Issues arising in determining whether to recognize revenue on a gross or net basis
Here’s an extract from the Alberta Securities Commission’s recent Corporate Finance Disclosure Report, issued in December 2013:
- “IAS 18, paragraph 8 states that revenue includes only the gross inflows of economic benefits received and receivable by the entity on its own account. Amounts collected on behalf of third parties are not economic benefits of the entity and should not be recognized as revenue. In agency relationships, the amounts collected on behalf of the principal are not revenue to the entity; instead, revenue is limited to the amount of commission or fees collected. We noted instances where RIs (reporting issuers) inappropriately recorded revenues on a gross basis for transactions where they were acting on behalf, and for the benefit, of another party in an agency agreement.
- In one example, the RI provided project management services; in return for these services, the RI received a certain percentage share of net profits generated from its partner’s projects. A significant portion of the RI’s reported revenue related to its project management services, and its disclosure indicated that the RI was reporting the gross profits generated from projects of the partner as revenue with a corresponding gross cost of sales amount. We questioned the RI’s basis for recognizing the revenue as principal since its disclosure seemed to suggest the RI was acting as agent. Upon further analysis, the RI concluded that it was not exposed to the significant risks and rewards associated with the sale of goods or the rendering of services, other than the project management services provided as outlined in the agency agreement. The RI corrected this error by restating its interim and annual financial statements to report revenue on a net basis for the project management services provided under the agency agreement. Given the material nature of this change, a news release was also required to be issued to explain the error.”
The report goes on to cite the factors set out in IAS 18.21: “Indicators that suggest the RI is acting as the principal include if it: assumes the risk of inventory before or after the customer order; is responsible for providing the goods or services to a customer; has the ability to establish prices, either directly or indirectly; and assumes the credit risk on the receivable due from the customer.” In the specific case cited by the ASC, it was probably fairly clear on this basis that the entity had no reportable interest in the broader revenues relating to the projects as a whole. In practice though, situations often arise where these points don’t particularly help, because they’re not particularly applicable.
For example, assessing the risk of inventory may not be relevant, if the business consists of providing services that don’t entail any inventory. Determining the responsibility for providing the goods or services can sometimes be ambiguous, if for example the vendor engages a middleman to carry out some of the client-facing steps. Not having the ability to establish prices may not mean much one way or the other, if for example the item being sold is widely distributed, with a widely advertised and thus inflexible sticker price. And in some situations, credit risk may not be a big factor either – for example where it’s a primarily cash business, or where the vendor takes steps at the outset of the transaction to minimize that risk. In other words, the factors cited by IAS 18 to distinguish between a principal and an agent may often fall one way or the other because of the inherent nature of the business, or because of how the entity has chosen to structure and manage its affairs. This might often be the case, for instance, in electronic commerce, where transactions occur so quickly and interdependently that it can be difficult to determine who involved did what, or what its relative importance was.
What could go wrong?
It’s often useful in such situations to step back and ask: what could go wrong with this transaction, and if all those things did go wrong, where would the losses fall? This isn’t a litmus test, but as a general rule, if one is being paid to perform a limited role in a chain of commerce – which is typical of an agent – then it would be peculiar to expose oneself to a risk of loss disproportionate to the possible gain (as IAS 18 puts it, the amount one earns for acting as an agent is often “predetermined,” whether as a fixed fee per transaction or a stated percentage).
This kind of assessment also helps clarify the underlying point of this aspect of IAS 18. When the “gross/net” issue comes up, it’s usually because an issuer recognizes revenue on a gross basis, and regulators or others suspect a net basis is more appropriate. But it’s equally plausible to imagine cases where the dynamic would be reversed, and recognizing a particular income stream on a net basis masks the issuer’s involvement with the transaction as a whole, and its consequent risk of loss in the future…
The opinions expressed are solely those of the author