Pick any class of upper-level accounting students, and give them a few cases of supplier/customer relationships for which “gross versus net presentation” of revenues is an issue, and I’ll wager that the class will come to a consensus on the presentation most consistent with the objectives of financial accounting 90% of the time.
Yet, somehow, this issue has become the first battleground over the new joint revenue recognition standard with the IASB.
How Did This Get So Hard?
The question is nothing more than this: if two parties are involved in selling goods and services to a customer, how should each of the parties involved in the sale present their revenues? Not all of the fact patterns are basic, but let’s start with one that is:
Facts—An online retailer receives an order from a customer. The customer uses a credit card to pay the retailer $100. The retailer notifies its supplier, who ships the merchandise directly to the customer. Soon thereafter, the retailer pays the supplier $85. The retailer’s gross margin is $14, which is straightforwardly calculated as $100 minus $85, and minus $1 withheld by the credit card company.
Question—How should the retailer present revenue and cost of sales: (a) $100 revenues and $86 cost of sales; or (b) $15 and $1 cost of sales?
It would seem that an accounting standard would not be necessary to get the online retailer to the correct answer, which is that it may only record $15 in revenue. But since 1999, a long list of subjective criteria have been added to the authoritative literature to cover this mundane situation. IMHO, this was owing to widespread auditor reluctance to push back against a “creative” client without an accounting rule for a crutch.
A Bit of a History Lesson
During the .com boom era, “profitable internet IPO” was an oxymoron. Consequently, the sales pitch to investors was that nothing mattered more than capturing market share. In other words, revenue growth — and not conventional measures of profitability — should have been the key performance metric. It’s not surprising, therefore, that it would have been common for an online retailer to recognize $100 in revenue and $86 in cost of sales — even though the merchandise never passed through its warehouse. EITF 99-19 (ASC 605-45) put a stop to most of these abuses by requiring an issuer to determine whether it was acting as a “principal” to its customer, or merely as an “agent” of … somebody. If the latter, then the appropriate amount of revenue to recognize would only be the net $15 retained after paying the supplier minus the credit card processing fee.
The New Order
Now, let’s fast forward to the present. The FASB and IASB jointly issued a new revenue recognition standard a few months ago, which established common criteria for determining whether gross or net presentation would be appropriate. Considering the many many other changes made by the new standard, gross versus net presentation would appear to the casual observer to be no more important than a flea on the hind quarter of of a Holstein. So whaddya know, it became the very first topic to be considered by the boards’ Transition Resource Group.
And I’m sure that the leadership of the TRG now regrets it. By all unbiased accounts, the TRG’s maiden deliberations were a fiasco. Perhaps it was because the principal v. agent framework would be applied within a new overarching concept of transfer of control. This might be problematic when selling services instead of tangible goods as in our first example. During the discussion, it also came out that some TRG members on the IFRS side of the table were more than a little concerned that current practice would be affected. (Whaddya know.)
Making Common Sense Out of Gross versus Net Presentation
As I see the problem, it is that the principal/agent dichotomy is being misapplied to model relationships that vary on a continuum, as opposed to a strict principal/agent dichotomy. An either/or solution might work well for the extreme cases, but many other fact patterns fall through the cracks. The defining characteristic of arrangements having multiple purveyors of goods/services and one final customer is not the mere presentation of revenue, but recognition of expenses.
Let me explain. An implicit assumption of these fact patterns is that the issuer knows what it’s gross margin is from a transaction. The remainder of the accounting question boils down to an algebraic equation with two unknowns: revenues and cost of sales. Instead of letting the amount of revenue recognized determine the amount of cost of sales to plug, an issuer should have to determine whether the amount of expense recognized is appropriate.
That would require a conceptual definition of “expense,” so let’s start with this one:
Expenses, except for interest, taxes, and other obligations to deliver assets, are outflows or other using up of real economic resources that the entity controls from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
My definition is very similar to the FASB’s definition as set forth in CON 6, and should produce the same results, but I made my own variation so as to be clear that the general case of an expense is the use of an economic resource, i.e., a real asset, which is independent of how acquisition of the resource will be paid for. Moreover, I want to take this opportunity to point out that we make an exception to the criterion of real asset consumption for interest and taxes because these are distributions to other stakeholders (i.e., lenders and governments), which are reasonably regarded as “expenses” from the perspective of common shareholders.
Applying the definition of “expense” to the retailer example is straightforward. Since the retailer never had any control how the asset would be used, it can’t have an expense; and since gross margin of $14 is known, the only possible measure of revenue is $15.
Okay, let’s try another example. The TRG spent a long time discussing one similar to this:
A “bricks and mortar” retail store offers gift cards for sale. For $X, a purchaser of the gift card is entitled to spend $Y at a local restaurant. The grocery story remits $Z to the restaurant, and (ignoring the cost of the card) earns a gross margin of $X minus $Z.
If you don’t think that it’s obvious how much revenue the grocery store should recognize, then I nominate you for the TRG. You wouldn’t believe the esoterica that was discussed at the meeting; and I won’t bore you with any of it here. I merely want to point out how easy it is under my suggested approach to determine how much revenue the grocery store would report from the transaction. Since none of the costs of serving the customer do not meet the conceptual definition of an expense for the retail store, its revenue is limited to the amount it earned, $X minus $Z.
Finally, let’s try a “hard” problem. This is one that the TRG might not consider, but is nonetheless very prevalent; and to my knowledge, practice varies considerably:
A real estate investor owns a hotel property, and engages a management company to operate its hotel. All of the operating cash flows from the hotel are collected/paid by the management company. They are subsequently remitted to the real estate investor, minus the management fee.
It would be a ludicrous exercise for the management company to determine whether it is acting as a principal or an agent for the real estate investor. Reference to criteria for expense recognition, however, would be a relative piece of cake. For example, depreciation and interest are not expenses of the management company, but most other operating costs probably are. And since the management company would know: (1) what those other operating costs are; and (2) its gross margin from providing management services, that would dictate the amount of revenue to recognize.
* * * * * *
Revenue presentation should not be a hard accounting problem. Yet, the TRG couldn’t even agree on how a grocery store should present its revenues from sales of gift cards! Compared to the other questions that issuers will want the TRG to address before the new standard becomes effective, that one should have been low hanging fruit. Instead, it has become a litmus test for the TRG and maybe even for the new revenue recognition standard itself.
But to be fair, the TRG didn’t cause the problem. Fifteen years ago, the FASB punted the revenue presentation inquiries from auditors to the EITF, which proceeded to introduce a brand new concept to financial reporting, and it did so without any real semblance of “due process” that should accompany such weighty and consequential deliberations.
It may have worked for a while, but it has finally blown up in their faces.