Gross Versus Net Presentation of Revenue

EITF 99-19 addresses an issue that frequently arises for resellers and other companies—the question of whether to report the entire amount received from the end-user as revenue and the amount paid to the supplier as cost of sales, or to report just the net amount as revenue, as if that amount were a commission paid by the supplier for generating a sale from the supplier to the end-user. Essentially, the process for making this determination boils down to evaluating the relationships between the supplier, the company, and the end customer. Gross reporting treats the transaction as the company purchasing a product or service from the supplier and then selling that product or service to the end-user, while net reporting treats the transaction as the end-user making a purchase from the supplier, with the company acting as a sales agent.

This question often arises for companies that sell goods or services over the Internet. Many of those companies do not stock inventory and may arrange for third-party suppliers to drop-ship merchandise on their behalf. Those companies also may sell services that will be provided by a third-party service provider. However, the issue is an important one for many companies that are not Internet-based, as well. The underlying factor that causes difficulty in answering the question of gross versus net reporting is that many companies do not assume all of the risks and rewards of ownership of the products they sell before entering into the sales transaction, or do not take on all of the responsibility to provide the services they sell. Rather, through contracts or by operation of the business, some or all of these risks and responsibilities remain with the supplier of the goods or services.

EITF 99-19’s scope is quite broad, and its guidance is applicable regardless of industry or transaction type, unless guidance is specifically provided in other authoritative literature.¹ Gross versus net reporting of most products and services is, therefore, within the scope of EITF 99-19.

The EITF ‘s consensus on this question does not draw bright lines or provide objective answers. Rather, the EITF identified a number of indicators that a company should evaluate during its consideration of this issue. These indicators must be considered in the determination of whether the company has taken on enough risks to be considered the principal in the transaction.

PRACTICE ALERT: The EITF has addressed two gross versus net issues involving derivative instruments that fall within the scope of FAS-133. EITF 02-3 addresses gains and losses (realized and unrealized) on derivative instruments “held for trading purposes” that are within the scope of FAS-133. The consensus on EITF 02-3 indicates that such gains and losses should be shown net in the income statement, regardless of whether the derivative instrument is physically settled. EITF 03-11 addresses realized gains and losses on physically settled derivative contracts not “held for trading purposes” that are within the scope of FAS-133. The consensus in EITF 03-11 indicates that determining whether realized gains and losses on such instruments should be reported on a gross or net basis is a matter of judgment that depends on the relevant facts and circumstances. In analyzing these facts and circumstances, the guidance in EITF 99-19 and APB-29, Accounting for Nonmonetary Transactions, should be considered. If these issues are applicable to an entity’s financial reporting, the final Abstracts should be consulted for additional information.

Indicators of Gross Revenue Reporting

1. The company is the primary obligor in the arrangement. The primary obligor is the party responsible to the customer for providing the product or service that is the subject of the arrangement. In substance, the primary obligor is the party the customer will look to for fulfillment and for ensuring its satisfaction. If this party is the company, and not the supplier, the company has significant risks and rewards in the transaction that indicate it is at risk for the full amount of the contract, not just a commission. Representations made by a company during marketing and the terms of the sales contract generally will provide evidence as to whether the company or the supplier is the primary obligor (EITF 99-19, par. 7).

2. The company has general inventory risk. General inventory risk is the risk normally taken on by a company that buys inventory in the hopes of reselling it at a profit. Front-end general inventory risk exists if a reseller maintains an inventory of a product by taking title to and assuming all risks and rewards of ownership of the product before that product is ordered by a customer. Back-end general inventory risk exists if the customer has a right of return and the reseller will take title to and assume the risks and rewards of ownership of the product if it is returned. In a service transaction, a risk similar to general inventory risk exists if the reseller commits to purchase service from its supplier before it has found customers for that service. General inventory risk not mitigated by terms of the arrangement between the reseller and the supplier is a strong indicator that the reseller should record revenue gross.

   However, factors that mitigate general inventory risk must be considered as well. For example, a company’s risk may be reduced significantly or essentially eliminated if the company has the right to return unsold products to the supplier or receives inventory price protection from the supplier. Similarly, back-end inventory risk is mitigated if the company has the right to return to the supplier any products returned by the customer (EITF 99-19, par. 8).

3. The company has the ability to determine the price at which it sells the product or service. When a company has reasonable latitude to establish prices for the products and services, it is an indication that the company is acting as a principal, rather than as another company’s agent (EITF 99-19, par. 9).
4. The company changes the product or performs part of the service. If a company physically changes the product (beyond its packaging) or performs part of the service ordered by a customer, the company does not appear to be acting solely as an agent. In addition, this fact may indicate that the company is partially or fully responsible for fulfillment, potentially making it the primary obligor in the arrangement (EITF 99-19, par. 10).

PRACTICE POINTER: Transporting the goods, repackaging them, or providing marketing services related to the products or services is not sufficient to conclude that this indicator of gross reporting exists, even when such actions do add value to the product or service.

5. The company has discretion in supplier selection. When a company has multiple suppliers for a product or service ordered by a customer and discretion to select the supplier that will provide the product or service ordered by a customer, it is an indication that the company is acting as a principal (EITF 99-19, par. 11).
6. The company is involved in the determination of product or service specifications. If a company must determine the nature, type, characteristics, or specifications of the product or service ordered by the customer, that fact might indicate that the company is primarily responsible for fulfillment (EITF 99-19, par. 12).
7. The company has physical loss inventory risk (after customer order or during shipping). Physical loss inventory risk exists if the reseller holds title to the product at some point between the time a customer order is placed and the product is delivered to the customer. Because the amount of risk inherent in taking title during this time is so low, physical loss inventory risk is a weak indicator of gross reporting (EITF 99-19, par. 13).
8. The company has credit risk. If a company assumes credit risk for the amount billed to the customer, that fact may provide evidence that the company has risks and rewards as a principal in the transaction. Credit risk exists if a company is responsible for collecting the sales price from a customer but must pay the supplier regardless of whether the sales price is fully collected. A requirement that a company return or refund only the net amount it earned in the transaction if the transaction is cancelled or reversed is not evidence of credit risk for the gross transaction. In some cases, credit risk may be mitigated to such an extent that this indicator is virtually meaningless—for example, if a customer pays by credit card and a company obtains authorization for the charge in advance of product shipment or service performance, credit risk has been substantially mitigated (EITF 99-19, par. 14).

Indicators of Net Revenue Reporting

1. The supplier is the primary obligor in the arrangement. If the supplier is responsible for fulfillment and customer satisfaction, that may be an indication that the company does not have risks and rewards as a principal in the transaction and therefore should recognize only its net fee as revenue. Representations made by a company during marketing and the terms of the sales contract will generally provide evidence as to a customer’s understanding of whether the company or the supplier is responsible for fulfillment (EITF 99-19, par. 15).
2. The amount the company earns per transaction is fixed (in dollars or as a percentage of the arrangement fee). When a company earns a fixed dollar amount per customer transaction or a stated percentage of the amount billed to a customer, it appears to be acting as an agent of the supplier (EITF 99-19, par. 16).
3. The supplier has credit risk. If credit risk exists (that is, the sales price has not been fully collected prior to delivering the product or service) but the supplier assumes that risk, the company appears to be acting as an agent of the supplier (EITF 99-19, par. 17).

End Note 1: For example, SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, FAS-45, Accounting for Franchise Fee Revenue, EITF 02-3 and 03-11 (Energy Traders) and the AICPA Audit and Accounting Guides for Casinos, and Investment Companies, include guidance on presenting revenue on a gross versus a net basis.

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Copyright 2006 CCH Publishing, a WoltersKluwer business. Excerpted by permission.