The ASC 606 transition for construction contractors: Identifying the performance obligations – Principal versus agent considerations
To properly identify and account for performance obligations when other parties are involved in providing goods or services to a customer, a construction contractor must determine whether its performance obligation is to provide the good or service itself (i.e., the contractor is the principal) or to arrange for another party to provide the good or service (i.e., the contractor is an agent). The determination of whether the contractor is acting as principal or agent will affect the amount of revenue recognized by the contractor.
When a contractor is determined to be the principal, the revenue recognized is the gross amount to which the contractor expects to be entitled.
When a contractor is determined to be the agent, the revenue recognized is the net amount to which the contractor is entitled to retain in return for its services as the agent.
The determination of principal versus agent is not always clear. The new standard provides these indicators of when a performance obligation involves an agency relationship:
- Another party is primarily responsible for fulfilling the promise to provide the specified good or service
- The contractor does not have inventory risk before or after the goods have been ordered by a customer, during shipping, or on return
- The contractor does not have discretion in establishing prices for the other party’s goods or services, and therefore the benefit that the contractor can receive from those goods or services is limited
- The contractor is not exposed to credit risk for the amount receivable from a customer in exchange for the other party’s goods or services
Example of acting as the principal
The construction of a manufacturing facility requires air handling equipment with unique specifications. The contractor works with the customer to develop the specifications for the equipment, which the contractor communicates to a supplier and the contactor enters into a subcontract agreement with that supplier. After agreeing on the equipment specifications and the scope of the work, the contractor and the customer agree to a price for the equipment. The contractor arranges to have the supplier deliver the equipment directly to the customer. Upon delivery to the customer, the terms of the contract require the contractor to pay the supplier the price agreed to for manufacturing the equipment. The contract between the customer and the contractor requires the customer to seek remedies for defects in the equipment from the supplier under the supplier’s warranty; however, the contractor is responsible for any corrections to the equipment required resulting from errors in specifications.
Conclusion
The contractor evaluates the contract terms requiring the procurement and delivery of the specialized air handling equipment and determines that the contractor is acting as the principal in this scenario. The contractor concludes that it has promised to provide the customer with specialized equipment. Although the contractor has subcontracted the manufacturing of the equipment to the supplier, the contractor concludes that the development of the specifications and the manufacturing of the equipment are not distinct because they are not separately identifiable.
The contractor is primarily responsible for fulfilling the promise to provide the specialized equipment by determining the specifications, communicating those specifications with the supplier, entering into a supplier agreement to provide the equipment including the negotiation of price directly between the contractor and supplier and, thus, provides a significant service of integrating those items into the specialized equipment. In addition, these activities are highly interrelated and as a result the contractor concludes that it controls the specialized equipment before it is transferred to the customer.
In the scenario, the contractor agreed to the scope and pricing with the customer and was exposed to credit risk for the amount receivable from the customer in exchange for the specialized equipment. As a result, the contractor would recognize revenue equal to the amount agreed upon with the customer for the equipment and recognize costs in an amount equal to the terms agreed upon in the subcontract with the supplier on a gross basis.
Example of acting as the agent
A contractor enters into a construction contract with a healthcare entity to build a new medical clinic. The medical clinic requires a specific scanner. The contract terms between the contractor and the customer indicate that the customer is responsible for the specifications, price negotiation and installation of the scanner by a supplier; however, the contractor is responsible for procuring the equipment and ensuring the building space can accommodate the equipment. The contract terms allow the contractor to include the cost of the equipment in its computation of general conditions and contractor profit.
Conclusion
The contractor evaluates the contract terms requiring the procurement of the equipment and concludes that it is acting as the agent in this scenario. The contractor determines that the scanner supplier is primarily responsible for fulfilling the promise to manufacture, deliver and install the equipment based on specifications provided by the customer. The contractor provides no significant service of integrating the equipment into the overall construction of the medical clinic.
As a result, the contractor concludes that the good or service is distinct and a separate performance obligation under the contract with the customer. In addition, the customer is responsible for negotiating the price with the supplier and therefore the benefit the contractor can receive from the procurement of the good or service is limited to its general conditions and profit percentages as defined in the contract. Therefore, the contractor would recognize revenue equal to the amount agreed upon with the customer for general conditions and profit related to the cost of the equipment on a net basis.
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