“When another party is involved in providing goods or services to a customer, the entity shall determine whether the nature of its promise is a performance obligation to provide the specified goods or services itself (i.e. the entity is a principal) or to arrange for those goods or services to be provided by the other party (i.e. the entity is an agent)…” —IFRS 15.B34
At first sight, it seems more or less straightforward to determine if an entity is a principal or an agent in a transaction where another party is involved.
However, if you have already come across this topic, you may have experienced that the “principal or agent?” question is not easy to answer. The determination requires a lot of judgement and detailed analysis of the specific facts and circumstances of the transaction concerned. In this article, I will try to provide some guidance on what to consider when doing the assessment.
Why does it even matter?
Certainly, the most significant difference to consider is the presentation of the revenues received from the customer. If you are the principal of the transaction, you must account for the gross total of revenues received and transfer the commission to the agent afterwards. If you are the agent, you are required to show only the commission you are entitled to receive, meaning you must account for the net total of revenues received. However, there is no effect on the profit and loss.
It may seem like this analysis isn’t required if—in the end—the result is the same. But in the context of financial ratios or other financial issues, such as calculations like bank covenants or management bonuses dependent on the revenues from sales, it does indeed very much matter.
What are the requirements of IFRS 15?
Source: Revenue Issues In-Depth (Second edition), May 2016, KPMG
Most entities are probably already aware of the requirements as defined in the standard, which says that if the entity satisfies the performance obligation itself or is able to control the specified goods or services before transferring them to the customer, then the entity is clearly a principal. But the difficult part is that it is not always crystal clear if the entity has obtained control of the specified good or service. Therefore, IFRS 15 provides three quite useful indicators (which, however, may be more or less relevant when determining who is a principal or an agent, depending on whether the matter of control can be determined satisfactorily). The three indicators are who has responsibility for fulfilling the promise; inventory risk; and price discretion.
What factors should be considered?
When assessing these indicators, the following considerations—not to be considered an exhaustive list—could be helpful:
Primary responsibility for fulfilling the promise:
- Entity has discretion with respect to accepting and rejecting orders from customers
- Entity can source the inventory item ordered by an end-customer from more than one supplier
- Entity is responsible for sales strategy
- Entity is responsible for delivery and any loss or damage between pickup from the supplier and delivery to the end-customer
- Entity is the party that the customer believes is responsible for fulfilling the promise
- Entity is liable for damage and product loss for inventory in its possession prior to sale to the end-customer
- Entity is liable for customer returns
- Entity has no right of return with respect to unsold inventory
- Arrangement between supplier and entity includes minimum order quantities
- Entity has discretion on setting prices that are substantive
- Entity may decide whether the amount it pays to the supplier is fixed or variable (in this context it would be fixed for principles, variable for agents)
These factors, among others identified in the individual agreements, are to be assessed based on the concept of transfer of control, weighted, and put together to form an overall picture. In general, it is expected that your conclusion will be based on several indicators rather than one single factor.
In a nutshell
As said above, the determination for being a principal or an agent, and the presentation thereof in the financial statement, is certainly not easy in most cases. It is therefore essential to carefully consider all facts and circumstances so as to arrive at the correct result. And whenever judgement is involved in the assessment, please be reminded to disclose it in the notes of the financial statement.
I will dig a bit deeper into details in my next blog article on this topic. So stay tuned to learn more on this complex accounting issue!