Net Vs. gross revenue recognition

The Financial Accounting Standard Board (FASB) is in charge of developing and transmitting financial accounting and financial reporting standards in the United States of America. It is a non-profit board of seven accounting practitioners. The Generally Accepted Accounting Principles (GAAP) was another name for the FASB standards (GAAP). They are recognized as authoritative by the Securities and Exchange Commission (SEC) and offer guidelines in the preparation of a company's financial reporting. The Spider-Web Corporation "Spider" case scenario is synonymous with sales identification. The FASB codification that provides for the basis in which a company should recognize its revenue is ASC 605-45 Revenue Recognition: Principal Agent Considerations. The codification provides for two ways in which a company can present or report its revenues in the financial statements. Gross is one way in which Spider can recognize its revenues while the net is the second way (Dutta and Zhang 68). When a company recognizes revenue on gross basis, then it reports the amount billed to the customer because the company has earned it. On the other hand, net basis refers reporting the revenue using the amount billed to the customer minus the amount paid to the supplier. Like Spider, many companies in the e-commerce find it difficult to determine the basis in which they should recognize and report their revenues (Dutta and Zhang 68). This is because such companies do not assume all risks and reward of ownership or title of the products they sell before they get into a sale transaction. Besides, such companies do not bear the entire responsibility to provide the goods or services they sell.

Background

FASB and IASB had a meeting on June 22, 2015, to discuss a potential amendment to the revenue standards in determining whether a company is a principal or an agent and when to report on the gross or net basis. Both bodies voted to the same proposed amendments in relation to gross and net revenue recognition. The issue of principal agent relationship arises if there are more than two parties in a sale transaction (Harmon and Ntseh 1). For instance, in Spider’s case, there is the partner, the advertiser or the customer and the company itself. The new standard states that in such a transaction, an entity is a principal if it controls a product or a service before it is transferred to the customer. In other words, the principal provides goods or services to the customer and recognizes revenue based on the gross amount it receives from the customer. On the other hand, an agent arranges for another party to provide products or services and it reports only the commission or fee received as its revenue.

ASC 605-45 provides a list of indicators in which a company can determine whether to report revenue on the gross or net basis (Dutta and Zhang 70). Therefore, a company should evaluate each of the following indicators qualitatively to determine the basis on which to recognize its revenue.

Gross Basis Indicators

The entity is the primary obligator in the arrangement;

The entity has general inventory risk;

The entity has latitude in setting the price charged to the customer;

The entity changes the product or performs part of the service;

The entity has discretion in supplier selection;

The entity is involved in determining the product or service specifications;

The entity has physical loss inventory risk; and

The entity has credit risk.

Net Basis Indicators

The entity’s supplier is the primary obligor in the arrangement;

The amount the entity earns is fixed and

The supplier has the credit risk

Certain factors need to be assessed since they have more weight in gross vs. net revenue recognition evaluation. For instance, if the company is the primary obligor in the arrangement meaning that it is responsible for providing the product or the services, then it is a strong indicator that the company is the principal in the arrangement and should recognize its revenue on a gross basis. Secondly, an entity is the principal in an arrangement if it has assumed unmitigated inventory risk. On the other hand, weak indicators that a company should report its revenues on gross basis include credit risk and physical inventory loss (Dyson 22). Similarly, if the company's supplier is charged with full responsibility for fulfillment, then there is a likelihood that the company's role in the transaction is that of an agent and revenue should be recognized on a net basis. In the analysis of Spider's case, every indicator will be analyzed to determine the basis in which the company should record its revenues.

Spider Web Corporation Analysis

Online advertising spending, display advertising as well as paid search has significantly increased over the recent past. Almost every website has advertisements, and they make money from such advertisements. Spider Web Corporation is a privately-owned company based in the United States. It has its headquarters in Silk Valley, CA and has various websites such as Yourspace and Bling. YourSpace is a social networking website while Bling is a search engine website. The main issue in this memo is to determine whether Spider should recognize its revenue on a gross basis or net basis. Gross basis refers to the amount billed to a customer because the company has earned revenue from the sale of goods or services, while in net basis revenue is recognized as the amount billed to the customer less the amount paid to the suppliers because the company has earned a fee or a commission as an agency.

Several questions need to be answered to determine the basis in which Spider should recognize its revenue. Answering such questions will help in determining whether Spider should report its revenue on a gross basis or net basis. The questions relate to both gross and net reporting indicators. Firstly, is the company responsible for providing services to the customers? The answer is yes. Spider has a sole responsibility in fulfilling its obligation per the provisions in the contract between the company and the advertisers. Advertisers only have an agreement with Spider, and therefore, Spider is responsible for fulfillment including the acceptability of the products or services offered and it is the primary obligor in the arrangement. Secondly, it is important to respond to the question on whether Spider has inventory risk. The answer is no. In this form of arrangement, Spider does not have inventory risk since the company does not take the title of a product before the customer takes it. Besides, the customers cannot return a product. This is because Spider pays its partners after receiving payments from the advertisers. Besides, none of the arrangements between Spider and its partners reduces the company's risk. The spider cannot return any of the unsold products and do not receive any inventory protection from the partners. This is so because the company does not own anything before the advertisers for the service. Similarly, Spider has no obligation to compensate the partners for the work performed whether the customer accepts the work or not since partners only receive payments when the advertisers pay Spider.

The third question is in relation to the company's latitude in establishing the price for the products or services. In other words, Spider has reasonable latitude within financial constraints to establish the most suitable exchange price with the advertisers. The fees charged by the company to every advertiser are in its standard price list and are specified in individual agreements between Spider and the advertisers. The pricing structure varies, and it is dependent on the type of advertisement the customer selects. For instance, impression displays or key-word link spider are only charged when an end user clicks on the linked advertisement.

The fourth question is whether Spider performs part of the service ordered by its customers and whether it is responsible for fulfillment which includes the ultimate acceptability of the total services furnished by the partners. The answer is yes. Spider manages the advertisement spaces on its websites as well as helps other website owners in filling their advertisement spaces. In case a customer wants a specific advertisement space in a particular website is not available, Spider and the customer should agree on an alternative website. On the other hand, if the partner does not feel that an ad is not suitable for its website, then Spider and the advertisers come to an agreement on an alternative website. Therefore, Spider can change the product or perform part of the service.

Spider has discretion in the selection of the supplier. In other words, it is at the discretion of the company to select the partner that provides the services ordered by the advertisers. When preparing to get a contract with the advertisers, Spider provides them with a list of websites in which they can choose from. However, the company does not disclose the name of the owners of websites that advertisers have selected to place their advertisements. Besides, Spider enters into agreements with other network partners that own websites to give their customers a variety of websites to choose from in which they can place their advertisements. The other question in which we need to ask ourselves to determine whether Spider should recognize its revenue on gross or net basis relates to Spider's involvement in determining the specification of a product or a service. Spider determines the nature, type, and characteristics of the service or product ordered by a customer. In other words, the company has full responsibility for determining the website in which to place an ad based on the list of the websites that the customer has chosen.

Concerning the physical loss inventory risk that a company may have after the customer has placed an order or during shipment, Spider does not have any such risk. There is no title transfer of a product to Spider at any point of the transaction since it is a web-based company and does not deal with physical inventory. Therefore, physical inventory risk does not apply to the company. The other point is in relation to the credit risk of Spider. Advertisers or the customers submit their payments to the company directly, and it is charged with the full responsibility for paying a 51% of the gross advertisement revenue that is already adjusted. The payments from customers are only made when the advertisement has been displayed. Therefore, there are no measures to mitigate credit risk. There are chances that the customer will refuse to pay for the services offered.

As pointed earlier, the sole obligor in this form of arrangements is Spider. There is no transaction between the partner and the customer. Instead, Spider connects the two it places ads on the partner's website and the receives payments from the advertisers. However, the network partners have credit risk. Partners do not receive any money for their advertisement spaces until Spider has collected fees from the advertisers. Therefore, they face a risk of never receiving any payments. In case Spider incurs any out of pocket expenses, the agreement does not provide for any reimbursement from the customers. Considering the fact that advertisers do not have any agreement between them and the partners, then the out-of-pocket expenses incurred are between the partner and the Spider. Examples of out of pocket expenses include agency commission and fees, creative fees as well as sales commissions and fees. Spider has neither shipping nor handling costs since as seen earlier, it does not deal with physical inventory. It earns its revenues through online advertising which does not require any inventory.

Conclusion

According to the FASB, revenue is recognized when it is realized or realizable and earned. ASC 605-45 provides for the basis in which revenue should be recognized. Besides, GAAP gives guidelines on how specific industries should recognize revenue (Du, Alford, and Smith, 1676). On the other hand, IFRS requires revenue to be recognized under two conditions. Firstly, if there is a probability that economic benefits will flow to the entity in future and secondly such benefits can be measured with reliability. Paragraph 93 of the IASB's Framework for the Preparation and Presentation of Financial Statements indicates that revenue should be recognized after earning it. Also, paragraph 8 of the IASB 18 requires recognition of revenue to be done on the net basis in an agency relationship form of businesses (Du, Alford, and Smith 1677). Paragraph 21 of the IASB gives examples of when a company is acting as an agent or principal. However, unlike FASB, IFRS does not provide ways in which specific industries or transactions should recognize their revenues. Conclusively, Spider Web Corporation should recognize its revenue on gross basis meaning that the revenue reported in the income statement should be the billing amount to the customer.





Works Cited

Du, Ning, R. Mark Alford, and Patricia L. Smith. "Do GAAP And IFRS Differ In Collectiblity Judgments Related To Revenue Recognition?." Journal of Applied Business Research (JABR) 32.6 (2016): 1675-1686.

Dutta, Sunil, and Xiao‐jun Zhang. "Revenue recognition in a multiperiod agency setting." Journal of Accounting Research 40.1 (2002): 67-83.

Dyson, Robert A. "Case studies in the new revenue recognition guidance." The CPA Journal 85.3 (2015): 22.

Harmon, Frederick, and Desmond Ntseh. "The New FASB & IASB Revenue Recognition Standards; Implementation and Effects." (2016).