Why do we say that if there have been large decreases in unearned revenues, that could be seen as a manipulation of earnings?
I mean whether you increase or decrease your unearned revenues, you already collected cash, so what difference does it make?
Earnings come from the income statement, not the cash flow statement.
It makes a big difference, Onda. The fact that you would even ask that question raises serious questions in my mind about your grasp of basic accounting principles. I mean, this is sophomore-level stuff. It’s truly basic, about as basic as it gets.
In accounting terms, (a) Unearned Revenues (typically labeled ‘Deferred Revenue’) are on the balance sheet as a liability, and (b) Earned Revenues (usually labeled ‘Revenue’) are on the top line of the income statement. Unearned revenues typically occur when a customer has been billed for goods or services that have have not been delivered to the customer.
Think of it in terms of a law firm. Assume that it sends an invoice to Client A for a $5,000 retainer. The DR/CR for that entry is: DR: Accts. Receivable for $5,000; CR: Deferred (a.k.a. Unearned) Revenue for $5,000. The law firm then receives a check from the client for $5,000. It debits Cash and credits Accts. Receivable.
As the firm provides legal services to the client, Deferred Revenue will be debited (decreased), and Earned Revenue will be credited (increased). In other words, as the liability on the balance sheet goes down (with debits), the top line on the Income Statement goes up (with credits).
I hope I’ve explained this clearly. Please let me know if my explanation makes sense. If there’s anything I said that doesn’t make sense, I’ll be glad to try again.
Good luck. I think you’re going to need it.
Earnings and cash are not the same. If there are large swings in deferred revenue it could be a sign that management is using this line item to manage (or manipulate) its earnings.
I want to apologize to Onda for both the tone and the content I used in my post three days ago in response to his post that ended with “What difference does it make?”
I’m truly sorry, Onda. I wish you all the best. In response to your question, let me just say that it really does make a difference. In my mind, that difference is significant, but reasonable people might not see it that way or feel as strongly about it as I do.
And good luck in pursuing the CFA designation. It’s well worth having. Please don’t hesitate to email me (cfa2005@gmail.com) if there is anything I can do to help you or if you’d like to discuss topics related to accounting, finance, and/or industrial economics. The latter field was Michael Porter’s focus in his doctorate at Harvard almost 50 years ago.
Good luck with the exam, and best regards–
Warren