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.
Example: Online Retail Provider Classified as Agent
Bond.com is an online retailer platform that provides deals and coupons for customers. Various companies offer their products and services on Bond.com and, based on contractual agreements, remit 10-30 percent of the sale price to Bond. Silva Company agrees to sell its ergonomic chairs on Bond.com for $200 (the chairs cost Silva Company $100 to produce) and remit 10 percent of each sale to Bond. Customers buy the chairs on Bond.com using credit or debit cards, with payments going directly to Bond. Bond then arranges the shipping of the item from Silva’s warehouse to the customer (shipping paid for directly by Silva), and remits the sales price less 10 percent to Silva Company. At the end of the year, Bond had sold 1,000 chairs. Is Bond the principal or agent in this transaction?
Bond is an agent in the transaction, as shown by an analysis of the three factors below.
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service. Bond is not responsible for providing the ergonomic chairs. Instead, it facilitates the sale of the ergonomic chairs from Silva Company to the end customers.
- The entity has inventory risk before or after the specified good or service has been transferred to a customer. Bond does not control the inventory before or after the transaction, nor does it lose money on unsold units.
- The entity has discretion in setting prices. Bond agrees to sell the chairs at the price Silva offers to customers through the website and cannot change that price.
None of these factors indicate that Bond would have control of the goods or services before they are transferred to the customer. Additional factors that could indicate that Bond is the agent in this transaction are (1) the 10 percent commission structure of Bond’s revenue in this transaction and (2) the very limited consumer credit risk that Bond will experience in credit card transactions.
Since Bond Entity is an agent, it will recognize net revenue of $20,000 [1,000 chairs * $200 price * 10% commission]. Silva Company will recognize gross revenue of $200,000, cost of goods sold of $100,000, and a commission expense for the amount remitted to Bond.
McDonald’s (the Company) establishes cooperatives to facilitate advertising services for Company-operated and franchised restaurants as well as contracting with third-party marketing agencies. These services are outlined in a marketing plan voted on by members of the cooperative annually, and McDonald’s facilitates the billing and collection under such plan.
Under the Company’s franchise agreement, a franchisee is required to pay an initial fee for the right to operate a McDonald’s restaurant, a royalty for brand support, and rent for continued use of the real estate. The franchise agreement also obligates the franchisee to advertise the restaurant to the public based on a percentage of gross sales each year. However, the franchise agreement does not include an obligation by the Company to provide advertising services. Therefore, any advertising services performed by a third-party agency are separate contracts with distinct services offered to the restaurants, even if McDonald’s is the contracting party.
In response to an SEC comment letter, the Company considered the indicators for control outlined in ASC 606-10-55-39, and included how each point may be applicable to McDonald’s:
- The entity is primarily responsible for fulfilling the promise to provide the specified good or service.
- McDonald’s is not primarily responsible for providing advertising or marketing activities to restaurants. A third party advertising or marketing agency selected to execute a marketing campaign is responsible for fulfilling the contract for these services…Notably, the operating and governance model of the cooperative does not allow for McDonald’s to unilaterally approve or make changes to the annual marketing plan and its campaigns therein.
- 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.
- Inventory risk does not apply in McDonald’s cooperative arrangements as the arrangement is to facilitate the delivery of advertising and marketing services, not a product or good that would be considered subject to inventory risk.
- The entity has discretion in establishing the price for the specified good or service.
- Through the voting structure of the cooperative described above, McDonald’s does not have the ability to control the annual contribution rate that restaurants pay to the cooperative each year. McDonald’s also does not have the discretion to set the price that the cooperative pays for the advertising services as that is dictated by the independent agencies providing the services.
Based on these factors, McDonald’s determined that it acts as an agent for the advertising services managed through cooperative arrangements, rather than a principal (June 2020 letter to the SEC).
Kontoor Brands (Kontoor) is a global lifestyle apparel company with a portfolio of consumer brands such as Lee, Wrangler, and Rock & Republic. Under a typical concession arrangement, Kontoor maintains a dedicated sales area within its retail locations to use the space in exchange for payment of a concession fee. In a letter dated April 29, 2021, the SEC sent Kontoor the following request:
Please tell us if you recognize concession sales on a gross or net basis and explain how you assessed the guidance in ASC 606-10-55-36 through -40 in determining the appropriate accounting treatment and your role as principal or agent.
In its response, Kontoor highlighted that since it “owns the brand, designs and manufactures the product, selects each concession location as part of its overall retail strategy, determines the product assortment to be offered in each concession location, and manages the brand image,” it is primarily responsible for providing the specified goods to the customer. The concessionaire is simply “a party acting on the Company’s behalf to facilitate the final sale to the end consumer.”
Kontoor also owns all the inventory and retains inventory risk until the merchandise is sold. Since Kontoor is also obligated to accept any product returns, it is exposed to risk for any unsold products at the end of a season. While the “concessionaire has physical possession of the product…it is holding the inventory in custody for the Company until the time of sale to the end consumer.” Therefore, Kontoor retains all inventory risk before and after transferring control to the end consumer.
Lastly, Kontoor and its concessionaires have discussions to determine the product’s pricing, especially during seasonal sales. Thus, it has a significant influence in determining prices for the products sold to the end consumer.
Based on these factors, Kontoor determined that it is the principal in its concession sales and thus qualifies for gross reporting according to ASC 606-10-55-36 through 40 (May 2021 letter to the SEC).
In addition to cruises, Norwegian Cruise Line (Norwegian) also offers pre-cruise and post-cruise services to its customers, such as flights and hotels. Norwegian determined that it is the principal for these services and recognizes revenue on a gross basis. On August 29, 2018, the SEC sent Norwegian the following request:
Provide us with your analysis regarding how you determined gross reporting for pre-cruise and post-cruise services was appropriate pursuant to ASC 606-10-55-36 through 39. Please specifically address how you considered the definition of control and how you are directing any third-party providers.
For flights, Norwegian explained that its responsibility is to make sure passengers arrive at the cruise terminal in time for their cruise. Norwegian obtains plane tickets (or the rights to fly on a specified flight), then transfers those tickets (rights) to its passengers. If anything goes wrong, Norwegian is responsible for all customer service aspects of the travel and will arrange for new flights or transportation for the passenger. In addition, Norwegian has some inventory risk for the flights, although limited. While Norwegian does not book a block of tickets in advance, it is responsible for increased costs due to delays and does occasionally charter its own flights to remote locations. Finally, Norwegian has complete discretion over prices for its passengers’ airline tickets, since it charges the customer before buying tickets from a contractor.
For hotel services, Norwegian determined it is also a principal because it purchases room blocks from the hotels, then sells rooms from that block to its passengers. Norwegian has inventory risk for the rooms because it will pay for the room whether or not the passenger uses it. In addition, Norwegian is responsible for handling any complaints from its passengers. Norwegian also sets the prices of the rooms for its passengers, and the hotels have no input on those prices.
Based on these factors, Norwegian determined that it is the principal for both of these pre-cruise and post-cruise services because it is primarily responsible for the service to its customers, has inventory risk, and has the ability to set the prices of the services (September 2018 letter to the SEC).
Echo Global Logistics (Echo) provides transportation and supply chain services to its customers by connecting businesses with carriers that can transport goods. To provide this service, Echo uses its network of truckload contract carriers, rail providers, and international air and ocean carriers. Echo considers itself the principal in these transactions. In a letter dated July 11, 2019, the SEC sent Echo the following request:
Please provide us with your analysis regarding how you determined gross reporting for your transactional revenue was appropriate pursuant to ASC 606-10-25-25 and 606-10-55-36 through 40. Specifically address how you considered the definition of control and how you are directing any third-party providers.
In its response, Echo identified the services it provides to its transactional clients as brokerage and transportation management services. These services include “scheduling delivery, tracking the freight, notification of any in-transit updates, delivery of the freight and, if required, claims management for damaged goods.” Echo sets prices for the customer and retains the right to direct carriers to perform the intended services. Echo has ongoing communication with and control over the actions of the third-party carriers. Echo is responsible for resolving customer claims.
In addition, Echo has some inventory risk. Echo doesn’t contract with third-party carriers until it has a customer contract for a specific shipment, but once a contract with a third-party carrier has been established, Echo must pay the carrier even if it doesn’t receive payment from the customer. Echo may also have to pay a fee to the carrier if the customer cancels their shipment.
Based on these factors, Echo determined that it does have control over the brokerage and transportation management services before they are transferred to the customer, which makes Echo the principal in the transaction (July 2019 letter to the SEC).
American Multi-Cinema (AMC) is the largest movie theater chain in the world. You can purchase movie tickets from AMC in one of three ways: directly at the theater, through AMC’s website, or through a third-party’s website. AMC considers itself the principal for all these services, including the transactions made through a third-party website. On July 23, 2018, the SEC sent AMC the following request:
We note from your disclosure on page 12 that prior to your adoption of ASC 606 you recognized online ticket fee revenues net of third-party commission or service fees, but in accordance with ASC 606 guidance, you believe you are a principal in the arrangement with third-party internet ticketing companies and now recognize revenues based on a gross transaction price. Please provide us with your analysis regarding how you determined you are the principal in these transactions.
In response, AMC explained that in online ticket sale arrangements, it promises customers to “(1) provide access to AMC’s ticket inventory and showtimes…and (2) exhibit the movie.” In other words, AMC argued that it was providing customers with access to available showtimes and ticket inventory in addition to the actual exhibition of the show. AMC argued that it controls both of these services before they are transferred to the customer or to the third-party online-sales entity. AMC controls the movie showtimes and has control over the ticket inventory. The third parties do not have physical possession of or an obligation to pay for tickets until it sells them to customers. The third-party sellers are also obligated to notify AMC when they change their service fee prices. Based on these factors, AMC concluded that it has control over both of the services before they are transferred to customers and is therefore the principal in these transactions (July 2018 letter to the SEC).
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.