Deferred revenue

[TheMotorcycleBoy]

Back in Share Ideas re. Sophos (SOPH) I stated that Sophos had never reported a profit.

Alaric replied:

But given their P&L position of loss so far, it's a mystery to me that the current PE valuation of the firm sits at about 90.

On a superficial view, they get revenue which they then defer. That enables them to report positive revenues, positive cash flow but negative profit. The implication is that they charge up front for future services which is perhaps something of a traditional software model.

If the business is mature, not making a profit does however suggest they are spending more on marketing , expenses, research and development than they get back in profit on sales.

I later observed deferred revenue as being mentioned in sophos's balance sheets:

https://investors.sophos.com/en-us/medi ... t-2018.pdf

Current liabilities		2018	2017
Deferred revenue		423.9	330.6

Non-Current liabilities		2018	2017
Deferred revenue		331.8	250.4

but why is it referred to as a liability?

Alaric replied again:

It's money in the bank that cannot be declared as profit. Classing it as a liability makes it work that way in double entry accounting. Roll forward a period and some of it can be declared as a profit.

As an example, you sell a software licence for 100, but it may cost anywhere between 0 and 50 in support costs over the declared product lifetime. Profit (this year) is 50, even though revenue is 100.

I have to say, I'm still a bit confused. Though I admit I've not been mulling it over that long...

All I can currently say, is it sounds very much like the reverse of the "Capitalisation of Expenses into Intangible Assets". i.e. instead turning a cost to an asset, the income has been turned to a liability. Correct?

[PinkDalek]

... All I can currently say, is it sounds very much like the reverse of the "Capitalisation of Expenses into Intangible Assets". i.e. instead turning a cost to an asset, the income has been turned to a liability. Correct?

Not really. You are defining debtors and/or cash receipts against future events as income. Whereas the treatment is correctly treating such receipts as a liability until whatever actions that need to be performed have been carried out, such that's there's no longer a liability and the profit (hopefully) can be correctly calculated.

Thus the revenue is deferred.

Probably a more succinct explanation and video is here:

https://www.investopedia.com/terms/d/de ... evenue.asp

[Alaric]

All I can currently say, is it sounds very much like the reverse of the "Capitalisation of Expenses into Intangible Assets". i.e. instead turning a cost to an asset, the income has been turned to a liability. Correct?

Pretty much so. That's a hazard with accounts and how they handle multi-year transactions. Perhaps because accountants like it that way, there can be considerable flexibility in reporting whether or not a Company is profitable.

Capitalisation of expenses can be likening to spending money and pretending you haven't, whilst Deferred Revenue is receiving money and pretending you haven't.

[Charlottesquare]

All I can currently say, is it sounds very much like the reverse of the "Capitalisation of Expenses into Intangible Assets". i.e. instead turning a cost to an asset, the income has been turned to a liability. Correct?

Pretty much so. That's a hazard with accounts and how they handle multi-year transactions. Perhaps because accountants like it that way, there can be considerable flexibility in reporting whether or not a Company is profitable.

Capitalisation of expenses can be likening to spending money and pretending you haven't, whilst Deferred Revenue is receiving money and pretending you haven't.

Better than recognising it too early-step forward Carillion .

You want to match revenue with the costs relating to that revenue, the very old SSAP2 covered it in the four fundamental accounting concepts. If you do not you would tend to overstate or understate profits.

Also beware thinking in money movements re accounts, movement of money tends to follow after the accounting transactions detailed in the accounts rather than being the primary driver of them, money tends to follow other transactions

e.g Sale on credit is -Dr Debtors Cr Sales.

Receiving the money is-Dr Bank Cr Debtors.

The latter transaction is merely the exchange of one asset , debtors, for another asset, cash in bank, it has no impact on the I & E and merely impacts the BS.

The first transaction is the one that is reflected in the I & E within sales.

[TheMotorcycleBoy]

Whereas the treatment is correctly treating such receipts as a liability until whatever actions that need to be performed have been carried out, such that's there's no longer a liability and the profit (hopefully) can be correctly calculated.

Thus the revenue is deferred.

Probably a more succinct explanation and video is here:

https://www.investopedia.com/terms/d/de ... evenue.asp

Thanks PD, the video was helpful.

All I can currently say, is it sounds very much like the reverse of the "Capitalisation of Expenses into Intangible Assets". i.e. instead turning a cost to an asset, the income has been turned to a liability. Correct?

Pretty much so. That's a hazard with accounts and how they handle multi-year transactions. Perhaps because accountants like it that way, there can be considerable flexibility in reporting whether or not a Company is profitable.

Capitalisation of expenses can be likening to spending money and pretending you haven't, whilst Deferred Revenue is receiving money and pretending you haven't.

Better than recognising it too early-step forward Carillion .

Definitely!

You want to match revenue with the costs relating to that revenue, the very old SSAP2 covered it in the four fundamental accounting concepts. If you do not you would tend to overstate or understate profits.

Thanks CS,

So now that I think that I've grasped it, I've tried to create an example:

In 2017 a firm attracts sales of 1000M, but they've only completed 600M of the goods.
In 2018 they win an additional 800M of sales which they can deliver as well as completing the deferred sales from 2017 of 400M.

So I reckon that for 2017, their P&L is:
Revenue: 600M

And their BS is:
Deferred revenue (liability): -400M

For 2018 because they make the 400M of earlier sales, the deferred revenue vanishes and becomes 400M cash and they report 800+400M revenue for that report.

So for the 2018 P&L:
Revenue: 1200M

The BS:
Cash: 400M

Does that sound about right now?

Thanks Matt

[Charlottesquare]

So now that I think that I've grasped it, I've tried to create an example:

In 2017 a firm attracts sales of 1000M, but they've only completed 600M of the goods.
In 2018 they win an additional 800M of sales which they can deliver as well as completing the deferred sales from 2017 of 400M.

So I reckon that for 2017, their P&L is:
Revenue: 600M

And their BS is:
Deferred revenue (liability): -400M

For 2018 because they make the 400M of earlier sales, the deferred revenue vanishes and becomes 400M cash and they report 800+400M revenue for that report.

So for the 2018 P&L:
Revenue: 1200M

The BS:
Cash: 400M

Does that sound about right now?

Thanks Matt

Pretty much.

Year one they post a sales invoice say

Dr Debtors 1000
Cr Sales 1000

But as they have not completed all the work they adjust at year end:

Dr Sales 400
Cr Deferred Revenue 400

This avoids them overstating the actual amount they have earned in the year, they have not done all the work so do not recognise all the revenue.

So the I & E has Sales 600 CR (1000-400)
The BS has Debtors DR 1,000 and Deferred Revenue Cr 400
They may or may not have received cash re the debtors at that year end, the part they have received reduces the asset, debtors and increases the asset cash, so if say they had received 500 then Dr Cash 500, Cr Debors 500, so Balance Sheet

Debtors DR 500
Cash DR 500
Deferred Revenue 400CR
Reserves CR 600 (YR1)

Next year they invoice 800, so Dr Debtors 800 CR Sales 800

By end on that year all sales completed so they reverse the deferred sales, DR Deferred Revenue 400 Cr Sales 400

So sales are as you say 1200 CR (800+400)

What the debtor position looks like depends on the further cash received, the cash received merely impacts what asset debtor and what asset cash is held, so it could be another say 900 received, in which case year two balance sheet is

Dr Debtors 400 (1000+800-500-900)
Dr Cash 1400 (500+900)

Cr Reserves 1800 (YR 1 600, YR 2 1200)

The key is here the profit is driven by the sales not the cash, the cash merely indicates in what form the assets acquired arising from the sales are held (in debtors or in cash)

There are myriad types of entity that could have these sorts of things, for instance if I offer an annual lift maint contract for 2400 pa and invoice it to you on 31st October for 12 months but my year end is 31 December, then at 31 December 2018 I have only performed 2/12ths of £2400 work, so 400 is actual work done in year to 31/12/2018 and 2000 work I will do next year in year ending 31/12/2019, the 2000 needs to be treated as deferred revenue otherwise I overstate the 2018 sales and profits.

Understanding and thinking about double entry re transactions ,and what they ought to reflect ,is one key to understanding accounts and why things happen as they do, if not looked at a basic accountancy textbook that covers the Debits and Credits will possibly be a useful few hours of study and assist you in understanding some of the accounting conventions used and why they are used (Do not read that as my approving of all accounting rules, I do not, for instance in FRS102 there are myriad approaches/interpretations re financial instruments that leave me cold, but things like prudence, matching concept, going concern and consistency do have a legitimate place in accounting thought )