An accounting question.

[WeiChiLoh]

Hey guys,

 

I have hit an accounting roadblock that I can't seem to get my head around. Can someone help?

 

If we have a company that provide long term services to customers (say 3 or 10 years) which are paid upfront in cash, but recognize the revenue and incur expenses ratably over the life of the services....how should one think about the cash balance? Say the company operates in a 90% tax regime (always good to push theory to the limit to test it).

 

I would think the EV of the company is artificially low because that cash in the balance sheet is needed in the future for expenses and tax outflow. If the company has a 100% margin...dont we have to cut that cash balance by 90% (tax) as that cash is not actually excess and is required?

 

How would it impact the 3 statements? Is it sort of like an off balance sheet liability?

 

I would really appreciate some insights as there is this company that has such a characteristic and I can't seem to crack it.

[thepupil]

You talking about STON?

[jawn619]

Hey guys,

 

I have hit an accounting roadblock that I can't seem to get my head around. Can someone help?

 

If we have a company that provide long term services to customers (say 3 or 10 years) which are paid upfront in cash, but recognize the revenue and incur expenses ratably over the life of the services....how should one think about the cash balance? Say the company operates in a 90% tax regime (always good to push theory to the limit to test it).

 

I would think the EV of the company is artificially low because that cash in the balance sheet is needed in the future for expenses and tax outflow. If the company has a 100% margin...dont we have to cut that cash balance by 90% (tax) as that cash is not actually excess and is required?

 

How would it impact the 3 statements? Is it sort of like an off balance sheet liability?

 

I would really appreciate some insights as there is this company that has such a characteristic and I can't seem to crack it.

 

I think about it like this. I count cash collected as real cash. The company can spend it or do whatever it wants with it. Then when I look at deferred revenue, I almost ignore it. While it is a liability because the future services are owed to the customer, It's not like debt where it has to be paid off with cash. Owing services and owing interest and principal are very different. For example, take Rosetta stone. It has deferred revenue from it's software and recognizes the revenues with the memberships expiring. If the company you're talking about isn't as asset light as a software company and has service contracts that require expenses, i would probably adjust for future earnings to be lower to account for the added costs required to provide the owed services. Either way, cash up front is great for the business.

[WeiChiLoh]

Hey guys,

 

I have hit an accounting roadblock that I can't seem to get my head around. Can someone help?

 

If we have a company that provide long term services to customers (say 3 or 10 years) which are paid upfront in cash, but recognize the revenue and incur expenses ratably over the life of the services....how should one think about the cash balance? Say the company operates in a 90% tax regime (always good to push theory to the limit to test it).

 

I would think the EV of the company is artificially low because that cash in the balance sheet is needed in the future for expenses and tax outflow. If the company has a 100% margin...dont we have to cut that cash balance by 90% (tax) as that cash is not actually excess and is required?

 

How would it impact the 3 statements? Is it sort of like an off balance sheet liability?

 

I would really appreciate some insights as there is this company that has such a characteristic and I can't seem to crack it.

 

I think about it like this. I count cash collected as real cash. The company can spend it or do whatever it wants with it. Then when I look at deferred revenue, I almost ignore it. While it is a liability because the future services are owed to the customer, It's not like debt where it has to be paid off with cash. Owing services and owing interest and principal are very different. For example, take Rosetta stone. It has deferred revenue from it's software and recognizes the revenues with the memberships expiring. If the company you're talking about isn't as asset light as a software company and has service contracts that require expenses, i would probably adjust for future earnings to be lower to account for the added costs required to provide the owed services. Either way, cash up front is great for the business.

 

Yes I agree it is good because negative WC yeah yeah....but what if this is a company in liquidation. Market cap is $50m but has $100m in cash...also has $100m in deferred revenue that is has to recognize....say that $100m in deferred revenue will hit the income statement next year...and the company has a 50% EBT and 40% tax rate....dont this mean the company will have a cash outflow of $50m (expenses) and $20m (tax outflow)? So the true cash balance is actually $30m..

 

Am I thinking about this right?

[WeiChiLoh]

Hey guys,

 

I have hit an accounting roadblock that I can't seem to get my head around. Can someone help?

 

If we have a company that provide long term services to customers (say 3 or 10 years) which are paid upfront in cash, but recognize the revenue and incur expenses ratably over the life of the services....how should one think about the cash balance? Say the company operates in a 90% tax regime (always good to push theory to the limit to test it).

 

I would think the EV of the company is artificially low because that cash in the balance sheet is needed in the future for expenses and tax outflow. If the company has a 100% margin...dont we have to cut that cash balance by 90% (tax) as that cash is not actually excess and is required?

 

How would it impact the 3 statements? Is it sort of like an off balance sheet liability?

 

I would really appreciate some insights as there is this company that has such a characteristic and I can't seem to crack it.

 

I think about it like this. I count cash collected as real cash. The company can spend it or do whatever it wants with it. Then when I look at deferred revenue, I almost ignore it. While it is a liability because the future services are owed to the customer, It's not like debt where it has to be paid off with cash. Owing services and owing interest and principal are very different. For example, take Rosetta stone. It has deferred revenue from it's software and recognizes the revenues with the memberships expiring. If the company you're talking about isn't as asset light as a software company and has service contracts that require expenses, i would probably adjust for future earnings to be lower to account for the added costs required to provide the owed services. Either way, cash up front is great for the business.

 

Yes I agree it is good because negative WC yeah yeah....but what if this is a company in liquidation. Market cap is $50m but has $100m in cash...also has $100m in deferred revenue that is has to recognize....say that $100m in deferred revenue will hit the income statement next year...and the company has a 50% EBT and 40% tax rate....dont this mean the company will have a cash outflow of $50m (expenses) and $20m (tax outflow)? So the true cash balance is actually $30m..

 

Am I thinking about this right?

 

Assuming no non-cash expense of course.

[WeiChiLoh]

You talking about STON?

 

Well...not exactly the same...the company i am looking at has a finite life. But i am looking at STON as a potential short though...but the yield scares me.

[petec]

WeiChiLoh I think you are thinking about it right and I would focus hard on how known the expenses are.  If they are locked in then your reduced cash balance can be counted upon, but if they are liable to change (and the change can't be passed through to the customer somehow) then those changes will have a big impact on the value of the company.

[Patmo]

Hey guys,

 

I have hit an accounting roadblock that I can't seem to get my head around. Can someone help?

 

If we have a company that provide long term services to customers (say 3 or 10 years) which are paid upfront in cash, but recognize the revenue and incur expenses ratably over the life of the services....how should one think about the cash balance? Say the company operates in a 90% tax regime (always good to push theory to the limit to test it).

 

I would think the EV of the company is artificially low because that cash in the balance sheet is needed in the future for expenses and tax outflow. If the company has a 100% margin...dont we have to cut that cash balance by 90% (tax) as that cash is not actually excess and is required?

 

How would it impact the 3 statements? Is it sort of like an off balance sheet liability?

 

I would really appreciate some insights as there is this company that has such a characteristic and I can't seem to crack it.

 

I think about it like this. I count cash collected as real cash. The company can spend it or do whatever it wants with it. Then when I look at deferred revenue, I almost ignore it. While it is a liability because the future services are owed to the customer, It's not like debt where it has to be paid off with cash. Owing services and owing interest and principal are very different. For example, take Rosetta stone. It has deferred revenue from it's software and recognizes the revenues with the memberships expiring. If the company you're talking about isn't as asset light as a software company and has service contracts that require expenses, i would probably adjust for future earnings to be lower to account for the added costs required to provide the owed services. Either way, cash up front is great for the business.

 

For fair comparison wouldn't you have to also adjust your denominator to add the revs and remove the exps that this cash will incur? Otherwise it's like comparing apples to oranges, kind of like comparing EV to NI. It would get pretty complex when you can just add back unearned revs to your EV and call it a day, no?

 

Then you would have to also treat prepaid expenses in opposite fashion, I guess? Probably not, for conservatism purposes?

 

[wondering]

To me it would depend on whether the deferred revenues are repeating or not.  If they are constantly repeating year over year, I see no reason to treat cash as any differently as any other company.  If it is a one-time revenue event, then cash obvious should be treated differently.  An analysis of the net cashflows (without the deferred revenue) would have to be done. 

 

Perhaps I have stated the extremely obvious and my comments are of no help. ;D ;D

[mcliu]

Given that the company is in liquidation, I think your thinking is correct. You've basically collected the $100 million upfront, but have not earned it yet. The true cash flows would be the $100 million net of the costs that would be incurred to provide the good or service to the customer. The current cash balance is likely much lower since you would be earning it over the next few years.

[WeiChiLoh]

Thank you very much for your reply. How about the tax impact? does it occur ratably or will it be upon receipt of cash...the latter doesn't make sense to me as the cost position is still an uncertainty...

 

Given that the company is in liquidation, I think your thinking is correct. You've basically collected the $100 million upfront, but have not earned it yet. The true cash flows would be the $100 million net of the costs that would be incurred to provide the good or service to the customer. The current cash balance is likely much lower since you would be earning it over the next few years.

[mcliu]

I think the tax paid would be the same as any other company in that jurisdiction. What you should see is the deferred revenue balance shrinking as the amount is earned and booked into the income statement as revenue with accompanying expenses. The tax should be based on the earned income of the year adjusted for whatever tax accrual/deferrals..

[SharperDingaan]

Hate to tell you this but the cash is restricted, & any residual has to be returned to the payer as the underlying services were not performed.

 

Identical to selling goods on consignment; in the event of a liquidation the consignors get the option of either taking their stock back or dumping it alongside the liquidation of the BKs stock. In this case the consigned goods are cash, & the consignee will be taking it back. Deduct it from the BS & reduce equity.

 

SD