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

. 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. Some dealerships report income
when a payment is received instead of when it is earned in accordance with the note which
may lead to a timing adjustment.
The terms of the note must be reasonable. The note should call for full payback to occur
evenly within a 1 to 5 year window. There may be issues 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).
c. Note Transfers
It would be prudent for the examiner to scrutinize any trend of dispositions of notes, either
gains or losses, as related or unreported transactions could be occurring.
In the event that 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 auto buyer defaults the bank CAN NOT look to
the dealer for payment. Notes sold "without recourse" are discounted to a significant
degree.
A note sold "with recourse" means that if the auto buyer 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. 77 sets forth conditions, all of which must be met, in order for the
transferor to record a sale. These include: the transferor’s surrender of control of the
economic benefits associated with the receivables; the transferor’s ability to make a
reasonable estimate of its obligations to the transferee under the recourse provisions; and
the transferee’s inability to require the transferor to repurchase the receivables, except in
accordance with the recourse provisions.
B-3