Conservative Today, Aggressive Tomorrow

The Wall Street Journal (October 26, 2016) reported on Apple: “Profits, though down from 2015, were actually bolstered by a decrease in deferred revenue compared to a year ago. That’s because the decrease in deferred revenues increased operating margins and hence profits for 2016. … Deferred revenue is accounted for as a liability on a company’s balance sheet because it represents the estimated costs a company expects to pay to provide future updates or services, which should be recorded against the revenue Apple books when it sells a device…. ‘What Apple did was basically lower a liability that has the effect of increasing revenue…’”

Deferred revenue is a conservative accounting procedure, which decreases current revenue and income, shifting revenues to future periods. Conservatism is endemic to accounting. It tends to decrease current revenue/income as well as asset values. Writing off immediately intangible investments (R&D, brand enhancement, IT expenditures), restructuring costs, or assets and goodwill write-downs (but not write-ups), are all conservative accounting procedures, decreasing current earnings and asset values. They are generally justified as countering executives’ alleged natural tendency to inflate, or hype earnings. A good thing, say accountants.

What accounting regulators ignore, or don’t understand is that any conservative procedure reduces earnings today but necessarily inflates future earnings, like the Apple’s case opening this article. There is no “conservatism forever.” Since long-term reported earnings equal cash flows, if current earnings are reduced by conservative accounting procedures, future earnings must be inflated. If the costs of a drug’s development are immediately expensed, the future revenues of this drug will be reported without the development costs, thereby inflating income. Same with all other accounting conservative procedures. Fully accounting for all expected restructuring costs today means that future restructuring benefits will be reported without costs, thereby inflating earnings.

Conservative accounting is, of course, an invitation to earnings manipulation. In good times, substantial revenues can be deferred, and when needed in leaner future periods, such deferred revenues will be reversed to increase reported revenues and earnings. During periods of losses, when companies often restructure operations, restructuring costs (expected employee layoffs, closing operations) can be exaggerated, only to reverse these costs to earnings in future periods. Endless manipulation possibilities created by the “good intentions” of conservative accounting.

The lesson for investors: Be wary of reversals of past revenue deferments or reversals of restructuring/write-offs. These additions to earnings don’t say anything about future profitability, and to the extent that investors can identify them from footnote disclosure, they should be ignored (deducted from reported earnings).

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