What is ASC 606?
In 2014, the Financial Accounting Standards Board (“FASB”) released a pronouncement that completely revamped revenue recognition and reporting as well as some of its associated costs. Effective for private companies with fiscal years ending after December 15, 2018 and for public companies with fiscal years ending after December 15, 2017, this standard has caused adtech companies to rethink their revenue recognition process to ensure that they are in compliance. One common area of confusion is how the presentation of costs that are closely linked with revenue streams are presented: gross of the associated costs or net of them.
What Exactly is Principal vs Agent Reporting?
For companies that act as an intermediary for services, careful consideration needs to be placed on how revenues are presented: gross or net of their related costs. For example, in its simplest form, if an adtech company connects a customer to publishers through its platform, how would the costs associated with advertising inventory be treated? Would the revenue be presented in the same line item as costs, or would revenue be presented separately and the costs presented in costs of revenue?
In March 2016, new guidance, (Accounting Standards Update 2016-08), was released under ASC 606 to clarify how a company can identify whether it is the principal or an agent in a revenue transaction. The major focus in this new guidance is whether the company has the right to direct the goods or services (“asset”) and their use, or to control the asset, before it is transferred to the customer. A principal in a revenue transaction has control over the asset and transfers the asset itself. An agent in a revenue transaction does not control the asset and arranges for the asset to be transferred.
In instances where the company has control over the asset, it is considered the Principal in the transaction and revenues are presented on a gross basis, or separate from their related costs.
In instances where the company does not have control, it is considered the Agent in the transaction and revenues are presented net, or together with their costs.
In order to determine if a company has control over the asset, there are three primary indicators that a company needs to consider:
- The company is responsible for fulfilling the promised advertising. Should there be any question of the acceptability of the ads served, the company would have to reimburse or replace the contracted advertising spend.
- Before transferring a good or service, the company has inventory risk. For example, should a company obtain ad space prior to a customer order/contract, they would hold the risk of inventory.
- The company has discretion in establishing the price that a customer pays for an advertisement from a publisher. There are times, however, when an agent will have some flexibility over pricing.
It is important to note that not any one factor is necessarily considered more compelling than another without a specific analysis by each company. It is the combination of all factors that determines proper treatment of revenues and specific indicators may be more significant than others when considering the revenue process of each individual company. Additionally, there are other questions that the company should consider during its analysis which include, but are not limited to: does the company have the power to redirect vendors assigned to a contract to other customers, or by being entitled to the consideration in the customer contract, has the company obtained any benefits of resources provided by the service provider.
The Old and the New
A major difference between the old and the new standard, as it relates to the concept of gross versus net reporting, is that the former standard considered five different factors to determine who was the principal and agent in the transaction. ASC 606 does not include the consideration of who had exposure to credit risk, or whether consideration is in the form of a commission. This could cause complications or changes in reporting for those companies that used these as defining factors in their decision making process.
More on ASC 606
Now Give Me Some Examples
Adgiant sells the use of its seat on an ad exchange to its customers. Agencies log in to the company platform and purchase advertising space by publisher on an on demand basis at a 10% markup of prices negotiated between the publishers and the agency. Agency A purchases $99,000 of space which costs $90,000. No modifications are made to the “inventory” sold. Should the publishers underperform on promised impressions, Adgiant is not held responsible.
Based only on the limited facts above, Adgiant would be considered an agent in this transaction and present its revenues net of associated ad inventory costs, so top line revenue would amount to $9,000. The company does not take on inventory risk, as the inventory is purchased by Adgiant at the point in time it is ordered by the customer. Additionally, Adgiant is not responsible for the fulfillment of the promised advertising. Should the publishers underperform, they would be responsible for nonperformance on the contract, not Adgiant. Adgiant simply serves as an access point to the advertising inventory. Finally, Adgiant has no influence over the prices charged by the publisher as the agency negotiates the prices directly.
Adglam sells advertising space to agencies through the use of its platform. Agencies log in to the platform and purchase advertising space by type by location on an on-demand basis. Adglam purchases “inventory” when ordered by its customers and negotiates all pricing with the publishers before adding a 10% markup to the final cost. Agency B purchases $99,000 of space that costs Adglam $90,000. No modifications are made to the “inventory” sold. Any issues with the impressions provided are handled by Adglam directly.
Based only on the limited facts above, Adglam would be considered a principal in this transaction and present its revenues gross of associated ad inventory costs so top line revenue would be amount to $99,000, with the $90,000 cost of advertising inventory presented as cost of revenue. Adglam does not take on inventory risk, as the inventory is purchased by them at the point in time it is ordered for the customer. Adglam does, however, would be responsible for nonperformance on the contract in the event that there is an issue with the provided advertising or if the ad under performs once it is placed. Finally, Adglam has influence over the prices charged to the agency as they negotiate directly with the publishers to set prices and then add their mark-up to the inventory. Since two of the three factors are met, Adglam determined that the evidence of gross reporting was compelling.
The Bottom Line
Improper reporting under gross versus net accounting may not have an impact on your net profit, but it has a significant impact on your top line. Presenting revenue gross inappropriately can mislead the financial statement readers, including your investors, and give the impression that your company is larger than may have been projected. Should you have to make the change from gross to net, this significant fluctuation in your reporting is challenging to explain to your investors. Since top line revenue is key performance indicator in the tech space, this can cost you investor dollars that could have a substantial impact on your business.
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