Principal-agent relationship

What is a principal-agent relationship or an agency relationship? It is an arrangement where one party (the principal) appoints another party (the agent) to act on its behalf for a predetermined purpose. For example, an insurance company appoints an agent to sell the company’s insurance policies on behalf of the company.

This arrangement transfers a legal right to the agent to act on behalf of the the principal and sometimes to collect payments from customer on behalf of the principal. There are various laws and regulations in different countries to regulate the agency relationship, however, from an accountant’s perspective, we are interested in knowing the accounting of agency sales.

Accounting of agency sales

How should the agent record its revenue? If an agent sells products on behalf of his principal and gets commission from the principal, will he record the gross sales or only the commission earned?

As a rule of thumb, we should remember that revenue does not include amounts collected or collectable on behalf of third parties. So, in agency sales, an agent should only record the commission earned as his revenue. Gross sales amount is not the revenue of agent as he has just collected the amount on behalf of his principal.

Let’s take a look at the following example to get a better picture of this accounting concept.

Example – Principal-agent relationship

COOL Company is a washing machine manufacturer who has an agency agreement with SMART Company, an agent who sells the washing machines to earn 15% commission on each sale. During the year ended 31 December 20X1, SMART manages to sell washing machines worth $100,000 on behalf of COOL. As per the agency agreement, SMART deducts its commission from the amounts received from customers and transfers the remaining amount to COOL, the principal.

During the year, SMART received $100,000 cash from sale of machines, and paid $85,000 to COOL after deducting his commission of $15,000. What should be the amount of revenue recorded in the books of SMART, the agent?

The accountant of SMART has recorded sales revenue of $100,000 and cost of sales of $85,000 resulting in gross profit of $15,000. Is this right? Not at all!

Amounts received on behalf of other parties are not revenue, and therefore, only the amount of commission should be recorded as revenue. Following are the correct entries for the given scenario.

Dr. Cash or bank ——- $100,000
Cr. Payable to Principal —– $85,000
Cr. Commission income —- $15,000

Following entry will be made when the amount is paid to COOL, the principal.

Dr. Payable to Principal —– $85,000
Cr. Cash or bank —————— $85,000

On the other hand, the principal records the gross sales and records commission as a selling expense. Following entries will be made in the books of account of COOL, the principal.

Dr. Receivable from Agent — $85,000
Dr. Commission expense —– $15,000
Cr. Sales revenue ——————- $100,000

Following entry will be made when the amount is received from SMART, the agent.

Dr. Cash or bank ———— $85,000
Cr. Receivable from Agent —- $85,000