Before recognizing revenue under ASC 606, an entity must determine whether it is a principal or an agent for each promised good or service. This classification affects the amount of revenue recognized by an entity—a principal recognizes revenues at the gross amount received for the goods and services, while an agent recognizes revenue at the net amount (i.e., the fee or commission the entity receives). Although the application of this guidance is unlikely to change an entity’s net income, it can significantly impact the top-line revenue and gross profit percentages, which are often critical indicators of the value of an entity.
The primary difference between a principal and an agent is the nature of the performance obligation being satisfied. The principal has a performance obligation to provide the specified good or service to the end consumer, whereas the agent merely arranges for the principal to provide the specified good or service (ASC 606-10-55-36). A contract with a customer may include more than one specified good or service, and an entity may be an agent for some and a principal for others.
Principal/Agent Status Depends on Control
ASC 606 states that “[a]n entity is a principal if it controls the specified good or service before that good or service is transferred to a customer” (ASC 606-10-55-37). A principal obtains control over any one of the following (ASC 606-10-55-37A):
- A good or another asset from the other party which the entity then transfers to the customer. Note that momentary control before transfer to the customer may not qualify.
- A right to a service to be performed by the other party, which gives the entity the ability to direct that party to provide the service to the customer on the entity's behalf. For example, an entity purchases airline tickets, planning to resell them.
- A good or service from the other party that it then combines with other goods or services in providing the specified good or service to the customer. For example, a furniture manufacturer purchases goods from multiple vendors to build its products.
If the entity obtains control over one of the above before the good or service is transferred to a customer, the entity could be considered a principal. The FASB has provided a list of indicators that suggest an entity has obtained control over a good or service before transferring it to a customer. This list does not override the assessment of control and should not be viewed in isolation. Furthermore, this list is not exhaustive and its application can require significant judgment (ASC 606-10-55-39):
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service. For example, the entity is responsible for the good or service meeting customer expectations.
- The entity has inventory risk before or after (i.e., customer has a right of return) the specified good or service has been transferred to a customer. Inventory risk indicates that the entity controls the good or service even before it obtained a contract with the customer.
- The entity has discretion in setting the price for the specified good or service. This may indicate that the entity has the ability to use or direct the use of the good or service. Note that agents sometimes have flexibility in setting prices too, so this indicator is not always helpful.
No indicator is more important than another; the facts and circumstances of an arrangement will alter which indicators carry greater weight. Other indicators not listed above may also provide more convincing evidence of control. Entities should judge which indicators provide the strongest evidence in determining whether the entity has control of the promised goods or services. When indicators of control conflict, companies should evaluate which indicators are most suggestive of control in the specific transaction.
An entity classified as a principal may satisfy a performance obligation by itself or it may subcontract another entity to fulfill the obligation on its behalf. A contractual side agreement such as this would not necessarily change the entity’s classification. However, if the other party assumes the performance obligation in such a way that the entity is no longer responsible for fulfillment of the performance obligation, then the entity is no longer acting as a principal and does not recognize revenue for that performance obligation on a gross basis.
Principal/Agent Examples and SEC Comment Letters
Some industries deal with principal/agent considerations more often than others. Travel agencies, shipping/transportation services, online shopping services, and oil and gas entities often need to evaluate whether they are the principal or agent in their contracts. Below, we have provided an example and several SEC comment letter discussions from a variety of industries.
Special Consideration for Shipping and Taxes
ASC 606 does not have specific rules for shipping and handling, unlike prior guidance. It also no longer has the policy election for gross or net presentation of taxes. Tax collections should be presented based upon the substance of the tax arrangement instead of a policy election. Question #27 in the FASB’s January 2020 Q&A highlights several additional indicators to help an entity determine whether it is a principal or agent for shipping and handling, taxes, and other costs.
For shipping and handling costs, an entity needs to consider the following potential indicators that the entity is a principal:
- The entity is responsible for directly providing or for procuring the shipping service.
- The entity can set the price charged for shipping and handling.
- The entity’s profit or loss on the shipping and handling is not fixed.
- The entity is responsible for payment to the shipping provider regardless of its ability to collect the shipping and handling fees billed to the customer.
In relation to taxes and other assessments remitted to government authorities, an entity should consider the following as potential indicators that the entity is a principal:
- The entity is primarily responsible for paying the tax, not the customer.
- The entity has latitude with respect to the amount charged to the customer. If the entity is responsible for paying the tax, it can choose to seek reimbursement from the customer through billings.
- The margins retained by the entity are not fixed and are set based on a business decision about the price customers are willing to pay.
- The entity is responsible for paying the tax whether or not it collects amounts billed to customers.
Allocating Transaction Price When an Entity is Both a Principal and an Agent
Another area of frequent concern is the application of discounts to bundles of goods or services for which an entity is the principal for some of the goods/services and an agent for others. The TRG has discussed two views: (A) allocate the discount to all performance obligations, regardless of whether the entity is the principal or agent (both gross and net amounts), and (B) allocate the discount only to the transactions for which the entity is the principal (only gross amounts). The TRG did not spend much time discussing this issue, and experience so far suggests that it is not an area of great controversy.
In a recent Q&A issued by the FASB in January 2020, the FASB expressed that the entity should evaluate whether it has one customer (the end customer) or multiple (the end customer and the originator for the elements for which it is an agent). If the entity has a single customer, then View A is most likely the best way to allocate the discount. If the entity has multiple customers, then allocating a discount across the contracts may not be appropriate since there are now contracts with two or more unrelated parties. In addition, the FASB explains that an entity should evaluate whether it is a principal for only some goods or services if these goods or services are not separable from other parts of the contract.
Under ASC 606, the concept of control is used to determine principal and agent status. The simplified list of indicators provided in the standard is meant to assist in determining control. This area of ASC 606 often requires significant judgment, as SEC comment letters and responses illustrate. Questions often arise related to shipping and handling, taxes, or allocating transaction price when an entity is both a principal and an agent.
- ASC 606-10-55-36 to 40
- ASU 2016-08: "Principal versus Agent Considerations."
- FASB TRG Memo 1: “Gross versus Net Revenue.” 18 July 2014.
- FASB, “Revenue Recognition Implementation Q&As.” January 2020. Question 27.
- KPMG, Handbook: “Revenue Recognition.” December 2019. Section 9.
- EY, “Revenue from contracts with customers (ASC 606).” January 2020. Section 4.4.