Primary obligor accounting

SAMPLE ACCOUNTING ISSUES MEMO

The following accounting issues memo illustrates the determination of whether Flyaway.com, introduced in the opening scenario of Chapter 3, should report its revenue on a gross or net basis.

Memorandum

To: Flyaway.com accounting files

From: Student Name

Date: X/X/XXXX

Re: Gross or Net Reporting of Online Ticket Sales Revenues

Background Note: This memo is only addresses one issue so all background is included here.

Flyaway.com (“Flyaway” or the “Company”) sells airline tickets to customers through an online platform, where customers can choose the airline of their choice. Once a customer purchases a ticket, Flyaway remits payment for the travel to the airline and retains a commission (roughly 10% of the ticket’s value). The airlines set all ticket prices. If a flight is canceled, the airline must refund the customer. On the other hand, if the customer’s payment is invalid, Flyaway.com assumes credit risk.

Issue(s):

1. Should Flyaway.com report its ticket revenue on a gross basis (as a principal) or net (as an agent)?

Analysis of Issue 1: Should Flyaway report its ticket revenue on a gross basis (as a principal) or net (as an agent)?

Flyaway.com (“Flyaway” or the “Company”) must determine whether its ticket sales revenue should be reported gross (for the amount billed to the customer) or net (for the amount retained after remitting customer payments to the airlines). ASC 605–45 (Revenue Recognition—Principal Agent Considerations) addresses transactions and activities including:

15-2(b). Services offered by an entity that will be provided by a third-party service provider.

In this case, since the airline will be providing the actual services (flights) to customers, this arrangement is within the scope of this subtopic.

Presentation guidance within ASC 605–45 states that it is a matter of judgment whether an entity should report revenue on a gross or net basis (par. 45–1). However, the guidance goes on to present eight indicators which may support gross revenue recognition, and three indicators that may support net recognition. We will evaluate these indicators – and their application to Flyaway – in turn.

Indicators of Gross Reporting

Flyaway has analyzed the indicators of gross reporting in ASC 605–45 and has determined that only one of these indicators is met for its ticket sales arrangements. This indicator is:

1. The entity has credit risk.

ASC 605–45–45–13 describes this indicator as follows:

45–13 If an entity assumes credit risk for the amount billed to the customer, that fact may provide weaker evidence that the entity has risks and rewards as a principal in the transaction and, therefore, that it should record revenue gross for that amount. Credit risk exists if an entity is responsible for collecting the sales price from a customer but must pay the amount owed to a supplier after the supplier performs, regardless of whether the sales price is fully collected.

In this case, Flyaway (and not the airline) is responsible for collecting customer payments and remitting those payments (net of its fees) to the airline. In the event a customer defaults on its payment, Flyaway bears the risk of that default. Therefore, this indicator of gross reporting is met. However, par. 45–13 states that this indicator provides “weaker evidence” that an entity has risks and rewards as a principal in a transaction.

The seven other indicators of gross reporting, from par. 45–4 through 45–12, were not met for this arrangement. These are:

1. The entity is the primary obligor in the arrangement (a “strong” indicator).

Analysis: The airline is the primary obligor and is the entity that must fulfill the promise made to the customer (for travel).

2. The entity has general inventory risk or must pay the service provider even if the customer does not accept the service, also a “strong” indicator.

Analysis: Flyaway does not have inventory risk, nor is it obligated to pay the airlines if customers miss (or otherwise do not complete) their flights.

3. The entity has latitude in establishing price.

Analysis: The airlines (not Flyaway) set all ticket prices.

4. The entity changes the product or performs part of the service ordered by the customer.

Analysis: Flyaway does not provide part of the service that the customer most wants (air travel).

5. The entity has discretion in supplier selection.

Analysis: The customer – and not Flyaway – determines which airline (aka, supplier) will perform the service.

6. The entity is involved in determining product or service specifications.

Analysis: Flyaway is not responsible for setting product or service specifications. The airlines select the dates and times of travel, locations, and so on.

7. The entity has physical loss inventory risk.

Analysis: This indicator is not applicable to this arrangement.

As only one “weak” indicator of gross reporting is present, it appears that gross recognition may be inappropriate. Next, Flyaway must consider which indicators of net reporting are present.

Indicators of Net Reporting

Three indicators are provided in ASC 605–45 which would support net reporting.

1. The entity’s supplier is the primary obligor in the arrangement (a “strong” indicator).

2. The amount the entity earns is fixed.

3. The supplier has credit risk.

Flyaway.com will analyze each of these indicators in turn. First, ASC 605–45–45–16 describes the primary obligor condition as follows:

45–16 Whether a supplier or an entity is responsible for providing the product or service desired by a customer is a strong indicator of the entity's role in the transaction. If a supplier (and not the entity) is responsible for fulfillment, including the acceptability of the products or services ordered or purchased by a customer, that fact may indicate that the entity does not have risks and rewards as principal in the transaction and that it should record revenue net based on the amount retained (that is, the amount billed to the customer less the amount paid to a supplier)…

Flyaway has concluded that this indicator of net reporting is met for this arrangement. That is, the airlines, acting as suppliers in this arrangement, are the primary obligor that the customers look to for fulfillment and acceptability of the service.

Next, par. 45–17 provides the following guidance with respect to the second indicator of net reporting:

45–17 If an entity earns a fixed dollar amount per customer transaction regardless of the amount billed to a customer or if it earns a stated percentage of the amount billed to a customer, that fact may indicate that the entity is an agent of the supplier and should record revenue net based on the amount retained.

This indicator also appears to be met, given that the facts of this case state that Flyaway retains a commission from each ticket sold, of roughly 10% of the ticket price. However, it is not entirely clear whether this is a stated percentage (consistent with the par. 45–17 description). This issue would need to be further clarified before an accounting treatment is selected.

The final indicator of net reporting – that the supplier has credit risk – is not met for this case. That is, Flyaway, and not the supplier, has credit risk. Flyaway assumes the risk that the sales price has not been fully collected prior to delivery of the service (date of travel).

Conclusion

As two indicators of net reporting are met, namely that Flyaway is not the primary obligor, and that Flyaway appears to earn a fixed percentage of sales, and given that the primary obligor indicator is a strong indicator, it appears that net reporting is most appropriate for Flyaway. By contrast, only one weak indicator of gross reporting was met (related to the assumption of credit risk).

Accordingly, after weighing these two alternatives, it appears that net reporting is most appropriate for Flyaway’s recognition of its online ticket sales revenues. However, management will need to confirm the assumption that Flyaway earns a stated percentage of sales before reaching a final determination on its accounting.

Financial Statement and Disclosure Impacts

ASC 605-45 provides the following disclosure guidance for entities who report revenue on a net basis:

50-1 Voluntary disclosure of gross transaction volume for those revenues reported net may be useful to users of financial statements. Such disclosure can be made parenthetically in the income statement or in the notes to the financial statements. However, if gross amounts are disclosed on the face of the income statement, they shall not be characterized as revenues (a description such as gross billings may be appropriate), nor shall they be reported in a column that sums to net income or loss.

Flyaway.com can therefore choose whether to disclose gross transaction volume. If such disclosure is made, Flyaway can further choose whether the disclosure should be made parenthetically in the income statement or in the footnotes. The company will need to consider its past practices, practices of other companies in its industry, and usefulness to financial statement users when deciding whether and, if so how, such disclosure should be made.

4 Skills for Accounting and Auditing Research, 2nd Edition

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