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Accounting, Audit & Corporate Finance Library

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Specialized Industries

Dealerships

Chapter 1 Overview of Dealerships

100 Introduction

100 Introduction

100.1 When the word dealership is mentioned, most people think of automobile dealerships. With the number of automobiles on the

road today, that is understandable. However, there are other dealerships that sell heavy trucks, farming machinery, boats, and

recreational vehicles. While this Guide concentrates on vehicle dealerships (those selling automobiles and light trucks), the accounting

principles and tax requirements for other types of dealerships are, for the most part, identical.

100.2 Even though there is a vast market for their products, dealerships are in fierce competition with each other to sell new and used

vehicles. Consequently, profit margins are low.

100.3 Most dealerships make a slightly higher gross profit on used vehicles than on new ones. Used vehicle demand has increased as

higher prices for new vehicles have made them unaffordable for many people. However, due to continued low financing rates for new

vehicles and other aggressive incentives offered by many manufacturers, the difference between the number of new and used vehicles

sold by franchised dealers has been declining.

100.4 In addition to the competition for buyers among new and used vehicle dealerships, there is competition among new vehicle

dealerships. Steeper prices and sky-high insurance payments are driving away buyers in their late teens and early twenties. Also, aging

baby boomers continue to favor more functional transportation, such as family sedans, minivans, and sport utility vehicles.

100.5 The National Automobile Dealers Association publishes NADA Data annually. NADA Data is a comprehensive statistical analysis

of the franchised new vehicle dealership industry and is available on the Internet at www.nada.org.

100.6 It is important to understand today's dealership industry and anticipated changes. This chapter is designed to facilitate that

understanding.

© 2012 Thomson Reuters/PPC. All rights reserved.

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© 2013 Thomson Reuters/RIA. All rights reserved.

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Dealerships


101 Forms of Organization

101 Forms of Organization

101.1 Like other businesses, dealerships may be organized in one of several different forms. That decision is often based on the

dealership's overall objectives, such as minimizing income taxes or limiting liability. Significant factors to consider include:

• The required financing.

• Whether income or a loss is expected in the near term.

• The risk of significant liabilities resulting from the business.

• Whether capital will be needed.

• The tax consequences.

• The personal wealth of the owners.

101.2 While a detailed discussion of the various organization forms is outside the scope of this Guide, the following paragraphs

describe the advantages and disadvantages of several organization forms that may be used by dealerships.

Proprietorships

101.3 Proprietorships are the most basic and usually the simplest form of business organization. In a proprietorship, the owner holds

title to property, conducts business for profit, and is directly and personally liable for all obligations of that business. In most cases, the

owner's personal assets can be seized to satisfy debts of the proprietorship. Some of the advantages and disadvantages of this legal

form are as follows:

• Advantages:

•• Easy Formation. Fewer filings, elections, and registrations.



•• Simple Operations. The owner manages his or her business.

•• Easy Asset Sales.

•• Fewer Administrative Complexities.

•• No Double Taxation. The proprietorship's taxable income, losses, and credits pass through to the owner. This avoids

double taxation of business income and allows current deduction of business losses.

• Disadvantages:

•• Difficult to Sell. The assets of the business are transferable, but the business entity is not. When a proprietorship is

sold, the business assumes a new identity.

•• Limited Capital. A proprietorship's primary sources of capital are equity contributions from the proprietor and loans

obtained by the proprietor.

•• Unlimited Liability. This is especially important in businesses that are susceptible to personal injury and product liability.

•• Limited Management Resources. Because ownership cannot be shared, the skills and experience of others who have

vested interests in the successful operation of the enterprise may be lacking.

General Partnerships

101.4 General partnerships are composed of two or more partners who join together to carry on a trade or business. Some of the

advantages and disadvantages of the general partnership form include:

• Advantages:

•• No Double Taxation. The partnership's taxable income, losses, and credits generally pass through to the partners.

•• Fewer Administrative Requirements. For example, general partnerships often have no formal state registration

requirements.



•• More Management Resources. Partnerships have multiple owners who bring more skills, expertise, and different

perspectives to the business. This is especially important when the partners' skills and expertise are complementary.

•• More Sources of Capital. Although general partnerships are normally limited to the same sources of capital as

proprietorships, their potential pool of capital is normally greater because they have multiple owners.

• Disadvantages:

•• Personal Liability. In most states, general partners are liable for all the partnership liabilities (not just a share of the

liabilities based on their ownership percentage). Normally, they are also liable for wrongful acts committed by their

partners. Furthermore, any partner may be able to bind the partnership in a contract within the scope of the business

operations.

•• Limited Life. A general partnership dissolves whenever a majority of the partners die, become disabled, or withdraw

from the partnership. However, provisions can be made in a partnership agreement to keep the business in operation.

•• Less Management Control. Partners enjoy less management control than sole proprietors. The existence of multiple

owners may lead to disagreement about management and control issues, resulting in inaction.

•• Difficult to Transfer. Partnership interests can be difficult to transfer. Doing so requires finding a willing buyer and

obtaining the approval of the other partners.

Limited Partnerships

101.5 Limited partnerships have two types of partners—general partners and limited partners. General partners manage the daily

operations. They are personally liable for the partnership's obligations. Limited partners are passive investors whose liability is normally

limited to the amount of their investment.

101.6 Limited partnerships have many of the same advantages and disadvantages as general partnerships. The following are some of

the differences between the two types of partnerships:

• Administrative Burden. State laws generally establish certain requirements for forming limited partnerships. For example, limited

partnerships often must file a certificate of limited partnership with the secretary of state or other state or county offices.

• Many Investors. Limited partnerships can have a large number of limited partners. These partnerships can raise capital from a

large number of investors.

• Management Control. Limited partnerships are controlled primarily by the general partner(s).



• Longer Life and Transferability. Limited partnerships may endure upon the death, disability, or withdrawal of a limited partner. In

theory, limited partner shares can be transferred more easily, but it may be unlikely that a market for limited partnership interests

will exist.

• Passive Activity Losses. The deductibility of partnership losses by limited partners might be restricted under the passive activity

loss rules if the limited partners do not meet the tests for material participation.

• Limited Liability. Limited partners' liability is normally limited to the amount of their investment. (However, if the limited partnership

does business outside the state of its creation, these limitations may not be effective in the other states.)

Corporations

101.7 Corporations are business entities created under state law. Legally, they are considered artificial persons created to conduct

business. Thus, they can hire employees, enter into contracts, acquire assets, and incur liabilities. The following are some of the key

advantages and disadvantages of the corporate form of business:

• Advantages:

•• Limited Liability. Generally, stockholders are not personally liable for a corporation's obligations. However, stockholders

are often required to personally guarantee bank debt as a condition of obtaining a loan.

•• Continuity of Life. The corporation continues indefinitely, even after the death, bankruptcy, or retirement of a

stockholder. Dissolution requires a resolution of the directors and approval of the stockholders (voluntary) or judicial

action (involuntary). Although indefinite life is usually an advantage, it causes dissolution to be a potentially expensive

process.

•• Transferability . Theoretically, transferability of ownership is easier for a corporation than for other forms. In reality, two

factors reduce this advantage:

— Closely held stock is not very marketable.

— Many stockholders are more interested in limiting transferability than promoting it.

•• Management Resources and Control. When there is a single stockholder, the corporation generally offers the same

flexibility and control as a sole proprietorship. Multiple owners provide a greater pool of management resources for the

business.



• Disadvantages:

•• Corporate Level Taxation. The taxable income of C corporations is subject to a separate corporate income tax.

Dividends distributed to shareholders are taxable to the shareholders but not deductible by the corporation. This results in

double taxation of corporate profits. Also, losses of C corporations are not passed through to stockholders but can be

carried back or carried forward to other tax years by the corporation.

•• Double Taxation on Liquidation. When a C corporation liquidates, double taxation may also occur. The corporation is

taxed on the gain from the sale or disposition of assets (when the distribution is deemed a sale at the fair market value of

the assets). Stockholders are taxed on the distributions received from the corporation.

101.8 C Corporations and S Corporations

Federal tax law recognizes two types of corporations—

• C Corporations. C corporations are separate taxpaying entities.

• S Corporations. S corporations generally do not pay federal income taxes. Their income, losses, deductions, and credits pass

through to stockholders. Corporations must file elections and meet certain eligibility requirements to qualify as S corporations.

101.9 To qualify for S status, the following requirements must be met:

• The corporation must be a domestic corporation.

• The corporation must be an eligible corporation. (For example, it cannot take the Puerto Rico and possessions tax credit for doing

business in a United States possession.)

• The corporation cannot have more than 100 stockholders.

• The corporation's stockholders must be U.S. citizens or residents, estates, charitable organizations, or certain qualifying trusts.

(S corporation stockholders cannot be corporations, foreign entities, or nonqualifying trusts.)

• The corporation can have only one class of stock.

101.10 The corporation must file an election (Form 2553) on or before the 15th day of the third month of the year for which the election

is made (or, in the case of a newly formed corporation, the activation date). 1 All stockholders at the time of the election must consent



to the election on Form 2553 or on a separate statement attached to Form 2553. Also, if the election is made during the taxable year for

which it is to be effective, all persons who were stockholders during the year prior to the election must consent.

101.11 New C corporations and S corporations should both consider qualifying their stock for treatment under IRC Section 1244.

Basically, Section 1244 allows a loss on the disposition of qualifying stock to be treated as an ordinary loss rather than as a capital loss

for tax purposes. Ordinary loss treatment is also available if the stock becomes worthless. As an added benefit, any loss that qualifies

as an ordinary loss under IRC Section 1244 is also treated as a trade or business loss in computing a shareholder's net operating loss

(NOL). Consequently, Section 1244 losses are allowed for NOL purposes without being limited by nonbusiness income.

Limited Liability Companies

101.12 Limited liability companies (LLCs) are entities, owned by members, that combine many of the tax advantages of a partnership

with the liability protection of a corporation. Each state establishes its own LLC rules and characteristics.

101.13 The advantages and disadvantages of LLCs include:

• Advantages:

•• Members are not personally liable for LLC obligations. (However, members are personally liable for their own actions

and the actions of people they supervise.)

•• The number of members is not limited, and members can be corporations, trusts, partnerships, other LLCs, or others.

•• Double taxation is avoided. (Taxable income is passed through to the members.)

•• Members can participate in managing the LLC.

•• Distributions to members do not have to be directly proportional to the member's ownership percentage as they do for

S corporations.

•• LLCs can have two or more classes of ownership.

•• Assets flow in and out of the LLC at tax basis, not fair market value.

• Disadvantages:

•• LLCs may have a limited life depending on state law. (In some states, affirmative votes are required of all members to

continue operations if a member dies or withdraws.)



•• Transfer of interests is more difficult. (Although a member may transfer an equity interest in an LLC, the new owner

does not necessarily acquire all the rights and attributes of a member.)

•• In some states, LLCs must have at least two members.

•• Some states do not provide special tax status for LLCs.

1 PPC's 1120 Deskbook discusses possible ways to overcome missed filing deadlines.


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102 Franchise Relationships

102 Franchise Relationships

Franchise Agreements

102.1 New vehicle dealerships have a different relationship with their suppliers (i.e., the manufacturers) than most commercial

businesses have. They must enter into franchise agreements (also known as sales and service agreements) with manufacturers to

obtain the vehicles they sell and to perform warranty work. Those agreements are personal service contracts that may not be assigned

to others.

102.2 Franchise agreement may be a misnomer because an agreement assumes that the affected parties have negotiated and

compromised before reaching the agreement. In most cases, the terms of a franchise agreement are unilaterally set by the

manufacturer. Most states have laws to protect the dealer from abuse by the manufacturer. However, it is unclear whether, or how,

federal bankruptcy of manufacturers will affect state protection.

Common Requirements of a Franchise Agreement

102.3 Most dealership franchise agreements include requirements such as the following:

• Timely submission of monthly financial statements to the manufacturer.

• The sales and service performance or responsibilities the dealership has to meet.

• The necessity for the dealership to advertise and provide activities that promote the sale of new vehicles.

• The manufacturer's right to approve a dealership's change of location or addition of another franchise. In contrast, the

manufacturer may establish additional dealerships without approval of an existing dealership since franchise rights ordinarily are

not exclusive to territories. Most states have motor vehicle commissions to regulate the manufacturers and provide a forum for

dealer complaints.

• A prohibition on the dealership's knowingly exporting vehicles for sale or use outside of the United States.

• The manufacturer's right of first refusal if the dealership is to be sold. Changes in ownership must be approved by the

manufacturer, and the manufacturer generally has the right to substitute another buyer for the one the dealership has selected.



That right may be detrimental to the dealership because qualified buyers may be reluctant to bid if they feel the manufacturer will

substitute another buyer. Manufacturers may use the right of first refusal to control the makeup of the dealership's governing body.

All franchise agreements are subject to state franchise laws.

Term of the Agreement

102.4 A franchise agreement may be perpetual but is generally for a specific time period.

Termination of the Agreement

102.5 Each failure to meet a requirement of a franchise agreement does not warrant termination. If a dealership is in violation of the

agreement, the remedies are termination, specific performance, or other civil action. An agreement in the process of being terminated

remains in effect until that process is completed. If an agreement is terminated, the dealership cannot sell vehicles or perform warranty

work. However, terminations involved with manufacturer bankruptcy may provide for a more orderly wind-down.


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103 Industry Trends

103 Industry Trends

103.1 The dealership industry has been forced to react rapidly to changing economic, regulatory, and technological factors that affect

vehicle sales and service, as well as dealership continuity. For example, for a continuing dealership, a depressed economy will

generally increase the sale of used vehicles while decreasing the sale of new vehicles. However, aggressive manufacturing incentives

may counteract this trend. Service departments are becoming more profitable because buyers are keeping their vehicles longer and

having them repaired rather than trading vehicles every two or three years. Customers may lease vehicles rather than buying them in

order to get better vehicles for their money. Those leased vehicles are returned to the used vehicle market, resulting in increased

availability of quality late model used vehicles.

103.2 The economic contraction that began in 2008 has had a significant effect on the dealership industry. The effects of the

contraction on dealership financial statements are discussed in section 106.

New Car Prices

103.3 The average price of a new car, including accessories and options, has generally been decreasing but many still believe it is too

high for the average consumer. Manufacturers may need to consider additional ways to keep from pricing individuals out of the market,

for example, by establishing standardized specifications for automatic transmissions and parts, such as alternators, seat tracks,

batteries, and electrical connectors. This could result in substantial cost savings.

Used Vehicle Superstores

103.4 The demand for quality used vehicles has resulted in a differing marketing concept, the used vehicle superstore. An example is

CarMax (which is publicly traded). Those stores typically differ from the usual used vehicle operation in the following ways:

• A larger selection is offered. Each lot carries an average of 300 to 450 used vehicles. Their focus generally is on cars one to six

years old with less than 60,000 miles.

• No-haggle pricing is used instead of negotiated sales. Generally, the sales staff is paid an identical, fixed-dollar commission on

every vehicle sold, not commissions based on a particular make, model, or price of a vehicle.

• Technology is used to match customers with vehicles. Shoppers enter information such as the type of vehicle they are seeking

into computer terminals and find vehicles on the lot that meet their criteria. In addition, the inventory of vehicles at all sites is listed

on the company website, allowing customers to shop for vehicles at home and order cars not at their regional superstore.

• A positive shopping experience is being sold instead of price because their prices tend to be higher than other used car lots.



• If they want to trade in a vehicle, buyers get an appraisal that they can take in cash if they do not find what they want to buy.

• They generally get their inventory from vehicle auctions, financial institutions, manufacturers selling leased vehicles, companies

disposing of fleet vehicles, and direct purchase from consumers.

103.5 To more effectively compete with used vehicle superstores, factory-sponsored used vehicle dealerships may band together to

have a larger inventory. Manufacturers recognize that used vehicle superstores are pushing traditional dealerships to focus more on

serving used vehicle customers and that certifying used vehicles and offering manufacturer-based warranties for used vehicles is

necessary.

103.6 The superstore marketing concept is not limited to used vehicles. For example, CarMax is selling new cars from Chevrolet,

Chrysler, Dodge, Jeep, Scion, Nissan, and Toyota at certain locations.

Fewer Dealerships in the Future

103.7 The U.S. auto market has been in a transition. Consolidation, spin-offs, restructurings, and closings have reduced the number of

new car dealerships in the U.S. This decline is expected to continue as more franchised dealerships are consolidated or closed and as

major manufacturers make concerted efforts to reduce competition among their own dealerships and restructure their own operations.

103.8 Prior to the economic contraction that began in 2008 (see section 106), the “Big Three” automakers, Ford, GM, and Chrysler, had

begun taking steps to weed out unprofitable dealers in the bigger market areas. Because they were manufacturing fewer vehicles each

year, they needed fewer dealerships to sell them. When there are too many dealers, owners cannot afford to reinvest in their

dealerships. Sales suffer when facilities are not maintained, especially when a dealership is competing with a megastore that has

bright, modern facilities. And, as discussed in paragraph 103.16, more and more buyers are turning to the Internet to either begin the

purchasing process or to actually complete a vehicle purchase, another factor contributing to the need for fewer dealerships. The 2008

economic contraction exacerbated that situation as both GM and Chrysler filed for bankruptcy.

103.9 Chrysler had consolidated numerous dealerships into dealerships carrying all three Chrysler brands under one roof. GM had also

combined Pontiac, GMC, and Buick dealerships into one channel before discontinuing the Pontiac brand in 2009. As part of their 2009

restructurings, GM shut another 1,100 dealerships and Chrysler closed approximately 800.

Megadealerships

103.10 When the automobile industry was born over a century ago, buggy and wagon makers such as Buick and Studebaker had

networks of local businessmen who sold their vehicles across the country. As carriage makers started building cars, their networks of

buggy shops turned into networks of car dealerships. Through those networks, manufacturers control how their vehicles are sold

without the costs of maintaining their own retailing networks.

103.11 Big dealerships bought out smaller low-performing dealerships, creating megadealerships that own more than one facility and

often sell different brands. Even though most megadealerships are still family owned and operated, they are not small businesses. For

example, they generate millions of dollars in annual revenues, support large sales staffs, and, in many cases, own prime real estate.

103.12 Many of those owners are nearing retirement age, and their children may not be interested in continuing the business. The

megadealerships may not be easy to sell because potential buyers need substantial amounts of capital. Some dealerships are being

sold to investment companies, as discussed beginning at paragraph 103.13.

Retail Chains

103.13 Investment bankers and venture capitalists have the capital to buy dealerships and consolidate them into retail chains. And, the

aging of the owners of some megadealerships affords investment companies the opportunity to acquire whole groups of dealerships at

once.



103.14 Several companies, including Lithia Motors, Sonic Automotive, United Auto Group, AutoNation, and Asbury Automotive Group,

actively acquired dealerships and instituted cost saving measures. They entered the dealership industry with its inefficient marketing

and distribution system and seized a competitive advantage by reducing those costs. For example, they can buy advertising in bulk,

consolidate parts and service operations, and install centralized management information systems to reduce the clerical staff required.

103.15 Publicly Held Retail Chains

Another trend has emerged that affects retail chains. During 1996, Cross-Continent Auto Retailers became the nation's first automobile

dealership to go public. AutoNation has purchased hundreds of new vehicle dealerships. Other publicly held dealership groups include

United Auto Group, Sonic Automotive, Hometown Auto Retailers, Lithia Motors, Penske Automotive Group, and CarMax.

Online Marketplaces

103.16 The newest way to purchase a car might be to skip the retail dealership altogether and buy online, or at least get a connection

to a dealership's Internet sales department. Since a dealership's Internet sales department makes its commissions on volume, not

price, it can often offer a better price to an online customer than a traditional salesperson can offer at a dealership. Buyers can save

time and money and overall may have a more pleasant buying experience. Both new and used vehicles are sold online. Online retailers

carry no inventory but are able to find the exact car, options, color, etc., that the buyer wants by searching nationwide inventories.

Financing and smaller details, like extended warranties and rust proofing, can also be arranged online. Some Internet sites email free

dealership quotes to customers while others act more like brokers. In some cases, even when a purchase is made through a dealer,

the buyer feels like he or she is dealing directly with the Internet seller, and the car is delivered right to the customer's front door.

Demand for Lease Vehicles

103.17 As mentioned in paragraph 103.1, leasing grew in popularity because a customer can buy a more luxurious vehicle at a lower

initial cost and lower payments. Some dealerships have started leasing used vehicles. Leasing programs have advantages and

disadvantages for the dealership. A leasing program flattens out the business cycle by having contract renewals or replacements year

round, but it cuts down on F&I (finance and insurance) and extended service contract income. Dealerships that have strong lease

programs have a constant source of good used vehicles. However, customers who lease often have no brand loyalty, and they often do

not use the dealership's service department unless there is a warranty problem.

103.18 The average lease terms have increased, with many exceeding 36 months. As lease terms lengthen, there is concern that there

may be fewer off-lease customers to purchase new vehicles and that there will be fewer quality, low-mileage off-lease vehicles

available for sale as used vehicles.

Direct Repair Programs

103.19 Insurance companies, eager to repeat the way managed care has controlled health care costs, have been applying similar

concepts to fixing vehicles in programs called direct repair. Customers are encouraged to use one of a prescribed list of collision repair

shops, thereby streamlining costs and improving service. They usually get their vehicles back faster (thus saving on rental fees) and

often get a lifetime guarantee on the repairs. Dealerships may affiliate with multiple insurance companies.

103.20 While direct repair programs are not new for some insurance companies, increased competition in past years has prompted

other insurers to offer them as a way to lower expenses and improve service. Repair shops videotape or digitally photograph the

damage and transmit the tape or photos immediately to a claims adjuster's office, allowing damage to be assessed and repaired faster

than before. In effect, the repair shops have taken over some of the duties of the insurance companies, such as administrative work

and some claims functions.

Other Trends

103.21 A list of some other trends affecting the dealership industry follows:

• Internet Sites Where a Buyer Can Obtain Information about a New Vehicle. Kelley Blue Book (www.kbb.com) provides new

vehicle sticker and invoice prices and manufacturer rebates as well as used car prices. Microsoft's MSN Autos

(http://autos.msn.com) provides new vehicle sticker and invoice prices, dealer Internet links, online purchasing and quotes, and



used car classifieds. Currently, the information at those websites is free. The Fighting Chance Information Service

(www.fightingchance.com) costs $39.95 for one vehicle with additional orders at the same time costing $15 each. The buyer is

furnished the sticker price and dealer invoice price; the latest issue of CarDeals, a biweekly report on the manufacturer's cash

incentive programs; an analysis of how the manufacturer and vehicle model have been doing in the marketplace; several articles to

help interpret the information and provide additional insight into the nuances of purchasing a vehicle; and a telephone number to

call to discuss the purchasing process.

• Comparative Marketing. Marketing campaigns that feature a direct comparison with competing vehicles have gone to a new level.

• Longer Extended Warranties. With longer factory warranties on engines and transmissions, extended warranties are also

expanding.

• New Dealership Architecture. Many manufacturers are emphasizing brand image through their dealerships and are implementing

redesigned showrooms. Manufacturers often state that standardized dealerships help to differentiate their brands from the

competition.

• Fuel-saving Hybrid Automobiles. Higher gasoline prices have created increased consumer demand for more fuel efficient

automobiles, spurring automakers to accelerate plans of hybrid vehicles. Currently, most of the major vehicle manufacturers offer

hybrid electric vehicles, which use both batteries and fuel-burning engines to provide power. That combination of power sources

increases gas mileage and reduces pollution while meeting consumers' desires for vehicles that can be driven anywhere. The

growth in the hybrid market is expected to continue, especially now that hybrids have been around long enough for buyers to trust

the technology, more options are available, and there is a much wider selection of brands and models.

• Non-combustion Fuel Cell Automobiles. Most of the large car manufacturers are developing cars and/or trucks that will run on fuel

cells. The new, non-combustion engine runs on hydrogen and produces neither smog nor emissions, except water vapor. Plus, the

mileage capacity is expected to be much more than electric cars.

• Bi-fuel and Alternative Fuel Automobiles. Natural gas is relatively inexpensive, clean-burning, and readily available in North

America. Honda touted its natural gas-powered Civic GX as the cleanest vehicle ever built with an internal combustion engine.

Ethanol-based automobiles have been well-publicized as a viable alternative fuel, specifically those that use E85 ethanol fuel (85

percent ethanol and 15 percent gasoline).

• Consignment Sales. Some dealerships are selling used vehicles on consignment. The vehicles do not have floor plan expense

and generally sell for more than other used vehicles. The dealerships retain a percentage of the sales price or a flat sum based on

the vehicle's estimated value.

• Competition for Service Work. Service providers, like Wal-Mart and discount parts stores, are proving to be strong competitors

with dealership service departments.



• Expanding Accessories Market. The market for accessories like running boards, mud flaps, bug screens, etc. is growing. Those

accessories are even selling well at car washes. Some dealerships are focusing on selling accessory packages for used vehicles

and vehicles purchased at other dealerships.

• No-haggle Pricing. Industry analysts predict that it may increase modestly but not take over the industry.

• Salaried Salespeople. Paying salespeople a salary or a salary plus a bonus instead of a commission may become more

prevalent. Longevity bonuses may reduce turnover, which historically has been very high for dealerships.

• Scrutiny of Lending Practices. Highly visible lawsuits and regulatory scrutiny against automotive dealerships for potential lending

violations against the federal Truth-in-Lending Act (TILA) and the Uniform Deceptive Trade Practices Act (UDTPA) have raised

dealers' concerns about their lending practices. Common complaints include incomplete disclosure in the contract of after-market

products and inconsistent collection of certain fees. Many dealerships are now emphasizing increased communication and

disclosure with the consumer.

• Increased Customer Privacy. The Federal Trade Commission's Safeguard Rule requires that dealerships provide administrative,

technical, and physical safeguards to protect customer information. Dealerships have had to ensure that reasonable policies and

procedures exist to protect the security and confidentiality of information collected from (and about) customers, including

information obtained from the dealership's internet website.


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104 Dealership Consolidations

104 Dealership Consolidations

104.1 As discussed beginning at paragraph 103.7, many manufacturers have had programs to reduce the number of dealerships.

Essentially, the consolidation programs are trying to align franchises and physical facilities in terms of (a) location (i.e., obtaining right or

better locations), (b) improved facilities and image, and (c) product availability and product mix in terms of make and model of brands.

One benefit of such a reduction is significant savings in distribution and marketing costs. This section discusses reduction programs

and steps accountants can take to assist their dealership clients in preparing for the effects of those programs. Section 106 discusses

accounting considerations related to the current economic contraction.

104.2 Although there is no standard consolidation program for all manufacturers, the following generalizations seem to apply:

• Each manufacturer has its own plans for realigning its franchise network. Over the past few years, Ford, without fanfare or

publicity, implemented an aggressive consolidation program.

• If most manufacturers could start all over again today, many of their dealerships would not be found to be in the right locations

with the right product mix.

• Some dealerships are protected from having their selling agreements terminated for arbitrary reasons by state law to some

degree, but that degree of protection varies from state to state.

• The specifics of consolidation programs and activities are constantly changing in shape and impact. Some of the factors

influencing a manufacturer's activities at any given time include:

•• Local circumstances in the dealership's primary market area.

•• The degree of resistance or passivity dealerships offer, either individually or collectively.

•• The strength or weakness of state dealership protection laws and the willingness of manufacturers to test them.



• Dealerships are not treated consistently by manufacturers under consolidation programs, so it is reasonable to expect some

degree of confusion and inefficiency to accompany their implementation.

• Complex decisions with major tax consequences may have to be made under critical time pressures. Dealerships and their

accountants should reevaluate buy-sell agreements, estate and succession planning, dealership valuations, and corporate and

individual income tax strategies. More than ever before, dealerships need competent accountants, attorneys, brokers, and advisors

who understand the dealership industry and the rapidly changing environment in which dealerships operate. Paragraph 104.5

discusses actions accountants can take to minimize the consequences of consolidation programs to their dealership clients.

• Many dealerships lost significant value almost overnight. Dealerships that received not viable letters, that were linked to the fate

of other dealerships, or that gave up site control to manufacturers have far less value than they had previously.

• Dealers who do not have realistic valuations of their dealerships stand to lose even more. Every valuation should address the

question, “What is the dealership's status with respect to possible consolidation?” The answer to that question must consider,

among other things, the effect of the consolidation programs of other manufacturers on their dealerships in the same market area.

The valuation must be reconsidered over the next few years as dealerships in the market area are closed or expanded.

• It is critical that dealerships fighting to survive or planning to expand have adequate capitalization. Significant funds may be

necessary to finance facilities that comply with new image standards and other program requirements. Factory incentives, cash

payments, loans, and lower financing costs are often available, but dealerships must aggressively seek them out and bargain for

them.

• There is no specific cutoff date on which the manufacturers' attempts at consolidation and managed attrition will cease. Many

believe consolidation will continue well into the future. It is expected that those dealerships that survive will be better off and more

profitable in the long run.

Terminating Franchises

104.3 Some manufacturers may attempt to terminate franchises for cause without compensation. There are several reasons a

manufacturer may give for the termination. For example, the dealership may have:

• Produced insufficient sales according to the manufacturer's criteria.

• Received a poor customer satisfaction rating. Those dealerships will not add any new lines and may lose the ones they have.

• Failed to maintain adequate working capital (resulting in out of trust problems), or there may be other going concern

considerations.

• Reported transactions dishonestly to the manufacturer, especially those transactions involving warranty claims and sales

incentive programs.



• Occupied inadequate or deteriorating facilities that have not been upgraded or repaired.

• Formulated an inadequate succession plan.

• Initiated a transaction that is not permitted in the franchise agreement.

The manufacturer may also try to terminate a dealership's franchise if the dealer is convicted of a criminal activity or if there is adverse

publicity brought on by the behavior of the dealer or another key employee.

Stand-alone Franchises

104.4 Stand-alone franchises are dealerships with only one franchise (that is, they represent only one manufacturer). Dealerships that

have stand-alone franchises should find out what the manufacturer's plan is for them, even though they may have to press the

manufacturer to find out. If they are at risk of losing their franchises or being closed down, they have the following options:

• Purchase a complementary franchise.

• Obtain a current valuation of the at-risk dealership and try to sell it immediately, either to another dealership or to the

manufacturer.

• Do nothing, anticipating that the manufacturer's consolidation initiative may lose momentum over a period of time due to

personnel changes at the manufacturer or other circumstances.

Involvement by Accountants

104.5 There are several steps accountants can take to minimize the consequences of consolidation programs to their dealership

clients. For example, accountants can:

• Review the franchise agreement to determine the answers to the following questions:

•• When does the current agreement terminate?

•• Under what circumstances can it be terminated?

•• To which termination conditions is the dealership most vulnerable?



• Obtain a copy of any state laws that provide protection to the dealership. A written summary may be available from the state

dealership association.

• Review any recent valuations of the dealership that were completed in light of the manufacturer's consolidation program.

Accountants can determine how significantly the value of the dealership affects the dealer's post-retirement cash needs and other

goals. They can also review buy-sell agreements and other estate planning documents.

• Prepare a valuation by vehicle line or franchise if pressure is expected from the manufacturer in connection with dualing or stand-

alone status.

• Prepare supporting financial and other information in response to claims or statements made by the manufacturer (in

correspondence, telephone calls, and seemingly informal conversations) to the dealership. Correspondence from the manufacturer

should always be truthfully answered. Responses should be directed to the letter's originator, but copies should be sent to other

interested parties at the factory.

• Conduct a survey or compliance check to determine the dealership's exposure, if any, to manufacturer warranty claim or incentive

program audits initiated in conjunction with consolidation programs.

With that information, accountants can discuss either proactive or defensive strategies with dealership management and legal advisors.

Accountants may also be asked to provide accounting guidance for events and transactions related to the current economic

contraction. See section 106.


END OF DOCUMENT -




Checkpoint Contents


Editorial Materials


Dealerships


105 Independence and the Performance of Nonattest Services for Dealerships

105 Independence and the Performance of Nonattest Services for

Dealerships

105.1 Independence is an important issue for many small practitioners because, as discussed more fully in Chapter 9, the only type of

report a CPA can issue on financial statements when he or she is not independent is a compilation report. However, independence is

much easier to define than to apply. An infinite variety of situations can occur that raise questions regarding independence issues but

are not necessarily independence problems. Therefore, it is important for CPAs to understand the various rules that govern

independence. The following paragraphs discuss the authoritative literature relating to independence, the conceptual framework for

independence, and the impact of performing nonattest services for dealership attest clients. Throughout the discussion, the authors

generally use the terms practitioner, accountant, member, and auditor interchangeably.

105.2 The primary rules governing independence are found in the AICPA Code of Professional Conduct (Code of Conduct). The

authors recommend that the CPA read Rule 101 of the Code of Conduct, the interpretations of Rule 101, and the independence rulings

for guidance concerning independence. 2 This guidance can be found in the AICPA Professional Standards, ET 101 and 191.

Independence requirements also can be found in the SSARS, SASs, SSAEs, and AICPA Statement on Quality Control Standards

(SQCS) No. 8, A Firm's System of Quality Control. Not having independence when required can have significant negative ramifications

for the firm and the nonindependent practitioner. Complying with the independence requirements of the Code of Conduct ensures that

the related independence requirements of SQCS No. 8, SSARS, SASs, and SSAEs are met. While the authoritative literature governing

the various types of engagements contains a great deal of discussion about the concepts of independence, identifying independence

problems, and resolving nonindependence situations, the basic concept of independence is the same regardless of the level of service

or the type of engagement. Basically, accountants are independent if they are free from obligation to or interest in their clients.

105.3 Quality Control Standards (QC 10.25) require that the firm obtain written confirmation regarding compliance with the firm's

independence policies and procedures from all personnel required to be independent. It also requires the firm to accumulate and

communicate relevant information to its personnel to enable them to readily determine whether they are independent. PPC's Guide to

Quality Control discusses independence in detail and provides for firm personnel to sign an independence representation. It also

includes an Independence, Integrity, and Objectivity Questionnaire to aid in making the representation.

105.4 Many threats to independence are specifically addressed in Rule 101 and its related interpretations and rulings. For

independence-related matters that are not explicitly addressed in the Code of Conduct, AICPA members are required to apply the risk-

based approach found in the Conceptual Framework for AICPA Independence Standards (the Framework) (ET 100.01).

Conceptual Framework for Independence

105.5 The Framework describes the risk-based approach used by PEEC to analyze independence matters when it develops standards.

Applying the Framework is discussed in the following paragraphs.

105.6 No Independence Interpretations or Rulings

In situations where there are no independence interpretations or rulings that address a practitioner's particular independence

circumstance, Interpretation 101-1 requires the practitioner to evaluate whether his or her particular independence situation would lead



a reasonable person who is aware of all of the facts to conclude that the practitioner is not independent. When making that

determination, practitioners must refer to the risk-based approach described in the Framework.

105.7 Unacceptable Risk

The Introduction to the Conceptual Framework indicates that under a risk-based approach to analyzing independence, a member's

relationship with a client is evaluated to determine whether it poses an unacceptable risk to the member's independence. Risk is

unacceptable if the relationship would compromise (or would be perceived as compromising by an informed third party having

knowledge of all relevant information) the member's professional judgment when rendering an attest service to the client.

105.8 Threats

Threats to independence are circumstances that could impair independence. Many different circumstances (or combinations of

circumstances) can create threats to independence. Some examples include the following:

• Self-review Threat. Reviewing your own nonattest work, or that of your team, as part of the attest engagement.

• Familiarity Threat. Practitioners who have close or longstanding relationships with attest clients.

• Undue Influence Threat. Attempts by an attest client's management to exercise influence over the practitioner, such as pressure

to reduce audit procedures for the purpose of reducing audit fees.

• Management Participation Threat. Performing management functions on behalf of an attest client, such as making hiring

decisions.

105.9 Safeguards

Safeguards are controls that mitigate or eliminate threats to independence. To be effective, safeguards must eliminate the threat or

reduce to an acceptable level the threat's potential to impair independence. Safeguards are generally created or implemented by one of

the following three sources:

• Profession, Legislation, or Regulation. Examples include continuing education requirements on independence and ethics, and

external review of a firm's quality control system.

• Attest Client. Examples include a tone at the top that emphasizes the attest client's commitment to fair financial reporting and

policies and procedures that are designed to achieve fair financial reporting.

• CPA. Examples include rotation of senior personnel who are part of the attest engagement team, and the involvement of another

firm to perform part of an engagement.

105.10 Required Documentation

If threats to independence are not at an acceptable level, safeguards should be applied to eliminate the threats or reduce them to an

acceptable level. In instances where threats to independence are not at an acceptable level, thereby requiring safeguards, the following

should be documented:



• The threats identified.

• The safeguards applied to eliminate the threats or reduce them to an acceptable level.

105.11 This over-arching principle in determining independence may cause legal liability concerns for CPAs no longer able to strictly

use a rules-based approach to determining their independence. A copy of the Code of Conduct, which includes the Framework, can be

found on the AICPA's website at www.aicpa.org.

Nonattest Services

105.12 CPAs who perform attest services for dealership clients (i.e., audits, reviews, and compilations) may also perform, or be

requested to perform, consulting or other nonattest services for the dealership. An independence issue may arise when practitioners

provide any nonattest service, such as accounting, bookkeeping, or data processing services for a dealership attest client. According to

Interpretation 101-3, “Nonattest Services,” of the Code of Conduct (ET 101.05), before CPAs perform nonattest services for an attest

client, they should determine that the requirements of Interpretation 101-3 have been met. 3

105.13 If the requirements of Interpretation 101-3 have not been met during the period of the attest engagement or the period covered

by the financial statements, independence is considered impaired unless, for nonattest services performed during the period covered

by the financial statements—

a. the nonattest services were provided prior to being engaged to perform the attest engagement (period of engagement),

b. the nonattest service related to periods prior to the period covered by the financial statements, and

c. the financial statements for the period to which the nonattest service relate were audited by another firm.

105.14 During an attest engagement, the CPA will often communicate with management about issues related to the engagement. The

following discussions are considered a normal part of an attest engagement and would not be subject to the Interpretation:

• The client's selection and application of accounting standards or policies and financial statement disclosure requirements.

• Whether the client's accounting and financial reporting methods are appropriate.

• Adjusting journal entries proposed by the practitioner.

• The form or content of the financial statements.

The CPA is cautioned to consider whether the level of involvement constitutes a separate nonattest service.

105.15 Interpretation 101-3 requires the following with respect to the performance of nonattest services:

• The CPA should not assume any management responsibilities.



• The client must agree to perform certain specific functions in connection with the nonattest services.

• The CPA should establish and document in writing the understanding with the client regarding the nonattest services.

Chapters 9-10 discuss attest and nonattest engagements for dealerships. Note that the ability to perform those engagements may be

affected by the discussion in the following paragraphs.

105.16 Under the Interpretation, independence is considered to be impaired if a member (or his or her firm) assumes management

responsibilities for an attest client. However, the member may assist management in those responsibilities. For the member to remain

independent, before the start of the nonattest engagement, the client should agree to perform all of the following functions in connection

with the nonattest services:

• Assume all management responsibilities.

• Oversee the services by designating an individual who possesses suitable skill, knowledge, and/or experience, preferably within

senior management.

• Evaluate the adequacy and results of the services performed.

• Accept responsibility for the results of the services.

105.17 In addition, before the start of the nonattest engagement, the member should be satisfied that the client will be able to meet all

of these criteria, make an informed judgment on the results of the nonattest services, and make the significant judgments and decisions

that are management's responsibility. In cases where the client is unable or unwilling to assume its responsibilities, the member's

performance of the nonattest services would impair independence.

105.18 The Interpretation also requires the member to establish and document in writing his or her understanding with the client

regarding the following:

• Objectives of the engagement (i.e., the nonattest services).

• Services to be performed.

• Client's acceptance of its responsibilities.

• Member's responsibilities.

• Any limitations of the engagement.



105.19 The Interpretation does not specify how the understanding is to be documented, so the practitioner has flexibility. For example,

the understanding might be documented in a separate engagement letter, in the workpapers, in an internal memo, or in the

engagement letter obtained in conjunction with an attest engagement. The authors believe it is common in many dealership attest

engagements to also provide nonattest services, such as tax return preparation or bookkeeping services. Therefore, the sample

engagement letter at DLR-CL-1.1 includes the language necessary to meet the documentation requirements under Interpretation 101-3

(ET 101.05). If the practitioner chooses to document the understanding with the client about the performance of nonattest services

other than in the engagement letter, the checklist at DLR-CX-1.2, “ET Interpretation 101-3 Documentation Form” can be used.

105.20 Certain activities performed as part of a nonattest service are considered to be management responsibilities and, therefore,

create a management participation threat that would be so significant that no safeguards could reduce the threat to an acceptable level.

Performance of those activities for an attest client would impair independence regardless of whether the practitioner complies with the

other requirements of Interpretation 101-3. The Interpretation lists common nonattest service activities and notes whether they are or

are not considered to impair independence. The Interpretation states, “It is not possible to specify every activity that is a management

responsibility. However, management responsibilities involve leading and directing an entity, including making significant decisions

regarding the acquisition, deployment, and control of human, financial, physical, and intangible resources.” The Interpretation provides

the following examples of activities that are considered management responsibilities and would impair independence (that is, they

would preclude the practitioner from being independent):

• Setting policies or strategic direction for the client.

• Directing or accepting responsibility for the actions of the client's employees except as permitted when using internal auditors to

provide assistance for services performed under auditing or attestation standards.

• Exercising authority on behalf of a client, such as authorizing, executing, or consummating transactions, or having the authority to

do so.

• Preparing source documents, in electronic or other form, that evidence the occurrence of a transaction.

• Having custody of client assets.

• Deciding which of the auditor's, or other third parties', recommendations should be implemented or prioritizing those

recommendations.

• Reporting to those in charge of governance on behalf of management.

• Serving as a client's stock transfer or escrow agent, registrar, general counsel, or its equivalent.

• Accepting responsibility for the management of a client's project.



• Accepting responsibility for the preparation and fair presentation of the client's financial statements.

• Accepting responsibility for designing, implementing, or maintaining internal control.

• Performing ongoing evaluations of the client's internal control as part of its monitoring activities.

Interpretation 101-3 includes a table listing various types of nonattest services and addresses the impact of those services on

independence.

105.21 Interpretation 101-3 (ET 101.05) also addresses tax compliance services. Preparing a tax return and transmitting the tax return

and related payment, either electronically or in paper form, to a taxing authority does not impair independence as long as the

practitioner does not have custody or control of the client's funds and the individual overseeing the tax services (a) reviews and

approves the return and payment and (b) signs the return prior to transmittal, if required for the filing. Signing and filing a tax return

impairs independence unless the practitioner has legal authority to do so and—

• the taxing authority has prescribed procedures, allowing the taxpayer to permit the practitioner to sign and file a return on their

behalf, that meet the standards for electronic return originators and officers outlined in IRS Form 8879, or

• an individual in client management who is authorized to sign and file the tax return provides the practitioner with a signed

statement that indicates—

•• the return being filed.

•• that the individual is authorized to sign and file the return.

•• that the individual has reviewed the return, including accompanying schedules, and it is true, correct, and complete to

the best of the individual's knowledge and belief.

•• that the individual authorizes the practitioner to sign and file the return on behalf of the client.

The Interpretation also indicates that the practitioner's representation of the client in an administrative proceeding before a taxing

authority does not impair independence providing the practitioner obtains the client's agreement prior to committing the client to a

specific resolution with the taxing authority. Independence is impaired if the practitioner represents the client in court to resolve a tax

dispute.

105.22 In addition, under Interpretation 101-3 (ET 101.05), certain appraisal, valuation, or actuarial services are considered to impair

independence. Performing appraisal, valuation, or actuarial services impairs independence if the results are material to the financial

statements and the service involves significant subjectivity. For example, a material asset appraisal or business valuation generally



involves significant subjectivity, and therefore would impair independence if performed for financial statement purposes. However, an

actuarial valuation of a client's pension liabilities ordinarily does not require significant subjectivity and, therefore, would not impair

independence even if the amount was material.

105.23 Under Interpretation 101-3 certain types of forensic accounting services may impair independence. Independence is impaired if

a practitioner conditionally or unconditionally agrees to provide expert witness testimony for a client. However, under certain defined

conditions, independence is not impaired if the practitioner provides expert witness testimony for a large group of plaintiffs or

defendants that includes the practitioner's client. If the practitioner provides litigation services where he or she is a trier of fact, special

master, court-appointed expert, or arbitrator in a matter involving a client, independence is impaired.

105.24 In some cases, the auditor may perform extended audit services for a client. Extended audit services may include assistance

with the client's internal audit function or an extension of audit services beyond the requirements of generally accepted auditing

standards. Interpretation 101-3 also addresses the impact of those services on the auditor's independence. According to the

Interpretation, performance of internal audit assistance services does not impair the auditor's independence as long as the auditor is

not an employee of the client or does not act in the capacity of management (for example, determining the scope, risk, and frequency of

internal audit activities). The auditor should be satisfied that the client understands its responsibility for directing the internal audit

function. The general requirements of the Interpretation discussed previously (such as documenting the understanding with the client)

also must be met. With respect to providing assistance with the internal audit function, the auditor should be satisfied that the board of

directors and/or audit committee (if one exists) is fully informed of the engagement. Generally, performing procedures that are merely

an extension of the auditor's scope applied in the audit of the client's financial statements (such as confirming accounts receivable)

would not impair the auditor's independence even if the extent of testing exceeds the requirements of generally accepted auditing

standards.

105.25 Should Proposing Journal Entries and Preparing Financial Statements in Connection with an Attest Engagement be

Viewed as Bookkeeping and, Therefore, Nonattest Services?

Interpretation 101-3 includes bookkeeping as an example of a nonattest service. Rather than define bookkeeping, the Interpretation

provides several examples of services that would be considered bookkeeping. Two of those examples are (a) proposing standard,

adjusting, or correcting journal entries or other changes affecting the financial statements to the client and (b) preparing financial

statements based on information in the trial balance. 4 Practice questions have arisen as to whether those examples mean that

proposing journal entries and preparing financial statements in connection with an attest engagement should be viewed as

bookkeeping and, therefore, nonattest services subject to the Interpretation. As a practical matter, small and midsize nonpublic entities

typically view proposing journal entries and preparing financial statements as part of the attest engagement, and, based on

implementation guidance provided in questions and answers published by the AICPA Professional Ethics Executive Committee (PEEC)

during 2004 and 2005, the authors believe it is clear that PEEC did not intend for Interpretation 101-3 to view those services as

separate from the attest engagement.

105.26 The authors view bookkeeping services as services that involve processing an entity's transactions or preparing an entity's

accounting records. For example, preparing an entity's accounting journals and ledgers by entering information provided by

management into Peachtree® or other accounting software is a bookkeeping service because it involves preparing an entity's

accounting records. Bookkeeping services that—

a. Constitute management functions, such as authorizing or approving purchase orders or preparing sales invoices, would impair

independence.

b. Do not constitute management functions, such as recording disbursements approved by management, would not impair

independence provided the practitioner obtained the understanding with the entity required by the Interpretation. Failure to obtain

the required understanding would impair independence. However, failure to comply with the Interpretation's requirement to

document that understanding would not impair independence but would be a violation of Rule 202, Compliance With Standards, of

the Code of Conduct.



105.27 The authors believe performing procedures in connection with an audit that are designed to address audit risk arising from the

lack of control activities, such as reconciling carrying amounts of assets and liabilities with amounts reported by third parties, would not

be considered bookkeeping services. Similarly, preparing financial statements as part of an attest engagement would not be considered

a bookkeeping service. Neither of those services involves processing the entity's transactions or preparing its accounting records.

105.28 Proposing adjustments of an entity's accounting records in connection with an attest engagement also would not be considered

a bookkeeping service. To illustrate, assume that as part of the audit of the financial statements the auditor proposes journal entries to

capitalize improvements recorded as repairs expense and to charge to expense repairs capitalized as improvements; to record

depreciation calculated using the auditor's depreciation software; to convert the carrying amounts of inventory and cost of sales from

amounts determined using the first-in, first-out method to the last-in, first-out method based on the auditor's calculation of indexes and

changes in layers; to recognize liabilities for subsequent disbursements; to record the valuation allowance for customer account

balances; and to record the current and deferred income tax provisions. Those are adjustments of the accounting records prepared by

the entity. Accordingly, the authors would not view them as bookkeeping services and, therefore, would not view them as subject to the

Interpretation.

105.29 Since the entity is required to accept responsibility for the fair presentation in the financial statements of financial position,

results of operations, and cash flows in conformity with generally accepted accounting principles, the authors believe the number of

journal entries proposed in connection with an attest engagement is not relevant to whether that is a bookkeeping service and,

therefore, subject to the Interpretation. As a practical matter, however, the entity's accounting records may be in such poor condition

that an auditor cannot perform sufficient procedures to determine the journal entries needed to express an unmodified opinion. To

overcome the scope limitation, bookkeeping services may be performed to bring those inadequate accounting records into substantial

completion so that the auditor can perform sufficient procedures.

105.30 To illustrate, assume that an entity changed accounting software during the year and did not have sufficient controls in place to

ensure the proper transfer of accounting information and that since the conversion, totals of subsidiary ledgers have differed materially

from the related general ledger account balances. In that situation, the auditor would be unable to perform sufficient procedures to

determine the journal entries needed to express an unmodified opinion. That scope limitation could be overcome by having the entity,

members of the auditor's firm, or a bookkeeping service prepare adequate accounting records for the period from just prior to the

conversion through year-end.

105.31 Practitioners who are unable to make a judgment as to whether they are providing bookkeeping services are not prohibited from

concluding that they are providing services subject to the Interpretation and following the Interpretation's requirements.

105.32 Additional Questions in Applying Interpretation 101-3

The following additional questions are likely to arise as practitioners apply the requirements of Interpretation 101-3 (ET 101.05). The

responses reflect the authors' views on such matters based on the guidance in the Interpretation and the related nonauthoritative

guidance published by the AICPA.

a. Providing Routine Advice to Clients.

Question—If a client calls the auditor and asks a technical question, would this be considered a nonattest service for which ET

Interpretation 101-3 would apply?

Response—No, routine activities performed by the auditor, such as providing advice and responding to clients' technical questions

as part of the normal client relationship, are not considered nonattest services for which ET Interpretation 101-3 would apply. (See

discussion at paragraph 105.14.)

b. Inadvertent Noncompliance.

Question—What if the practitioner inadvertently fails to comply with the Interpretation's requirement to document in writing the

practitioner's understanding with the client?



Response—A failure to document the understanding with the client is not considered to impair a member's independence provided

such understanding has been established. Rather, such a failure, regardless of whether it was isolated or inadvertent, would be

considered a failure to comply with an ethics standard under Rule 202, Compliance with Standards.

c. Assessing Whether an Individual Possesses Suitable Skill, Knowledge, or Experience.

Question—How does an auditor assess whether a client's designated employee possesses suitable skill, knowledge, or experience

as required by the Interpretation?

Response—It is not intended that the client employee possess a level of technical expertise equal to the auditor's (that is, sufficient

to perform or reperform the auditor's services). The client employee need only understand the nonattest services enough to be

able to provide general direction for the services; understand the key issues the auditor identifies; make any required management

decisions; and evaluate the adequacy of, and accept responsibility for, the results of the auditor's work. The designated individual

fulfills the competency requirement by possessing suitable skills, knowledge, and/or experience based on factors such as his or

her understanding of the service, knowledge of the client's business and industry, general business knowledge and education, and

position at the client. When assessing the employee's competency, the relative importance of those factors is considered in relation

to the service being performed. The auditor may educate his or her client in order for them to assume their responsibilities. For

example, if the auditor performs routine bookkeeping services for an attest client, he or she could ensure compliance with the

requirements of the Interpretation by reviewing the proposed journal entries with the client and explaining in general terms how

each entry affects the financial statements. The client should then be in a position to approve the journal entries and accept

responsibility for the financial statements.

d. Nonattest Services Performed before the Client Becomes an Attest Client.

Question—The practitioner accepts an audit engagement for a client for whom he or she has previously provided only bookkeeping

services. Prior to accepting the audit engagement, the practitioner does not have a written understanding with the client under

Interpretation 101-3 (ET 101.05). Has the practitioner violated the requirements of the Interpretation?

Response—No, the ET 101-3 documentation requirement does not apply to nonattest services performed before the client

becomes an attest client. The auditor would be permitted to prepare the required documentation upon acceptance of an audit

engagement, provided the auditor is able to demonstrate his or her compliance with the other general requirements during the

period covered by the financial statements, including the requirement to establish an understanding with the client. As a practical

matter, practitioners who are initially engaged to only provide nonattest services but expect to subsequently be engaged to also

provide attest services may consider structuring the engagement so that performance of the nonattest services will not impair

independence for the attest services.

105.33 Illustrative Examples

The following paragraphs provide several scenarios relating to accounting services in which auditors' independence might be impaired.

Also included with each scenario are the authors' views (considering the guidance in Interpretation 101-3 and related nonauthoritative

guidance) about whether or not the services are permitted under Interpretation 101-3 (that is, whether or not the services impair

independence).

Example 1-1: Auditor has authority to sign or co-sign checks.

Scenario: Auditors accept the responsibility of signing or co-signing a client's checks in emergency situations.



Is Independence Impaired? Yes, independence would be impaired because such activities are considered management

functions. Having the authorization to sign or co-sign checks on a client's bank account, even if such activity is never

performed, impairs independence.

Example 1-2: Auditor provides payroll services that include co-signing payroll checks.

Scenario: The auditor provides payroll services for a client that consist of calculating the payroll amounts, preparing

journal entries to record those amounts, preparing and co-signing payroll checks, making electronic payroll tax payments,

and preparing quarterly and annual payroll tax returns.

Is Independence Impaired? Yes, independence would be impaired because signing checks, or having the authority to

sign or co-sign checks, is a management responsibility. Preparation and signing of payroll tax returns and transmitting

payment to a taxing authority does not impair independence as long as the requirements outlined in paragraph 105.21

are met.

Example 1-3: Auditor codes check stubs based on information provided by the client.

Scenario: When performing monthly accounting services for a client, the auditor codes the check stubs (that is,

determines the general ledger accounts to which the disbursements should be recorded and writes the appropriate

account numbers on each check stub) based on the description provided by the client on the check stubs.

Is Independence Impaired? No, independence is not impaired. Normally, coding check stubs will not impair the auditor's

independence as long as the client provides sufficient detail to clearly identify the nature of each transaction. Note that, in

some cases, the auditor can determine the nature of a transaction based on the payee (for example, the electric

company, office supply company, etc.). However, the auditor needs to be careful not to assume the role of management,

thereby losing independence with respect to the client.

Example 1-4: Auditor records journal entries in the client's accounting system.

Scenario: An auditor records journal entries in the client's accounting system.

Is Independence Impaired? No, the auditor's independence would not be impaired provided that the client understands

the nature and impact of the journal entries. For example, the auditor could provide the client with a printout of proposed

journal entries accompanied by clear explanations, ask the client to review the printout, and then ask whether the client

has any questions about the entries. Although not required, some auditors obtain the client's written approval of the

proposed journal entries by, for example, signing or initialing the journal entries or on a separate journal entry approval

form, such as the one included in this Guide at DLR-CX-12.1.

Example 1-5: Auditor installs pre-packaged accounting software.

Scenario: An auditor installs pre-packaged accounting software, such as QuickBooks, for his or her client and sets up the

chart of accounts and financial statement format defaults.

Is Independence Impaired? No, the auditor's independence is not impaired. In its Background and Basis for

Conclusions, the Professional Ethics Executive Committee stated that independence is not considered impaired, as this

type of service does not constitute designing a system, provided the auditor does not create or change the source code(s)

underlying the pre-packaged software.



The AICPA website at www.aicpa.org has instructions for using an Ethics Hotline where members of the AICPA's Professional Ethics

Team answer questions about independence and other behavioral issues.

105.34 Staff Members on Loan

An independence problem that often arises concerns participation in the audit by staff members on loan from another firm who have

some prior involvement with the client, e.g., providing accounting or other nonattest services. The Code of Conduct (ET 92) defines the

term covered member for purposes of Rule 101 on independence. The definition makes clear that the independence requirements

apply to all employees and all contractors participating on the engagement team. (Specialists such as actuaries, appraisers, engineers,

and environmental consultants who do not directly participate in the audit, and persons performing only clerical functions, such as

typing, are not considered members of the engagement team.) This means that staff on loan from another firm become covered

members for purposes of determining independence, and if they have any relationship to the client that impairs their independence, the

firm engaged to perform the audit is not independent.

105.35 A related question is whether staff on loan from another firm are not independent of the client simply because a partner of that

other firm is not independent of the client. In other words, do the individual staff members of the other firm carry a taint of

nonindependence that arises solely from their regular employment by a firm that is not independent? Ruling No. 71 (ET 191.142-.143)

clarifies that the use of the staff will impair independence, but that the “use of the work of such individuals in a manner similar to internal

auditors is permissible provided that there is compliance with the Statements on Auditing Standards.” An auditor may make use of

internal auditors to provide direct assistance in performing an audit as long as the auditor (a) supervises, reviews, evaluates, and tests

their work appropriately and (b) exercises his own judgment on matters such as sufficiency of tests and materiality of misstatements. To

be in conformity with Ruling No. 71, the authors recommend that staff members on loan from a nonindependent firm be treated

analogously to internal auditors. As long as there is proper supervision of their work, their participation in the engagement generally will

not create an independence problem.

105.36 Unpaid Fees

An auditor's independence can be impaired by unpaid fees. Specifically, Ruling No. 52 (ET 191.103-.104) states that independence will

be considered impaired if fees (billed or unbilled) or a note receivable arising from such fees for professional services rendered more

than one year prior to the date of the current year's report remain unpaid when that report is issued. (While Ruling No. 52 does not

indicate that the unpaid fee needs to be of a certain amount before it impairs independence, the authors believe that amounts that are

clearly inconsequential would not impair independence.) An accounts receivable aging may be reviewed periodically to monitor past

due accounts. Auditors need to ensure that all prior year's fees are collected before the current year's report is issued. In addition, if

prior year fees are unpaid, auditors need to consider the reasons why the fees might remain unpaid. Chances are that if past fees have

not been paid, future fees will also not be paid. Consequently, auditors ought to seriously consider not accepting a new client or

continuing an existing engagement if prior year fees are unpaid.

105.37 Client Employee

When an individual in the immediate family of an engagement team member is employed by the client, independence violations can

occur. However, Interpretation 101-1 (ET 101.02) of Rule 101 includes an exception specifically allowing individuals in a covered

member's immediate family (spouse or dependent) to be employed by a client in a position other than a key position. A key position

includes one involving:

• primary responsibility for significant accounting functions that support material financial statement components,

• primary responsibility for financial statement preparation, or

• the ability to exercise influence over financial statement content (such as by being a client's president; controller; or chief

executive, financial, operating, or accounting officer).



105.38 There are also independence concerns when a former partner or professional employee becomes an employee of a client. The

primary concerns are that partners or professional employees who leave the CPA firm to work for a client have close relationships with

the engagement team, know the engagement approach, and could potentially circumvent procedures. In addition, junior engagement

team members might have great respect for the person and might not be able to objectively question him or her. According to Ethics

Interpretation 101-2 (ET 101.04), “Employment or Association with Attest Clients,” a firm's independence will be considered to be

impaired when a former partner or professional employee becomes a key employee of a client unless all of the following conditions are

met:

• Amounts due the former partner or professional employee for his or her previous interest in the firm and for unfunded, vested

retirement benefits are not material to the firm, and the formula used to calculate the payout benefits is not variable.

• The former partner or professional employee is not in a position to influence the firm's operations or financial policies.

• The former partner or professional employee does not participate or appear to participate in the firm once employment with the

client has commenced.

• The engagement team considers the appropriateness of modifying the engagement procedures to compensate for the risk that

engagement effectiveness could be reduced by the former partner or professional employee's knowledge of the engagement plan.

• The firm assesses whether the engagement team members have the appropriate experience and status to effectively deal with

the former partner or professional employee, if he or she will significantly interact with the engagement team.

• The engagement workpapers are reviewed to ensure the engagement team maintained an appropriate level of skepticism when

evaluating the representations and work of the former partner or professional employee.

105.39 Financial Interests

A practitioner who has a direct or material indirect financial interest in a client is not considered to be independent. Similarly,

practitioners who have a material financial interest in nonclients related to clients through common control or joint ventures are not

considered to be independent.

105.40 Other Independence Requirements

Regulatory agencies, certain state CPA societies, and state boards of accountancy may have established independence requirements

applicable to CPAs under their jurisdiction that are more restrictive than those of the AICPA. A practitioner should, therefore, be aware

of applicable requirements before accepting an engagement.

2 In addition to the AICPA's Code of Professional Conduct and underlying interpretations and rulings, a variety of independence-

related resources are available. The AICPA, through its website at www.aicpa.org, provides resources, publications, and recent

developments on the topic of professional ethics. The AICPA also issues an Independence and Ethics Developments Audit Risk Alert

that addresses recent developments in independence and ethics, and provides information that assists with the understanding of

independence rules. The AICPA has provided an Independence Toolkit at



www.aicpa.org/InterestAreas/PrivateCompaniesPracticeSection/Resources/KeepingUp/Pages/PCPSIndependenceToolkit.aspx

that includes The Plain English Guide to Independence, FAQs, and other resources.

3 On June 29, 2012, the AICPA's Professional Ethics Executive Committee (PEEC) issued an omnibus exposure draft containing

proposed revisions to Ethics Interpretation 101-3. The exposure draft indicates that performing ongoing evaluations of the effectiveness

of the client's internal control system impairs independence and calls for judgment in determining whether services performed, including

separate evaluations of control effectiveness, constitute ongoing monitoring. The exposure draft also adds a requirement for a member

to consider whether performing multiple individually permitted nonattest services would, in the aggregate, create a significant threat to

independence. In addition, the proposed revisions consider financial statement preparation and cash-to-accrual conversions performed

by the member as nonattest services, even if the services are performed as part of an attest engagement. No proposed effective date

was provided; however, the revisions to consider financial statement preparation and cash-to-accrual conversions as nonattest services

will likely have a two-year transition period. Future editions of this Guide will update the status of this proposed guidance.

4 See footnote 3 at paragraph 105.12.


END OF DOCUMENT -




Checkpoint Contents


Editorial Materials


Dealerships


106 The Economic Contraction That Started in 2008

106 The Economic Contraction That Started in 2008

Introduction

106.1 Generally accepted accounting principles require considering the effects of declining business conditions on measurements and

disclosures in the financial statements of dealerships, such as by reducing the carrying amounts of receivables or inventories for

impairment or disclosing subsequent events and contingent liabilities. In addition, the effects of the declining business conditions may

be severe enough to require consideration of disclosures and report modifications for uncertainty about the ability of the dealership to

continue as a going concern, or to require preparing the dealership's financial statements on the liquidation basis of accounting.

106.2 Under generally accepted accounting principles, the carrying amount of an asset generally is based on the costs incurred in

acquiring the asset, and the carrying amount of a liability generally is the amount owed. However, generally accepted accounting

principles require considering the need to reduce the carrying amount of an asset when it exceeds the fair value of the asset, and they

require some recurring measurements at fair value and some recurring disclosures about fair value.

106.3 The need to consider a reduction in the carrying amount of an asset generally comes from an event that causes the fair value of

the asset to decrease. Generally accepted accounting principles refer to the decline in fair value as impairment, and the event that

triggers the need to consider whether an impairment adjustment is necessary is a declining business condition.

106.4 Dealerships, like other businesses, often face declining business conditions. Some of those are unique to the dealership, such as

the introduction of a competing dealership in the same geographical area or the loss of a talented general manager, and some are

more general, such as the loss of a major employer in the area. Declining business conditions may also result from regional or national

economic contractions, such as a recession in the national economy.

106.5 However, the contraction that started in the third quarter of 2008 was unique in the pervasiveness of its effects, especially on

dealerships. The pervasiveness of the effects of the contraction not only increased the frequency with which dealerships need to

consider impairment adjustments and expanded disclosures, it also often made the determination of fair value highly subjective.

106.6 This section looks first at the characteristics of the contraction, and then looks at how the contraction can affect the application of

generally accepted measurement and disclosure principles by dealerships. The discussions in this section are summaries. More

detailed discussions can be found in Chapters 3 and 4 of this Guide and in PPC's Guide to Preparing Financial Statements.

The Characteristics of the Economic Contraction

106.7 Near the end of 2007, there was general agreement that there would be an economic contraction during 2008 but that it would be

relatively mild and isolated. In the third and fourth quarters of 2008, a number of cascading events occurred that hastened the severity

and pervasiveness of the contraction. The early attempts to stop or at least slow down the contraction proved futile and in the minds of

many observers actually heightened the general loss of confidence in the ability of federal and state governments to predict or control

an economic collapse.

106.8 There was significant uncertainty about the stability of the banking system and the Big Three domestic manufacturers of cars,

cross-over vehicles, and light-duty trucks. Their failure or significant changes in their operations would have far-reaching



consequences. There was also significant uncertainty about when the stock market would stop declining and to what extent it would

recover.

106.9 A pervasive feeling of uncertainty significantly altered spending patterns. Despite the warnings by well-respected economists that

this would only exacerbate the economic contraction, all types of consumers, who were already uncertain about whether conditions

would improve, felt that reducing spending was the only prudent approach.

106.10 There are significant differences of opinion among economists as to when the economy will stabilize and how fast conditions will

improve once it stabilizes. There are also significant differences of opinion as to the likely effect of the unprecedented increases in

federal spending and how to address the unprecedented deficits.

106.11 The uncertainties stemming from what has happened with the manufacturers and fundamental changes in buying behavior by

consumers affect not just dealerships selling domestic products, but also dealerships selling foreign products. There is uncertainty not

just about how bad things will get but also about many mitigating factors. For example, if a product line is discontinued by a domestic

manufacturer, will there be financial settlements with the dealership? In addition, what will be the consequences of the purchase of the

line by a foreign manufacturer or a private domestic group?

106.12 Similarly, if a dealership's franchise is terminated, will it be able to wind down the operations in an orderly fashion without a

significant loss, for example, by timely reductions in compensation and other significant expenses? Will it be able to add profitable

lines? If a dealership also carries other product lines, will sales of those products increase as sales of the discontinued product line

decline?

106.13 The significance and pervasiveness of the economic contraction has required special consideration in the preparation of

financial statements of many dealerships. In many cases, the uncertainty has been so great that estimates became highly subjective.

The uncertainty about the effects of the economic contraction on dealerships persists and has not fully impacted the financial

statements of some dealerships. The contraction is likely to continue requiring at least some of the following measurement and

disclosure considerations for dealerships preparing financial statements in conformity with generally accepted accounting principles:

a. Determining the net realizable value of receivables from manufacturers, parts distributors, financing entities, and other entities

whose operating activities are likely to be significantly impacted by the economic contraction.

b. Determining the market value of inventories of vehicles manufactured by entities that have elected or are considering bankruptcy

or have discontinued product lines.

c. Considering the effect of the significant shift in customer buying patterns in determining the market value of vehicles inventories.

d. Evaluating the effect of the declines in the market values of vehicles and the effect of the economic contraction on debtors when

considering the need to provide a valuation allowance for long-term receivables secured by vehicles.

e. Determining whether a decline in the fair value of securities is other-than-temporary.

f. Considering whether the fair values of intangible assets and long-lived assets are less than their carrying amounts and

recognizing losses for the difference.

g. Determining the fair value of long-lived assets when there are no active markets.



h. Recognizing obligations for costs incurred in ceasing activities.

i. Recognizing the financial statement effects of a troubled debt restructuring.

j. Determining liquidation values.

106.14 The declining business conditions will also likely continue requiring presentation and disclosure considerations for many

dealerships, such as the following:

a. The ability of the dealership to continue as a going concern.

b. Subsequent changes in the fair value of marketable securities and other assets.

c. Subsequent changes in activities, including changes in relationships with manufacturers and parts suppliers or changes in floor

plan arrangements such as the discontinuance of a floor plan line or a special payment required.

d. Commitments, contingencies, risks, and uncertainties, including the subjectivity of measurements, such as the fair values of long

-lived assets.

106.15 The economic contraction may also increase the legal exposure of accountants who express assurance on the financial

statements of dealerships. Actual or threatened litigation against accountants is often used as a means of subsidizing losses suffered

by third parties. Accountants should therefore pay special attention to considering the effects of the economic contraction on the

dealership's financial statements.

106.16 The discussion in the remainder of this section addresses the likely effects of the economic contraction on the preparation of

financial statements of dealerships in four areas:

a. Fair Value Measurements and Disclosures. Since the economic contraction is likely to continue to cause many dealerships to

consider the need for fair value measurements, the general guidance in FASB ASC 820, Fair Value Measurements and

Disclosures, is discussed. The discussion begins at paragraph 106.17.

b. Accounting Considerations. The economic contraction is likely to continue affecting the measurement, presentation, and related

disclosures for certain assets, liabilities, and expenses of small and midsize nonpublic dealerships in preparing their financial

statements in conformity with generally accepted accounting principles. The discussion begins at paragraph 106.30.

c. Liquidation of the Dealership. If a dealership is terminated or if discontinuance of a product line is so severe to the dealership's

operations that it cannot survive, liquidation may occur. Liquidation of the dealership is discussed beginning at paragraph 106.79.



d. Disclosure Considerations. Certain disclosures that are not necessarily related to measurements and presentation in the

financial statements—the ability of the dealership to continue as a going concern (see paragraph 106.82); disclosure of

subsequent events (see paragraph 106.88); and disclosure of commitments, contingencies, risks, and uncertainties (see

paragraph 106.93)—may also be needed.

Illustrative disclosures are provided in paragraph 106.99.

Fair Value Measurements and Disclosures

106.17 Authoritative Literature

One unusual result of the economic contraction is the focus some FASB guidance has received—the initial fair value measurement

guidance in FASB ASC 820, Fair Value Measurements and Disclosures. The media, politicians, and others seemed to blame the near

collapse of the financial system on this guidance, and largely in response to political pressure the FASB issued additional guidance.

However, some accountants view the additional guidance as in substance interpretations of the original intent rather than substantive

changes.

106.18 FASB ASC 820 does not prescribe generally accepted accounting principles for when fair value measurements are required.

However, when generally accepted accounting principles require either a recurring or nonrecurring adjustment of the carrying amount

of an asset or liability to fair value, it provides guidance on how to determine the fair value. The guidance also applies to determining

fair value information that generally accepted accounting principles require disclosing, such as the disclosure of fair value information

about financial instruments discussed in section 411.

106.19 FASB ASC 820 requires certain disclosures whenever fair value information is presented. Those disclosures are generally

designed to provide information about the subjectivity of the fair value measurements and are required in addition to any other

disclosures required about fair value measurements. As an example, the FASB ASC 820-10-50 disclosures are required in addition to

the disclosures about the fair value of investments in debt and equity securities required by FASB ASC 320-10-50 or fair value of

financial instruments required by FASB ASC 825-10-50.

106.20 A summary of how the guidance affects most small and midsize nonpublic dealerships follows.

a. FASB ASC 820 applies to consideration of the need to recognize a loss for the impairment of long-term receivables.

b. It applies to consideration of the determination of the fair value of securities in inactive markets.

c. It applies to consideration of the need to recognize a loss for the impairment of long-lived assets.

d. It applies to measurement of obligations for costs incurred to exit activities.

e. The measurement guidance in FASB ASC 820 does not apply to consideration of the need to recognize a loss for the

impairment of inventories. Instead, FASB ASC 330-10-30 provides the relevant measurement guidance, and its guidance is not

affected by FASB ASC 820.

f. Its measurement guidance does not apply to consideration of the need to recognize a valuation allowance for deferred tax

assets. Instead, FASB ASC 740, Income Taxes, provides the relevant measurement and disclosure guidance.



106.21 As a practical matter, dealerships may find that the guidance is especially helpful in determining fair value during the economic

contraction. For example, the guidance addresses subjectivity in fair value determinations.

106.22 Fair Value Measurement and Disclosure Principles

Because fair value is an important concept for measuring assets and providing disclosures during the economic contraction, the

following paragraphs provide an overview of fair value measurement and disclosure principles under GAAP. A more detailed discussion

of fair value accounting can be found in Chapter 19 of PPC's Guide to Preparing Financial Statements.

106.23 Fair value is defined throughout GAAP as “the price that would be received to sell an asset or paid to transfer a liability in an

orderly transaction between market participants at the measurement date.” While the notion of fair value is relatively simple, its

application raises a number of practical questions. For example—

a. Should the fair value of a group of assets or liabilities be determined based on fair values of the individual items comprising the

group or should the fair value of the group as a whole be determined?

b. Should the fair value determination assume a time limit? For example, should the determination assume a forced sale, an

orderly liquidation, or an optimum time to allow for negotiations?

c. Must there be an active market in order to measure the fair value of an asset or liability?

d. Should the fair value determination consider transportation and other direct costs of the assumed transaction?

106.24 GAAP looks at how fair value should be determined by providing a fair value hierarchy consisting of three levels—levels 1, 2,

and 3—generally ranging from the most objective determination of fair value to the most subjective. The levels vary depending on the

objectivity of the information used in valuation techniques to determine fair value. The levels are referred to as categories of input into

those techniques.

a. Level 1 inputs are quoted prices in active markets for identical assets or liabilities.

b. Level 2 inputs generally consist of available indirect information, such as quoted prices for similar assets or liabilities in active

markets, or quoted prices for identical or similar assets or liabilities in markets that are not active.

c. Level 3 inputs are the most subjective, generally based on the dealership's own assumptions developed using the best

information available in the circumstances.

106.25 Fair value measurements generally should be based on the most objective information available. For example, level 1 inputs

should be used whenever possible, and level 3 inputs should only be used when level 1 or level 2 inputs are not available. This three-

level hierarchy should accommodate most fair value measurements of small and midsize nonpublic dealerships. However, depending

on the facts and circumstances, it may not be practicable to determine the fair value of certain financial instruments, financial assets

and liabilities involved in transfers, guarantees, nonmonetary transactions, pension and postretirement benefits, or asset retirement and

restructuring obligations. Practicability exceptions are permitted in those cases.



106.26 However, the authors believe the need for a practicability exception should be rare for small and midsize nonpublic dealerships.

The discussions of fair value in authoritative literature appear to encourage fair value estimates even if they are highly subjective. The

degree of subjectivity can be communicated to the readers of the financial statements through disclosures. For example, FASB ASC

275-10-50 requires disclosure of estimates for which there is a reasonable possibility of a material change in the near term.

106.27 Inactive Markets

In situations where there is little or no market activity for an asset at the measurement date, the fair value objective is still to determine

the price at that date that would be received in an orderly transaction that is not a forced liquidation or distressed sale. However, in an

inactive market, it is not appropriate to assume that all market activity represents forced liquidations or distressed sales or to

automatically assume transaction prices reflect fair value. Instead, fair value is dependent on the facts and circumstances and may

involve significant judgment as to whether market activity represents forced liquidations or distressed sales.

106.28 When measuring the fair value of an asset, it may be appropriate to use the dealership's own assumptions about future cash

flows and risk-adjusted discount rates when relevant observable inputs are not available. Also, level 2 observable inputs may require

significant adjustment based on unobservable data, making the result a level 3 fair value measurement. For example, if trading activity

has significantly declined, prices have varied significantly, or prices are not current, observable market inputs may not be relevant and

might require significant adjustment. No matter which valuation technique is used, there must be appropriate risk adjustments that

market participants would make for nonperformance and liquidity risks.

106.29 For inactive markets, broker or pricing service quotes are not necessarily determinative of fair value. In determining whether a

broker quote is an appropriate input to a fair value measurement, less reliance should be placed on quotes that do not reflect actual

market transactions. Further, the nature of the quote should be considered when weighing available evidence. For example, some

quotes may only be an indication of interest rather than an actual price at which a market participant would purchase or sell the asset.

Accounting Considerations

106.30 Dealerships are used to making adjustments to fair value in a number of situations. For example, they routinely provide

valuation allowances to reduce the amount outstanding under current and long-term receivables to their net realizable value.

Dealerships also routinely provide valuation allowances to reduce the carrying amounts of inventories to reflect impairment losses from

declines in their market value, and dealerships that have portfolios of marketable securities routinely adjust the carrying amounts of the

portfolios to fair value. However, the economic contraction has likely introduced more subjectivity into a dealership's routine

considerations of the need to provide for unrealized impairment losses on receivables, inventories, and deferred tax assets.

106.31 The economic contraction has also likely required nonroutine considerations for many dealerships. For example, for the first

time—

a. It may be necessary to determine whether the fair values of intangible assets and long-lived assets have declined below their

carrying amounts and to consider whether adjustments are needed. The economic contraction may also increase the subjectivity in

determining fair value of the assets and the judgment required to consider whether adjustments are necessary.

b. Dealerships may need to determine whether declines in the fair value of marketable securities are other-than-temporary. The

resulting losses should be recognized in earnings rather than other comprehensive income.

c. Dealerships may need to consider disclosing changes in the fair value of securities that occurred subsequent to year-end.

d. Dealerships may enter into troubled debt restructurings, which require special accounting considerations.



e. Dealerships may need to consider the appropriate recognition of costs incurred in response to the economic contraction, such

as costs to exit certain activities or to terminate employees or contracts.

f. Dealerships may need to present results of certain discontinued operations separately.

106.32 This section discusses the effects of the economic contraction on recurring and nonrecurring considerations. However, it is

designed only to alert dealerships to special measurement, presentation, and related disclosure considerations caused by the

economic contraction. This section is not designed to provide detailed discussions of generally accepted accounting principles. Those

discussions can be found in other parts of this Guide and in PPC's Guide to Preparing Financial Statements.

106.33 Receivables

FASB ASC 450-20-25 requires accrual of losses from uncollectible receivables if a loss is probable and the amount of the loss can be

reasonably estimated. The accrual must be made even though the particular receivables that are uncollectible may not be identifiable.

The carrying amount of receivables is typically a significant portion of the assets of small and midsize nonpublic dealerships. However,

many of those receivables settle quickly. For example, contracts in transit and customer accounts for vehicles typically settle within no

more than a few days. In addition, accounts with manufacturers typically are net-settled electronically regularly during the month.

106.34 While most of the receivables of small and midsize nonpublic dealerships are due within one year, some dealerships provide

long-term financing for sales of vehicles. The financing is typically for vehicle sales to individuals with higher-than-normal credit risk, is

secured by the vehicle sold, and provides for repayment over periods longer than one year. FASB ASC 310-10-35 requires a reduction

in the carrying amount of long-term receivables if they are determined to be impaired.

106.35 FASB ASC 310-10-35 establishes the presumption that the carrying amount of the impaired receivable should be reduced to the

present value of expected future cash flows discounted at the loan's effective rate. Use of the effective rate rather than the current rate

means that the new carrying amount differs from the fair value of the receivable. However, there are two practical alternatives to that

general presumption—

a. the carrying amount of the receivable can be reduced to the loan's observable market price (fair value) or

b. if the receivable is collateral-dependent, the carrying amount can be reduced to the fair value of the underlying collateral.

106.36 FASB ASC 310-10-35 does not prescribe how fair value should be determined and FASB ASC 820-10 does not revise the

general presumption of present value measurement. Accordingly, impairment should be recognized at either—

a. the present value of expected future cash flows discounted at the effective rate of the receivable or

b. the fair value of the receivable or the fair value of the secured vehicle, with fair value determined following the guidance in FASB

ASC 820-10.

However, when the dealership determines that foreclosure is probable, impairment should be measured based on the fair value of the

secured vehicle, adjusted for estimated costs to repossess and to sell.

106.37 Typically, the loans have no observable market price, and the dealership considers the need for a valuation allowance based on

payment history and the fair value of the secured vehicle. The economic contraction may affect the subjectivity of both of those

considerations. The general slow-down in buying activity, discontinued product lines, and uncertainty about the direction the

manufacturers are taking may make the determination of the secured vehicle's fair value and costs to sell more subjective. In addition,



the economic contraction may increase the subjectivity of considering the likelihood that the debtor will not be able to pay the principal

outstanding. Loan impairment is discussed in more detail in section 406 of this Guide and section 302 of PPC's Guide to Preparing

Financial Statements.

106.38 Inventories

FASB ASC 330-10-35 generally requires reporting inventory at the lower of its cost or market. For that purpose, market generally

means current replacement cost. However, if current replacement cost declines below cost, the new carrying amount—

a. should not be greater than the net realizable value of the inventory and

b. should not be less than the net realizable value of the inventory reduced for an approximately normal profit margin.

106.39 FASB ASC 820-10 does not change the description of the new carrying amount from market to fair value and does not change

how market is determined. As a practical matter, depending on the facts and circumstances, a carrying amount at market determined

under GAAP may be the same as the inventory's fair value.

106.40 Inventories comprise most of the carrying amount of the assets of small and midsize nonpublic dealerships, and the dealerships

are used to the notion of adjusting the carrying amount of inventories to their market value. As a practical matter, however, recurring

adjustments to market value are typically limited to inventories of used vehicles that are carried at cost determined under the specific

identification method. The carrying amounts of inventories of new vehicles and parts are typically determined using the last-in, first-out

(LIFO) method and declines in market value are usually not great enough to require a reduction in the carrying amount. In addition,

parts manufacturers and wholesalers typically have return policies that enable dealerships to return slow-moving items.

106.41 The economic contraction may increase the subjectivity of estimating the net realizable value of vehicles. The amount realized

depends on whether someone wants to buy the vehicle and how much the person is willing to pay. Whether someone wants to buy a

vehicle may be significantly affected by announcements that product lines will be discontinued. Discontinuance of a product line may

create significant uncertainty for potential buyers about whether future servicing will be available and whether there will be a resale

market. Announcements about manufacturer plans to shift their focus in designing new vehicles may have a similar effect. Moreover,

the economic contraction has led to a general slowdown in spending, especially for large expenditures, which may lead potential buyers

to postpone buying a vehicle. Pricing used vehicles is discussed further beginning in paragraph 302.27.

106.42 Depending on the facts and circumstances, an adjustment to reduce the carrying amount of vehicles to market value may be

necessary even if cost is determined using the LIFO method. As a practical matter, however, the likelihood of that occurring decreases

the longer a dealership has used the LIFO method. The long-time use of the LIFO method for new vehicles may result in basing a

substantial amount of the inventory's carrying amount on costs incurred two or more decades ago.

106.43 The uncertainties that affect the determination of the market value of vehicles also affect the determination of the net realizable

value of parts inventories. That determination may also be affected by uncertainty about whether parts manufacturers and wholesalers

will be able to continue their return policies.

106.44 Deferred Tax Assets

Most small and midsize nonpublic dealerships are organized as pass-through entities so that taxes on their earnings are paid by the

owners rather than the dealership. Dealerships organized as taxable entities typically have deductible and taxable temporary

differences, and as a result of the economic contraction are likely to have carryforwards such as carryforwards of charitable

contributions, excess Section 179 depreciation, and net operating losses. FASB ASC 740-10-30 requires recognizing as an asset the

portion of the deferred tax benefit of carryforwards that has greater than a 50% chance of being realized. That is accomplished by

recognizing the deferred tax benefit of the carryforward, then providing a valuation allowance that reduces the carrying amount of the

deferred tax benefit to the amount that more likely than not will be realized.



106.45 The economic contraction may cause the dealership to conclude that there is no greater than a 50% chance that the deferred

tax benefit of a carryforward with a short utilization period will be realized, especially for a carryforward with limitations based on annual

taxable income. For example, contributions can be carried forward for five years, but the amount that can be deducted annually is a

percentage of taxable income.

106.46 The longer a carryforward is available, the more likely there is greater than a 50% chance its benefit will be realized. For

example, carryforwards of Section 179 deductions are available indefinitely, and carryforwards of net operating losses are available for

20 years. However, whether realization is more likely than not can be affected by a variety of factors, such as whether there is

substantial doubt about the ability of the dealership to continue as a going concern or whether future taxable income is likely to be

limited because the dealership plans to curtail activities. Considering the need for a deferred tax valuation allowance is discussed

further in section 406 of PPC's Guide to Preparing Financial Statements and in PPC's Guide to Accounting for Income Taxes.

106.47 Goodwill and Other Intangible Assets

FASB ASC 350, Intangibles—Goodwill and Other, generally requires considering whether goodwill and intangible assets are impaired

and, if they are, reducing their carrying amounts to the fair value of the assets. GAAP looks at impairment of intangible assets in two

major categories—goodwill and other intangible assets—and it looks at impairment of other intangible assets with indefinite useful lives

differently from those with finite useful lives.

106.48 FASB ASC 350-20-35 introduced the term implied fair value in considering the need to adjust the carrying amount of goodwill

for impairment. An adjustment is needed if the implied fair value of goodwill is less than its carrying amount.

106.49 Goodwill generally is determined as the excess of the consideration paid in a business combination over the fair values of

identifiable assets and liabilities acquired, and the implied fair value of goodwill is determined following the process used for

determining goodwill in a business combination. The determination requires first identifying the reporting unit that has the goodwill. A

reporting unit is defined as an operating segment or one level below an operating segment. As a practical matter, small and midsize

nonpublic dealerships typically have only a few activities that are considered to be operating segments—sales of new vehicles, sales of

used vehicles, sales of mechanical services, and sales of parts. Sales of body shop services and providing customer financing may

also be operating segments if those services are offered.

106.50 A product line is not an operating segment. For example, a discontinued product line is part of the sales-of-new-vehicles

component. However, a discontinued product line could likely be considered one level below an operating segment. Therefore, if

goodwill arose from the purchase of a dealership that only sold one product line that is now being discontinued, discontinuance of the

product line would likely reduce the implied fair value of that goodwill to zero. If the goodwill arose from the purchase of a dealership

that sold that product line and one or more other product lines, the reporting unit for determining the implied fair value would likely need

to be the dealership as a whole.

106.51 GAAP's fair value guidance applies to the determination of the fair value of the reporting unit. For example, if the reporting unit

is the dealership as a whole, its fair value may be determined using the techniques that would be used in valuing the dealership. That

may result in using a combination of an income approach that looks at the stream of cash flows from operations and a market approach

that uses multiples from transactions involving similar dealerships. The implied fair value of the goodwill would be the difference

between the fair value of the dealership and the fair values of its assets and liabilities. The economic contraction may have reduced the

fair value of the dealership, and it may have increased the subjectivity of the determination of fair value of its assets and liabilities.

106.52 FASB ASC 350-30-35 also provides guidance on considering the need for an impairment adjustment of the carrying amount of

an intangible asset that has an indefinite useful life. However, the guidance in FASB ASC 360-10-35 applies to considering the need for

an impairment adjustment of the carrying amount of an intangible asset that has a finite useful life. To illustrate which source of

guidance would apply to a dealership—

a. The franchise rights of a manufacturer would likely be considered to have an indefinite useful life, and the need for an

impairment adjustment of their carrying amount would be determined following the GAAP guidance for intangible assets with an

indefinite useful life. An impairment adjustment would be needed if the carrying amount of the franchise rights exceeds their fair

value. As a practical matter, the fair value of the franchise rights to a manufacturer that has announced its intention to discontinue

its product line would likely be zero.



b. A favorable lease acquired in a business combination has a finite useful life, and the need for an impairment adjustment of its

carrying amount would be determined following the guidance in FASB ASC 360-10-35. As discussed beginning in paragraph

106.53, an impairment adjustment would be needed if the undiscounted cash flows from the lease are less than its carrying

amount and the carrying amount of the lease exceeds its fair value.

106.53 Long-lived Assets

FASB ASC 360-10 generally looks at impairment of long-lived assets in two categories—those to be held and used in the dealership

and those to be disposed of by sale.

a. The carrying amount of a long-lived asset to be held and used in the dealership's activities should be written down to its fair

value if the carrying amount of the asset is not recoverable and fair value is less than the carrying amount. The carrying amount is

considered to be not recoverable if it is more than the undiscounted cash flows expected to result from the use and eventual

disposition of the asset.

b. The carrying amount of a long-lived asset to be disposed of by sale should be written down to its fair value less cost to sell.

GAAP prescribes the conditions that must be met in order for a long-lived asset to be considered held for sale. GAAP also requires

presenting the asset separately in the statement of financial position.

106.54 Long-lived assets of a dealership may include operating real estate or leasehold improvements if the operating facilities are

leased, for example, from an owner or an entity controlled by the owner. They also may include equipment used in providing

mechanical services, computer and other office equipment, signage, and other operating equipment. The economic contraction may

cause the carrying amounts of those assets not to be recoverable and the fair values of the assets to decline below their carrying

amounts. However, the contraction may also increase the subjectivity of the determination of fair value. For example, the fair value of

long-lived assets such as special mechanical equipment or signage that are related to a discontinued product line may be their scrap

value, but depending on the facts and circumstances, it may be practical to convert the equipment for other uses. There may also be no

active market for equipment.

106.55 Determining undiscounted cash flows for determining whether the carrying amount of a long-lived asset is recoverable requires

considerable judgment. Most of a dealership's long-lived assets do not produce their own stream of cash flows. Accordingly,

determining recoverability of the carrying amount for assets held and used requires identifying the lowest level of grouping of assets for

which cash flows can be identified. For example, consider the following assets that may be held and used:

a. For operating real estate, the lowest level of identifiable cash flows is likely the dealership itself.

b. For signage and other equipment directly related to a discontinued product line, there are likely no identifiable cash flows other

than the cash flows from ultimate disposal of the assets.

c. For mechanical service equipment, the group is likely to consist of all the service equipment and related facilities.

d. For computer and other office equipment, the group is likely to consist of the dealership itself.



106.56 The economic contraction may increase the subjectivity of estimating cash flows related to the grouped assets. As a practical

matter, however, depending on the facts and circumstances, it may be sufficient for the dealership to determine the fair value of the

asset, then assess the likelihood that undiscounted cash flows from use and disposal of the asset are less than the asset's carrying

amount. For example, management may reasonably believe that the dealership will continue using its present operating facilities for at

least 10 years and that, even though its fair value is currently less than its carrying amount, over 10 years, the fair value of the property

(and, thus, the cash flows from its ultimate disposal) will likely recover to the present carrying amount. In addition, management may

reasonably conclude that cash flows from the dealership's activities during that period will at least equal the difference between the

property's current carrying amount and its current fair value (disposal value).

106.57 Declines in the Fair Value of Marketable Securities

FASB ASC 320-10 requires the carrying amount of debt and equity securities whose fair value is readily determinable, and that are

either trading securities or available for sale, to be adjusted to their fair value. The underlying presumption is that because fair value is

readily determinable, it is an objective measurement and could readily be realized.

106.58 The accounting for unrealized appreciation and depreciation in the fair value of the securities generally depends on their use,

with the change in the fair value of trading securities recognized in earnings and the change in the fair value of securities available for

sale recognized in other comprehensive income. The guidance in FASB ASC 320-10 on determining fair value generally is not changed

by FASB ASC 820-10.

106.59 When the fair value of an available-for-sale or held-to-maturity security declines below its cost basis and the decline is

determined to be other-than-temporary, the security's fair value at the measurement date becomes its new cost basis. Generally, the

decline in value below cost should be accounted for the same as a realized loss with the amount of the write-down included in earnings.

106.60 FASB ASC 320-10-35 provides guidance regarding the meaning of other-than-temporary impairment and its application to

investments in debt and equity securities. It provides guidance for (a) determining when an investment is considered impaired, (b)

determining whether the impairment is other-than-temporary, and (c) measuring and recognizing an impairment loss if the impairment is

deemed other-than-temporary.

106.61 An investment in securities is deemed impaired if its fair value is less than its cost. A security's cost includes adjustments made

to its original cost basis for accretion, amortization, previous other-than-temporary impairments, foreign exchange, and hedging. If an

investment is deemed impaired, the impairment should be analyzed to determine if it is other-than-temporary.

106.62 FASB ASC 320-10-35 states that other-than-temporary does not mean permanent, but it does not provide specific guidance on

determining whether the decline in fair value below cost is temporary or other-than-temporary. Instead, it says to follow guidance that

would be pertinent and gives examples such as FASB ASC 325-40. However, if the dealership intends to sell an available-for-sale

equity security before recovery of its cost, the security is considered other-than-temporarily impaired in the period in which the decision

to sell is made.

106.63 If the dealership has invested in a debt security and—

a. intends to sell the security, a decline in the fair value of the security is considered to be other-than-temporary and the impairment

loss should be charged to earnings.

b. does not intend to sell the security, the dealership must assess whether it more likely than not will be required to sell the security

before the carrying amount of the security can be recovered, for example, to meet cash or working capital requirements or to

satisfy contractual or regulatory obligations. If it is more likely than not that the dealership will be required to sell the security before

its carrying amount can be recovered, the impairment loss should be charged to earnings.

c. does not intend to sell the security and it is not more likely than not that the dealership will be required to sell the security before

the amortized cost basis of the security can be recovered, an assessment should be made as to whether the decline is other-than-

temporary after considering all the relevant facts and circumstances related to collectibility of the security and other factors. If



analysis of the present value of cash flows expected to be collected from the security indicates the dealership will not recover its

amortized cost basis, an other-than-temporary impairment has occurred. If the loss is considered to be other-than-temporary, the

dealership should most likely charge the impairment loss to earnings. However, a portion of the loss may be charged to other

comprehensive income in certain circumstances.

Accounting for investments in debt and equity securities is discussed further in section 302 of PPC's Guide to Preparing Financial

Statements.

106.64 While FASB ASC 320-10 is clear that securities within its scope should be measured at fair value at the end of the reporting

period, it does not address whether subsequent changes in their fair value prior to issuance of the financial statements should be

disclosed. FASB ASC 820, Fair Value Measurements and Disclosures, also does not address the need to disclose subsequent

changes in fair value for fair value measurements.

106.65 As discussed beginning in paragraph 106.88, FASB ASC 855-10 applies to the accounting for and disclosure of subsequent

events not addressed in other applicable generally accepted accounting principles. FASB ASC 855-10 generally provides guidance on

two types of subsequent events—those recognized at the end of the reporting period and those not recognized at the end of the

reporting period.

106.66 A subsequent change in the fair value of assets or liabilities is given as an example of a nonrecognized subsequent event.

FASB ASC 855-10-50 requires disclosure of nonrecognized subsequent events if they are “of such a nature that they must be disclosed

to keep the financial statements from being misleading.” For nonrecognized subsequent events that meet that criterion, FASB ASC 855

-10-50 requires disclosure of the nature of the event and an estimate of its financial effect or a statement that such an estimate cannot

be made.

106.67 The fair value measurement required by FASB ASC 320-10 is intended to be a snapshot, generally computed by multiplying the

fair value per share by the number of shares. Factors that could affect the amount realized are not considered. For example, the

measurement does not consider control premiums, blockage factors, or selling costs. Similarly, changes in fair value before the

securities are sold are not considered. There is no implication that the carrying amount of the securities will be realized, and therefore

the measurement does not require disclosure of subsequent changes in the fair value of the securities.

106.68 Disclosure is only required if it would be necessary to keep the financial statements from being misleading. The authors believe

that may be the case if the subsequent changes, either increases or decreases, lead to a condition that should be disclosed so the

financial statements will not be misleading. It is therefore the condition caused by the subsequent change in fair value that requires

disclosure. If the change does not cause a condition that requires disclosure, disclosure of the subsequent change is not required. As a

practical matter, if the dealership plans to use cash from selling the securities to subsidize losses caused by the economic contraction

and the fair value of the securities declines materially subsequent to year-end, the dealership should likely disclose the decline and its

amount. Otherwise, a subsequent decline in the fair value of the securities is not likely to require disclosure as a subsequent event.

106.69 Troubled Debt Restructurings

FASB ASC 470-60 applies if a creditor grants a concession to the dealership for economic or legal reasons related to the dealership's

financial difficulties that it would not otherwise consider. Normally, a modification of terms should be accounted for prospectively and

does not affect the dealership's earnings in the year of modification. However, if the carrying amount of the debt exceeds the total future

cash payments specified by the new terms, the dealership should reduce the debt's carrying amount to the total future cash payments

specified by the new terms and recognize a gain on debt restructuring for the amount of the reduction. Subsequently, all cash payments

under the terms of the debt should be accounted for as principal reductions, and no interest expense should be recognized on the debt.

106.70 FASB ASC 470-60 only applies to changes in debt terms associated with a troubled debt restructuring. A substantial

modification in terms of existing debt other than in a troubled debt restructuring or an exchange of existing debt for new debt with

substantially different terms should be accounted for in accordance with FASB ASC 470-50. To clarify whether a modification or

exchange is within the scope of FASB ASC 470-60, guidance is provided in FASB ASC 470-60-55 as follows.

a. If a dealership is experiencing financial difficulty and the creditor grants the dealership a concession, the guidance for troubled

debt restructurings in FASB ASC 470-60 applies.



b. However, if the dealership is not experiencing financial difficulty or the creditor has not extended any concession in response to

the dealership's financial difficulty, the guidance for modification or exchange of debt instruments in FASB ASC 470-50 applies.

FASB ASC 470-60-55 provides guidance for determining whether a dealership is experiencing financial difficulty and whether a creditor

has granted a concession. Accounting for troubled debt restructurings and other debt modifications is discussed further in section 309

of PPC's Guide to Preparing Financial Statements.

106.71 Exit or Disposal Activities and Discontinued Operations

The dealership may incur a variety of costs in response to the economic contraction. For example, it may incur costs in terminating

employees or canceling an operating lease for facilities or equipment. It may also incur costs in moving to smaller facilities or otherwise

restructuring its activities as a result of financial difficulties or the discontinuance of a component of its operations. FASB ASC 420-10

applies to costs of exit and disposal activities, including restructuring costs and costs associated with disposal of a component of

operations. Although GAAP does not define exit or disposal activities, the authors interpret the term broadly and believe the recognition,

measurement, and disclosure guidance in FASB ASC 420-10 is likely to be relevant for many costs incurred by small and midsize

nonpublic dealerships in response to the economic contraction. The following are categories of costs associated with exit or disposal

activities:

• One-time termination benefits for terminated employees.

• Termination of a contract, other than a capital lease. (Termination of a capital lease should be accounted for under FASB ASC

840-30-40-1.)

• Other associated costs, including the consolidation of facilities or the relocation of employees.

106.72 Those costs should be recognized when they are incurred. For example, if a dealership decides to lay off employees, the cost of

termination benefits should generally be recognized when the employees are notified. However, recognition may vary if employees are

required to render future services. Similarly, the cost of terminating an operating lease should generally be recognized when the

dealership notifies the lessor.

106.73 An obligation for costs incurred should be measured at fair value. Often the amount is measured based on the amount of

payments the dealership expects to make discounted using an appropriate rate, generally if the payment period is longer than a year.

The discount rate ordinarily approximates the short-term borrowing rate that commercial lenders would offer the dealership at the time

the liability is recognized. As a practical matter, that approximates the fair value of the obligation under FASB ASC 820-10.

106.74 In addition, the required disclosures would provide the users of the dealership's financial statements with relevant information

about the effects of the economic contraction on the dealership's costs and activities.

106.75 FASB ASC 420-10 also applies to costs associated with disposal activities for a component of an entity. Operations and cash

flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the dealership are considered

to comprise a component of the dealership. A component may be a reportable segment or an operating segment, a reporting unit, a

subsidiary, or an asset group. Small and midsize nonpublic dealerships typically structure their operations around a small number of

activities—sales of new vehicles, sales of used vehicles, sales of mechanical services, and sales of parts. They may also offer body

shop services and financing. The authors believe each of those most likely meets the definition of a component. Under FASB ASC 205-

20-45, the results of operations of a discontinued component should be reported separately from the results of operations of continuing

components.



106.76 Under FASB ASC 420-10-25, the obligation for costs that will be incurred in disposing of the component should be recognized

when the liability is incurred. For example, even though the dealership expects to incur a substantial loss in the following year from

winding down those operations, the costs should not be recognized until they are incurred. FASB ASC 420-10-30 requires measuring

the liabilities recognized at their fair value. As a practical matter, the fair value of the liabilities is likely to approximate the present value

of expected payments discounted using an appropriate rate, generally if the payment period is longer than a year.

106.77 It is not likely that a dealership would dispose of a component in response to the economic contraction. For example, the

authors believe termination of a product line would not be considered disposal of a component. Instead, sales of a product line are part

of a component—selling new vehicles. However, if a dealership decided to stop selling new vehicles and instead only sell used

vehicles, the discontinuance of new vehicle sales would be considered discontinuance of a component. In addition to the presentation

and related requirements of FASB ASC 205-20-45, FASB ASC 420-10-50 prescribes disclosure requirements.

106.78 Accounting for the costs of exit or disposal activities is discussed further in section 313. Presenting discontinued operations is

discussed in more detail in section 415 of this Guide and in section 403 of PPC's Guide to Preparing Financial Statements.

Liquidation of the Dealership

106.79 When a dealership is in liquidation (or liquidation is imminent), a going concern assumption is no longer appropriate and the

dealership's financial statements should be prepared on the liquidation basis of accounting. That may occur, for example, if a

dealership is terminated or discontinuance of a product line is so severe to the dealership's operations that it cannot survive. As a

practical matter, the authors believe dealerships in liquidation will no longer have their financial statements audited or reviewed.

However, accountants may be called upon for guidance in this area.

106.80 Presentations of assets and liabilities at their historical bases are no longer relevant to liquidating entities, and dealerships

should adjust the carrying amounts of assets and liabilities to the amounts expected in liquidation. 5 This adjustment results in

measuring the assets at net realizable value and the liabilities at net settlement value and discounting the values when the effect is

significant. Since third-party fees, such as finder's fees for disposing of equipment, brokerage fees, and collection agency fees, are

often required in a liquidation, they should be considered in the estimates. Because the definition of fair value assumes an orderly

transaction, which is different than the environment in a liquidation, the carrying amounts determined for liquidation accounting do not

meet the definition of fair value; they represent the net proceeds expected to be realized under the plan of liquidation.

106.81 When deciding which financial statements to present for the year in which the conversion to liquidation basis occurs, the authors

recommend preparing statements of income and retained earnings and cash flows from the beginning of the year to the date of

conversion, a statement of changes in net assets in liquidation for the period from the date of conversion to the end of the year, and a

statement of net assets in liquidation at the end of the year. Additional detail on the liquidation basis of accounting can be found in

sections 313 and 415 of this Guide, and in PPC's Guide to Preparing Financial Statements.

Disclosure Considerations

106.82 The Ability of the Dealership to Continue as a Going Concern

While authoritative accounting literature acknowledges that financial statements generally are prepared under the assumption that the

reporting entity will continue in existence, it does not address whether that assumption should be reconsidered periodically or whether

measurement or disclosure is required if there is uncertainty as to whether the entity will continue in existence. 6 However, AU-C 570,

The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern (Redrafted), requires the auditor to consider the

adequacy of disclosure when there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period

of time. AU-C 570 also prescribes considerations in evaluating the adequacy of disclosure of that uncertainty and provides examples of

information that might be disclosed. AR 80 and AR 90 address going concern considerations in compilation and review engagements.

106.83 Neither AU-C 570 nor AR 80 and AR 90 require performing procedures specifically designed to determine whether there is

uncertainty about the entity's ability to continue as a going concern. Instead, AU-C 570 requires the auditor to consider whether the

audit identified conditions and events that, when considered in the aggregate, indicate there may be uncertainty about the entity's ability

to continue as a going concern. AR 80 and AR 90 take a similar approach, saying that “evidence or information may come to the

accountant's attention indicating that there may be uncertainty about the entity's ability to continue as a going concern.” The notion of



whether there is uncertainty about the ability to continue as a going concern raises the question of “For how long?” The answer in AU-C

570, AR 80, and AR 90 is the same—a reasonable period of time, not to exceed one year from the end of the period being reported on.

106.84 The objective of the guidance in AU-C 570, AR 80, and AR 90 is to determine whether the report on the engagement should be

modified. Those standards provide for report modification if disclosure of the going concern uncertainty is not adequate. They also

discuss including an emphasis-of-matter paragraph in the report, but they take different approaches as to whether the paragraph is

required. AU-C 570 requires including an emphasis-of-matter paragraph in the auditor's report whenever the auditor concludes that

there is substantial doubt about the entity's ability to continue as a going concern, but AR 80 and AR 90 only indicate that the

accountant may emphasize a going concern uncertainty in the compilation or review report.

106.85 Since neither the Auditing Standards Board nor the Accounting and Review Services Committee is authorized to prescribe

measurement or disclosure requirements, neither AU-C 570 nor AR 80 and AR 90 prescribe disclosure requirements for going concern

considerations. However, AU-C 570 provides examples of information that might be disclosed and says that it may be necessary to

disclose the principal conditions that raise a question about continued existence and related matters. Although AR 80 and AR 90 do not

provide guidance on evaluating the adequacy of disclosure of a going concern uncertainty, the authors believe the guidance in AU-C

570 regarding the adequacy of disclosure should be followed in compilation and review engagements. 7

106.86 Common questions in considering disclosure of a going concern uncertainty generally relate to when it is necessary and how to

word the disclosure. AU-C 570 notes that uncertainty about an entity's ability to continue as a going concern relates to its inability to

continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business,

restructuring of debt, externally forced revisions of its operations, or similar actions. The auditor's evaluation of an entity's ability to

continue as a going concern is not merely a matter of evaluating the recoverability, classifications, and amounts of recorded assets and

liabilities.

106.87 Some users of financial statements interpret going concern disclosures as predicting doom. In fact, many view them as causing

a business to fail. Accordingly, the decision to disclose the information should not be taken lightly. Normally, the disclosure is not

provided unless there are serious concerns about the viability of the business. In addition, the authors believe a going concern

modification for a manufacturer on which a dealership depends does not necessarily cause a going concern issue for an otherwise

healthy franchisee. (However, the dependency on the manufacturer and the fact that there is substantial doubt about the

manufacturer's ability to continue as a going concern should be disclosed.) If going concern disclosure is necessary, the authors

recommend the following:

a. The disclosure should include all relevant factors, such as:

(1) pertinent conditions and events giving rise to the assessment of the dealership's ability to continue as a going concern,

even if the information is apparent from the financial statements;

(2) the possible effects of the conditions and events, management's evaluation of the significance of the conditions and

events, and any mitigating factors;

(3) management's plans, including possible discontinuance of operations; and

(4) information about the recoverability or classification of recorded assets or the amounts or classifications of liabilities.

b. The wording should be neutral and should not be unduly pessimistic or optimistic.



c. If there are no mitigating factors or management has no specific plans to overcome the conditions, the disclosure should be

silent about their absence.

106.88 Disclosure of Subsequent Events

Due to the changing economic environment, small and midsize nonpublic dealerships may be faced with significant events that occur

after the date of their financial statements but before those statements are available for issuance. For example, the resolution of

matters related to manufacturer bankruptcies, loan defaults, subsequent declines in the market value of investments, discontinuance of

a product line, or even the termination of the dealership may occur after year end.

106.89 FASB ASC 855-10 provides guidance on two types of subsequent events.

a. The first type provides additional information about whether an asset was impaired or a liability was incurred at the end of the

reporting period. This information should be considered in determining the carrying amount of the asset or liability at the end of the

reporting period.

b. The second type provides information that does not indicate that an asset was impaired or a liability was incurred at the end of

the reporting period but may require disclosure so the financial statements will not be misleading.

106.90 To illustrate how to apply the guidance in financial statements prepared using generally accepted accounting principles, assume

that at year-end the dealership has a significant amount due under a trade account with a major customer that is having financial

difficulties and subsequent to year-end incurs a substantial uninsured loss. That information should be considered in determining

whether a loss should be recognized for impairment of the principal outstanding under the account at year-end.

106.91 Now change the illustration so that the customer was not having financial difficulties at year-end. Although the principal

outstanding under the trade account was not impaired at year-end, it may be necessary to disclose the subsequent uninsured loss in

order to keep the financial statements from being misleading. Similarly, decisions made after the date of the financial statements but

before their issuance to discontinue a product line would generally not be recognized in the financial statements but would be

considered for disclosure. Considerations in deciding whether to disclose subsequent changes in the fair value of marketable securities

are discussed beginning in paragraph 106.64.

106.92 FASB ASC 855-10-50 requires disclosure of the following:

• The date through which subsequent events have been evaluated by dealership management and whether that date is the date

the financial statements were issued or the date the financial statements were available to be issued.

• The nature of, an estimate of the financial statement effect of, or a statement that such an estimate cannot be made for

subsequent events that are of such a nature that they must be disclosed to keep the financial statements from being misleading.

Subsequent events are discussed in more detail in section 803.

106.93 Disclosure of Commitments, Contingencies, Risks, and Uncertainties

The economic contraction is likely to expose small and midsize nonpublic dealerships to commitments and contingencies that should

be disclosed to keep their financial statements from being misleading. The economic contraction is likely to create significant

uncertainty about judgments and measurements made in preparing the financial statements and about future operations. Disclosure of



significant uncertainties affecting the dealership and its financial statements is likely to be necessary to keep the dealership's financial

statements from being misleading.

106.94 Commitments.

Commitments are contractual obligations for a future expenditure. The economic contraction may lead a dealership to make

commitments that may or may not be recognized as liabilities. For example:

a. A dealership agrees to pay a one-time termination benefit to its new vehicles manager if he stays until the new vehicles services

are phased out. The obligation for the one-time termination benefit should be recognized and disclosed as discussed beginning in

paragraph 106.71.

b. As part of its efforts to increase sales of used vehicles, a dealership enters into an agreement with another entity to purchase a

minimum number of vehicles per quarter as their leases expire. The commitment for the future purchases should not be

recognized, but the financial statements of the dealership should likely disclose the commitment.

c. A dealership makes certain commitments to a manufacturer as part of continuing the dealership franchise, such as a

commitment to stay at the present location, make facilities improvements, or meet increased sales targets. The future

commitments should be disclosed, if significant.

106.95 Contingencies.

FASB ASC 450-10-20 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to

possible gain or loss to a dealership that will ultimately be resolved when one or more future events occur or fail to occur. The

economic contraction may create a contingency that may or may not be recognized. For example:

a. Because of the economic contraction, a commonly-controlled entity refinances its bank debt and, as part of refinancing the

dealership, along with other commonly-controlled entities, is required to guarantee the refinanced debt. The measurement

provisions of FASB ASC 460-10-25-1 would not apply to the guarantee by the dealership, but its disclosure requirements would

apply even if the likelihood of the dealership's guarantee being exercised is remote.

b. To help increase sales of used vehicles, a dealership begins offering its own limited warranty program for pre-owned vehicles

that it “certifies.” The dealership plans to absorb costs incurred under the program rather than obtain reinsurance. The dealership

estimates probable costs that will be incurred under warranties in effect within a range and recognizes a liability for the lowest

amount in the range since it believes no estimate in the range is better than any other estimate. Under FASB ASC 450-20-50-1 the

dealership should disclose the additional exposure to loss.

106.96 Risks and Uncertainties.

FASB ASC 275-10 provides the authoritative guidance on risks and uncertainties, the objectives of which are to:

• Require disclosure of risks and uncertainties that could significantly affect the amounts reported in the financial statements or the

near-term functioning of the dealership.

• Communicate to financial statement users the inherent limitations in financial statements.



106.97 Disclosure is not required of all risks and uncertainties, which would be an impossible task, but is required for certain risks and

uncertainties that meet specified criteria. Disclosure is required in the following four areas:

• Nature of operations.

• Use of estimates in the preparation of financial statements.

• Certain significant estimates.

• Current vulnerability due to certain concentrations.

106.98 The first two disclosures, nature of operations and use of estimates, are required for all financial statements and tend to be

somewhat boilerplate. The second two are required only for estimates and concentrations that meet specified criteria.

a. Disclosure of estimates is required if it is at least reasonably possible that an estimate affecting the financial statements will

change in the near term, which generally is the following reporting year, and the effect of the change would be material. As

discussed throughout this section, the economic contraction is likely to significantly increase the subjectivity of estimates and, as a

result, there is the reasonable possibility of significant changes in those estimates in future years.

b. Disclosure of concentrations existing at the date of the financial statements (for example, related to sources of revenue or

suppliers) is required if they make the dealership vulnerable to a near-term severe impact and it is at least reasonably possible

events that could cause the severe impact will occur in the near term. For example, the announced consideration of bankruptcy by

a major parts supplier would likely make the dealership vulnerable to a severe impact within the next annual reporting year.

Risks and uncertainties are discussed further in section 413 of this Guide and in PPC's Guide to Preparing Financial Statements.

Illustrative Disclosures

106.99 A variety of illustrative disclosures of the effects of the economic contraction on small and midsize nonpublic dealerships follow.

NOTE X—ABILITY TO CONTINUE AS A GOING CONCERN

Sales of the Pontiac product line were a significant component of gross profit from sales of new vehicles. Discontinuance

of the line therefore had a significant adverse effect on the dealership's operations. Although sales of the Buick and GMC

truck product lines have decreased significantly with the economic contraction that began in the third quarter of 2008,

management believes those sales will return to their levels prior to the start of the contraction within the next two to three

years. Management has made significant reductions in its work force and operating activities (see Note Y) and believes

cash flows from the present level of sales volume will be sufficient to fund those costs.

NOTE X—TERMINATION OF THE FRANCHISE

The dealership was notified that its franchise would not be renewed by the Chevrolet division of General Motors

Corporation. Effective June 30, 20X2, the dealership decided to liquidate and, accordingly, revalued its assets and

liabilities to the amounts expected to be collected and paid during the liquidation. The effect of the revaluation is included

in the statement of net assets in liquidation as other expenses. It is not presently determinable whether the amounts

realizable from the disposition of the remaining assets or the amounts that creditors will agree to accept in settlement of

the obligations due them will differ materially from the amounts shown in the accompanying financial statements.



Differences between the revalued amounts and actual cash transactions will be recognized in the year they can be

estimated. The gains and losses from liquidation will be taxable on distribution.

NOTE X—SUBSEQUENT INCREASE IN THE FAIR VALUE OF MARKETABLE SECURITIES

The carrying amount of marketable securities is their fair value at the end of the year, which reflected general market

declines during the last quarter. At the time these financial statements were issued, most of those market declines had

reversed themselves and the fair value of the portfolio was approximately $190,000. However, the market is still volatile,

and there is a reasonable possibility the fair value of the portfolio could change by a material amount in the near term.

NOTE X—POSSIBILITY OF A CHANGE IN THE MARKET VALUE OF INVENTORY

A substantial portion of the inventory of new vehicles consists of models of a product line that the manufacturer has

announced is being discontinued. The announcement has created uncertainty about the ability of the dealership to sell

the models in its year-end inventory. Management has estimated the market value of the models using information that is

currently available and provided for losses resulting from the excess of the carrying amount of the models over the

estimated market value. However, there is a reasonable possibility the amount actually realized from the sales will vary

materially from the amount estimated at year-end. The effects of the changes in those estimates will be included in the

results of next year's results of operations when the vehicles are disposed of.

NOTE X—DISCONTINUED OPERATIONS

Because of the effects of the economic contraction, the dealership has decided that it is no longer cost-effective to

continue offering body shop services. During the last two years, revenues from body shop services were material, but

they were the least profitable of the dealership's components. In the accompanying statement of results of operations, the

results of the body shop component are presented separately from the results of continuing operations.

Because of the contraction in the number of businesses in the area offering body shop services, there is no active specific

market for the dealership's body shop equipment, and there has been no recent activity for sales of similar equipment.

Accordingly, management estimated the fair value of the equipment and the costs to dispose of it based on the most

recent information available.

The equipment is reported in the accompanying statement of financial position at the net amount the dealership expects

to realize from its sale, and the loss recognized for the excess of the carrying amount of the equipment over the adjusted

amount is reported as a charge to the results of the discontinued body shop operations. However, there is a reasonable

possibility that the amount realized from the disposal of the equipment will vary materially from the amount estimated. The

difference will be recognized in the results of next year's operations when the equipment is disposed of.

NOTE X—SUBSEQUENT CHANGE IN FLOOR PLANNING

Two months after year-end, the primary floor plan lender announced that it was requiring the dealership to reduce the

principal outstanding on loans for vehicles that had been in inventory longer than six months. The reductions totaled

$70,000, and the dealership is looking at alternatives for funding them. Failure of the dealership to make the required

payments could result in the lender closing the line and seizing the collateral.

5 In July 2012, the FASB issued a proposed Accounting Standards Update on the liquidation basis of accounting. The proposed

standard would require an entity to prepare its financial statements using the liquidation basis of accounting when liquidation is

imminent. The proposed standard includes recognition, measurement, and disclosure requirements. The effective date will be

determined after considering feedback on the proposal.

6 In October 2008, the FASB issued an exposure draft of a proposed Statement of Financial Accounting Standards (SFAS) titled Going

Concern. The FASB issued the proposed guidance to move to the accounting standards the going concern guidance that currently

resides only in the auditing standards. At the time this Guide was completed, the FASB had announced that it will revisit whether and



how an entity should conduct a going concern assessment and will not address disclosure requirements apart from its separate project

on liquidity risk disclosures. A revised exposure draft is expected in the fourth quarter of 2012.

7 Exhibit B to the SSARS Codification is a “nonauthoritative exhibit” that considers going concern considerations in compilation and

review engagements. The information on disclosure considerations in that document is similar to the guidance in AU-C 570.


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Checkpoint Contents


Editorial Materials


Dealerships


107 Scope of PPC's Guide to Dealerships

107 Scope of PPC's Guide to Dealerships

107.1 Accountants who are familiar with PPC's Guide to Audits of Nonpublic Companies will see similarities between it and this Guide.

This Guide tailors the guidance in PPC's Guide to Audits of Nonpublic Companies to a typical dealership engagement. It also adapts

the engagement approach in PPC's Guide to Compilation and Review Engagements to be easily applied when providing compilation

and review services to dealerships. These two Guides can be consulted when unusual situations are encountered.

107.2 While the audit and compilation and review chapters are helpful on dealership engagements, this Guide also may be consulted

by financial managers and general managers of dealerships when questions arise. It comprehensively discusses dealership accounting

considerations, taxation issues, financial reporting, and valuation concerns.

107.3 PPC's Guide to Dealerships is divided into 10 chapters. These chapters (a) discuss authoritative accounting literature that applies

to dealerships, (b) provide practical guidance on how to apply auditing, review, and compilation standards to engagements to report on

dealership financial statements, (c) explain the complex income tax rules that dealerships must follow, and (d) discuss consulting

services and related standards relevant to dealerships.

107.4 This Guide also includes practice aids specifically tailored to dealership engagements, such as engagement programs (audit,

review, and compilation), confirmation letters, and checklists.

107.5 The authors believe that this Guide will familiarize users with the accounting and tax rules that apply to dealerships and provide

guidance for auditing, reviewing, or compiling dealership financial statements efficiently and effectively. It will also help users in

providing management consulting services to their dealership clients.


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