Revenue Recognition Standards Clarify Principal vs. Agent Considerations

The new revenue recognition standard codified in FASB Accounting Standards Codification (ASC) 606 has brought a number of challenges to accountants and other stakeholders. A specific area that has been scrutinized under the new regulations is principal versus agent considerations.

The concept of principal versus agent is not new to accounting. In 2011, Groupon made headlines as the company restated its financial results to correct for an error in the way it recorded revenue due to principal versus agent considerations. Historically, there has been diversity in practice surrounding how to apply the principal versus agent concept. The new revenue recognition rules have clarified and enhanced guidance surrounding the application.

How Agent vs Principal Can Impact the Recognition of Your Company’s Revenue

If a third party is involved in providing goods or services to your customer, your company should evaluate whether it is acting as a principal or an agent. This evaluation is necessary to properly assess the performance obligations within the contract.

This determination can have a significant impact to financial statement reporting:

• A principal should report revenue based on the gross amount billed to a customer, while
• An agent should report revenue based on the net amount retained, for example, the amount billed to a customer less the amount paid to the supplier, subcontractor, etc.

In the Groupon case noted above, its original filing of $1.52 billion in revenue was reduced to $688 million.

Determining if You Are an Agent or a Principal

Generally, a principal provides goods or services directly to the end customer, while an agent arranges for another party to provide its goods or services to the end customer. Said another way, a principal will have control of the goods or services before they are transferred to the customer, while an agent will not. Control is described further in the regulations, but some general indicators include:

• Primary responsibility for fulfilling the promise to provide the specific good or service
• Inventory risk
• Discretion in establishing the price for the specified good or service

The indicators noted above are to support an assessment of control. The conclusion of control should not be based on the presence of one or more of these indicators. Additionally, the revenue recognition rules note that an entity does not necessarily control a specified good if the entity obtains legal title to the good only momentarily before legal title is transferred to a customer.

A principal may satisfy its performance obligation to provide the specified good or service itself or it may engage another party to satisfy some or all of the performance obligation on its behalf. A common example would be a general contractor using a subcontractor to perform a certain aspect of the construction project. When a third party is involved in providing goods or services to a customer, an entity that is a principal obtains control of any one of the following before that good or service is transferred to a customer:

• A good or another asset from the third party that the entity then transfers to the customer
• A right to a service to be performed by the third party, which gives the entity the ability to direct the third party to provide the service to the customer on the entity’s behalf
• A good or service from the third party that the entity then combines with other goods or services in providing a specified good or service to the customer

While the additional guidance from the revenue recognition rules has helped with the application of principal versus agent considerations, the determination can still be challenging. The key point to remember is if a third party is providing goods or services to your customers, you must determine if your company is a principal or an agent in terms of your contractual relationship. Only then you can begin to sort out your company’s obligations under the new revenue recognition rules.

Contact Nevin Nussbaum nnussbaum@cohencpa.com at or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.