We rent apartments and supply utilities with rent. Are we agent or principal?
“A real estate company, which rents out units to different tenants and charges its own rate on utilities like electricity to tenants, at the rates set by the company (not by utility provider). The company pays the electricity bill for all the property to the utility company based on invoices.
One could arguably say that it is a principal relationship – the real estate company sets own rates to the electricity charged to tenants and it bears the credit risk.
Someone else might say that it is the agent relationship – the main provider of the utility is the utility company and the utility company is responsible for interrupted supply of that utility, like electricity.
For example, electricity bill is $50 from the electricity company and the real estate company charges $65 to tenants. How do you recognize revenue and expense?
If it’s a principal relationship, is the $50 a utility expense? But clearly, this is not fair representation because it inflates the real estate company’s utility expense. Or would this be cost of goods sold?
Or, is it an agent relationship and you only recognize the difference of 15 as revenue?”
Answer: Distinguish an agent from a principal
Yes, this is a great and very common example of a dilemma “principal or agent”?
IPople often get stuck when identifying the relationship, especially when the product consists of a few components and some of these components are delivered by the third parties.
How to get around?
How to identify principal and agent?
There are 2 steps:
- Determine distinct goods or services.
Before you start examining any criteria, you should determine the distinct goods or services provided to the customer.Sometimes, you will have a bunch of individual items, like you sell a car, and you provide 2-years of free repair service as a bonus.
These are 2 separate components – distinct goods (car) and services (repairs).
Sometimes, it may seem that the goods and services are distinct, but they are not in fact.
For example, you run a hotel and you sell the room with breakfast. The client gets the overnight stay and breakfast – two components but they might not be distinct because you cannot get breakfast without the room – just as an example.
- Assess each distinct good or service
Once you identify your distinct goods and services, you need to assess each individual distinct component separately.
When are you a principal?
IFRS 15 says that the entity is a principal when it controls the good or service before it is transferred to the customer.
And, IFRS 15 lists 3 basic indicators of entity controlling good before the transfer to the customer and thus being a principal:
- Primary responsibility for fulfilling the promises for goods and services,
- Inventory risk, and
- Discretion in establishing prices.
There can be more indicators so you should assess it carefully.
Illustration: rent with utilities
What about our real estate company from today’s question?
Let’s follow the 2 steps:
- What is a distinct good or service transferred to the customer?
Well, it’s just rent of premises including the water, electricity and other utilities.
I assume that the customer just signs the whole package, all inclusive.
I don’t think that the utilities here are distinct, because the customer cannot buy the electricity without renting the apartment in most cases.
It is just one bundle.
So, if this is the case, then you will need to assess the principal/agent relationship for the rental service as a whole.
- Can entity control the rent or an apartment before it is transferred to the customer?
What about our indicators?
Well yes, a real estate company is clearly a principal here, because it is the owner of the apartments and takes care about them.
Thus in this case, utility bill will be just cost of sales and the rental income will be recognized gross, including the electricity charges.
The situation can be different and you always need to assess what’s the distinct good or service and apply the indicators to that distinct good or a service.
Any comments or questions? Please let me know below. Thank you!
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Hi, This is Hardik
I work in Utility Industry and would able to help to switch on regular basis if tenets and owner are interested to pay less bills and to switch every year. I do remind them and find cheapest suppliers for them on their usage on yearly basis.
Hi Silvia
I worked with Garments industries which recognize the revenue only Cutting and Making charge but I am confused what will be the revenue of garments industry. The activity of our garments is only making charge, the fabric and other direct materials are sourced by the buyer or customer which is control by them so COGS major item is provided by buyer nominated supplier and the fund of this portion is out of control.
Hello silivia,
I had a question, take example of a real estate company which is in the business of renting commercial spaces, agreement entered into between the company and the tenants provides that, along with premisies service provider has to provide all neccessary amenities like water, power, DG back up etc with a condition that they will be charged separately…in respect of power , the agreement is that , whatever the power suppler charges per, per unit consumed same rate has to be charged to tenant’s, here the company procures power from different companies, say X, Y, Z.. X charges 8/- per unit, Y& Z charges 5/- per unit, from the company, but the company charges 8/- for all tenant’s and to avoid conflicts with tenant’s , from Y & Z the company is receiving invoice for 8 /- per unit, and later on from Y the company is getting credit note for 3/- and in case of Z, the company is charging some admin charges like that for 3/-,….in respect of credit note the company is reducing the cost of utilities and admin charges were shown separately as income, is tge accounting treatment correct……
Hello Silwia,
Does the argument about the hotel room and the breakfast that are not distinct services also work with the 5 step model of IFRS 15?
Let’s say for example that a company sells a service package containing proprietary software and updates of this software for 5 years. You can’t get those updates separatly since those are only sold if you buy the proprietary software (just like the breakfast)
Shouldn’t you still recognize 2 different performance obligations and recognize immediatly the revenue linked to the sale of the software and recognize over time the revenue linked with the updates?
Hi Marc, as soon as you assess that the goods or services are NOT distinct, then you have one performance obligation only.