Many buy here pay here dealers choose to self-insure their warranty or service contracts, but do they fully understand how a change from including an extended warranty to selling a service contract can impact their financial statements, tax returns and potential their loan agreements?
When a dealer sells (sells being the key word) a service contract not all of the revenue is recognized at the time of sale. Instead, it is recognized over the life of the contract and recorded as Deferred Service Contract Revenue in the liability section of the balance sheet. Each month and or year a portion of the deferred revenue is moved from liabilities to income.
When a dealer provides an extended warranty (at no additional cost to the customer) by including it in the price of the car, there should be a liability on the balance sheet for an accrued warranty reserve for future claims that are expected.
Finance companies have certain financial ratios they require you to maintain in order to loan you money and renew those loans. An example would be debt to equity and working capital ratios. Recording the above liabilities can make you exceed your debt to equity ratio. If you fail to keep these and other financial loan covenant requirements, it could end up costing you the ability to borrow at reasonable rates.
Decisions you make in running your business can have varying effects on the income, sales or other taxes you pay. The same decisions can also affect the proper reporting on your monthly or year-end financial statements, especially those prepared in accordance with Generally Accepted Accounting Principles (GAAP). Sometimes the effects on taxes and financial statement reporting are contrary to each other.
For example changing from one method of providing extended warranties to the other could save your buy here pay here business over $43,000 a year in cash, but cause you to fail your loan covenants.
A dealership has been in business for several years and sells an average of 50 vehicles a month. An extended warranty is given with each vehicle that provides power train coverage for 36 months or 36,000 miles. The dealership decided to change its business model and offer the same coverage as a service contract for $1,295 and lowers the price of each vehicle by $1,295.
Due to the age of these vehicles, the penetration rate of contracts sold is very high. For this example, assume a 100 percent penetration rate (a service contract on every vehicle sold). The cost to service these contracts can be accurately estimated at $500 per vehicle (50 percent of which is parts) over the life of the 36 month/36,000 mile contract.
In most states, separately priced service contracts are not subject to sales tax when sold as part of the vehicle sale. Since most states do not provide a method to recoup the uncollected sales tax on accounts charged off, this would result in a cash savings of $54,390 (50 contracts x 12 months x $1,295 per contract x 7 percent sales tax rate) up front per year on sales.
As parts are used to repair vehicles covered by the contracts, sales tax will be paid on those parts. Assuming that the average parts’ cost on service contracts expiring is $250, the sales tax paid on such parts would be $10,500 (50 contracts x 12 months x $250 per contract x 7% sales tax rate). The result is a savings of $43,890 per year in overall sales tax paid. That’s the good result; now for the bad result of switching to selling extended service contracts.
Revenue from separately priced, self-insured service contracts is deferred at the point of sale and generally recognized on a straight-line basis over the life of the contract for GAAP presentation. In this example, the number of vehicles sold remains steady, so at any point in time, the deferred service contract revenue (a liability) is $647,500. This assumes that the average contract in any year is 6 months expired with 30 months remaining.
Had the service contract instead been included as an extended warranty, the liability for accrued warranty expense in this example would be $250,000. The $397,500 difference in liabilities between the two methods could cause the company to fail its loan covenants. The covenants typically affected are the debt to equity ratio and the interest coverage ratio, both of which look at the liabilities or book income reported.
The economics of each transaction are virtually the same; however, the tax and financial reporting effects are very different. If you or your banking officer has questions about this or any other dealership or buy-here-pay-here issue, please contact an accountant experienced in buy here pay here operations.
David J. Wiggins and Lindsay A. Berge are CPA’s and advisors working with LarsonAllen, LLP, a nationwide CPA firm serving the new, used and buy-here pay-here industry. Lindsay or Dave may be reached at 314.336.3600.
Vol. 3, Issue 1