Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

To facilitate cash flow and to avoid collection responsibilities, the dealerships often transfer nonprime
or sub-prime installment contracts to an unrelated finance company shortly after the deals
are consummated for an up-front cash advance and the possibility of additional cash payments in
the future. Dealerships may do business with several finance companies, and may have paid a fee
and entered into a servicing agreement with each finance company prior to transacting business
with it. Servicing agreements vary among finance companies, and one finance company may have
a variety of programs, but the basic premise of most programs is the same. Upon transfer of the
installment contract, the finance company pays the dealership an advance which may range from
50 to 75 percent of the contract, depending on the credit rating of a particular customer or the
dealership’s aggregate pool of contracts. The advance can be based on the face amount of the
contract without interest, or the total contract amount including interest. After paying the
advance, the finance company collects the installment payments from the vehicle purchaser for a
fixed percentage of each payment, often 20 percent. In addition, the finance company will be
reimbursed for any out of pocket collection cost incurred. Only after recovering the fixed
percentage fee, out of pocket collection costs, and the advance, will the finance company begin to
pay the dealership for the remainder of the contract, known as the BACK-END
DISTRIBUTION.
To summarize, the finance companies apply the collections on the installment contracts in the
following order:
1. To pay the fixed percentage collection fee
2. To reimburse out-of-pocket collection costs (e.g. repossessions related expenses)
3. To repay the advance from the finance company to the dealerships, and
4. To remit any remaining funds to the dealer (back-end distribution)
Assuming a 20 percent fixed collection fee, and if the finance company has no out-of-pocket
collection costs, the dealer has the potential through the advance plus back-end distributions to
receive 80 percent of the installment contract (either the face amount of the contract or the face
amount of the contract plus interest, depending on the servicing agreement). However, because
of the order in which the collections are applied, dealers may not receive any back-end
distributions because the collections received will be subject to a high default rate and may never
exceed the sum of the 20 percent service fee, out-of-pocket costs, and the repayment of the
outstanding advances.
The chances of receiving back-end distribution are further diluted because the finance companies
aggregate the installment contracts rather than carry them individually. For example, if a
dealership transfers 20 non-prime or sub-prime contracts, the advances from the finance company
for all 20 contracts will be aggregated, and only after collections are received that exceed the
cumulative advances on all 20 contracts will any back-end distribution be made. Thus, as long as
the finance company keeps issuing advances, the cumulative advance balance increases and the
collections received may never be enough to cover this ever-increasing advance balance.
To rectify this, some finance companies offer pool capping. Under this arrangement, the
dealership may pays an additional fee to cap off one pool (or group) of contracts and to create a
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