Basic accounting for public companies can get confusing with different terms that mean the same thing (like deferred and unearned revenue), vs opaque definitions (such as recording a debit or credit on deferred revenues, assets, or expenses).
Let’s clear that up.
Of course, we should know that understanding the intricacies behind deferred revenue is of critical importance for financial statement analysis.
As author John Del Vecchio, CFA said in his great book What’s Behind the Numbers:
“Because the rest of the financials depend on revenue, it deserves the most scrutiny. Any doubt about the sustainability of revenue throws the rest of the financial model into question”.
Accounting is of such critical importance, that billionaire Charlie Munger suggested that for his partner Warren Buffett, understanding accounting to him was akin to breathing.
Even famed entrepreneur Phil Knight, the founder of Nike, cut his teeth as an accountant and had the lesson of “equity, equity, equity” drilled into his head as he ran his first company.
Deferred revenue and its function in the financial statements can be a major source of aggressive revenue recognition with companies (especially service or subscription based ones), which can lead to short term profitability jolts, which at the same time cripple future profitability.
Hopefully by now we understand the reasons why thoughtful analysis of deferred revenue is a very worthwhile use of our time. Let’s summarize, and then mastermind (hypothetically, of course).
The life of Deferred Revenue in Financial Statements
First off, deferred revenue and unearned revenue are ultimately the same thing—essentially, prepayment for goods or services yet to be delivered. The accounting treatment is as follows:
- Recorded as liability on the balance sheet
- Creates a debit (increase) to assets (cash)
- Creates a credit (increase) to liabilities (deferred revenue)
And then, as time passes:
- Deferred revenue converted to revenues as these services are delivered
- Recognizing revenue will debit (decrease) deferred revenue account and credit (increase) revenue in the income statement
Wait… But you just defined a credit and a debit as the same thing!
That’s right, which is why we have to go back to the basics of accounting in order to understand how deferred revenue flows through the financials.
The Basics of Accounting (5 Account Types)
There’s 5 account groups of accounting, with 2 having “backwards” treatment of credits vs debits, and 3 having more intuitive treatment of credits vs debits.
The 5 groups are created from the building block equation of accounting:
- Assets = Liabilities + Equity
We can further expound on this equation, and apply what we’re more familiar with regarding financial accounting of public companies, as:
- Assets = Liabilities + Shareholders’ Equity
- Assets = Liabilities + Available Capital + Retained Earnings
Now, “available capital” can be thought to encompass the following 3 components of Shareholder’s Equity (the fourth being Retained Earnings):
- Outstanding shares – think of this like the number of shares sold in an IPO
- Additional paid-in capital – think of this as the “profit” the company made from the IPO
- Treasury stock – the shares that the company has repurchased
Note: Additional paid-in capital, or APIC, is the amount paid for shares over par by an investor buying directly from the company. In a successful IPO, direct investors might pay over par because of the potential they see with the company.
So now we should understand the “Available Capital” represents the ownership stake in (and claims to) the business. We could also think of it as the “Owner’s Investment”, money put in as an investment into the business in order for an ownership claim on future profits.
Then, intuitively, retained earnings are just the profits not distributed back to the owners (through dividends)… or all of the money the business has made and reinvested in itself over time.
I’ll re-write the equation one more time:
- Assets = Liabilities + Owner’s Investment + Retained Earnings
Now, this is important because Retained Earnings are simply profits earned by the business. If profit = revenue – expenses, then we can modify our formula one last time:
- Assets = Liabilities + Owner’s Investment + Revenue – Expenses
- (1) = (2) + (3) + (4) – (5)
This is a full description of a company’s balance sheet from an accounting standpoint, and defines the 5 account types which be increased or decreased as a debit or credit depending on account type.
Defining Debit vs Credit
These two terms can get confusing because we think of it usually like we do for our personal finances, where a debit represents money coming out and a credit is money coming in.
But in business accounting, these terms are defined as:
- Credit = Source of cash ($$) value
- Debit = Use of cash ($$) value
We also need to understand that in this double entry accounting system, Debit = Credit, just like Assets = Liabilities + Equity.
This is the final tool to help us understand when to debit or credit an account or transaction type in a company’s financial statements.
Let’s start with credit. As a source of cash ($$) value, it is cash coming in that will drive profits. So, of the 5 types above that includes:
- Liabilities – like how a bank loan is a source of cash
- Owner’s investment – obvious source of cash
- Revenue – a source of cash from customers to the business
So, if the source of cash increases in this case, that’s a credit. In our purposes, if deferred revenue is a liability, and we’re adding to that account, that’s a credit to deferred revenue.
Likewise, an increase in sales is a credit to the revenue line item statement.
To understand debit, remember that it’s a use of cash ($$) value. We need to put this cash somewhere in order to make our profits (and run our business). That includes the remainders:
- Assets – accounts receivable, as it is increased the business will have more cash to use
- Expenses – Using cash to pay salaries to keep the business running
So if any asset balance is increasing, it’s preparing cash to be used later, which is a debit. If any expenses are increasing, this is also a debit, because expenses are a negative sign (-) in our 5 account types formula above.
Another shortcut to remembering deferred revenue debit or credit usage in accounting is that debit refers to the left side of the accounting equation and credit refers to the right side.
If we move expenses to the left side of the equation, like this:
Assets + Expenses = Liabilities + Owner’s Investment + Revenue
Then we have a nice representation of where increases mean a debit (left side), and where increases mean a credit (right side).
Important note: Expenses differ from liabilities because expenses are in the income statement, while liabilities are on the balance sheet. Expenses are related directly to activities that lead to operating profits, and so you can think of (Revenue – Expenses) in that capacity, separate from the other 3 account types which are more central to the balance sheet and/or long term.
Deferred Revenue Accounting Example
Let’s tie this all back together with deferred revenue now.
In today’s GAAP standards, revenue is recognized when it is earned, but it has two distinct phases:
- When revenue is realizable but not earned (deferred)
- When revenue is earned (and added to income statement)
Take the example of a magazine that collects an annual subscription upfront, a perfect representation of how deferred/ unearned revenue works.
- Customer pays $300 for an annual subscription
- Company receives $300 in cash = $300 debit to cash and cash equivalents
- Company increases deferred revenue = $300 credit to deferred revenue liability
Say that 9 months pass. The customer is still paid up for 3 more months of his/her subscription, so the company has delivered ¾ (or 75%) of the service. The business would adjust their accounting like so:
- Cash doesn’t change. CF statement doesn’t change.
- 75% of deferred revenue recognized as real revenue = (0.75 * 300) = $225 debit to deferred revenue liability.
- That debit is reconciled with a $225 credit to revenues.
This continues until the service, 12 months of a magazine issue, is completed. All sorts of businesses implement deferred revenue as a part of their business model, either on a recurring plan or just as a service with a long delivery time.
Deferred Revenue in Financial Statements Example (10-k)
Let’s examine the latest 10-k for a company in the technology space for professional services, Cognizant Technology Solutions ($CTSH).
With a quick search for “deferred revenue”, we can see the line item in their Consolidated Statements of Financial Position (balance sheet):
More information on a company’s deferred revenue should also be located in the Notes to the Financial Statements. In the case of Cognizant, they breakdown both unrecognized (deferred) revenues and amounts being recognized to revenue in the given year:
Notice how this reconciles with the changes in Deferred Revenue in the Balance Sheet, and the footnotes helps to bring clarity to how much of the deferred revenue liability was recognized in revenue, and how much was added to the balance.
Balance Sheet Reconciliation
- Deferred Revenue = Deferred Revenue (in Current Liabilities) + Deferred Revenue, noncurrent
- Deferred Revenue 2019 = 313 + 23 = $336 million
- Deferred Revenue 2018 = 286 + 62 = $348 million
- Change in Deferred Revenue = -$12 million
- Beginning balance 2019 = $348 million
- Ending balance 2019 = $336 million
- Change in Deferred Revenue = -$12 million
In essence, through the fiscal year 2019, $261 million of deferred revenue liability was recognized as revenue in the income statement. This added a credit (increase) to revenue and a debit (decrease) to deferred revenue liability.
The Consolidated Statement of Cash Flows is the other place where you should be able to see changes in Deferred Revenue. Cognizant laid it out as follows:
Now, this number doesn’t necessarily need to reconcile with deferred revenue changes in the balance sheet, as additional cash could be collected by the company in the form of new deferred revenues, while at the same time deferred revenues recognized as revenue could draw down the account.
Also, the number in the cash flow statement could be mismatched from the changes in balance sheet numbers due to foreign currency adjustments in OCI (or other comprehensive income), or other factors that may or may not be disclosed in the footnotes of the financials.
To track potential manipulations (or warning signs) around deferred revenue and revenue recognition, “Financial Chicanery” expert John Del Vecchio, who I quoted above, suggests the following two ratios:
- DSO, or Days Sales Outstanding
- DDR, or Days in Deferred Revenue
- And, DSO minus DDR
A quick synopsis of those ratios:
- DSO = 91.25 * (Accounts Receivable / Quarterly Revenue)
- DDR = 91.25 * (Deferred Revenue / Quarterly Revenue)
To analyze the ratios, look for a sequential increase in any of the ratios. If any increase substantially either YOY or by quarter, you could have aggressive revenue recognition on your hands.
If that’s the case, management could be masking current revenue struggles by aggressively drawing down on deferred revenues—which only pushes the can down the road for the revealing of problems to the public later.
Understanding the basics of accounting is a critical component to comprehending what’s going on with a company’s financial statements, and understanding the difference between credits and debits in those accounts is no different.
In the case of revenue recognition, the way accounts are treated can have a serious impact on what a company reports for future earnings, which can catch investors by surprise.
Hopefully, with your newfound understanding of deferred revenue accounting, you’ll be able to combine this knowledge with other important aspects (DSO or DSI red flags, studying footnotes, dissecting the 10-k) in order to put your capital into its best chances for success—away from companies already exhibiting clear problems ahead.