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.