MACRO RESEARCH
Accounting & Tax Policy
Portfolio Strategy
Quantitative Analysis
April 24, 2015
ACCOUNTING CASH FLOW TOP 10: DEFERRED REVENUES & CASH ADVANCES

This is the sixth report on the Top 10 accounting items to watch when analyzing cash flows. Over the
coming weeks, we will publish a new topic each Friday. Given significant GAAP and management
latitude in policy decisions, investors cannot simply take reported cash flows at face value. Often
overlooked, we believe proper analysis of cash flow is imperative when comparing common metrics
such as free cash flow yields, cash flow conversion, cash flow growth, and “cash” earnings across
companies. The topics of previous reports include (click for links): Income Taxes, Receivables Sales
& Securitizations, Pension Contributions, Cost Capitalization and Accounts Payable and Accrued
Expenses. This week, we examine how deferred revenues impact reported cash flows and financial
ratios.

Deferred Revenue and Cash Advances Enable Cash Flow Management. While cash received
upfront from customers is generally a positive development for companies, it does open the door to
comparability issues and potential reported cash flow manipulation. An increase in cash received in
advance boosts current period cash flows, but may cause future cash flow headwinds unless the
company maintains and grows the accelerated cash receipts. Business model changes, such as
moving from 1 year pre-paid contracts to 2 year pre-paid contracts will also result in a one-time cash
flow tailwind that may paint a more optimistic picture than reality.

Warning Signals from Changes in Deferred Revenue. When cash is received before revenue is
recorded, a deferred “unearned” liability is recorded on the balance sheet. Changes in the deferred
revenue balance should be investigated as to the cause, as declines in deferred revenues may be
indicative of more aggressive revenue recognition. As a detection metric, we find days’ deferred
revenue ratio most useful. To be sure, any accelerated cash receipt will provide a pool of resources
from which to potentially manage earnings.
Chris Senyek, CFA, CPA
Adam Calingasan, CFA, CPA
Chip Miller, CFA, CPA
(646) 845-0759
csenyek@wolferesearch.com
(646) 845-0757
acalingasan@wolferesearch.com
(646) 845-0752
cmiller@wolferesearch.com
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disclosures.
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Accounting & Tax Policy
Page 1 of 4
DEFERRED REVENUE ENABLES CASH FLOW MANAGEMENT
It’s hard to argue that receiving a cash payment from a customer is anything but a positive event.
However, the receipt of cash before revenue is recognized can enable both cash flow and earnings
management. Under accrual basis accounting, revenue is recognized in the income statement when
realized and earned. When cash is received prior to revenue recognition, a deferred revenue liability
is recorded on the balance sheet representing a future obligation to provide goods or services.
However, there is no free lunch. The early receipt of cash increases current operating cash flow, but
usually to the detriment of future operating cash flows. As revenue is recognized over time and,
absent additions to the deferred revenue account of an equal or greater amount, cash flow from
operations is reduced from the decrease in the deferred revenue liability account.
Many examples of this accelerated cash receipt occur in areas where there is a longer time horizon,
such as subscription software or a long-term supply agreement. The recording of the deferred
revenue account is shown as an operating cash inflow in the current period. If greater than one
period’s cash flows have been collected on an accelerated basis, a cash flow headwind will occur in
future periods.
Other examples of ‘front-loading’ cash include scenarios where a company requires cash deposits,
encourages customers to pay in advance, or lengthens the duration of certain contracts. Consider an
example of a subscription license that is fully paid up-front. If the company begins switching
customers to minimum two year contracts from one-year contracts, reported cash flow would appear
to be growing. However, the increase in cash flow would be solely due to changes in the contractual
term, not the volume of subscriptions sold.
Deferred revenue may take on different monikers and caution should be used when forecasting the
cash flow of companies with the flexibility to receive large up-front cash payments under contracts.
Below we use CA Technologies as an example: after a $97 million tailwind in 2012, a decline in
deferred revenue balance resulted in two consecutive years of cash flow headwinds in ‘13 and ‘14.
CA Technologies: Deferred Revenues Impact on Operating Cash Flow
Year Ended March 31,
(in millions)
Operating activities from continuing operations:
Net income
Income from discontinued operations
Income from continuing operations
Adjustments to reconcile income from continuing operations to net
cash provided by operating activities:
Depreciation and amortization
Deferred income taxes
Provision for bad debts
Share-based compensation expense
Asset impairments and other non-cash items
Foreign currency transaction losses
Changes in other operating assets and liabilities, net of effect of
acquisitions:
Decrease (increase) in trade accounts receivable
(Decrease) increase in deferred revenue
Decrease in taxes payable, net
Increase in accounts payable, accrued expenses and other
2014
2013
2012
914
(15)
899
955
(16)
939
951
(28)
923
426
(69)
7
82
10
10
475
13
7
78
12
16
399
(16)
(1)
89
20
8
42
(103)
(331)
82
35
(128)
(56)
6
(45)
97
(46)
6
(Decrease) increase in accrued salaries, wages and commissions
Changes in other operating assets and liabilities
(28)
(30)
(42)
35
58
(4)
Net cash provided by operating activities - continuing operations
997
1,390
1,488
Source: Wolfe Research Accounting & Tax Policy Research; Company filings.
WolfeResearch.com
Accounting & Tax Policy
Page 2 of 4
April 24, 2015
BENEATH THE SURFACE: CHANGES IN DEFERRED REVENUES MAY HAVE VARIED CAUSES
INCREASES IN DEFERRED REVENUES MAY NOT IMPROVE OPERATING CASH FLOW
Operating cash flow is not always improved when the deferred revenue liability increases. Let’s
assume a company ships inventory to a distributor but is not permitted to recognize revenue under
GAAP due to a right of return. Further assume that the inventory remains on the books on the selling
company. Assuming the company bills the customer when the inventory is shipped, the company
might record an increase to accounts receivable and an increase to a deferred revenue liability. Since
presumably no cash is collected, the cash inflow from the increase in the deferred revenue liability
would offset the cash outflow from the increase in accounts receivable.
There would be no improvement to operating cash flow from recording this type of deferred revenue
transaction unless the receivable was also collected in the same period. Although this does not seem
to be a preferable practice, analysts should review a company’s revenue recognition and billing
policies for potential differences among companies.
WATCH FOR DECLINING DEFERRED REVENUES – AGGRESSIVE REVENUE RECOGNITION?
A deferred revenue balance may be used for improper revenue recognition or to mask slowing
revenue growth. GAAP requires a deferred revenue liability to be recorded in situations where cash is
received prior to when revenue is allowed to be recognized.
For an ongoing business with growing sales, the deferred revenue liability should also grow each
period and be a source of cash in operating cash flow. The deferred revenue represents a pool of
future revenue. As an earnings management technique, a company may change how deferred
revenue is recognized or improperly draw down from this account. Therefore, we review this account
for material year-over-year and sequential declines, focusing on a “days deferred revenue” metric
similar to DSOs. It is calculated as the total deferred revenue divided by sales (annualized if
quarterly) multiplied by 365 days. A declining ratio may suggest a move to a more aggressive
revenue recognition policy, a slowing overall business, or a change in policy. Below, we show how
ProQuest’s decline in deferred revenue appeared to signal a forthcoming accounting issue.
One issue related to the restatement was the sale of products to educational institutions over a
subscription based period. The company’s deferred revenue account was understated as the
company prematurely recognized revenue from the sale of its software and learning products. As
shown in the exhibit below, one warning sign of this was the continued decline in the company’s days
deferred revenue ratio in 2004 and early 2005. This suggested that the company was managing the
deferred revenue account to inflate earnings.
ProQuest: Calculation of Short and Long Term Days Deferred Revenue
Decline in days
deferred rev.
was indicative
of aggressive
revenue rec.
Short term days deferred revenue
Long term days deferred revenue
Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005
87
111
89
76
52
59
38
37
26
23
17
13
Source: Wolfe Research Accounting & Tax Policy Research; Standard & Poor’s; Company filings.
WolfeResearch.com
Accounting & Tax Policy
Page 3 of 4
April 24, 2015
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April 24, 2015