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Understanding Deferred Revenue Accounting

In this article, we'll take a look at the "Deferred Revenues" line of the balance sheet, what it refers to, and how investors can use it to get a glimpse into the future results of reported revenues, as well as detect underlying trends within a business.

Define Deferred Revenue

So, what are "Deferred Revenues"? It is a line item in a company's balance sheet, generally under the short-term liabilities section, and often under long-term liabilities as well. Deferred revenues are received cash deposits that a company has collected, but not yet reported as revenue on the income statement. As they are reported as revenue in subsequent quarters (i.e., "amortized"), the amounts are deducted from the deferred revenue account. Amounts expected to be reported as revenue within the next 12 months fall under the short-term category, while amounts that will be amortized farther out fall into the long-term deferred revenues line item.

Not all businesses have a deferred revenues line. The most common sort of companies utilizing deferred revenues are service-oriented firms, where customers pay up front for a term of service. This cash goes directly into the company's coffers, but the firm will usually recognize revenue evenly over the term of the service.

An Example of Deferred Revenue

How this works is best illustrated by an example. Let's use a subscription example because it is easy for most folks to relate to. Fortunately, we have a good example currently in Magic Formula Investing (MFI) with Meredith Corp (MDP), which publishes popular periodicals like Better Homes and Gardens, Family Circle, and Ladies Home Journal.

Subscribers to BHG can opt for a one year subscription, or a longer, multi-year subscription which usually offers a lower price per issue deal.

When I choose the one-year subscription (say, for $24, or $2/issue), I send a check to Meredith which is added to the cash account of their balance sheet and also the short-term deferred revenues line, as all of my cash will be recorded as revenue within 12 months. Then, each month, Meredith will move $2 of my deposit out of deferred revenues and report it as revenue on the income statement.

The effect is similar for a multi-year deal. In this case, say I spend $36 for 3 years ($1/issue). In this case, $12 of my deposit goes into the short-term deferred revenues line, while the remaining $24 goes into long-term deferred revenues (because it will not be recorded until after 12 months). Each month, $1 from short-term is recorded as revenue, and $1 from long-term gets moved into short-term!

The great thing about deferred revenues is that it often gives you a glimpse into the forward trends a company is experiencing. For example, here are Meredith's short (ST) and long-term (LT) deferred subscription revenues for the past 5 years:

Fiscal 2010: ST = $159m LT = $131m
Fiscal 2009: ST = $171m LT = $148m
Fiscal 2008: ST = $175m LT = $158m
Fiscal 2007: ST = $191m LT = $168m
Fiscal 2006: ST = $200m LT = $169m

Clearly, the trend is poor. That is 5 consecutive years that subscriptions have been declining. Worse, the rate of decline is accelerating. In 2010, total deferred subscription sales fell 9%, well above the ~5% declines seen in prior years. From this, we can forecast that reported subscription revenues over the next year will be down approximately 7%, and potentially even higher in subsequent years.

This is why deferred revenues, despite being a "liability" on the balance sheet, are something we actually want to see going up, not down!

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