Online retailers that act as intermediate parties to manufacturers and customers must decide whether to report its revenues on a gross or net basis. The FASB codification 605-45-45-1 notes that it is a matter of judgment on the entity’s behalf to report revenue based on the following two principles:
1. The gross amount billed to a customer because it has earned revenue (as a principal) from the sale of the goods or services.
2. The net amount retained (that is, the amount billed to the customer less the amount paid to a supplier) because it has earned a commission or fee as an agent (Codification: 605-45-45-1).
Codification 605-45-45-[16-18] recognizes three scenarios in which companies would use the net method in revenue recognition.
1. The Entity’s Supplier Is the Primary Obligor in the Arrangement. If a supplier (and not the entity) is responsible for fulfillment, including the acceptability of the products or services ordered or purchased by a customer, that fact may indicate that the entity does not have risks and rewards as principal in the transaction.
2. The Amount the Entity Earns Is Fixed. If an entity earns a fixed dollar amount per customer transaction regardless of the amount billed to a customer or if it earns a stated percentage of the amount billed to a customer, that fact may indicate that the entity is an agent of the supplier.
3.The Supplier Has Credit Risk. If credit risk exists but a supplier assumes the credit risk, that fact may indicate that the entity is an agent of the supplier and, therefore, the entity should record revenue net based on the amount retained.
On the other hand FASB codification 605-45-45-[4-13] further states that there are certain elements for determining which method is appropriate. There are other factors that suggest the gross basis for revenue recognition.
1. The Entity Is the Primary Obligor in the Arrangement. If an entity is responsible for fulfillment, including the acceptability of the products or services ordered or purchased by the customer, that fact is a strong indicator that an entity has risks and rewards of a principal in the transaction.
2. The Entity Has Credit Risk. If an entity assumes credit risk for the amount billed to the customer, that fact may provide weaker evidence that the entity has risks and rewards as a principal in transaction.
Since the yahoo complies with the guidance as per the Codification 605-45-45-[16-18] it reports the revenue by gross method. Since Google adheres to codification 605-45-45-[4-13], the net method is more relevant.
Since in the calculation of free cash flows the analyst are primarily concerned with the bottom line so revenue recognition does not have an effect on it but on the other hand artificially high revenue numbers can make the future revenue and growth projections incorrect.
