How IFRS 15 affects an area where issues commonly arise in practice
As we summarized here, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2017 (NB this was subsequently amended to January 1, 2018). The standard is built around a five-step framework, including the key step of identifying the performance obligations in a contract – that is, all the promises in a contract to transfer to a customer goods or services that are distinct. In some cases, it’ll be important for an entity to determine whether each promise it makes is a performance obligation to provide goods or services that it controls itself (i.e. the entity is a principal) or rather to provide goods or services controlled by others (i.e. the entity is an agent). Of course, this distinction exists under current standards as well, but it’s more central to the structure of IFRS 15. It explains the concepts, and the key consequences, as follows:
- “An entity is a principal if the entity controls a promised good or service before the entity transfers the good or service to a customer. However, an entity is not necessarily acting as a principal if the entity obtains legal title of a product only momentarily before legal title is transferred to a customer. An entity that is a principal in a contract may satisfy a performance obligation by itself or it may engage another party (for example, a subcontractor) to satisfy some or all of a performance obligation on its behalf. When an entity that is a principal satisfies a performance obligation, the entity recognizes revenue in the gross amount of consideration to which it expects to be entitled in exchange for those goods or services transferred.
- An entity is an agent if the entity’s performance obligation is to arrange for the provision of goods or services by another party. When an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the other party to provide its goods or services. An entity’s fee or commission might be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.”
As in current IAS 18, the standard doesn’t provide a “bright line” for distinguishing between the two situations, but provides a list of indicators that an entity is acting as an agent. IFRS 15 provides different wording for these indicators, in part reflecting that their relative importance and purpose within the standard is different from before, but they go to the same essential points as the current standard: another party is primarily responsible for fulfilling the contract; the entity doesn’t have inventory risk before or after the goods have been ordered by a customer, during shipping or on return; the entity doesn’t have discretion in establishing prices for the other party’s goods or services and, therefore, the benefit that it can receive from those goods or services is limited; the entity’s consideration is in the form of a commission (this item isn’t currently specifically listed as an indicator in IAS 18, but is inherent in the very nature of acting as an agent); and the entity isn’t exposed to credit risk for the amount receivable from a customer in exchange for the other party’s goods or services.
I wrote here about this area as it applies under current IFRS, and many of the comments I made there will continue to apply. I noted that in practice, situations often arise where these points don’t particularly help, because they’re not particularly applicable. For example, assessing inventory risk may not be relevant, if the business consists of providing services that don’t entail any inventory. Determining the primary responsibility for fulfilling the contract can sometimes be ambiguous, if for example the vendor engages a middleman to carry out some of the client-facing steps. Not having discretion in establishing 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 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 it’s 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.
These and other practical difficulties consumed much of the initial meeting of the FASB-IASB Joint Transition Resource Group for Revenue Recognition in July this year, at which the group got tangled up in such issues as the interaction of different elements of the standard, and situations for which the indicators above provide contradictory evidence. This is what came out of that: “Board members instructed the staff to perform additional research on the topic. The focus of the additional research is to understand whether there are specific improvements the Boards could make that would assist stakeholders with making difficult judgements about the principal versus agent assessment. An update will be provided to all stakeholders after the staff completes the research.”
Until then, it seems to me it’ll continue to be useful in such situations to step back and ask: what could go wrong with this transaction (or aspect of a broader 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 fee or commission capable of being earned. In any event, this aspect of accounting for revenue will likely continue to attract particular interest from regulators. In the context of IFRS 15, the principal/agent distinction has further implications for the treatment of loyalty programs, which we’’ll discuss in a future article.
The opinions expressed are solely those of the author