Accounting Considerations in Sourcing Environments: Agreement Language

By: John Klee, Senior Advisor, TPI

* TPI is not an accounting firm and does not give accounting advice or guidance. Clients and service providers need to engage their own accounting groups for formal opinions; however, TPI is familiar with the RFP formation and industry practices that should be incorporated into the client decision process. 

 

There are several issues that must be considered around agreement language that can impact how the revenue is reported.

  • Gross versus Net Revenue reporting: Service provider costs, related party transactions and alliance agreements.
  • Pricing structure and embedded leases

GROSS VERSUS NET REVENUE REPORTING – Most service provider revenue is reported as gross sales.  That is if revenue is 100 and costs of sales are 97, the revenue is reported gross or 100.  However, some revenue has to be reported as net; that is, it is netted or charged against the actual expense in the service provider’s financial statements.  This lowers reported revenues and alters any reporting metrics that use these numbers.  You can see the impact on reporting below.

  • Simple Net Revenue reporting
    • Pass-through costs – The service provider is passing a cost directly through to the client without adding any value or assuming risk.
    •  Resale – Perhaps the most common of pass-through costs, is the service provider re-selling a product (hardware, software, etc) with the client having the financial risk.
    • Shipping & Handling (EXCEPTION) – Is reported as gross revenue.  While the service provider adds no value to this, they are the ones who purchase and are responsible for these costs.
  • Related Party Transactions
    • Parent / Subsidiary:  A parent company strikes an agreement with a subsidiary or significantly controlled company where one provides services to the other.  (For those with accounting backgrounds, you may recall eliminating entries that remove the revenue between related companies.)  Any revenue reported via sales between the two entities needs to be removed and reported net of any profit. 
    •  Alliance Agreements:  Clients may enter into relationships, often co-terminus, with service providers such that each assumes both role of client and service provider, aligning themselves for a common goal. These agreements normally have the service provider committing to sell or present to their other clients the original client’s products.  The challenge is that the contract language may create a relationship between the two parties that alters how they can recognize all or parts of revenue earned between the two agreements.  The contract language that most often creates this scenario is in the termination section.  This is a complex issue and both parties’ accounting experts (often outside auditors as well) will need to read the contacts to determine the appropriate accounting treatment for the revenue streams between the parties.   

PRICING STRUCTURE AND EMBEDDED LEASES – What is the service provider doing to win the deal?  What is the nature of the services being contracted for?  These questions need to be answered to determine service provider revenue recognition and client expense timing.  Embedded leases offer challenges for both parties. Clients may need to carve out part of their service costs, often with the service provider’s help.  Service providers must do the same with their revenue streams. The “lease” part of the transaction will be recognized in a different cadence (normally straight-line) than the actual billing or invoice streams.

  • Service provider and client issues:
    • Financial Engineering. Did the service provider shift fees to make the start up less financially stressful to the client?  Perhaps the deal starts towards the end of a fiscal year and the client does not want the hit to their cash around year end.
    • Services supported by dedicated assets.  Does the client physically control the asset or access to the asset?  Do they consume nearly all of the output? 

Both of these scenarios could force the service provider to recognize a lease on their books and straight-line some of the revenue recognition.  The cash AND expense timing are irrelevant.  Either situation above may also cause the client to carve out part of the service price and recognize it separately.   

As always, client and service provider accounting experts should be engaged, but we can offer direction to the teams on issues that need to be addressed.

Thought for the day, “Expense and revenue recognition don’t always mirror cash flows.  The matching principle, recognizing revenues and their related expenses in the same period, is not as straightforward as it used to be. Cash may be king, but generally accepted accounting principles are checkmate.”

More to come…