Recognition of revenue as principal or agent
That is a big question under IFRS 15. Recognise a large amount of revenue as a principal or only a fraction of that turnover as an agent. So the stakes are high!!
Royalty payments
Entity A has agreed to pay a royalty to Entity B for the use of intellectual property rights that Entity A requires to make sales to its customers. The royalty is specified as a percentage of gross proceeds from Entity A’s sales to its customers less contractually defined costs. Entity A is the principal in the sales transactions with its customers (i.e. it must provide the goods and services itself and does not act as an agent for Entity B).
The question is: In Entity A’s financial statements, should the royalty payments be netted against revenue or recognised as a cost of fulfilling the contract?
Because Entity A is the principal in respect of the sales to its customers, it should recognise its revenue on a gross basis and the royalty as a cost of fulfilling the contract. Guidance on the appropriate accounting for the costs of fulfilling a contract, including whether such costs should be capitalised or expensed, is provided in IFRS 15 95 – 104.
Principal versus agent
Some arrangements involve two or more unrelated parties that contribute to providing a specified good or service to a customer. In these instances, management will need to determine whether the company has promised to provide the specified good or service itself as a principal or to arrange for those specified goods or services to be provided by another party as an agent. This determination often requires judgment, and different conclusions can significantly impact the amount and timing of revenue recognition.
Management first obtains an understanding (it is English, this means you need to know all about it) of the relationships and contractual arrangements among the various parties. This includes identifying the specified good or service being provided to the end customer and determining whether the company controls that good or service before it is transferred to the end customer.
A company is a principal in a transaction if it obtains control of the goods and services of another party before it transfers control over those goods and services to the customer. A company that is a principal obtains control of any one of the following:
- A good from the other party that it then transfers to the customer
- A right to a service to be performed by the other party that gives the company the ability to direct that party to provide the service to the customer on the company’s behalf
- A good or service that the company then combines with others in providing the specific good or service to a customer
If the determination of whether the company controls the specified good or service (i.e., is a principal) is unclear, companies should evaluate the following indicators: Recognition of revenue as principal or agent
- Primary responsibility for fulfilling the promise
- Inventory risk
- Discretion in establishing price
No relative weighting is provided to the indicators
The principal versus agent assessment is often required for arrangements in the Entertainment & Media industry. For example:
- Determining whether a content owner or an online retailer is the principal with respect to the sale of an electronic book, a movie or a song to a consumer
- Determining whether a producer or distributing studio is the principal with respect to film exploitation
- Determining which of many potential parties is the principal in an internet advertising transaction
- Determining whether a video game company is the principal when hosting third party gaming software on its platform
With the growth of digital business models, which often involve no physical goods and little inventory risk, these judgments are expected to be more challenging in significance and complexity.
Cases
These two cases show the difference in revenue recognition in a role as a principal or agent:
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Case – Accounting for transportation costs: Entity is a principal |
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Retailer B enters into a contract with Customer C that involves the following two performance obligations:
Based on its evaluation of whether it controls the goods and services before transfer to C, B concludes that it is a principal for both performance obligations. B allocates the total transaction price between the two performance obligations and recognises revenue and costs for each performance obligation as follows.
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Case – Accounting for transportation costs: Entity is an agent |
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Modifying the above case from principal to agent, Retailer B instead determines that it acts as an agent for the shipping service, which is provided by a third party shipping company. The accounting for Product P is the same as above. However, when B is an agent for the delivery service, revenue for arranging the delivery service is recognised on a net basis – i.e. net of the amount payable to the third party shipping company – when B satisfies its obligation of arranging for the delivery service. |
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