Deferral accounting is a type of earnings management in which revenue and expense is recognized in the financial accounts at a later date than when the corresponding cash flow actually occurred.
In other words, deferred accounting delays the recognition of a payment that has already occurred.
How is deferral accounting used?
Used correctly, deferrals improve the accuracy of company accounts. Used incorrectly, deferrals can be a highly effective tool to manipulate accounts to smooth or inflate reported earnings. In fact, it is impossible to understand account manipulation without having a solid grasp of deferred accounting.
We first introduced the concept of deferrals in our discussion of income smoothing, where we noted that deferrals allow companies to match the timing of revenue and expenses with the period in which they are incurred or earned, providing a more accurate representation of financial performance over time.
Under generally accepted accounting principles (GAAP), the purpose of deferred accounting is to ensure that financial statements accurately reflect economic reality.
It is impossible to understand account manipulation without having a solid grasp of deferred accounting
In pursuit of this objective, companies are required to pursue accounting conservatism, meaning a company should report the lowest possible profit. Thus, a company reporting revenue conservatively will only recognize earned revenue when it has completed the tasks required to have full claim to money already paid. Deferrals facilitate this objective.
Deferred revenue
Deferred revenue commonly relates to service contracts that are paid in advance. Insurance is the most commonly quoted example. Software service agreements are another.
Some types of equipment leases are also typically paid in advance, especially in dangerous locations such as oil rigs, mines, construction projects in remote locations; basically, anywhere there is a serious risk of not getting paid.
When a company delays recognition of revenue, it sits on the balance sheet as a liability, usually under the heading of “deferred revenue”. As a company delivers services, deferred revenue is gradually recognized on the income statement to the extent the revenue is "earned."
Categorizing deferred revenue as earned revenue too quickly, or simply bypassing the deferred revenue account altogether and posting it directly to revenue on the income statement, is considered aggressive accounting and effectively overstates sales revenue.
We shall see an example of this momentarily.
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Deferred expense
The concept of deferred expense is much broader than the concept of deferred revenue. All of the items previously listed as deferred revenue represent a deferred expense to the purchaser. However, these items are typically listed as a pre-paid expense in the current assets section of the balance sheet.
Deferred expenses with a service flow lasting more than a year are “capitalized” and sit in the non-current asset section of the balance sheet.
Capitalized costs are depreciated or amortized over time instead of being expensed immediately. This means that the company allocates the cost of the asset over the years during which the asset will be in use, instead of allocating the entire cost to the accounting year in which the asset was purchased.
The list of expenses that can be capitalized is long; including items such as startup costs, the purchase of a new plant or facility, relocation costs, R&D, advertising expenses, debt issuance fees and acquisitions.
Capitalized expense is the ultimate weapon for account manipulation
Capitalized expense sits on the balance sheet as plant & equipment, goodwill or some other kind of intangible asset.
Deferred expense is especially prevalent in the tech and healthcare sectors where intangibles can typically represent more than fifty percent of a company’s balance sheet.
Unless one actually works for a company and understands the specific nature of expenses being incurred, it is virtually impossible to judge whether it should be recognized or a legitimate item to be capitalized. This feature makes capitalized expense is the ultimate weapon for account manipulation.
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Examples of deferrals to manipulate accounts
Almost every major example of accounting fraud involves the heavy use of capitalized expense to understate costs and inflate earnings. Some also improperly post deferred revenue as earned revenue, but the scope for manipulation using deferred costs is usually far greater.
In our discussion of income smoothing, we used the example of Enron which capitalized the costs associated with cancelled projects as assets.
These costs should have been recognized immediately and the capitalized value of the cancelled projects should have been written down to zero. By the time of its demise, Enron had billions worth of cancelled projects that investors believed were still being developed.
This method of capitalizing regular expenses became known as "the snowball" because snowballs grow as they roll down a hill. Similarly, the depreciation cost of excessive expense capitalization grows until it becomes unmanageable.
Short-sellers almost always accuse their targets of snowballing. In a recent example, Jehoshaphat Research accused a Hong Kong tool maker of "stuffing billions of dollars' worth of routine expenses into various asset accounts, year after year."
Short-sellers almost always accuse their targets of snowballing
In a very recent example, a failed software company used both deferred expense and deferred income accounting to manipulate earnings.
On the expense side, the company capitalized all costs associated with the software development process, including salaries of engineers, research expenses, and other overhead costs.
Under GAAP, the cost of software development can only be capitalized if the software is intended specifically for internal use. For example, a bespoke accounting system or a production automation system for an auto factory would be suitable for capitalization.
This company, however, capitalized the development cost of software it intended to sell to customers. Needless to say, this practice made the company appear vastly more profitable than it really was.
Meanwhile, the company secured a material contract from a major company that would generate significant long-term revenue. Instead of recognizing the revenue proportionately over the contract's life, they accelerated the recognition, recording the full amount of revenue upfront.
Thus, this company improperly pushed revenue recognition forward while delaying the recognition of expenses. By doing so, the company looked remarkably profitable.
Unfortunately for the company, however, the major order fell through and the company was forced to come clean and recognize the loss. Realizing the accounting shenanigans, the company soon ran into problems raising capital. It needed capital because in reality the company ran at a loss and needed cash.
When the flow of capital ceased, the company failed.
