Recording Revenue at Gross or Net (#97)
/In this podcast episode, we discuss the criteria for reporting revenue at either gross or net. Key points made are noted below.
The Two Revenue Recordation Methods
Recording at gross means that you record all of the revenue from a sale on your income statement. Now at this point, you’re probably saying, hello, that’s what I’m already doing. Well, there is another way.
Recording at net usually means that you’re only recording a commission on the sale as your entire revenue. If there isn’t strictly a commission, you can still report revenue at net by netting the amount billed to the customer against the amount paid to the supplier.
Presentation Impact of the Methods
Recording at gross or net has no impact on your bottom line, but the difference in reported revenue is gigantic.
A commission may only be for a few percent of the total revenue, so your company looks a lot smaller if you record revenue at net. And this means that some companies prefer to record their revenue at gross, just to give the impression that they’re much larger than they really are. Their main concern is that some investors value a company based on a multiple of its revenues, so reporting a pile of revenue could result in quite a payoff if they sell the business.
So that’s the basic issue. Now, most companies record all of their revenue at gross. At the other extreme, if you’re paid a commission, and it’s called a commission, then you record the commission as your revenue, and that is net reporting.
Which Way to Record Revenue
The trouble is, there’re lots of situations that fall into a gray area where revenue could be reportable at gross or it could be reportable at net. For example, what if you’re a broker for magazine subscriptions, or you have a third party drop ship all of your product sales to customers, or what if you sell airline tickets, or sell anything that’s on consignment? These are the cases where it’s not so simple.
The Emerging Issue Task Force set up a bunch of guidelines for this in their issue number 99-19. The title of the issue is “Reporting revenue gross as a principal versus net as an agent.” I’m going to talk about the EITF’s guidelines, but keep in mind as I go through them that recording the situation at gross or net is a matter of judgment. There’s a continuum of situations with gross reporting and net reporting at either end, and you have to figure out where you’re positioned between the two. The trouble, and I’ve confirmed this with several audit partners, is that as long as your revenue situation is in a gray area, and you document your decision, you can pretty much argue a case to report revenues either way.
So. The guidelines. Here are the indicators that should point you in the direction of reporting revenue at gross:
First. You are the primary obligor in the sales transaction. This means, are you responsible for providing the product or service, or is the supplier? If you’re doing the work or shipping the product, you can probably record at gross. This one is a major determinant.
Second, you have general inventory risk. So, if you take title to the inventory before you sell it to the customer, and you take title to any returns from customers, you can probably record revenue at gross.
Third, you can select suppliers. This one is important, since it implies that there isn’t some key supplier operating in the background who’s actually running the transaction.
Fourth, you have credit risk. This means that if the customer does not pay, then you eat the loss, and not a supplier. However, if you’re only at risk for losing a commission if the customer doesn’t pay, then you’re probably looking at recording the revenue at net.
And finally, if you get to set the price, then you probably have control over the entire transaction, and you can record the revenue at gross.
Now, what are the guidelines that point you in the direction of reporting revenue at net?
The first is that the amount you earn is fixed. This indicates a commission structure, which is sometimes set up as a fixed payment per customer transaction. A twist on this is if you earn a percentage of what the customer pays, which is also an indicator that you report revenue at net. In either case, you’re really just an agent for someone else.
And the other two guidelines for reporting at net are just the reverse side of some earlier guidelines. If a supplier has credit risk, or if a supplier is responsible for providing products or services to the customer, then you’re probably looking at reporting revenue at net.
For most companies, you can pretty easily pick which guidelines apply to you, and in most cases you probably record your revenue at gross. But here are some considerations.
Let’s say that you run an Internet store, and you collect money from customers, and then instruct a supplier to ship the goods to the customer. In this case, you have credit risk, so there’s an indication that you can probably record revenue at gross. And in fact, most Internet stores do. But what if there’s also a statement on the website that the website operator only accepts orders on behalf of suppliers, and the operator is not responsible for any problems with shipments? Chances are, you’re now looking at net revenue reporting.
Let’s try a different arrangement, where you develop specifications for custom products with the customer, and then you find a supplier who can make it. In this case, you can record revenue at gross, because you have credit risk and you get to pick the supplier.
Here’s another example. You’re a travel discounter, and you negotiate with the airlines for reduced prices. You then advertise the reduced rates to the public. You bill the customer, and you’re responsible for delivering the ticket to the customer. But – once the customer receives the ticket, the airline is responsible for all subsequent service. There’s no inventory risk and the primary obligor is the airline, which points you toward net reporting. On the other hand, you can set the price and you bear the credit risk, which tends to point toward gross reporting.
This is an interesting one, because you can go either way. The EITF says that the primary obligor issue overrides the other ones, and that one points you in the direction of reporting at net.
And that brings us back to my earlier point about documenting your position. You could have two companies in the same industry with identical business models, and one can record revenue at gross and the other at net – and they may both able to justify their positions to their auditors. So, this is one of those screwy topics that can go in either direction.