I am at the moment valuing Activision Blizzard using the methodology of the book “Valuation: Measuring and managing the value of companies” by McKinsey.
In the statements of the company there is an item named “deferred cost of revenues” under “other current assets” in the balance sheet.
I wanted to ask what does this item represent since I cannot find an answer on google. Also, do you think that the deferred cost of revenues is a operational or nonoperational item?
First is not named “deferred cost of revenues” than “deferred cost or accrued revenue” if is shown on Asset part of BS.
This item may represent miscellaneous operating costs for services purchased and paid within period but referred to future period consuming (eg. paid insurance premiums, subscription fees, other fees paid upfront etc).
If is accrued revenue, it is related to services delivered and referred to period but which will be invoiced and paid in the future period (eg. delivered auditing, accounting services, etc).
Both are related to operating result and due to cost and revenues matching within period, a fundamental accounting assumption.
It will help if you would provide some additional information about this company, sector or similar info.
This company operates within the video game industry.
This is what is written in the most recent 10-K in a footnote:
"Included in “Other current assets” of our consolidated balance sheets are deferred cost of revenues of $186 million and $216 million at December 31, 2016 and 2015 respectively.
I tried to search more info on this item in the 10-K but had no success.
Also, within “Other current assets”, I was able to find foreign currency forward contracts (which I consider nonoperational) and intellectual property licenses (which I am not sure if I should consider this item operational or nonoperational).
I think is the typing error, should be deferred costs or accrued revenue.
If is Video gaming industry, may be some subscription based operating costs. I suggest take previous 1 or 2 years back balance sheet than try to analyze trending on this position. Anyway, during next period or two, partially should be shown in P/L like amortization.
Look out, if currency forwards are used solely as hedge of operating cash flow, it will be shown on generic position, under operating assets. If are used for speculation, should be short term financial asset and financial G/L.
The purpose of the foreign currency forward contracts is to hedge foreign currency risk. Should I consider it as an “operational asset” since the company transacts business in various foreign currencies all over the world?
Correct. Hedge instrument should be considered as part of operating activity if is the hedge of operating earnings and operating cash flow its only purpose. This is required by GAAP.
I searched the previous year 10-K (2015) and I found that the “deferred cost of revenues” is substituted by “deferred cost of sales-product costs” so it is definitely a typo just like you said.
According to the 10-K product costs are:
Product costs -includes the manufacturing costs of goods produced and sold. These generally include product costs, manufacturing royalties, personnel-related costs, warehousing and distribution costs.
Given this information, I think this should be considered an “operational asset”, don´t you agree?
Also, what is your opinion about intellectual property licenses? Should they be considered an “operational asset”? According to the latest 10-K “Intellectual property licenses costs represent fees paid to intellectual property rights holders for use of their trademarks, copyrights, software, technology, music or other in the development of our products.”
Prepaid COGS given description in 10-K should be prepaid licenses, renting costs and similar input costs in video gaming production. Since they should be matched with revenues upon sold products, they are deferred.
It is dependent on economic purpose of paid license costs in software industry. It may be treated as intangible asset under assumption of long term economic benefits. Otherwise may be a part of periodical operating costs in production process. What matters is consistency of accounting policies for same positions.
This is standard practice required by GAAPs. If they have process lasting more than one financial period they cutoff periodical production costs to match revenue from sale within same period. If they would not take such action, they would have overestimated costs in one period and overestimated Sales in another.
Yeah, based on the description these are expenditures that the company has already incurred but has decided to capitalize on the Balance Sheet rather than expense through the Income Statement. Presumably, they will release these into the Income Statement when the company performs some revenue-related activity for its customers.
If it is a material amount, I would expect the company to disclose some information on what they are deferring and the rationale behind it. If they don’t, it is a signal of perhaps poor financial reporting and the analyst should take that into consideration. This is a ripe area for accounting disagreements.
If you are curious about high-level accounting principles, check out US GAAP’s “Conceptual Framework”. This principle is called “the matching principle”.
I don’t know for US companies but that’s 100 % normal in Europe. There is no entity with no deferred position which is used for cutoff expenses/revenues within periods. However, this may or may not be the red flag for misreporting and or financial fraud. I would advice examine few annual periods BS and P/L and follow balance trending on such positions.
Flashy, I don’t think this line is related to a cutoff like with accrued revenue or accrued expenses. They are capitalizing expenditures already incurred. I browsed through their “summary of significant accounting polices” and didn’t see anything on this (admittedly, I ran through it pretty quick). However, the amounts recognized in their Cost of Revenues sections appear to involve significant management judgment. I’d say this line in question is the same thing.
I don’t know anything about this company or industry norms here, but these types of capitalizations catch my eye. For a cautionary tale google “AOL deferred subscriber costs”.
