Deferred Revenue Accounting

D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E 23 DETC OCCASIONAL PAPER
Deferred
Revenue
Accounting
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
DETC OCCASIONAL PAPER
NUMBER 23
Deferred Revenue Accounting
by
Mr. Walter Miller, CPA, Director of Finance, College of the
Humanities and Sciences Harrison Middleton University
Published by the Distance Education and Training Council
1601 18th Street, NW, Washington, D.C.20009
202-234-5100; fax: 202-332-1386; www.detc.org
July 2005
DETC OCCASIONAL PAPERS are essays intended to stimulate and encourage
candid exchanges of ideas between distance study professionals. For a complete set
of Occasional Papers, write or call the DETC.
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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Introduction
The Accreditation Standards of the DETC require that an institution be
financially able to deliver high quality instruction and educational
services.1 When evaluating this standard, the Accrediting Commission
uses comparative financial statements from the institution prepared
using the accrual method of accounting in conformity with generally
accepted accounting principles. One specific area evaluated in the Self-
Evaluation Report (SER) is the reserves kept for honoring future service
obligations, bad debts, and refunds.2
Reserves
When dealing with reserves, financial statements presented according to
generally accepted accounting principles (GAAP), and demonstrated
operations, you encounter several elements that need to be addressed.
These elements have a financial statement impact and, for those schools
which are for-profit, an income tax impact. These elements are:
• Reserve for bad debts – this is an estimated amount of the school’s
accounts receivable (usually tuition) that will not be received in the
future.
• Actual bad debts – these are the actual accounts receivable that the
school has determined will not be paid and have no further remedies
that will or can be pursued for collection.
• Reserve for unearned income – this represents the amount of tuition
the student has paid or signed a contract for which the school has
not earned the right to keep.
• Refund reserve – this represents the obligation the school has to
repay money received from a student calculated on the DETC
minimum standards.
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• Reserve for future services – this represents an estimate of the cost
to provide services the school is contractually obligated to perform
based on tuition that has been received and is not subject to refund.
• Accrual of tuition income – this represents services that have been
provided to students but have not been paid by the students.
• Accrual of expenses – this represents expenses that have been
incurred for services to students where the expenses have not been
paid.
In order to demonstrate that it has a sound and financially responsible
operation, an institution accredited by the DETC must adequately
address each of the items above.
Reserve Treatment
A typical accounting transaction for tuition could follow two basic
paths:
1. A student enrolls and pays the full tuition in full (“up front”) for the
course or program.
2. A student enrolls and enters into a contractual agreement to pay the
tuition over a period of time, usually several months. There is
usually a down payment required and interest is charged on the
outstanding balance owed.
The accounting treatment for the first pattern would be to record the
receipt of cash as an asset and the balancing entry would be to “reserve
for unearned income,” a liability account. As lessons/courses are
submitted for school servicing, income from services would be recorded
by reducing the reserve for unearned income and increasing income.
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When the entire course has been completed, i.e., when the last required
assignment has been submitted to the school by the student, all the
tuition would be included in income and the associated liability would
be zero. Using this method would provide an adequate reserve/liability
for refunds required under the DETC Accreditation Standards, and no
reserve for future services would be required.
Balance Sheet: An Illustration
Assets
Cash $1,000
Liabilities
Reserve for unearned income $1,000
First lesson completed -100
All lessons completed -900
0
Income Statement
Tuition income First lesson completed 100
Tuition income All lessons completed 900
1,000
The reserve for unearned revenue may also be eliminated by the
expiration of the contract. The use of a fixed contractual term for each
student enrollment is allowed by DETC standards. This contractual
term must be of sufficient duration to allow a typical student to
complete the course/program within that period. Institutions should be
able to prove that a clear majority of students complete the course/
program well within any term period. The expiration of the contract
term would allow the school to include in income all tuition that had
been received and eliminate any related reserve for unearned income on
that contract. As the expiration of the contract terminates the obligation
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for future services to the student, no liability would need to be recorder
for future services.
Under the second pattern, the school would record the down payment as
an increase in the asset – cash, the tuition receivable as an asset (if the
period the receivable is payable over more than twelve months, it would
be split between a current and a long term asset), and an off-setting
liability – reserve for unearned income. The income recognition would
follow the first pattern with a supplemental evaluation of the
collectibility of the tuition receivable.
The collectibiltiy of receivables must be reviewed periodically. This
evaluation would result in the establishment of a reserve for bad debts.
The offset to the reserve for bad debts is a bad debt expense on the
income statement. This reserve can be established based on historical
analysis of collectibility of accounts and/or actual analysis of the
existing receivables. As any tuition receivable is deemed to be
uncollectable, the amount should be written off. To write off tuition
receivables, the school would reduce the accounts receivable asset and
reduce the allowance for bad debts. This may also require an adjustment
to the reserve for unearned income. If the income related to the
receivable had not been included in income, then the offset to the
receivable would involve the reduction of the reserve for unearned
income.
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Balance Sheet
Assets
Cash $100
Payment on accounts receivable 100
Payment on accounts receivable 500
$700
Accounts receivable 900
Payment on accounts receivable -100
Payment on accounts receivable -500
$300
Reserve for bad debts -300
Liabilities
Reserve for unearned income 1,000
First lesson completed -100
All lessons completed -900
0
Income Statement
Tuition income First lesson completed 100
Tuition income All lessons completed 900
1,000
Bad debts -300
Net income $700
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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Alternative Reserve Treatment
Some schools may record the entire tuition as income when received or
when a contract is signed. Schools using this approach would be
required to establish reserves for refunds and reserves for future service
obligations. The reserve for refunds should be calculated based on the
DETC minimum tuition refund policies for all existing students. This
requires an analysis of the number of courses/lessons completed to
determine the school’s financial obligation to the students. When the
refund reserve is established, income would be reduced by the same
amount.
Even though the school does not have an obligation to refund tuition, it
may have an obligation to provide services to the student. This
obligation—reserve for future services—should reflect the anticipated
cost to provide the educational elements to the student. This reserve
creates a liability on the balance sheet and an expense on the income
statement.
If the school uses a reasonably and justifiable fixed contract term, both
of the above reserves would be reduced to zero at the end of the term
contract period.
Use of the alternative reserve method should be done with caution, as a
standard accounting principle is to match income and expense to the
period in which the income is earned. If a school’s contractual
obligation with a student is greater than twelve months, the alternative
method could overstate current period income. For example, a student
enrolls in a four year bachelors degree program for $20,000. The
student completes half of the program by the end of year two, and
pursuant to DETC guidelines, is no longer entitled to a refund. The
school would take $10,000 into income in that year (the amount that
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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was previously treated as a refund reserve), and set up a reserve for
future services to offset that income. This net of the two items would be
the net income for that student’s remaining involvement with the
school. Then, for the next two years allotted to the provisions of
services, the school would show no income or expense. For illustration,
assume the amount for future services is $5,000 and there are 100
students in that situation. The school in year two would include
$500,000 ($10,000 – 5,000 = $5,000; $5,000 * 100 = $500,000) in net
income for year two and nothing in years three and four.
In today’s tumultuous accounting environment, schools should use
conservative accounting practices in dealing with income recognition
and reserves.
Income Tax Issues
Unfortunately for for-profit schools, the tax treatment of income and
reserves is significantly different than the financial statement treatment.
The Internal Revenue Code requires the inclusion in income of any cash
received that does not have a contractual obligation to be repaid. The
Code also does not allow the deduction of reserves from income. It only
allows the deduction of actual incurred expenses. In the example at the
end of the last section, the tax result would be taxable income of
$1,000,000 ($10,000 per student no longer required to be repaid times
100 students).
Summary
DETC’s continued stature as a “nationally recognized” accrediting
association hinges on its accredited institutions maintaining a high level
of financial responsibility, and running a sound and ethical operation.
The proper and conservative handling of reserves has a significant
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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impact on demonstrating the school’s ability to be financially able to
deliver high quality instruction and educational services.
Notes
Accounting standards and the tax laws are constantly changing. The
information included in this DETC Occasional Paper is for general
guidance only, and is based on DETC standards, accounting standards,
and tax laws in effect on May 31, 2005. Each institution should consult
its own qualified legal, accounting, and tax professionals for guidance
in their unique situations.
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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Appendix 1
Footnote 1: (Accreditation Standard X)
X. FINANCIAL RESPONSIBILITY (The institution is financially able
to deliver high quality instruction and educational services.)
A. Financial Practices
The institution shows, by complete, comparative financial statements
covering its two most recent fiscal years, that it is financially responsible
and that it can meet its financial obligations to provide instruction and
service to its students. (Financial statements must be prepared “in
conformity with generally accepted accounting principles.”)
B. Demonstrated Operation
In all respects, all institutions must document continuous sound and ethical
operations. Applicant institutions must document two* continuous years of
sound and ethical operation as a bona fide electronically-delivered, online
or other delivery method of distance study (*one year if the parent
company is accredited by another accrediting agency that is recognized by
either the U.S. Department of Education or the Council for Higher
Education Accreditation). This documentation shall show that the name
being used by the school is free from any association with activity that
could damage the standing of the accrediting process, such as illegal
actions, unethical conduct, or abuse of consumers.
Footnote 2:
IX.A. 6. Describe what reserves are kept for honoring future service
obligations, bad debts, and refunds.
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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Appendix 2
Under DETC’s D.1. - Examiner’s Rating Form for All Institutions, under Standard
IX. Financial Responsibilities, you should be able to answer “Yes” to the following
questions.
IX. A. Financial Practices
1. Do the institution’s financial statements demonstrate overall financial
responsibility or does the parent company guarantee financial stability?
a. Are the financial statements complete?
b. Are all notes and supplementary schedules to statements included?
c. Do the statements include an income statement, balance sheet, statement
of cash flows, and explanatory notes?
d. Did the institution provide detailed operating statements for institution
divisions?
e. Are the statements prepared using the accrual method of accounting?
2. Did the institution submit a properly executed copy of the appropriate Teach-
Out Commitment form?
3. Does the institution use an adequate budget-making process?
4. Are current assets sufficient to meet current liabilities?
5. Did the institution answer “No” to the question, “Has the institution ever
entered into bankruptcy?”
6. Are the reserves for honoring future obligations, bad debts accurate, and
refunds adequate?
7. Do the accounts payable (numbers, amounts, and age) reflect sound financial
responsibility and management?
8. Are inventories of course materials adequate for current and future servicing
requirements?
9. Does the institution have adequate insurance coverage, and is it properly
allocated?
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10.For an institution with resident training program(s), is there adequate liability
coverage for students at resident training sites?
IX. B. Demonstrated Operation
1. Has the institution documented at least two continuous years* of experience as
a distance education institution (with the period starting with the date of the
first enrollment)? (*one year if the institution or its parent is accredited by
another recognized accrediting agency.)
2. Has the institution (or parent company) demonstrated sound financial
responsibility and ethical operation for the preceding two years?
3. Has the institution presented the proper documentation proving it is approved
or licensed as appropriate?
4. Has the institution documented that the name being used by the institution is
free from any association with activity that could damage the standing of the
accrediting process?
5. Does the institution offer instruction that is predominately at a distance?
6. Degree Program(s): Can the institution document that it has a completely
developed curriculum with at least one academic degree program in which
students have been enrolled for a minimum of two years (one year if parent
company is accredited by another recognized accrediting agency)?
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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Appendix 3
H.2. Policy on Commission-Requested Financial Statements
When the Accrediting Commission requests a financial statement from an
accredited or applicant institution, the financial statement must be prepared “in
conformity with generally accepted accounting principles,” often referred to as
“GAAP.” This includes the use of accrual method of accounting. The Commission
has the option of requesting one of these two types of financial statements:
1. An audited financial statement certified by an outside, independent, certified
public accountant in accordance with standards established by the American
Institute of Certified Public Accountants.
2. A reviewed financial statement. A “reviewed financial statement” consists of
inquiries of institution management by an outside, independent, certified
public accountant and includes analytical procedures applied to financial data.
It is less in scope than an audited statement and does not have an “opinion”
regarding the financial statements. The accountant must, however, state that he
or she is not aware of any material modifications that would need to be made
to the statements in order for them to be in conformity with standards
established by the American Institute of Certified Public Accountants.
All financial statements should cover the activities of the legal entity that has the
responsibility for operating the accredited distance education institution.
Minimum Acceptable Financial Statements
At a minimum, the financial statements (audited or reviewed) must be comprised
of:
A. A Comparative Statement, which displays the most recent two fiscal years of
financial data, preferably in side-by-side columns.
B. Balance Sheet, reflecting assets, liabilities, equity, and retained earnings;
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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December 30, 2005
Mr. Michael P. Lambert, Executive Director
Distance Education and Training Council
1601 18th Street, NW
Washington, DC 20009
Dear Mr. Lambert:
As a certifying officer, I acknowledge my responsibilities for establishing and
maintaining controls and procedures that ensure that I am aware of material
information relating to [name of institution]. The attached report discloses (a) all
material weaknesses in internal controls that came to the attention of certifying
officers, (b) any fraud involving management or employees with significant
responsibilities, and (c) any significant changes in internal controls, including
actions to correct material weaknesses, during the period covered by this report.
C. Income Statement, reflecting revenues, expenses, and profits and losses;
D. Statement of Cash Flows, reflecting the sources and uses of working capital;
and
E. Explanatory Notes, which reflect all of the disclosures or footnotes required
by generally accepted accounting principles.
These statements must be as of the date of the institution’s most recently ended
fiscal year or a date otherwise specified by the Accrediting Commission.
Letter of Financial Statement Validation
This letter must accompany an institution’s financial statements when submitted as
an exhibit with a Self-Evaluation Report, or anytime when the Accrediting
Commission calls for a financial statement from an institution, or when an
institution’s Annual Report submission requires a financial statement (e.g., when
there’s a loss is reported).
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
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I have reviewed this report. Based on my knowledge:
(1) This report contains all the facts needed to prevent it from being misleading
and it contains no untrue statements;
(2) Financial statements and other information fairly present the financial
condition, results of operations and cash flow.
Certified by:
Chief Executive Officer: _____________________________________
Chief Financial
Officer:________________________________________
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
Other Occasional Papers Available
Number 1—Student Services: Achilles Heel or Crown Jewel? by
Michael P. Lambert, Executive Director, DETC
Number 2—What Manager Doesn’t Study at Home? by Dr. Gordon
Wills, Principal, The International Management Centres
Number 3—Toward Better Service and Testing by Dennis Foltz,
Vice President of Education and Operations, Gemological Institute
of America
Number 4—Testing Home Study Advertising by Jack Thompson,
Consultant
Number 5—Conducting Graduate Surveys by Mary McKeown,
Vice President, American School
Number 6—Enrollment Contracts for Home Study Schools by
William Wright, American School
Number 7—Evaluating Your School’s Worth by Michael P. Lambert,
Executive Director, DETC
Number 8—Getting the Most PR for Your School by Sally R.
Welch, Assistant Director, DETC
Number 9—The Effectiveness of the Home Study Method edited by
Sally R. Welch, Assistant Director, DETC
15
DETCOCCASIONALPAPERTWENTYTHREE
16
Number 10—Home Study Academic Transcripts by Sally R.
Welch, Assistant Director, DETC
Number 11—Admissions Policies: The Key to Success by
Josephine L. Ferguson, Member, DETC Accrediting Commission
Number 12—How to Write an Analytical Self-Evaluation Report
by Josephine L. Ferguson, Member, Accrediting Commission of
the DETC
Number 13—Building a Distance Education Faculty by Dr. John
E. Jessup, Academic Dean, American Military University
Number 14—Embracing the Internet by Carol Oliver and Dr.
Gordon Wills, International Management Centres
Number 15—Strategies for Helping Students Transfer Credits by
Ali Fares, Cleveland Institute of Electronics
Number 16—How to Develop a Plan of Succession by Robert
McKim Norris, Jr., Andrew Jackson University
Number 17—How to Assess Experiential Learning by Lisa J.
Davis, California College for Health Sciences
Number 18—Managing Education Programs in the Information
Age by Tina J. Parscal, ISIM University
Number 19—Converting Courses to Online by Dr. Judith M.
Smith, SiteTrainer.com.
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
Number 20—Confessions of an Early Internet Educator by Jack
R. Goetz, Concord University School of Law
Number 21—Global Activities of DETC Institutions by Irving H.
Buchen, IMPAC University
Number 22—International Academic Equivalence: A Primer by
Irving H. Buchen, IMPAC University and David John Le Cornu,
St. Clements University
D E T C O C C A S I O N A L P A P E R T W E N T Y T H R E E
1601 18TH STREET, N.W.
WASHINGTON, D.C. 20009-2529
(202) 234-5100
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E-Mail: detc@detc.org
DISTANCE EDUCATION AND TRAINING COUNCIL