when to judge earning quality of deferred revenue, does the increase in defferred revenue lower the quality of earning? what exactly deferred revenue is? Thanks.
Deferred revenue is same as Unearned Revenue (a liability). If you are a magazine publisher, you have collected the revenue of $120 for a year’s subscription from a reader, but you have only delivered the current month’s issue to the customer, then record the one month’s part of the annual subscription ($10) as Revenue in Income Statement and other 11 months’ portion is recorded as deferred Revenue under Liabilities. But, I am not sure whether deferred revenue will lower the quality of earnings. Although it seems as if it would increase Operating liability and hence reduce the Net Operating Assets (Operating Asset - Operating Liability). Thus deferred revenue may lead to reduction in Accruals ratio and that will mean the quality of earnings is going up. The second paragraph above is my guess. I do not have the book in front of me. Let us see what others have to say.
Hmmm tricky one. Hopefully, someone with a better handle on this will weigh in but I will give my attempt. Deferred revenue is just customer pre-payments for services yet to be rendered. It does not affect current income. It lowers net operating assets because I believe its an operating liability (can someone confirm?). So (change in NOA)/(Avg NOA) if we are 100 Beg 110 End we get 10/105 = .09238 If we assume we had 5 of deferred revenue Its a liability, so Beg stay the same (it occurred this period) and ending would drop 5 to 105 So we get Beg 100 End 105 which is 5/102.5 = .04878 A lowers accruals ratio = higher earning quality. So my guess on exam day would be deferred revenue increased quality of earnings. Which I guess makes sense. If your customer pay in 30 days (lower earnings quality), pay in cash (higher earnings quality), then prepaying (getting the cash first) must be even better? That being said, I am not certain that’s the right answer. So if someone else can provide help?
It can lower earnings quality because it is subjective when company starts recognizing deferred revenue on its I/S. If times are tough, start dumping those unearned revenues on your I/S.
I agree with you 100% dreary on manipulation but this scares me as a backwards way of testing the accruals ratio that would result in a higher earnings quality. Its definitely an area that can be manipulated by management. Lets walk through it: 1) If management doesn’t recognize enough deferred revenue, then earning quality high but NI is understated 2) If management is aggressive in recognizing deferred revenue, then earnings quality is low but NI is overstated That leads me to believe that even though management can manipulate earnings with deferred revenues, the quality of earnings are affected correctly so I am leaning towards deferred revenues increase quality of earnings. However, it does open the door to manipulation so its important to compare both earnings quality and NI.