The new revenue guidance ASC 606 that was first introduced by Accounting Standards Update (ASU) 2014-09 are in effect for the 2019 calendar year for private companies. A question often asked by clients is whether certain transactions should be recorded as Gross vs. Net. The answer to this depends on the determination of whether your Company is acting as an agent or principal.
To illustrate this point, we will utilize the following case study.
An online marketplace retailer sells hotel rooms to travelers for $500 per night. Travelers may select the specific hotels, rooms, dates, etc. on the marketplace and knows exactly what they are choosing. In turn, the online marketplace retailer receives a commission from the hotel at 10% of the booking cost, or in this scenario $50. Should the online marketplace retailer record this transaction using the gross method or the net method as illustrated below?
|Gross Presentation||Net Presentation|
|Cost of sales||(450)||0|
|Net income from operations||$50||$50|
Please note that in this scenario either method results in the same net income from operations. However, the presentation on the financials could drastically differ.
Agent vs. Principal
ASU 2016-08, Principal versus Agent Considerations (Reporting Revenue Gross versus Net) was subsequently issued to clarify revenue recognition guidance within ASC 606 for these types of transactions. Within the guidance, it specifies that to determine the nature of its promise to the customer, the entity should:
- Identify the specified goods or services to be provided to the customer; and
- Assess whether it controls each specified good or service before that good or service is transferred to the customer.
An entity is a principal if it controls the specified good or service before that good or service is transferred to a customer. If an entity does not control the good or service before it is transferred to the customer, the entity is an agent in the transaction. However, an entity does not necessarily control a specified good if the entity obtains legal title to that good only momentarily before legal title is transferred to a customer.
Control of an asset is present if the company can direct the use of, and obtain substantially all the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, an asset.
It can sometimes be difficult to determine whether control exists for a Company. ASU 2016-08 provided the following three indicators of control that can be useful in making this determination:
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service.
- 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 (for example, if the customer has a right or return).
- The entity has discretion in establishing the prices for the specified goods or service.
Solution to Case Study
Based on the guidance noted above, and considering the facts and circumstances noted from the Case Study, the online marketplace retailer should record such transactions as net due to the following fact pattern:
- The hotels are responsible for fulfillment
- The online marketplace retailer is only responsible for providing a marketplace for users and hotels to connect and earns a commission based on the sale, not the hotel services performed. Thus, the online marketplace retailer does not have any rights of non-performance by the hotel.
- The hotel sets the prices for the specified goods or services.
However, if the online marketplace retailer bares the responsibilities of fulfillment, to provide alternative hotel places if the original hotel provider does not deliver such services, and/or sets the pricing for such specified goods, then the gross method may be more accurate.
Entities that are currently implementing the new revenue guidance should carefully assess whether to report as principal or agent. If you have any further questions, please contact your Larson advisor for details.