounts.
Auto dealerships typically
maintain distinct inventories
and tend to account for them
differently. Among the types of
inventoried items are:
-
New vehicles
-
Used vehicles
-
Parts and Accessories
The methods used for valuing and
accounting for these classes of
items do differ from dealership
to dealership but are generally
directed by the size of the
firm. We can look at inventory
issues as falling into one of
three categories:
Used
Car Dealerships:
The smaller "lots" usually
do not wish to invest the time,
energy, and financial resources
into a complex inventory system.
They tend to use Lower of Cost
or Market (LCM) to value
vehicles and do not maintain any
other inventories. At yearend, a
valuation guide may be used to
value the automobiles on an
individual basis using 100
percent of the average wholesale
valuation quote. The dealership
then determines an ending
inventory adjustment for the
year. (See Rev. Rul. 67-107 and
Treas. Reg. section 1.471.4)
Smaller New Vehicle
Dealerships:
This middle class of
dealerships may employ any range
of inventory techniques with
little consistency among them.
The dealerships range from small
low volume motorcycle shops to
medium sized multi-vehicle type
lots. Here it is important to
make sure that all items that
should be inventoried are being
correctly accounted for. It is
not uncommon for a dealer of
this size to inventory vehicles
and expense parts and
accessories. In any case, the
method of valuation should be
determined and inventory
physically observed. The agent
should determine the actual
physical inventory, compare it
to the amount shown on the tax
return and make an adjustment
for the difference.
Large Multi-Entity
Dealerships:
For tax purposes, the large
dealerships may use LIFO for new
vehicles, used vehicles, and
parts and accessories with
profit center costing
allocations. They often have
related used car and truck
ventures, usually resulting from
trade-ins for new vehicles sold.
These trade-ins may be accounted
for under the LCM method
discussed previously. Certain
items are accounted for under
the specific identification
method due to rarity, such as
repossessions. The lower of cost
of market can be used for these
items under the rules discussed
for used vehicles. It is
recommended that all inventories
be scrutinized as they have a
material impact on taxable
income and could be valued
incorrectly.
The various methods of inventory
valuation and the authority for
utilizing them are:
First-in,
First-out (FIFO), Treas. Reg.
section 1.471-2(d)(2)
-
Lower of Cost or Market
(LCM), Treas. Reg. section
1.471-2(c)
-
Specific Identification,
Treas. Reg. section 1.471-3
-
Last-in, First-out (LIFO),
Treas. Reg. section 1.472
FIFO is only advantageous in a
deflationary economy, and
historically the United States
economy has exhibited
inflationary tendencies,
therefore it is improbable an
auto dealership would use the
FIFO method of inventory
valuation. LCM on the other
hand, offers an attractive
method for handling used
vehicles since their value at
the end of the year may be less.
Most, if not all, dealerships
use specific identification for
the inventory value of new
vehicles for book purposes. This
is based on the actual flow of
goods. FIFO is an assumed flow
of goods and is different from
specific identification (cost or
LCM) or LIFO. They may not use
FIFO for vehicle inventory since
the vehicles can be identified
with specific invoices.
Lastly, LIFO, given the
inflationary nature of the
United States economy, is
attractive to auto dealers and
is frequently the inventory
valuation method of choice. Full
consideration of this topic
demands a working knowledge of
the rules and procedures
governing it.
LIFO
Background
Overview of the Method:
A large problem area
concerning the examination of
auto dealerships occurs where
the LIFO method of inventory
valuation is used. This has been
a problem due to the technical
complexity of the method coupled
with the volumes of records that
must be examined to determine
whether there is compliance.
Auto dealerships elect the LIFO
method because the benefits
offered outweigh the negative
aspects of its use for most.
During inflationary times taxes
are deferred by changing the
flow of costing inventory
through a sequence of valuation
steps.
The last costs incurred are
placed into the cost of sales
and the earliest costs are
retained as inventory (layers).
This means that units in ending
inventory are valued at the
oldest unit costs available and
units in cost of goods sold are
valued at the newest unit costs
available. Accordingly, the LIFO
method of valuation reverses the
normal (assumed) flow of costs
reflected in the FIFO (cost)
method. LIFO is merely removing
inflation from ending inventory
and expensing it as part of the
cost of goods sold.
When comparing the flow of LIFO
costs to the flow of FIFO costs,
we see that FIFO charges the
cost of inventory items to cost
of sales in the order of their
acquisition. The cost of the
inventory on the balance sheet
under the FIFO method more
clearly reflects the replacement
cost than does the LIFO method.
Under the FIFO method, when
inventory is sold and then
replaced at a higher cost, the
difference between the
inventories' selling price and
the replacement cost, causes
recognition of a phantom profit
and fails in an economic sense
to provide the best matching of
costs and revenues.
The LIFO approach attempts to
match the most recent costs of
purchases from the computation
of inventory costs. Where LIFO
is used, if prices increase, a
deferral of taxes will result
and profits are decreased. The
later higher costs are charged
to costs of sales and earlier
lower costs remain in inventory.
This means inventory costs are
removed in the reverse order of
their acquisition.
The difference between the LIFO
and non-LIFO inventory values is
called the LIFO Reserve. The
LIFO reserve represents the
inflation that has been deducted
through increasing Cost of Goods
Sold, which results in lower
taxes. It is important to note
that the reserve must be brought
back into income at some future
date. The reserve is only a
temporary deferral, not a
permanent one; a timing
difference. To better understand
LIFO concepts, see, Amity
Leather Products Co. v.
Commissioner, 82 T.C. 726
(1984), Hamilton Industries,
Inc., Successor of Mayline
Company, Inc. and Subsidiary v.
Commissioner, 97 T.C. 120
(1991), and Fox Chevrolet,
Inc. (Maryland) v. Commissioner,
76 T.C. 708 (1981).
LIFO has taken on complexity
that may or may not have been
intended. To appreciate the
problems associated with the
election by automobile dealers
to value their inventories using
this method, we may want to see
where this complexity began and
have an understanding of
problems present today.
Origins of the Method:
Prior to 1939, taxpayers
were only allowed to use the
specific identification and the
FIFO methods of inventory
valuation. Taxpayer litigation
seeking permission to use a LIFO
forerunner was fruitless to this
point. See Lucas v. Kansas
City Structural Steel Company,
281 U.S. 264 (1930).
The Revenue Act of 1939 extended
the privilege to use the LIFO
method to all taxpayers. Along
with the privilege of using LIFO
for tax purposes, the 1939 Act
also instituted a strict
financial reporting conformity
requirement.
Regulations issued pursuant to
the 1939 Act indicated that the
use of LIFO would only be
allowed to taxpayers with few
basic fungible commodities that
could be measured in terms of
common units, such as tons,
yards, barrels, etc. As a result
of the limitations imposed, the
"specific goods" or unit LIFO
method was the only official
method authorized.
Under the specific goods method,
taxpayers with diverse and
non-homogeneous inventories,
such as motor vehicles, could
not, as a practical matter, use
the specific unit method.
Taxpayers with such non-fungible
inventories were, in effect,
denied the use of the LIFO
method of accounting.
The Revenue Act of 1942 made two
major changes to the LIFO method
of accounting. First, the
reporting requirement mandated
in the 1939 Act was burdensome.
It applied to all financial
reports. Congress relaxed the
requirement by limiting its
application to annual reports.
Second, prior to this Act, as
stated above, the specific unit
method was the only allowable
LIFO method. At this time a
concept was introduced using a
method which measured changes in
inventory investment pools by
reference to standard base year
dollars and inflation indices
relating back to the base year
dollars. This dollar value
method introduced a significant
concept, which is referred to as
"pooling," which considers a
grouping of items within a
product line. The 1942 Act
authorized limited application
of the dollar value method. In
1949, the LIFO regulations were
amended permitting all taxpayers
to use the dollar value method.
See T.D. 5756, 1949-2 C.B. 21.
In
1961, final dollar value
regulations were issued. These
remained virtually unchanged
until 1981. In the Economic
Recovery Act of 1981, Congress
enacted a number of provisions
designed to simplify the LIFO
method and make it more
accessible to small businesses.
See IRC section 472(f), allowing
use of certain external indices
the producer price index (PPI)
and the consumer price index
(CPI); IRC section 474 providing
a simplified dollar value LIFO
method, also known as the IPI
Method, applicable to certain
small businesses.
A
Short History of LIFO
Applications:
Auto Dealership LIFO and the IRS
LIFO gained widespread
acceptance by automobile dealers
in the early 1970s as a result
of sharp increases in automobile
prices. However, the
complexities of the application
of dollar value LIFO concepts to
the inventories of auto
dealerships proved to be
difficult to work with not only
for automobile dealers but also
for practitioners and revenue
agents for both technical and
practical reasons.
Problems computing dollar value
LIFO for the auto dealership
industry revolved around two
concepts, averaging within
submodels and assigning
inflation to new vehicles.
A
method used by many dealerships
defined an item of inventory as
the "make," model or sub-model.
As quality increased, less
expensive vehicles were replaced
with more expensive vehicle. By
averaging within submodels,
higher priced vehicles would be
grouped with lower priced
vehicle. Though these groupings
entailed working within the same
model group, this comparison of
dissimilar submodels produces an
index higher than that
attainable by comparing the
higher priced submodel vehicles
to other like kind higher priced
submodel vehicles and lower
priced submodel vehicles to
other like kind lower priced
submodel vehicles.
The following example is offered
to illustrate the preceding
paragraph:
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Averaging Within Submodels
Corolla
|
1985
|
1986
|
|
1702
|
5,967
|
6,319
|
50,941 / 48,959=
1.041
|
1703
|
6,285
|
6,654
|
|
1712
|
6,190
|
6,543
|
|
1787
|
7,352
|
7,669
|
|
1795
|
7,060
|
7,360
|
|
1788
|
7,950
|
8,121
|
|
1798
|
8,155
|
8,275
|
|
|
48,959
|
50,941
|
|
-
Correct Submodel Cost
Extension
Corolla
|
Unit End
Inv
|
1985 Cost
|
1985
Extended
|
1986 Cost
|
1986
Extended
|
|
1702
|
1
|
5,967
|
5,967
|
6,319
|
6,319
|
860,222 /
835,077
|
1703
|
2
|
6,285
|
12,570
|
6,654
|
13,308
|
= 1.030
|
1712
|
1
|
6,190
|
6,190
|
6,543
|
6,543
|
|
1787
|
25
|
7,352
|
183,800
|
7,669
|
191,725
|
|
1795
|
26
|
7,060
|
183,560
|
7,360
|
191,360
|
|
1788
|
27
|
7,950
|
214,650
|
8,121
|
219,267
|
|
1798
|
28
|
8,155
|
228,340
|
8,275
|
231,700
|
|
|
110
|
|
835,077
|
|
860,222
|
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Example 1. "Averaging Within
Submodels" does not consider
actual numbers of units in
ending inventory, but only
considers the average of
specific submodel ranges. The
"Correct Submodel Extension"
example considers items in
ending inventory.
Consider an ending inventory of
$2 million. A dealership with
only 200 vehicles in ending
inventory with a value of
$10,000 each would have a
$2,000,000 inventory. The
difference between application
of an index of 1.04 and 1.03 to
this inventory is $20,000.
($2,000,000 x 1.04 is 2,080,000;
$2,000,000 x 1.03 is
$2,060,000.) As an addition to
the reserve, this would produce
a deferral of the tax on
$20,000. As a decrease to gross
profit, this would produce a
$20,000 cost of goods sold
deduction. This example was
rather basic and involved only
one sub model group. In
practice, the results produced
by averaging within many
submodel groups becomes
increasingly material with
higher indices using this
method.
Another area of concern was that
some dealers were comparing
newly introduced models to
existing items. A new vehicle
has no item that preceded it to
which a comparison in measuring
years could be made to determine
inflation. Therefore, a new
vehicle should receive no
inflation or an index of 1.000.
Another issue was that some
dealers did not construct the
cost of a new vehicle as
required by the regulations.
In
some instances new items
entering inventory were
receiving improper inflation
through "reconstructions" of
supposed like kind vehicles. In
some cases, there was no vehicle
that previously existed which
could be compared to a new
vehicle. Such comparisons known
as "reconstructions” could
produce higher indices, thus a
higher deferral in the reserve
and an increased annual cost of
goods sold deduction.
There were other problems,
including a lack of adequate
record retention. Some dealers
were not maintaining records, as
mandated by the regulations,
which would enable the Service
to determine the level of
dealership compliance.
An
additional problem concerning
the computation of option
indices was encountered. The
Link Chain Method envisions
accounting for each item in
ending inventory. Once the items
in ending inventory are
determined, each item needs to
be priced and inflation assigned
to it. LIFO contemplates two
methods of costing or pricing
items in ending inventory. One
of these pricing methods would
be elected on the dealers Form
970. Pricing entails going back
1 year under the Latest
Acquisitions Method or 2 years
under the Earliest Acquisitions
Method.
Application of these methods of
costing encompasses the
following analysis. If there
were 300 vehicles in ending
inventory for a particular year,
those invoices needed to be
secured. It is not uncommon for
a midsize dealership to have
this volume in ending inventory.
The invoices were scheduled and
a determination was made that
they represent the items in
ending inventory. Once this was
done, each vehicle was listed
showing the current year price
and the price for this same item
in the preceding year or years,
if it was in existence. Doing
this with 300 vehicles was
cumbersome, but workable. Such
was not the case concerning
options.
Some domestic vehicles listed
almost everything as an option.
It was not uncommon for the
invoices associated with these
domestic vehicles to have 10, or
more, options per vehicle. Each
option needed specific pricing
for the necessary measuring
years, just as the vehicles did.
Foreign vehicles were better,
but not much. Invoices utilized
for a particular manufacturer at
this time showed about 5 options
per vehicle.
The domestic vehicles and
associated options for the
ending inventory cited above
would require individualized
accounting and pricing for
approximately 3,300 items for
each year of the LIFO election
using the Latest Acquisitions
Method. The number of accounting
and pricing requirements would
double if the Earliest
Acquisitions Method was used.
The foreign vehicles cited above
would require pricing for
approximately 1,800 items under
the Latest Acquisitions Method
and 3,600 under the Earliest
Acquisitions Method for each
year of the LIFO election. Some
of the cases being worked at
this time had 10 years or more
of LIFO indices that required
individualized accounting and
pricing of each item in those
ending inventories.
Statistical sampling was
contemplated, but deemed not
appropriate for two reasons.
First, the pure Link Chain
Method contemplated actual
pricing of each item in ending
inventory. Second, the dealers
would not allow the Service to
perform a statistical sample,
although many used one
themselves. They wanted the
Service to price every item if
their indices were going to be
challenged knowing this was very
difficult, if not impractical.
A
solution to this unseemly
situation was developed. Working
these cases, it was found that
options involved "about 10
percent of the dollar value and
90 percent of the work." It was
found that by determining the
index on vehicles in ending
inventory and applying this
index to the dollar value of the
options, in ending inventory,
the differences between the
actual option calculation and
this simplified method was de
minimis. If allowed to proceed
with this method, 90 percent of
the work could be eliminated and
an accurate LIFO index could be
computed. This simplified method
proved to be quite effective
where adequate records were
maintained and workable where
there were few or no records.
To
address these complexities and
to provide a workable system to
compute automobile LIFO, Rev.
Proc. 92-79, superceded by Rev.
Proc. 97-36, was issued. This
provided a methodology for
computing Alternative LIFO for
new cars and new light duty
trucks. In 2001 Rev. Proc.
2001-23 was issued providing the
industry with the Used Vehicle
Alternative LIFO Method.
Rev. Proc. 97-36 allows the auto
dealer to compute indices by
using a simplified method. The
computations were to be arrived
at using base to base pricing,
comparing vehicles to vehicles,
and applying the resulting index
to the dollar value of the full
inventory. There is no
requirement to provide a
separate accounting and pricing
for options. More on Rev. Proc.
97-36 later in this section.
The agent who is considering
addressing auto dealership LIFO
computations for dealers who
have not elected Rev. Proc.
97-36, must be cognizant of the
"Definition of an Item"
coordinated issue which requires
inflation analysis for specific
components of manufacturers
option packages. A copy of this
coordinated issue is included in
the Appendix of this ATG.
Some dealerships may have filed
a Form 3115 under Rev. Proc.
97-27 to change their
computation method. Others may
prefer to wait until they are
examined and file a Form 3115 in
the first 90 days of the
examination.
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