Deferred Revenues and the Matching of Revenues and Expenses

Posted: 15 Dec 2008 Last revised: 24 Dec 2013

See all articles by Rachna Prakash

Rachna Prakash

University of Mississippi - Patterson School of Accountancy

Nishi Sinha

Analysis Group

Date Written: December 14, 2011

Abstract

An increase in the complexity of firms’ contracts with customers, combined with changes in reporting regulations, has resulted in a substantial increase in revenue deferrals in recent years. Between 2002 and 2009, each year nearly forty percent of industrial firms on COMPUSTAT reported a deferred revenue liability, with the liability averaging at least ten percent of sales revenue. This study examines the implications of revenue deferrals for firms’ financial statements, equity values, and for analysts’ forecasts of sales and earnings. When revenues are deferred but some of the associated expenses are recognized as incurred, revenue deferrals depress current margins and improve margins in the period in which revenue is recognized. Analysis in this paper shows that the deferral of revenues without the capitalization of associated costs adversely affects earnings predictability, which, in turn, results in significant errors in analyst forecasts of both sales and margins and in mispriced securities. The results show that market participants use current sales and margins to predict future earnings without making adequate adjustments for the fact that revenue deferrals depress current sales and margins and inflate future sales and margins. Therefore, when revenue deferrals increase, analysts underestimate future earnings and investors undervalue the firm. Conversely, when revenue deferrals decrease, analysts overestimate future earnings and investors overvalue the firm.

Keywords: Revenue Recognition, Deferred Revenues, Cost Capitalization, Matching, Analyst Forecasts, Mispricing

JEL Classification: M41, M44, G14

Suggested Citation

Prakash, Rachna and Sinha, Nishi, Deferred Revenues and the Matching of Revenues and Expenses (December 14, 2011). Contemporary Accounting Research, 2013, Vol. 30 (2) : 517-548. Available at SSRN: https://ssrn.com/abstract=1316286 or http://dx.doi.org/10.2139/ssrn.1316286

Rachna Prakash

University of Mississippi - Patterson School of Accountancy ( email )

200 Conner Hall
University, MS 38677
United States

Nishi Sinha (Contact Author)

Analysis Group ( email )

111 Huntington Avenue
10th floor
Boston, MA 02199
United States
2025502040 (Phone)

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