We recently had training on certain key aspects of revenue recognition that we encounter in our practice. One of them is the determination of Principal vs Agent.
In that recent training activity, we discussed the analysis required to determine when an entity is the Principal in a revenue arrangement and when an entity is the Agent.
Here is what makes this so important:
- When an entity is the “principal” in a revenue arrangement, revenue recognition follows the “gross” presentation which allows the entity to recognize more of the arrangement revenue, which is a desirable outcome.
- When an entity is the “agent” in a revenue arrangement, revenue recognition follows the “net” presentation which allows the entity to recognize less of the arrangement revenue, which is a less desirable outcome.
In the guidance of ASC 606, the entity that controls the specified good or service before it is transferred to the customer is the “principal” and recognizes the gross amount as revenue. An “agent” is simply an entity that is not considered the principal in the transaction. This area involves a very judgmental analysis, with several factors to consider.
Factors that indicate that an entity controls the specified good or service before it is transferred to the customer include, but are not limited to, the following:
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service. This typically includes responsibility for the acceptability of the specified good or service (for example, primary responsibility for the good or service meeting customer specifications).
If the entity is primarily responsible for fulfilling the promise to provide the specified good or service, this may indicate that the other party involved in providing the specified good or service is acting on the entity’s behalf.
Please note the language “this may indicate” because not one of the criteria alone is sufficient for a conclusion. All relevant criteria must be considered before reaching a conclusion. Besides, it is often the case that an entity will meet that first criteria, but you should not stop the analysis there.
- The entity has inventory risk before the specified good or service has been transferred to a customer or after transfer of control to the customer (e.g., if the customer has a right of return).
For example, if the entity obtains, or commits to obtain, the specified good or service before obtaining a contract with a customer, that may indicate that the entity has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service before it is transferred to the customer.
Be careful because this criteria is not limited to tangible property inventory risk. It can still be relevant where software and services are involved. For example, a reseller may commit to purchase a minimum amount of software or services from the entity primarily responsible for fulfilling the promise to provide the specified software or services. The reseller agrees to assume the risk that it will purchase a minimum amount, and, if it cannot resell all of it, the reseller will bear the economic loss and is not entitled to any type of refund. The handling of product returns or the assumption of credit risks are further examples of risks that can be assumed by the reseller.