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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