At a recent ETS session in Princeton, New Jersey, a participant asked whether the year-over-year growth in deferred revenue on the firm’s balance sheet was a positive or a negative trend. After all, deferred revenue is a current liability; many of us have been taught to reduce our own liabilities and personal debts.
The answer to whether growth in a liability is good or bad is, as always, it depends.
At ETS, deferred revenue connected directly to its business operations. Educational Testing Services (ETS) provides many different tests and assessments to its customers, including well-known ones like the SAT and GRE. Typically, people register and pay for a test several weeks or even months before they take it. When they pay to lock in their registration, ETS receives cash. But, because it has yet to deliver the test, those pre-payments get booked as deferred revenues. In other words, the more tests it sells the more the liability on ETS’s balance sheet grows.
Pre-payments remained a liability until the customer took the test. When they did, in conformance with GAAP rules, the deferred revenue converted into actual revenue on ETS’s Statement of Activities (i.e., income statement). GAAP revenue recognition guidelines call for revenue to be recognized (i.e., recorded it on the income statement) when the customer received the actual good or service. In this case, when the person took the test. The situation is similar to buying an airline ticket in advance of your trip: the airline collects your money, but it doesn’t recognize the revenue until you take the flight (i.e., receive the service).
So, growing deferred revenue meant a healthy future revenue stream for the company. As long as the deferred revenue converted to revenue, the growing liability pointed to the business’s success, rather than any problem. The situation, however, could be much different at another business: growing deferred revenue/backlog might indicate the company has fallen behind on deliveries/serving its customers. Hence, the need to understand the nature of the business and ask questions. Doing that will help you decide whether something like deferred revenue growth is, in fact, a positive liability.