Principal Versus Agent: Which Are You?
The Financial Accounting Standards Board (FASB) has implemented one of the most extensive changes to revenue recognition standards in its history with the issuance of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. As entities address and apply the standard’s provisions, one key element they must determine is how to report their revenues. Entities can report revenue at the gross amount of consideration they expect to receive (with associated fees presented as a cost) or on a net basis, which is the gross amount of consideration less any fee or commission directly related to the obligations.
But how an entity reports its revenue is determined by whether the company is a principal or an agent. Because of this, it is crucial to know what constitutes a principal and an agent.
What Are Principals and Agents?
A principal, according to ASU 2016-08, is the company that is providing the good or service to the customer, and an agent is the company arranging for the good or service to be provided to the customer. An agent acts on behalf of the principal and normally will receive a commission for its services. Principals report revenue on a gross basis, and agents report their revenue on a net basis.
Let’s look at an example to make this clearer. A customer buys a coupon for a service from an e-commerce marketplace for $50. Of the $50 the e-commerce marketplace receives, it must pay $5 back to the service provider. In this case, the e-commerce marketplace is an agent since it is arranging for the transaction between the provider and the customer but is not actually providing the good or service to the customer. Since the e-commerce marketplace is receiving $50 and is paying out $5 to the provider, it should recognize $45 revenue (net basis) on its income statement.
Most of the time the determination between principal and agent is straightforward, but it can be more difficult to determine as transactions become increasingly complex. For situations such as these, the FASB has provided the following guidelines:
- Is the nature of its promise in the performance obligation to provide the specified good or services itself (principal)?
- Is the nature of its promise in the performance obligation to arrange for the good or service to be provided by another company (agent)?
An entity must complete this evaluation for each specified good or service that it has promised to a customer. Two aspects that can help lend further clarify are rights and control.
One challenge an entity faces here is determining if its promise to a customer is for the delivery of the good or service or the right to the good or service. For example, if an entity sells the right to an airline ticket, it can fulfill its promise with a vendor of its choosing. However, a travel agent that sells a specific ticket on a specific airline and receives a commission is arranging for the delivery of a service. The first is a right to an airline ticket, which would make it a principal. In the case of the travel agency, the company is arranging the transfer of a service and would therefore be agent. In more complex transactions, it becomes more important to discern between the delivery of a good or service and the right to a good or service.
Control of a good or service means the company can direct the use of – and obtain substantially all of the benefits from – the good or service. An entity’s ability to direct the use of a good or service refers to the company’s right to do the following:
- Use that asset in its activities,
- Allow another company to use that asset in its activities, or
- Restrict another company from using that asset.
The analysis of principal versus agent hinges on who has control of the specified goods or services (or rights to specified goods or services) before they are transferred to the customer. If the reporting company determines that it has control and is, therefore, a principal, the specified goods and services (or rights to goods and services) should fall into one of the following categories:
- A good or another asset from the other company that the reporting company then transfers to the customer,
- A right to a service to be performed by the other company, which gives the reporting company the ability to direct the other party to provide the service to the customer on its behalf, or
- A good or service from the other company that the reporting company combines with other goods or services in providing the specified good or service to the customer.
As long as the reporting company is able to classify the specified goods or services into one of the categories above, then it does have control. It would be a principal in the transaction and would report revenue at the gross amount.
For example, an entity that manufactures a good or actually performs a service will always be a principal even if the company transfers control of that good or service to its customers. An automotive manufacturer that sells parts to a dealer would still be a principal even though it is not ultimately providing the car to the customer. In this regard, U.S. GAAP recognizes that the automotive manufacturer’s customer is the dealer and not the end-user of the car. To look at it another way, the automotive manufacturer is the principal in selling the automotive to the wholesale customer (the dealer), and the dealer is the principal in selling the automotive to the retail customer.
The FASB does provide additional indicators to help a reporting company determine if it controls a specified good or service prior to transferring it to a customer. This following should not be seen as an all-encompassing listing of indicators, but it can help provide additional clarity. An entity controls a good or service if the following is true:
- The company is primarily responsible for fulfilling the promise to provide the specified good or service.
- The company has inventory risk, which is defined as exposing the company to risk factors such as a decline in the value of inventory, waste costs, damage costs, theft cost, etc.
- The company has discretion in establishing the price for the specified good or service.
It is important to note that the FASB does not consider credit risk to be an indicator of control. This was specifically removed from the indicators noted above with the issuance of ASU 2018-06.
As an entity is evaluating its revenue reporting under the new revenue recognition standard, it is important to carefully assess whether to report as a principal or agent. If you have questions about how your company should report, please contact your KSM advisor.
*It is important to note that FASB clarified its language and enhanced its guidance with the issuance of ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net).
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