One of the more interesting challenges we had in the past twelve months was convincing a client that they didn’t really have revenues and expenses but instead commissions. It actually held up the issuance of the review of their financial statement until we had agreement.
The issue in question had the following fact pattern:
- OpCo (the client we were reviewing) had a contract with a larger business (GenCo) to provide a specific set of services at a price established by GenCo.
- OpCo would sign up customers who would receive GenCo services
- OpCo did not purchase GenCo goods or services for resale
- GenCo provided all the technical expertise and it was included in the price customer paid
When OpCo submitted their financial statements, it reflected $2.0 Million in revenues and $1.5 Million in “cost of sales”. OpCo, anticipating the issue, engaged another firm to address the ASC 605-45 “Principal versus Agent” issue. This firm’s research concluded that the revenue met the criteria for reporting as a Principal.
Our starting point was at the 50,000 foot level. Why does it matter if revenues are reported net or gross? The client was insistent it had to be gross. In any type of attest engagement, the big red warning flags start coming out when a client is insisting on a specific treatment. By asking a few questions about their motivation we discovered that they were trying to woo a prospective buyer who was only interested in a target with a certain level of turnover.
Knowing this, we applied the key points of ASC 605-45. The first issue is, “Who fulfills the contracted services?” Our reading of the contract clearly indicated that GenCo had the technical team which would provide the services. OpCo had sales agents who went out and signed up customers but those customers were ultimately engaging GenCo.
The next key point was, “Who set the price?” The contract stated that the base price for GenCo’s service was $15,000 and their suggested customer price was $20,000. OpCo earned 50% of the spread between the final negotiated price and the $15,000. While this was a little tricky, the substance is that GenCo set the floor and ceiling prices. As a matter of fact, no customer agreement had a price above $20,000 and the only time it was lower was when a customer had multiple sites and therefore earned a volume discount.
Another major point, but related to the first one, was “Was the service modified in anyway by OpCo?” Since the service was provided by GenCo and, other than having an OpCo sales agent complete the paperwork, there was no ongoing involvement by OpCo EXCEPT for sales follow-up, it appears that OpCo did not modify the service.
We ended up in a meeting with the client’s senior management and the other firm. We pointed out the flaws in the logic and, ultimately, the risk to both the Company and us as the reviewing firm, if we allowed the statements to be issued on a gross basis. The net effect was the same: The problem is that there was going to be reliance upon the statement which could have been considered misleading. The client agreed to restate the financial statements to report only the “commissions” earned.
If you are unsure if your accounting treatment is correct and would like to discuss the impact of how you are reporting, feel free to contact me. We will look at the big picture and work our way down to the appropriate level of detail so you can feel comfortable that your position is accurate. Remember, your business is issuing a financial statement that someone plans to rely upon so using an inappropriate accounting model could cause you problems down the road. And if you would like more information on how our audit and review services could be helpful to your business or non-profit, find out more about us here.
Have a great Tuesday.