Under GAAP, the accounting for pass-through expenses turns on a single question from ASC 606: did your company control the good or service before it reached the customer? If yes, you are the principal and record the full amount as revenue with the pass-through cost as an expense. If no, you are the agent and record only the fee or commission you keep. The economic bottom line is the same either way, but almost every ratio built on the top line changes depending on which side you land.
What Counts as a Pass-Through Expense
A pass-through expense is a cost one company pays on behalf of another and later gets reimbursed for. A marketing agency pays a media company for ad placements and bills the client. A staffing firm covers weekly payroll for temporary workers placed at a client site. A technology reseller purchases software licenses and sells them to end users. Cash moves through the intermediary’s accounts in each case, and the question is whether the intermediary is adding something of its own or simply acting as a conduit.
Classifying this wrong inflates both revenue and expenses. A company that should report $2 million in net fees instead reports $10 million in gross revenue with $8 million in costs. Profit is unchanged, but revenue growth, gross margin percentage, revenue per employee, and anything tied to a revenue covenant all shift. ASC 606’s principal-versus-agent framework exists to prevent exactly that distortion.
The Control Test
Before you can record the full transaction amount as revenue, you need to have controlled the specified good or service before it was transferred to the customer. Control means the ability to direct the use of, and obtain substantially all the remaining benefits from, the good or service, including the ability to prevent anyone else from doing so.1Financial Accounting Foundation. Proposed ASU – Revenue from Contracts with Customers (Topic 606) Principal versus Agent Considerations
Three specific scenarios demonstrate that control:
- You obtain a good or asset from a third party and then transfer it to the customer. A distributor that buys inventory from a manufacturer before selling it to a retailer fits here.
- You obtain the right to a service performed by a third party and direct that party to provide it to your customer on your behalf. A general contractor engaging subcontractors but remaining responsible for the finished project fits here.
- You obtain goods or services from third parties and combine them with your own to deliver something integrated. A technology firm that bundles third-party software with its own consulting and implementation services fits here.
If your role in a contract doesn’t fit one of these patterns, you are likely an agent. The evaluation runs separately for each distinct good or service in a contract, so you can be principal for one deliverable and agent for another inside the same arrangement.
Three Indicators of Principal Status
When the scenarios above don’t settle the question, ASC 606 lists three indicators that support principal status:
- Responsibility for fulfillment. You are on the hook if the good or service doesn’t meet what the contract promises. You are the entity the customer looks to when something goes wrong, and you bear the risk that the third party’s work won’t be acceptable.
- Inventory risk. You are exposed to loss if the good can’t be sold, becomes obsolete, or gets returned. This includes committing to purchase a good before any customer is identified. Simply agreeing to resell a specific volume does not by itself prove control.
- Pricing discretion. You set the final price the customer pays. An agent typically earns a fixed fee or a percentage of a price set by someone else.
These indicators support the control analysis rather than replace it.1Financial Accounting Foundation. Proposed ASU – Revenue from Contracts with Customers (Topic 606) Principal versus Agent Considerations No single one is decisive, and the standard doesn’t weight any one more heavily than the others. An entity can have pricing discretion and still be an agent if it never controls the good or service.
When Indicators Point in Different Directions
This is where most companies struggle. A SaaS reseller might have discretion over pricing (suggesting principal) but never take possession of or modify the software and have no ability to prevent the vendor from providing the service directly (suggesting agent). The resolution comes from returning to the fundamental question: did the entity control the specified good or service before it reached the customer? The entity with more evidence of directing the use and capturing the benefits before transfer is the principal. When indicators conflict, document the analysis thoroughly. Auditors and regulators focus on the reasoning, not just the conclusion.
Gross Method: Recording as a Principal
When you are the principal, the full consideration from the customer is revenue, and the amount paid to the third-party supplier is cost of goods sold or an operating expense. Suppose you charge a client $50,000 for a project and pay a subcontractor $38,000. Your income statement shows $50,000 in revenue and $38,000 in cost of goods sold, yielding $12,000 in gross profit.
The entries are straightforward. When you pay the subcontractor, debit Cost of Goods Sold for $38,000 and credit Cash for $38,000. When the client pays, debit Cash for $50,000 and credit Revenue for $50,000.
Higher top-line revenue can look appealing, but it carries real consequences. Gross margin percentage drops because the actual margin is divided by a much larger revenue base. Revenue per employee and price-to-sales ratios become less comparable against peers that operate as agents. Debt covenants tied to revenue thresholds can trip earlier than they would under net reporting.
Net Method: Recording as an Agent
When you are the agent, only the fee or commission you earn hits revenue. Using the same numbers, your income statement shows $12,000 in revenue and nothing in cost of goods sold related to this transaction.
The entries run through a clearing account. When you pay the third party, debit a Receivable (or Due from Client) for $38,000 and credit Cash for $38,000. When the client pays, debit Cash for $50,000, credit the Receivable for $38,000, and credit Revenue for $12,000. The pass-through cost never appears on your income statement as either revenue or expense.
Net reporting gives a cleaner picture of what the business actually earns, though the top-line number is smaller. For early-stage companies trying to demonstrate scale, that can feel like a disadvantage, but using the gross method when the facts support agent status creates serious compliance risk.
Scenarios That Commonly Trip Companies Up
SaaS and Software Resale
A company that resells another vendor’s cloud software often concludes it’s an agent. The reseller typically cannot modify the software, doesn’t provide the underlying service, and can’t prevent the vendor from delivering it. In many arrangements the customer’s contract is ultimately with the software vendor, and the reseller facilitates the sale and provides support. Unless the reseller integrates the third-party software into a broader combined offering or takes on meaningful fulfillment risk, it generally reports only the margin or commission as revenue.
Service Integration
The analysis shifts when a company takes goods or services from multiple third parties and integrates them into something new. ASC 606 treats this as control. The integrating entity first obtains control of the inputs and then directs their use to create a combined output.1Financial Accounting Foundation. Proposed ASU – Revenue from Contracts with Customers (Topic 606) Principal versus Agent Considerations A consulting firm that hires subcontractors, purchases third-party data feeds, and combines everything into a custom analytics platform is providing a significantly integrated service. The firm is the principal for the entire deliverable and reports the full contract value as revenue.
Out-of-Pocket Travel Costs
Travel reimbursements are a frequent source of confusion. Under the predecessor standard, ASC 605, reimbursed out-of-pocket expenses were generally required to be reported as revenue. Under ASC 606 the answer depends on the same control analysis. If you booked the flights, chose the hotel, and bear the risk if the trip is wasted, the reimbursement is part of the transaction price and is allocated across performance obligations. If you are simply passing through a cost the client directed, you are the agent for that specific expense and report it net.2FASB. PCC Meeting – Revenue Recognition Out of Pocket Expenses In practice, most professional service firms end up reporting these reimbursements gross because they control the travel arrangements, but the analysis is fact-specific.
Sales Taxes Are a Separate Election
Sales taxes don’t follow the same analysis automatically. ASC 606 includes a practical expedient (ASC 606-10-32-2A) letting you make an accounting policy election to exclude all sales and similar taxes from the transaction price, presenting them net. The election is all-or-nothing: if you make it, every such tax is presented net across every jurisdiction.
Companies that do not elect the expedient must run a separate principal-versus-agent analysis for every tax jurisdiction. Where the company is legally obligated to pay the tax to the government, it is the principal in the tax transaction and presents the tax gross. Where it merely collects on behalf of the government, it is the agent and presents the tax net. Most companies elect the expedient to avoid the jurisdiction-by-jurisdiction work.
What Happens If You Get It Wrong
Misclassifying pass-through revenue is not a minor bookkeeping issue. For public companies, a revision from gross to net reporting (or the reverse) is treated as a correction of an error, not a reclassification. If the error is material, it triggers a Big R restatement: the company must publicly disclose that previously issued financial statements can no longer be relied upon. SEC registrants typically file an Item 4.02 Form 8-K to make that announcement.
The restatement requires disclosing the effect on every financial statement line item and any per-share amounts for each period presented. A company shifting from gross to net can see headline revenue drop 70% or more without any change to profitability.
There are regulatory consequences beyond the restatement. A company that overstates revenue by reporting gross when it should report net could cross the $1.235 billion annual gross revenue threshold for Emerging Growth Company status, losing reduced reporting requirements and other accommodations.3U.S. Securities and Exchange Commission. Re: Staking Services Revenue Recognition Accounting Guidance
Non-GAAP metrics don’t offer an escape hatch. The SEC has signaled that presenting a non-GAAP revenue figure that deducts transaction costs as if the company were an agent, when GAAP requires gross reporting, is potentially misleading. The reverse is equally problematic. A supplemental revenue breakdown by product line calculated in accordance with GAAP is not a non-GAAP measure. The moment you adjust those figures (netting what GAAP says is gross, or grossing up what GAAP says is net), you have triggered the SEC’s non-GAAP disclosure and reconciliation requirements.4U.S. Securities and Exchange Commission. Non-GAAP Financial Measures
Disclosure and Documentation
Whether you report gross or net, ASC 606 requires disclosures that let financial statement users understand your role in each type of transaction. At minimum:
- Nature of the arrangement. A narrative explanation of which performance obligations involve acting as principal and which involve acting as agent. When you act as agent, the disclosures should flag that you are arranging for another party to transfer the goods or services.
- Basis for the determination. The reasoning behind your principal-versus-agent conclusion for material transactions, including which control indicators you relied on.
- Revenue disaggregation. Qualitative information about how customer type, geography, sales channel, and contract type affect the nature, timing, and uncertainty of revenue and cash flows.
- Significant judgments. The methods, inputs, and assumptions in areas requiring judgment, such as whether variable consideration is constrained or how revenue is allocated across performance obligations.
Consistency across periods matters as much as the initial classification. Changing a principal-versus-agent determination without a change in facts and circumstances raises red flags. When a genuine change occurs, such as a contract renegotiation that shifts fulfillment responsibility, the change and its financial impact need to be explained in the footnotes.
Documentation is the other half of the job. Strong support for the classification includes the contract language that defines fulfillment responsibilities, evidence of which party bears inventory and nonperformance risk, pricing terms showing who sets the customer-facing price, and a written memo explaining how each indicator was weighed. For agent conclusions, the evidence should show why the entity does not control the specified good or service: clauses making the third-party vendor responsible for delivery and quality, terms showing the entity cannot modify the good or service, or evidence that the customer’s primary relationship is with the underlying provider. Documentation effort scales with ambiguity, and arrangements with conflicting indicators are where auditors spend the most time.