Some Audit processes, sub-processes and activities are common in all the industries but some are specific to particular Industry. In this article, I have tried to list down the Specific Key Areas for auto and auto components sector. This is a comprehensive list of focus areas but there is still a scope to include further points.
Revenue Recognition
The process of revenue recognition in auto and the auto component sector is complex, as it includes revenues from sales of goods and services (royalty, commission, after-sales services, etc.), and also income from customer financing. The internal auditor may review the contractual agreement and ensure that revenue is recorded only upon transfer of risks and rewards and no significant uncertainty exists regarding the amount of consideration (in line with AS 9). Revenue on a sale transaction can be recognized only if both of the conditions are satisfied.
The following aspects typical to the automotive and auto component industries impact revenue recognition in the industry:
- Consignment sales/ Stock transfer - Consignment Sales/ Stock Transfers are a common practice in the sector, where the material is dispatched by the company; however, the risks and rewards on the material are not transferred to the transferee. The terms/ basis of the transfer are agreed in the contract with the transferee. Based on such terms, the sales (if recorded in the financials) are required to be reversed and a provision is required to be created in the financials.
- Dumping of sales quantities - The automotive and auto component industry sales volumes are fixed by the senior management and are closely monitored for target achievement. On account of the same, there lies an increased risk of dumping of quantities to dealers without a corresponding demand for the same. The internal auditor may review the revenues recognized by the company and confirm that the same are in line with the agreement and sales returns should be analyzed in detail to confirm that the same do not relate to dumped sales quantities.
- Extended warranties - Revenue from extended warranty maintenance contracts should be deferred and amortized to income on a straight-line basis over the extended warranty contract period except where sufficient past evidence is available which indicates that the cost of performing service under the contract is incurred other than on a straight-line basis.
- Cash discounts - The industry involves high cycle time (conversion of inventory to realization). Therefore, companies in this sector prefer providing a cash discounts to customers for up-front payments. Such discounts should not be deducted from sales volumes (unlike trade discounts).
Warranty Provisions
Warranties are a very crucial aspect to companies in the sector; despite the fact that the sales have been executed and the risks and rewards have been transferred to the customer, the company needs to provide for warranties proportionate to the value of sales. The basis for provisioning for warranties is required to be documented and adequately reviewed as per the defined Schedule of Authority for the company. Contingent liabilities, on account of warranties, if any are required to be disclosed in the financials.
Provisions for Retrospective Price Revisions
Sale prices in the sector are, generally, based on the metal prices over a period of time (average)/ price as on a date. Therefore, as a prevalent practice, sales are made at a provisional price and the same are later revised (on finalization of basis benchmarked for sales price). For example, if a company sells aluminum castings (weighing 15 kgs) and agreement with the customer states that the sale price shall be based on the annual average price of aluminum (based on LME prices), the sale shall be initially recorded at the dispatch price; however a provision for revising revenue recognized shall be recorded based on the monthly trend of aluminum price fluctuations. The same methodology is also applicable for purchase price determination. The purchases/ sales should be adequately revalued prior to reporting the same in financials for a true and fair reporting.
Revision of Purchase Price
Purchase prices revised based on price manuals shared by large players in the industry. Various automotive majors/ OEMs release price lists for spare parts in the final product based on metal prices/ overhead rates, etc. The same is considered as purchase price for all spares purchased by the respective companies. On various occasions, the price lists released by these companies (market leaders) are used as the basis of purchase price revisions by other companies. Such revisions in prices are treated similar to revisions based on raw material price fluctuations.
Inventory Valuations
Companies are required to value their inventory at cost or realizable value, whichever is less (in accordance with Accounting Standard (AS) 2, “Inventory Valuations”). However, the cost of inventory would fluctuate at a later period based on retrospective invoicing. The impact of such revisions would impact the inventory purchase as well as realizable values. Company is required to revalue inventory in books in order to demonstrate a true and fair value of the financials.
Brand Fees
Generally, in specific segments like oil, paint, tyre, etc., manufacturers promote their brand by showcasing partnership with an automotive major. The automotive major charges a fee for usage of the brand name.
Royalties
Global automotive parent companies charge a royalty to the respective entities in various countries based on the sales from the entity during the period. The companies need to recognize and make provision for such royalty income/ expense. The provision recorded needs to incorporate the foreign exchange fluctuation rate as well, if applicable.
Scrap Purchases
The companies in the industry deal in steel, aluminum, copper and other such metals which can be re-melted and molded and therefore, have a high salvage value. Companies often explore opportunities of purchasing metals from scarp vendors instead of the organized vendors. Similarly, un- damaged glass doors/ windows may also be re-sold to car owners in need of replacements; as also removable parts like, headlights, blinkers, mirrors, seats, etc. Purchasing and re-selling of scrapped parts is a prevalent and profitable practice in the automotive and auto components industry.
Inventory Absolution
Auto and auto component companies need to plan ahead for all new designs; the finalization of the same is initiated 2-4 years ahead of the actual product launch. Inventory/ molds/ castings are procured in bulk based on such finalized designs in advance for a product launch. On account of the bulk purchases, resulting in the risk of blocking working capital and obsolete inventory; the auditor may link the purchase plan with the strategy for product launch to identify potential for obsoletion, if any. Companies need to agree on the pricing terms to ensure that the contracts for new products do not turn onerous, on account of fluctuation in raw material prices.
Tooling Advances
As a practice in the industry (detailed above), the tools for a new product launch are required to be designed and procured in advance. The design for component tools are finalized in advance and the same are provided to a partner (for manufacture). Generally, the auto company would require to provide an advance to the partner to enable acquisition of the assets necessary for manufacture of the tools. The duration of the advance may vary from 2-4 years (generally); the company is not entitled to charge depreciation on such advances.
Treatment for Molds
Various external components of vehicles are molded from plastic; eg., radiator grills, air ducts, fuel tank parts, air vents, bumpers and other exterior trims, dashboards, front interior assembly panel, etc. The molds for such items are procured by the manufacturer based on the designs and provided to third parties/ outsourced vendors for manufacture of the external components. Such molds are capitalized in the books of the manufacturer and retained by the third party.
Melting/ Casting Losses
All components that are molded from metal / plastic in the auto sector involve process losses on account of oxidation of the raw material. The mount of melting losses would be impacted by the moisture content in the material, furnace practices and the equipment used. Some companies follow a practice of claiming of abnormal melting losses from the vendor (where the same is on account of high moisture content). Companies need to define a procedure for treatment of normal as well as abnormal losses.
Confidentiality and Non-disclosure
Automotive companies have high confidentiality standards, to prevent leakage of their designs and technical know-how
The companies enter into non-disclosure agreements for assurance of the same and all parties involved are required to adhere to the same. Company needs to develop a practice Service Level Agreements (SLA) monitoring, in order to ensure that all the agreed terms and conditions have been adhered.
Liquidated Damages
Liquidated damages are imposed by the buyer based on contracted deadlines, i.e., in the event that the seller fails to meet a deadline then an agreed penalty is levied. The same is considered as “Other Income” by the buyer in financials. In the event that such Liquidated Damages are waived off, the company needs to document a process for obtaining exceptional approvals (in line with a Schedule of Authority) for such waivers.
Dealership Arrangements
In most auto companies, sales are made via authorized dealers. The same impact revenue recognition as well as sales planning. In a dealership arrangement, discount schemes, trading arrangements, etc., impact the revenue volumes for the dealer as well as the company.
Discount Schemes
Auto and auto components manufacturers issue various discount schemes for their dealers on a periodic basis which are based on sales targets (i.e., targets of sales to be made by the dealers within the validity of the scheme). The companies may also float various seasonal discount schemes for the customers; various factors impact the schemes like the quantity of stock with the dealer at the beginning of the scheme period, actual sales made by the dealers during the said period and the sales returns after the scheme period. Companies need to provide for the scheme discounts at financial closure, during the scheme period to reflect true and fair value of revenues. Companies would need to prepare a detailed working/ basis for provision of such discounts and the same is required be adequately reviewed, in line with the company’s schedule of authority prior to recording the provision.
Assets with Third Parties
Various assets (including molds or even inventories) are held by third parties in the auto industry. Companies need to track the status (and ownership) of such assets on a periodic basis to ensure true and fair valuation of assets in financials.
Rebates vs. Volume Discounts
The basic difference between rebates and volume discounts is that while rebates are dependent upon sales values, volume discounts depend upon quantities of goods sold. At each financial closure, an appropriate accrual is required to be recorded in the books of account for incentive schemes. At scheme closure, the company would also need to calculate the incentives to be awarded to the dealer based on the approved scheme.
Annual Maintenance Contracts
Such contracts are entered by the companies for after-sales services of the products sold.
Residual Value Agreements
The agreements for sales where the risk and rewards have been transferred to the buyer; however, the seller makes a commitment to the buyer which is to be fulfilled at a future date are called Residual Value Agreements. Some examples of residual value agreements would be buy-back agreements, minimum value guarantee agreements, etc.
The author can also be reached at cagyatigupta@gmail.com
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