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Insights — Exbo Group

Agent vs. Principal: How this Determination Affects Revenue Recognition

Revenue Recognition
8
Minute read

One of the fundamental decisions a business makes when applying ASC 606 in a given transaction is whether the business is a principal or an agent. This determination significantly influences revenue recognition. 

What is a Principal?

When a business acts as a principal, the business is responsible for directly providing a specified good or service to the end consumer. In this scenario, the business recognizes revenue at the gross amount, meaning the total received for the goods or services. 

What is an Agent?

Alternatively, when the business acts as an agent, its role is to arrange for another party, typically called the principal, to provide the specified good or service to the customer. In this case, the business recognizes revenue at the net amount, representing the fee or commission for facilitating the transaction. 

Is My Business a Principal or an Agent?

ASC 606 emphasizes the concept of control in determining whether a business is a principal or an agent. The defining factor is whether or not the business has control—the ability to both direct the use of the good or service and to obtain the benefits associated with it—over the specified good or service before it’s transferred to the customer. If the business has control, it’s more likely to be classified as a principal. 

ASC 606 provides a list of indicators to  help businesses assess whether they have this “control.” These indicators include:

  • Responsibility for fulfilling customer promises: The business is primarily responsible for ensuring that the good or service meets customer expectations.
  • Bearing inventory risk: The business holds inventory before or after the transfer to the customer. This signifies control even before a contract with a customer exists. 
  • Discretion in setting prices: The business can set or change the price for the good or service, suggesting the business can direct its use.

No single indicator is considered more valuable than the others, and businesses should be careful when making this determination since the assessment of control really depends on the specific facts and circumstances of each arrangement.

What is the Five-Step Model of Revenue Recognition? (ASC 606-10-05-3

The core principle under ASC 606 is that the business must recognize revenue when the control of the promised goods or services transfers to the customer in exchange for an amount the company expects to receive for those goods or services. This five-step model is a structured approach to achieving this principle: 

1. Identify the Contract with the Customer (ASC 606-10-25-1): A contract must have approval and commitment from both parties and be enforceable. If the company expects to collect consideration, a contract exists. 

2. Identify the Performance Obligations (ASC 606-10-25-14): 

Performance obligations are distinct promises to transfer goods or services to the customer. These can be explicit or implicit promises within the contract.

3. Determine the Transaction Price (ASC 606-10-32-2): 

The transaction price is the amount of consideration the company expects to receive in exchange for transferring goods or services to the customer. 

4. Allocate the Transaction Price to Performance Obligations (ASC 606-10-32-26): 

Each performance obligation should have a transaction price based on its standalone selling price. 

5. Recognize Revenue as Performance Obligations are Satisfied (ASC 606-10-25-27): 

Revenue should be recognized when the company satisfies a performance obligation by transferring control of goods or services to the customer. 

What Does This Model Look Like for an Online Marketplace Business?

Online marketplace businesses, such as Etsy, must first determine whether they are acting as agents or principals in their transactions.

They play a unique role in the sales process, often acting as intermediaries connecting sellers and buyers.

To apply the five-step revenue recognition model from ASC 606 effectively to these online businesses, you’ll need to consider the role they play between the customer and the principal service provider. 

1. Identify the Contract with the Customer 

Online marketplaces usually have standardized terms of service that apply to all users, setting the framework for transactions. This contract is typically established when a seller lists their services on the platform, and a buyer places an order. The contract should meet the criteria of approval, commitment, and enforceability, as specified in ASC 606-10-25-1

For Etsy, when a seller lists a product and a buyer makes a purchase, a contract is formed. Etsy ensures these contracts are approved, committed, and enforceable. 

2. Identify the Performance Obligations 

Performance obligations for online marketplaces are often straightforward. They include providing a platform for sellers to list their services, facilitating transactions, and offering customer support. These obligations can be explicit, such as providing a listing platform, or implicit, such as maintaining a secure payment gateway and ensuring customer satisfaction.

For example, Etsy provides a platform for sellers to list their products. This is an explicit performance obligation, as it's the main service offered to sellers. Etsy facilitates transactions by providing secure payment processing, order management, and messaging services, connecting buyers and sellers. This is an implicit performance obligation, as it's necessary for the transaction process. 

3. Determine the Transaction Price 

Online marketplaces earn revenue primarily through commissions or service fees charged to sellers based on a percentage of the transaction value. Determining the transaction price is usually clear-cut and defined by the percentage fee and the value of the transaction. However, if there are variable considerations, such as refunds or discounts, these must be taken into account in accordance with ASC 606-10-32-2

For instance, when a seller lists a product and a buyer purchases it, Etsy charges the seller a transaction fee, typically a percentage of the sale price, which contributes to the transaction price. 

4. Allocate the Transaction Price to Performance Obligations 

The transaction price may need to be allocated if the marketplace offers multiple services. ASC 606-10-32-26 suggests allocating the transaction price based on the standalone selling price of each distinct performance obligation. 

To illustrate, if a seller pays a $1.00 listing fee and a 5% transaction fee on a $50.00 sale, Etsy would allocate $1.00 to the listing platform performance obligation and $2.50 to the transaction facilitation performance obligation. 

5. Recognize Revenue as Performance Obligations are Satisfied 

In online marketplaces, revenue recognition typically occurs when the performance obligation is satisfied. This often coincides with the time of the transaction. For instance, revenue from a commission fee for a sale is recognized when the transaction is complete, i.e., when the buyer pays and the seller delivers the service. 

So, for the Listing Platform, revenue is recognized once the seller's item is listed on the platform. For Transaction Facilitation, revenue is recognized when the buyer pays, and Etsy processes the transaction.

Final Thoughts

The decision to classify a business as a principal or an agent under ASC 606 critically affects revenue recognition. The determination hinges on the concept of control— considering indicators like responsibility for customer promises, inventory risk, and pricing discretion. The five-step model of revenue recognition provides a systematic framework for implementing ASC 606 and offers a standardized approach across diverse business models. A clear understanding of these principles ensures a consistent and compliant application of ASC 606, helping businesses accurately navigate the complex landscape of revenue recognition.

If you have questions about how your business should be classified, or how your business' classification will affect revenue recognition, please reach out.