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:: Retail Industry Audit Technique Guide (ATG) - Chapter 3: Examination Techniques for Secific Industries (Independent Automobile Dealerships)   Table of Contents Chapter 3: Examination Techniques for Specific Industries (Independent Automobile Dealerships) Introduction Initial Interview Questions Books and Records Income Cost of Goods Sold and Purchases/Inventory Purchases Expenses Issues Related Finance Companies Non-Prime or Sub-Prime Finance Contract Other Issues Web Sites Glossary Statistics   Introduction The used car industry is composed of two major segments. The first segment is made up of the new car dealers who accept trade-ins on the sale of new automobiles and can also purchase used vehicles directly from customers, other car dealers, or at wholesale auto auctions. The new car dealers then sell the used vehicles either to retail customers, to used car dealers, directly to wholesalers through auctions, or to other miscellaneous customers. The second segment of the industry is made up of independent auto dealers. These dealers are not affiliated with an automaker and, their principal business is the sale of used vehicles. Since no trade franchise (that is, General Motors, Ford, etc.) is necessary, the size of the used car dealership and the capital required to enter the industry varies. However, every used car dealer must be licensed with the state in which the dealership is physically located. Most states have different laws that govern the ability of individuals or businesses to sell used vehicles without a license. For example, one state permits an individual to sell up to five vehicles per year without obtaining a license. Other states are more or less restrictive. Independent auto dealers acquire vehicles from trade-ins on the sale of used vehicles. Such dealers also purchase vehicles from individuals (private purchase arrangements), other new and used vehicle dealers, and at wholesale or retail auctions. Impact of state regulation and state law Every state regulates the operations of the independent dealer and requirements vary from state to state. The specific requirements imposed on a dealer depend on the particular state in which the dealer does business. Common dealership activities regulated by states include: Transfers, assignments, and reassignments of titles Title transfer processes Collection and repossession rights and liabilities Consignment rules and procedures Payments of commissions for referring buyers Additional information on state laws may be obtained from your state Motor Vehicle Division. Curbstoners One problem that the industry faces is competition from unlicensed dealers (curbstoners) who buy, sell, and trade more used vehicles than a state allows without a license. In almost every case, the curbstoner has no fixed place of business and fails to adhere to most of the accepted industry practices or customs. It is not known how much revenue the curbstoners generate, although industry officials acknowledge that the amount is significant. Since curbstoners do business illegally it is likely that their income from sales goes unreported. State attempts to enforce licensing laws against curbstoners are hampered by a lack of personnel and money. Furthermore, with no fixed place of business, a curbstoner is often difficult to track. Signs of potential curbstoning include: Multiple auto listings in a paper with the same phone number Displays of multiple vehicles "for sale" in shopping centers or similar parking lots all with the same phone number Records The Federal Truth in Mileage Act requires odometer statements to be retained by both the buying and selling dealers. Most states require that a licensed dealer maintain certain records, which must be available for inspection by the appropriate state licensing or regulatory agency. Information about the records a dealer is required to maintain in a particular state can be obtained from the state agency responsible for the regulation of independent dealers. (Normally this will be the state Motor Vehicle Division or the state Department of Revenue.) Aside from these state and federal requirements, other specific records that must be maintained will vary from state to state. The sophistication of the accounting and records system (including record retention) will normally vary with the dealer's size and location. However, there are certain common industry practices that provide documentation for a sales transaction. These practices will vary from state to state, since each state has different record retention requirements, but the basics will be the same. These industry practices are discussed in the various sections on income recognition and inventory. Currently, there is no overall computer accounting program specifically designed for independent dealers, however, there are many programs that are used by dealers. Car Jacket The key record of a car sale is the car jacket, customer file, or deal jacket. A separate file is normally maintained for each sale. Many dealers create a deal jacket whenever a vehicle is purchased and assign a stock number to the vehicle. In that case, the deal jacket may also be used to track the cost of the vehicle and the cost of reconditioning the vehicle for sale. The file generally contains: Cash Sale (No Trade-in) Sales, Retail Buyer‘s order (including the VIN), Buyer’s name, address and other information, Sales Price, Sales tax (depending on the state, sales tax may be on the gross sales price or net sales price), Documentary and Filing (Doc) fees, State and Federal Disclosure statements, including Odometer readings, Vehicle stock number, Extended warranty or service contract information and information on any insurance purchased, Form 8300, if applicable. Sales with Trade-ins Same items as for a cash sale, and Payoff on any outstanding loans, if applicable, ACV of trade-in. The customer file may be a separate manila folder, an envelope with the information in it, or simply papers stapled together. All are acceptable methods of record retention. A dealer will normally also maintain cash receipts records that will show the cash received by the dealer on a daily basis. An analysis of the deposits will indicate the sources of the dealer's revenues, which could include: Auto sales Collections on self-financed sales Commissions from service/warranty contracts sold Commissions from disability and life insurance contracts sold - Commissions from bank financing Customer paid service work Auctions Aside from customer trade-ins, the most significant source of inventory for dealers is an auction. Dealers use auctions both to buy and sell vehicles. Dealers use wholesale auctions, where only dealers are permitted to buy or sell. Most dealer transactions are handled by the wholesale auctions. Some states also permit retail auctions, which are open to the general public, and may be used by the dealers as well. Each auction company is run independently, maintains different records, and has its own procedures. Some common rules and procedures used in the auction industry include: Every dealer must register with the auction, The dealer will provide the auction with the year, make, VIN, and equipment of each vehicle offered for sale, either by phone or on site, The auction will issue the selling dealer an auction check, thereby assuming the risk of collection on the buyer's check, The auction will handle the actual assignment of title to the buyer.  The seller may set the floor or lowest price that the vehicle may be sold for by the auction. Generally, each auction holds its general wholesale sale once a week. It is common for dealers to attend more than one auction a week since each auction offers different types of vehicles in varying price ranges for sale. Special manufacturer and fleet auctions are held at various times throughout the year. Dealers often attend several auctions a month, many of which are in another state. By attending auctions outside of his or her area, a dealer is able to take advantage of better market conditions for a specific type of vehicle. For example, a dealer in Florida may want to purchase convertibles, which may have a high price in the Florida market. However, a Wisconsin auction may offer convertibles for sale at much lower prices due to the lack of demand there. The Florida dealer will travel to Wisconsin, buy the convertibles, and profit from their sale to customers in Florida. Thus a dealer from one part of the country can benefit from obtaining vehicles at an auction in another part of the country. While the overwhelming number of dealers may have a valid business reason for attending out-of-state auctions, such practices are also a compliance concern. A few dealers have been found attending out of state auctions to facilitate buying and selling vehicles "off the books." The starting point of an auction is the registration of the dealers participating in the auction whether they are buying or selling. The auction generally requires that the dealer be registered in advance. This usually involves obtaining a copy of the dealer's license. Once registered a dealer may participate in an auction. The selling dealer will provide the auction with the appropriate information about the vehicles offered for sale, as discussed previously. The vehicles will be assigned a number, which will be displayed on the windshield, and offered for sale. Since the seller has the right to set a floor price below which the vehicle may not be sold, not all vehicles offered for sale at an auction are sold. However, on average roughly 50 percent of the vehicles in a regular wholesale auction will be sold. Once a buyer has successfully bid on a vehicle at auction, he or she is afforded an opportunity to inspect the vehicle to be sure that all representations about the vehicle made by the seller are correct. If there are no problems, the buyer then proceeds to settlement, and gives the auction his or her check for the purchase price. The auction fills in the title in the buyer's name and delivers the title to the buyer. On the other side of the transaction, the seller will sign the title and deliver it to the auction for completion. The seller will then receive an auction check, with the restrictions noted below. Each party will also receive an invoice (Block Ticket) that shows the vehicle sold, as well as the identities of the seller and buyer. The auction invoice will also usually include an executed odometer statement. The auction will not usually issue payment to a dealer without proof that a business bank account exists. Additionally, the auction normally provides restrictive endorsements on the check issued to the dealer to be certain that the proceeds are deposited to that account. For example, an auction will not issue a check to an individual, but will issue the check in the individual‘s business name. The check will normally bear some restrictive endorsement on the back, such as, "For Deposit to Account of Payee Only." Many auctions request a copy of a dealer's check to verify with the bank that the dealer actually has an account there. Since the auctions guarantee that vehicle titles are lien-free, the auctions handle all title issues to ensure that the transfer is made correctly. Some common title problems include incorrect VIN, unsatisfied liens, incorrect title assignments, and an incomplete chain of title. The auctions have a great deal of experience with interstate transactions and generally have a very good working relationship with the various states Motor Vehicle Divisions. Titling Issues and Processes Titling procedures are determined by state law; thus there are 50 different sets of rules that apply. The state Division of Motor Vehicles, or similar agency, regulates the issuance and transfer of a vehicle‘s title and maintains a record of the owner. This information is available, although its usefulness in tracking an unreported sale or sales will depend on the database used by that particular state. In most states dealer-to-dealer transfers of title are accomplished through dealer reassignments. These reassignments are not usually recorded unless the state issued the original title or is recording the title once the vehicle is ultimately sold to a retail customer. All of these issues are compounded by the tremendous amount of interstate sales that occur. Although the use of state title transfers does have drawbacks and cannot be used to reconstruct or determine all of a dealer's sales, it remains a useful tool in checking the accuracy of reported sales. Despite no uniformity in titling rules or procedures, some very basic elements exist in all states: Every vehicle must have a title, There must be a written record of the sales transaction given to a customer, A title must contain certain specific information, although the contents will vary from state to state, A valid title must be produced in connection with a sale, but some exceptions exist for old vehicles in some states, Only dealers can reassign title, individuals cannot reassign titles. Generally, title to vehicles purchased at an auction is reassigned directly from the seller to the buyer, although some states require the auction to note on the reassignment of title that the transaction is an auction sale. Some dealers may also purchase vehicles purchased in Canada. Canadian titling laws are much different from those in the United States, and advice on procedures should be sought from an international examiner, who can put you in contact with the Revenue Service Representative for Canada. Do the same with any dealer transactions in Mexico. In most states, dealers need not take actual title to a vehicle, but can reassign the title. This may be done on the title, or on a separate sheet attached to the title. The significance of reassignment is that the dealer will not have to register the title with the Motor Vehicle Division until the vehicle is sold "at retail" to a non-dealer customer. This can make tracking the sale of a vehicle very difficult. Example of titling A dealer in Virginia takes a vehicle with a Maryland title in trade on a sale. The dealer then sells the trade-in at a North Carolina auction, where the title is reassigned to the North Carolina dealer who acquires the vehicle. That dealer then sells the vehicle to a Florida dealer with a reassignment of title. The Florida dealer then sells the vehicle to a New York dealer, again reassigning the title. Finally, the New York dealer sells the vehicle to a California dealer, by yet another title reassignment. The California dealer then sells the vehicle to a California resident. The State of California will issue the new title to the retail purchaser. California may notify Maryland, the state with record of the original title, of the new title. Maryland would then cancel the original title. The notice may show all of the reassignments. However, no title record of the vehicle's sales will appear in any of the intervening states. The Virginia, North Carolina, Florida and New York Motor Vehicle Divisions will not record the vehicle being sold in their state. However, each dealer should have a deal jacket for the transaction involving the vehicle. Back To Top   Initial Interview The initial interview is crucial in all examinations. When examining an independent used vehicle dealer, as with all other examinations, the standard interview questions are required. There are a number of specific industry-related questions that should also be included as part of the interview process. Sales: The examiner may want to ask the owner if he keeps a personal record or list of his or her profits on each vehicle or deal. What types of sales transactions did you have for the year under examination? Any sales at auctions? If yes, which? Any sales to wholesalers? If yes, which? Any sales to other dealers? If yes, which? Any consignment sales? If yes, volume? Any scrap sales? If yes, describe. Any in-house dealer financing sales? Any third-party financing sales? Did you have any other types of sales transactions? Did you have any sales that resulted in a loss on the sale? If yes, describe the nature of these sales. Interest income on dealer-financed sales? Commissions or referral fees on third-party financing? What third party financiers did you use? What was the fee/commission arrangement? Commissions or referral fees on vehicle insurance placement? Which insurance companies were used? What was the fee/commission arrangement? Commissions or referral fees on warranty/repair placement programs? What other commission/referral fee arrangements do you have income from? How Sales Are Recorded? When selling a vehicle, how do you report the sale? Gross sales price per Sales Contract? Net cash received upon sale after discount and/or trade-in? Through the use of a sales contract made in the year under examination, show me how you recorded the sale. Are sales taxes reported in the gross sales price? Are licensing fees or titling fees included in the sales price? (Note; if answer is no, look for them as expense items, if so, make the appropriate adjustment.) Do you sell warranty or service contracts? How do you record the income from them on the books? How do you record the expense items on the books? Note: Be attentive to proper timing of Income/expenses. Do you finance sales? How do you record the income from the financing on the books? Note: Be attentive to proper timing of income. Do you sell finance contracts? How does this transaction work? Who do you sell finance contracts to? Have the taxpayer walk you through a specific example? Do you own or are you a shareholder of the finance company? If the owner of the vehicle dealer is also an owner of the finance company, see Related Finance Companies under Accounting Methods, for additional information. Do you have a dealer reserve account at any financial institution? What other goods or services do you provide in your business? How are these transactions reported on the books? Vehicle repairs? Portering/detailing services? Vehicle mats, etc.? Pricing Policies and Discounts When setting an asking price for a vehicle, what information sources do you consult, for example, Blue Book? When valuing a trade-in vehicle, what method do you use, that is, resale value to a customer, wholesale value to another dealer, or some other method such as personal judgment. Please explain the method by giving an example? How do you arrive at the amount of discount you recognize on a sale? Please provide an example. When overvaluing a trade-in how do you record it on the books? How do your record this paper loss? When recording a sale of a trade-in on the books, how are the ACV and the discount recorded on the books? Inventory Items When setting an inventory value for a vehicle, what information sources do you consult, that is, Blue Book? Do you ever change this value? How is this change in value recorded on the books? What factors are considered when changing the inventory value? Do you always use one official valuation guide or do you consult more than one? Please explain. (Methods of fixing values differ among valuation guides. See Treas. Reg. section 1.446-1(a) (2) For any vehicle that is valued below cost, how does the asking price at any point in time differ from the value recorded on the books at year-end? Please explain. (The propriety of a write-down may be determined by actual sales price. See Treas. Reg. section 1.471-4(b) If a vehicle is portered or repairs are made to it for resale, how do you record these costs? Current expense? Added to the value of the vehicle? When junking a vehicle for scrap, how do you account for it? What value is used for vehicles in ending inventory? Does this value differs from the one originally recorded at the time of acquisition? In determining the yearly LIFO index, what is the vehicle in ending inventory compared to in the ending inventory of the preceding year (that is, the taxpayer's own cost for the same type of vehicle or a "reconstructed" cost from an official valuation guide for the same type of vehicle at the beginning of the year)? Explain how these vehicles are comparable. Miscellaneous Have you ever taken items other than vehicles in trade?  Please explain. How was this accounted for on the books? Explain the titling regulations that you are responsible for as a licensed vehicle dealer. Provide your log/record of titles for all vehicles sold for the year. Do you acquire vehicles at auctions? If yes, which auctions? Which, if any, are out of state? Do you acquire vehicles from wholesalers? If yes and a few are used, which wholesalers are used? If yes, and many are used, who are the primary wholesalers? What out of town wholesalers do you use? What other non trade-in sources of vehicles do you utilize? What business names do they operate under? Are any of these businesses out of state? If yes, which ones are out of state? How can I identify how a vehicle was acquired for resale? How do you gauge the used vehicle market at any given time? How does this affect your pricing and valuation practices? If you use a vehicle for business, what records do you keep? Back To Top   Books and Records Accounting methods Used car dealerships normally maintain an inventory, which is a material income producing item. Material income producing items are required to be accounted for under an accrual method of accounting. Nationwide, many used car dealerships have been found to be using an improper accounting method, either the cash method or the installment method. IRC section 448 places limits on the use of the cash method of accounting. IRC section 453(b) (2) (A) and (B) disallow the use of installment method on any dealer disposition and disposition of personal property that would have to be included in inventory if the property were on hand at the close of the taxable year. Smith v. Commissioner, T. C. Memo. 1983-472. The court ruled that where the purchase and sale of automobiles was the principal income-producing factor in a used car dealer‘s business, requiring the use of an inventory, the dealer was required to use the accrual method of accounting. Back To Top   Income Income reporting There are certain issues in dealer income recognition that agents should consider during an audit. These include: Not recording a trade-in on a sale, then selling the trade-in for cash. One way to avoid reporting all sales is by cash sales in which a trade-in is sold directly to a third party. The dealer takes a car in as a trade from customer A. Customer A signs the title, but the dealer does not put the car in inventory or show it on the dealsheet as a trade-in. The dealer then sells the car to customer B for cash and signs the title over to the customer. The dealer keeps the cash and the title shows a direct sale from customer A to customer B. There is no indication that the dealer was ever involved in the trade. Indications that this may be occurring include unidentified cash deposits, reconditioning costs incurred about the same time as the sale of the trade-in, but not allocated to vehicles, substantial sales discounts, or sales contracts that show a trade-in allowance with no corresponding stock number assignment. However, substantial discounts are frequently given by dealers to get rid of overage vehicles, where a cash (no financing) sale occurs or in similar situations. Reporting net sales based on financing obtained, omitting cash received. Comparing the sales contracts with the financing files should disclose this problem. Also, the state sales tax can be used to determine the sales price, which should include any cash paid. Not reporting the sale of all cars purchased. Comparing the purchase of vehicles acquired by trade and at auctions to a subsequent sale of that vehicle can provide information on accuracy of sales figures. Also, a review of claimed travel expenses can lead to information about auctions attended where possible purchases occurred or sales were made. However, dealers may attend auctions where they make no purchases or sales. Purchasing a group of cars, allocating the entire purchase price to only some of the units; then selling one or more units off the books. A review of the purchase documents may provide evidence of the number of cars purchased. Furthermore, an analysis of the cost assigned to the inventoried cars acquired in the package should be made for reasonableness. However, it is common for the buyer to assign a different value to each car in the group than the seller has assigned. The buyer is not privy to the seller's allocations, and generally bases his or her allocation on the relative value of each vehicle in the group. Purchases from other dealers are generally similar to purchases from auctions. However, there may be no written record of the transaction, and the transfer of title probably will be by a reassignment of title to the purchasing dealer. Frequently, the dealer may make a package purchase. This is a purchase of several cars for a lump sum. The purchasing dealer should record the cost of the cars based on the ACV of each car to the total purchase price. The ACV of cars sold in a package can vary greatly since it is common to put one or two cars that are difficult to sell in a package, with the expectation that the purchaser will want the other cars in the package enough to accept the entire package. As with cars purchased at auctions, the cost of the car will be increased by any reconditioning costs incurred in preparing the car for sale. As mentioned above, dealers may purchase — “clunker“cars as part of a package deal. The dealer may know this at the time of purchase, in which case a low market value will be placed on the inventory value of the vehicle. At other times, a dealer will not realize it bought a "clunker" until reconditioning has begun. At this point in time, the dealer has two likely options: - Sell the car from his or her lot, or - Sell the car at an auction. Either way, the likely result will be a loss on the sale of the vehicle and no further transactions with the other dealer. Other methods dealers may use to avoid reporting all income is to purchase four cars from another dealer or at auction. The purchase document will show four cars purchased. The dealer then books three cars into inventory and sells the fourth car without reporting the sale on his or her books. If such activities are suspected, check with the auction house as a third-party source. The independent used car dealer may take almost anything as a trade-in. Boats, trailers, snowmobiles, campers, etc. may be accepted as a trade-in. These traded items may or may not end up on the lot for sale. The owner of the dealership may be getting personal use of these items and sell them on the side as personal property instead of inventory.