When examining revenue, it isn’t always obvious whether the business is a principal or an agent. This difference is important as if a business is a principal, it needs to recognise revenue on a gross basis and if it is an agent, it needs to recognise revenue on a net basis. This article gives clear definitions and shows how to determine principals and agents, followed by some practical complexities and real life case studies.
Definitions of a principal and an agent
According to the guidance provided by IASB (International Accounting Standards Board), a principal is an entity which controls the specified good or service before it is transferred to the customer.
How to assess whether the entity controls the specified good or service?
In paragraph B34 – B 38, per IFRS 15 Revenue from Contracts with Customers, there are some indicators to assess whether the entity is a principal.
· Indicator one: the entity is primarily responsible for fulfilling the contract, for instance, the entity is primarily responsible in making the products.
· Indicator two: the entity bears inventory risk both before and after the goods have been ordered by a customer, for instance, a car dealer may have the right to return the unsold cars back to the car manufacturer and in this case, the car manufacturer bears the inventory risk.
· Indicator three: the entity has discretion to establish prices and receives benefit. However, in some industries, the entity may not have the absolute right to determine the selling price. For example, book publisher has its freedom to determine the selling price for each book, however, the bookstore or retailer also has the right to cap the selling price or to discount those books if they are not popular.
· Indicator four: the consideration received is not in the form of a commission. For instance, a restaurant in a large cruise may offer attractive coupons to customers and cruise company can buy those coupons in advance at a low price and resell them to customers at a higher price. Even though, in this case the cruise company may receive a commission from the restaurant for each coupon used by its customer, the cruise company also earns income with gains from selling those coupons.
· Indicator five: the entity has exposure to credit risk for the amount receivable from a customer. However, in retail industries, we do not normally focus on this criteria since customers are often required to pay in advance before they can get goods or services.
An entity is a principal even though not all the above indicators are fully met.
To simplify the idea, let’s say company A is a book publishing company the selling price for each book is $10 to the company B which is a book retailer business. Company B will then need to sell each book to the end customer at $15.
If company B is a principal and this means it controls the books before they are transferred to customers, the accounting journals would be to recognise the gross revenue and the associated acquisition costs paid to company A.
Step 1: recognise gross revenue
Dr Bank $15
Cr Sales revenue $15
Step 2: Recognise acquisition costs:
Dr Costs of sales $10
Cr Inventories $10
If company B is an agent, it can only recognise the net revenue as follows:
Dr Bank $15
Cr Trade payables $10
Cr Revenue $5
Uber is a high-tech car platform offering a network of independent taxi drivers who use their platform. Customers use an app to pre-order pick-up. Uber sets the fares and receive a share of fees from each hailing service. It currently recognises revenue on a net basis since it mainly receives commission from each taxi driver although there are lots of arguments that it should change to gross basis as it controls the service such as setting the fare before it is delivered to customers.
Napster provides music downloading services to users and pays artists based on the number of song plays. It currently recognises revenue on a gross basis because it regards itself as a principal in most transactions, although we could argue songs from most artists can also be found on other sources and therefore, they are not unique to Napster. However, users may primarily rely on playlists recommended by Napster and therefore, it is reasonable to be a principal in this case.
3. Tencent Holdings Limited
Tencent provides live broadcast, video streaming subscription and online games to users. It recognises revenue on a gross basis as it has freedoms to set prices and it is primarily responsible for delivering those services to customers.
Groupon is an e-commerce website allowing subscribers to purchase products or services online. It currently reports the direct sales on a gross basis as it is primarily responsible for fulfilling the contract and therefore, it also includes costs of inventory and shipping. Third party revenue such as the sales of flight ticket is reported on a net basis as it is not primarily responsible for fulling the contract.
5. Google Apps - in apps purchases through Google Play store
It currently reports revenue from in apps purchases through Google Play store on a net basis because Google only provides a platform enabling developers to develop applications and earns a commission income based on that.
The net profits impact would be the same regardless of whether the entity is a principal or an agent. Often, ratios such as asset turnover and profit margins would tend to be higher for the entity if it is an agent rather than a principal. However, the total revenue would tend to be lower instead. Different policies will also affect the key performance indicators in the business and therefore, the bonuses paid to management.