Adjusted deferred revenue

What Is Adjusted Deferred Revenue?

Adjusted deferred revenue refers to the reported deferred revenue figure, often modified by analysts or companies to provide a more insightful view into a company's financial performance, particularly within the realm of financial accounting. Deferred revenue, also known as unearned revenue, represents payments received for goods or services that have not yet been delivered or rendered. It is recorded as a liability on a company's balance sheet under accrual accounting principles. Adjustments might be made to account for specific business models, non-recurring items, or to better align the figure with an entity's future revenue potential.

History and Origin

The concept of deferred revenue has long been a fundamental aspect of accounting to match revenues with the period in which the goods or services are delivered, rather than when cash is received. However, the uniformity and disclosure surrounding how companies recognize revenue, and thus how deferred revenue is presented, significantly evolved with the introduction of new accounting standards.

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued converged standards on revenue recognition: ASC 606 in US GAAP and IFRS 15 in IFRS. These new standards replaced much of the previous industry-specific guidance with a five-step model for recognizing revenue from contracts with customers. The aim was to provide a more robust framework and improve comparability across entities and industries globally. These standards, effective for public business entities for annual periods beginning after December 15, 2017, significantly impacted how companies identify contracts, performance obligations, transaction prices, and how they allocate and recognize revenue over time or at a point in time.⁹, ¹⁰ The implementation of these standards brought greater scrutiny to the timing and classification of deferred revenue.⁸

Key Takeaways

• Adjusted deferred revenue offers a refined perspective on a company's future revenue prospects beyond the raw accounting figure.
• It is particularly relevant for subscription-based businesses, where upfront payments for services delivered over time are common.
• Understanding adjusted deferred revenue helps stakeholders assess a company's true financial health and growth trajectory.
• Adjustments often aim to provide a clearer picture of predictable future income and enhance forecasting accuracy.

Formula and Calculation

Adjusted deferred revenue does not have a single, universally mandated formula, as the "adjustment" is often specific to the analytical needs or the company's non-GAAP reporting. However, it generally starts with the reported deferred revenue and then incorporates specific modifications.

A conceptual formula for adjusted deferred revenue might look like this:

Where:

• Reported Deferred Revenue: The amount of unearned revenue shown as a liability on the balance sheet.
• Specific Adjustments: These could include:
  • Additions for unrecognized contractual backlog: Future revenue from signed contracts that may not yet meet the criteria for standard deferred revenue but represent committed future income.
  • Deductions for estimated cancellations or churn: An analytical reduction based on historical rates of contract cancellations, particularly relevant for subscription businesses.
  • Adjustments for unique revenue streams: Modifying for specific contract terms or multi-element arrangements that might distort the core recurring revenue picture.
  • Exclusions of one-time advance payments: Removing prepayments for non-recurring services to focus on sustainable revenue streams.

These adjustments are often part of a company's non-GAAP financial statements or an analyst's internal financial analysis to gain deeper insights into business operations.

Interpreting the Adjusted Deferred Revenue

Interpreting adjusted deferred revenue requires an understanding of the specific adjustments made and the context of the business. For companies with subscription models, a consistent increase in deferred revenue, even before adjustments, typically signals strong customer commitment and predictable future income.⁷ When adjustments are applied, they are intended to provide a more normalized or forward-looking perspective.

For instance, if analysts adjust deferred revenue upwards by including confirmed, but not yet invoiced, contractual commitments, it can indicate a stronger pipeline than the raw figure suggests. Conversely, if adjustments are made for expected churn in a volatile market, the adjusted figure may offer a more conservative and realistic view of the revenue likely to be recognized. Evaluating adjusted deferred revenue often involves comparing it against previous periods or industry benchmarks to identify trends and assess business momentum. This figure serves as a key component for various performance indicators used in financial modeling.

Hypothetical Example

Consider "CloudSolutions Inc.", a hypothetical Software-as-a-Service (SaaS) company. At the end of its fiscal year, CloudSolutions reports a deferred revenue of $10 million on its balance sheet. This represents annual subscriptions paid upfront by customers but not yet fully earned.

However, CloudSolutions' internal finance team believes this figure doesn't fully capture its future revenue potential because of the following:

1. Unbilled Contracted Revenue: CloudSolutions has signed new enterprise contracts totaling $2 million that start next quarter. While these haven't been invoiced or paid yet (so they aren't in deferred revenue), they are firm commitments.
2. Historical Churn Adjustment: Based on historical data, CloudSolutions anticipates about 5% of its deferred revenue from smaller clients might not convert into recognized revenue due to early cancellations. This amounts to $0.5 million (5% of $10 million).

To calculate "Adjusted Deferred Revenue" for internal analytical purposes, CloudSolutions would perform the following:

Reported Deferred Revenue: $10,000,000
Add: Unbilled Contracted Revenue: +$2,000,000
Subtract: Estimated Churn Adjustment: -$500,000

Adjusted Deferred Revenue = $10,000,000 + $2,000,000 - $500,000 = $11,500,000

This adjusted deferred revenue figure of $11.5 million provides CloudSolutions' management with a more comprehensive view of its future committed revenue, aiding in strategic planning and resource allocation, rather than solely relying on the GAAP-reported deferred revenue which would eventually convert to the income statement.

Practical Applications

Adjusted deferred revenue has several practical applications in financial analysis and strategic decision-making:

• Forecasting and Planning: For businesses with subscription or long-term service models, adjusted deferred revenue provides a more robust basis for cash flow projections and revenue forecasting. It helps management anticipate future financial resources and obligations.⁶
• Investor Confidence and Valuation: Companies often highlight their deferred revenue backlog to demonstrate future revenue visibility and recurring income, which can significantly enhance investor confidence. Adjusted figures, when transparently explained, can further strengthen this narrative, particularly for growth-focused investors.⁵
• Operational Management: By understanding the adjusted deferred revenue, companies can better allocate resources, plan capacity, and manage service delivery to ensure timely conversion of deferred revenue into recognized revenue. For SaaS companies, maintaining a healthy balance between deferred and recognized revenue is crucial.⁴
• Mergers and Acquisitions (M&A) Analysis: In M&A deals, potential acquirers analyze adjusted deferred revenue to gain a clearer picture of the target company's sustainable revenue base and future growth potential, often factoring in assumptions about customer retention and contract renewals.

Limitations and Criticisms

While useful, adjusted deferred revenue also comes with limitations and potential criticisms:

• Non-Standardization: Unlike standard GAAP or IFRS figures, "adjusted" deferred revenue is a non-standard metric. The nature and extent of adjustments can vary widely between companies or even within the same company over different periods. This lack of standardization can make cross-company comparisons challenging.
• Potential for Manipulation: Since the adjustments are not dictated by stringent accounting rules, there is a risk that companies might manipulate these figures to present a more favorable picture of their financial health, especially when used as non-GAAP measures without sufficient disclosure.³ Regulators, such as the SEC, have often scrutinized non-GAAP financial measures to ensure they are not misleading.²
• Assumptions and Estimates: Any adjustments based on future events, like estimated churn rates or contractual backlogs, rely on significant assumptions and estimates. If these underlying assumptions prove inaccurate, the adjusted deferred revenue figure could be misleading. The CFA Institute has highlighted concerns about the reliability of alternative performance measures due to issues like inconsistent definitions and questionable reliability.¹
• Focus on Quantity over Quality: A high adjusted deferred revenue balance, while indicating future commitments, does not inherently guarantee profitability or efficient service delivery. It's crucial to also assess a company's ability to fulfill its obligations profitably.

Adjusted Deferred Revenue vs. Deferred Revenue

The primary distinction between adjusted deferred revenue and standard deferred revenue lies in the purpose and presentation of the figure.

While deferred revenue is a fundamental financial accounting liability representing unearned income, adjusted deferred revenue is an analytical enhancement designed to offer deeper insights into a company's operational performance and future revenue pipeline, particularly in business models reliant on upfront payments.

FAQs

Why is adjusted deferred revenue important for subscription businesses?

Adjusted deferred revenue is crucial for subscription businesses because they often receive payments upfront for services delivered over a period. This adjustment helps provide a clearer picture of the actual contracted revenue that is expected to convert, accounting for factors like potential customer cancellations or additional confirmed contracts, which may not yet be in the standard deferred revenue balance.

Is adjusted deferred revenue a GAAP measure?

No, adjusted deferred revenue is generally not a Generally Accepted Accounting Principles (GAAP) measure. It is typically a non-GAAP financial metric or an internal analytical figure used by companies or analysts to gain a more tailored understanding of a company's future revenue potential, beyond what is strictly mandated by accounting standards.

How does adjusted deferred revenue relate to a company's cash flow?

While deferred revenue itself represents cash already received by the company, adjusted deferred revenue helps in forecasting future cash flow by providing a more refined estimate of revenue likely to be earned. This improved forecast supports better financial planning and management of a company's liquidity.

Can adjusted deferred revenue be negative?

No, standard deferred revenue, and by extension, adjusted deferred revenue, cannot be negative. Deferred revenue represents a liability, an obligation to deliver goods or services for which payment has already been received. Adjustments typically modify the positive balance of deferred revenue, either increasing or decreasing it based on specific analytical criteria, but they would not result in a negative liability.