As an automotive dealership, your inventory is your largest current asset, so properly measuring inventories against expenses and revenue is imperative. Key financial and operational decisions are made based on the information in your financial statements, forecasts, and projections, including decisions that help you manage shortfalls and overcome industry-wide obstacles. And properly accounting for automotive inventory, whether by Last-In, First-Out (LIFO) or Specific Identification, using valuation methods best-suited to your chosen accounting method plays a major role in ensuring your dealership’s short and long-term success.
Dealerships are authorized significant discretion in choosing inventory accounting methods, and it isn’t always a clear-cut choice. Every inventory account won’t fall neatly in a single method’s “bin.” Each category of inventoried items – such as new vehicles, used vehicles, and parts & accessories – may require a different inventory accounting method to clearly reflect your dealership’s income. Multi-entity dealerships can potentially employ varying methods across entities, so any methods chosen are cost-effective and work effectively for the type of inventory carried at all dealership locations. Choosing the most efficient inventory method across entities and accounts is never based on a one-size-fits-all formula.
As the end of 2020 approaches, the effects of year-end inventory shortages on inventory calculations have become a major industry focus. In the wake of widespread manufacturing shutdowns, labor shortages, supply chain issues, higher auction prices, and with trade-ins in short supply, inventory and production have yet to catch up with current demand, leaving many dealerships with new and used-car inventory shortages. Dealerships need tight inventory control to efficiently manage frozen capital and working capital, to shift with unpredictable supply and demand conditions, and to explore innovative channels that, even amid uncertainty, meet their financial and operational needs as they meet consumer demand.
The good news is, in spite of the onset of COVID-19, new and used vehicle demand is still alive. Government stimulus efforts and programs through the SBA, such as the PPP and the EIDL program, likely played a significant role in minimizing the hit to vehicle demand by keeping businesses open and workers employed. Still, the current climate does bring about questions about the best methods for maintaining and accounting for inventory. Is your dealership’s inventory plan designed to withstand economic headwinds?
Last-in, First Out (LIFO) Method of Accounting for Inventory
Dealerships often choose LIFO for new vehicle inventory, as they are able to report lower profits and defer income tax, resulting in a lessened annual income tax liability. While it certainly wouldn’t work for other industries, namely those carrying perishable items, the LIFO method can be advantageous to those accounting for automobile inventory. Simply defined, LIFO assumes the last item purchased will be the first item sold and allows your high-cost inventories to be recorded in cost of goods sold, while your ending inventory balance is based on previous, lower costs. Dealerships using LIFO are able to accurately match cost and revenue figures and recover material cost completely, making it a frequently chosen method of accounting for inventory for dealerships.
LIFO is a complex inventory method that involves both time and cost related to data collection and clerical work, so dealerships should weigh the internal cost of gathering data and reporting with their ability to recover deferred income at a lower tax bracket through the TCJA legislation. C Corporations using the LIFO method have additional tax considerations when contemplating an S corporation conversion, such as exposure to corporate-level built-in gains (BIG) tax. The immediacy of the hit taken is lessened slightly, however, as it is payable in four installments, over a four-year period. These considerations should be carefully examined against the potential increase to cost of goods sold, ability to shift the weight of impending tax liability, and ability to open cash flow channels.
While large, high-volume dealerships and multi-entity dealerships often experience significant LIFO benefits, dealerships of all sizes operating over a steady period of low inflation aren’t excluded from the potential benefits, regardless of inventory size. Manageable LIFO expense and an increase in LIFO reserve are still possible, even with a reduction in inventory. However, an anticipated decrease in year-end inventories this year will require careful planning and consideration. It is possible the inflation factor will not be sufficient enough to absorb a significant reduction in inventory, and LIFO income could result. Now, more than ever, careful consideration of your chosen methods for inventory valuation and allocation of costs to year-end have taken on a level of importance.
New Vehicle Alternative LIFO Inventory Method (ALM)
The new vehicle ALM is designed specifically for auto dealers to use when calculating new car or new light-duty truck inventory values necessary in accounting for inventory using the LIFO method. Because ALM takes inflation into account at the individual vehicle model level, it generally yields the most advantageous inventory valuations. With no requirement for annual comparability adjustments, ALM simplifies the process for dollar-value accounting.
Inventory Price Index Computation (IPIC) Method for Calculating Inflation
The IPIC method for calculating inflation is an option available for assisting with LIFO calculations. Pricing indexes published by the U.S. Bureau of Labor Statistics (BLS) are used in IPIC, so the accumulation of data necessary for calculations is simplified. Dealerships establish base year prices for beginning and ending inventory values. When compared to internal indexing calculation methods, IPIC may reduce the margin of error for inflation calculations. The IPIC method generally yields a lower deduction than ALM, however, as IPIC calculates inflation based on inventory as a whole.
Specific Identification Method of Accounting for Inventory
Many dealerships opt to use the Specific Identification Method to account for used vehicle and parts inventories, as it provides a higher level of accuracy in tracking actual cost of goods sold against actual ending inventory. The core requirement for using this method is your dealership’s ability to track each inventory item at an individual level through the use of specific identifiers, such as stock numbers, RFID tags, or serial numbers.
The Specific Identification method has the potential to yield a near-exact matching of cost to revenue. Using this method, inventory values are generally either using the lower of cost or market or replacement cost methods. Specific Identification has received criticism for the ease at which ending inventory calculations may be manipulated dishonestly to produce a desired tax benefit.
Lower of Cost or Market (LCM) Inventory Method
Dealerships most often use LCM to calculate used inventory values. Inventory is recorded on the balance sheet in the manner of the method’s namesake: the lower of the purchase price or the market value. The LCM method is ideal for valuing inventory that loses value rapidly, as inventory may be written down to align properly with replacement cost.
The LCM method allows dealership’s to correct for price fluctuation, as it assumes when purchase prices fall, selling prices are destined to fall, if they haven’t fallen already. Dealerships can record losses for inventory sold at prices below net realizable value and recognize losses in the period in which they occurred. Year-end valuation procedures, calculated based on the average wholesale value of each individual item, also allow dealerships using LCM to make an adjustment to their ending inventory. If an inventory item’s market value falls below its recorded cost, the year-end inventory value will be reduced; in turn, the deduction for the cost of goods sold increases, and taxable income is reduced.
There is a cost-effective and efficient inventory method “cocktail” for every dealership and dealer group, and the considerations for each entity and account are certainly multi-faceted. ARB’s Auto Dealership Services Group is dedicated to keeping our clients on the leading edge of industry trends, legislative updates, and best practices.
We are here to help your dealership with an inventory strategy specific to your needs. Contact us for more information, or to discuss your dealership’s other financial and accounting needs. Please also visit our COVID-19 Financial Resource and Tax Center for information on related tax and financial matters.
by the ARB Auto Dealership Group