A tectonic shift in corporate accounting rapidly approaches: the new standard for revenue recognition, slated to take full effect in 2018. It is the biggest change, to one of the most fundamental financial numbers, anyone has seen in years.
Corporate finance departments have been slouching toward implementation of that new standard for a while, dropping occasional hints at how they are updating accounting systems and policies to prepare for D-Day. So we were intrigued this week when we spotted this gem of disclosure in Microsoft’s latest earnings release:
When Microsoft adopts the new revenue standard, predominately all Windows OEM revenue will be recognized at the time of billing, which is similar to the revenue recognition for prior versions of Windows… Microsoft reflects the recognition of Windows 10 revenue at the time of billing in “as adjusted (non-GAAP)” revenue to provide comparability during the short period of time where Windows 10 will be recognized over the estimated life of a device, i.e., ratable, rather than at the time of billing.
What does that mean in plain English? That Microsoft is providing a temporary non-GAAP measurement of its revenue from Windows 10, because the product falls into an odd world where pending changes to Generally Accepted Accounting Principles (that is, the new revenue standard arriving in 2018) will catch up to how Microsoft believes Windows 10 revenue should be recognized.
We have a bit to unpack here, with non-GAAP metrics and how the new revenue standard will affect reporting of software sales. Let’s open the non-GAAP suitcase first.
The Securities and Exchange Commission allows companies to use non-GAAP metrics, so long as the company (1) explains why its chosen metric provides useful information to investors; (2) reconciles the non-GAAP metric back to the closest similar metric under GAAP; and (3) does not visually promote a non-GAAP metric more than GAAP in earnings releases, headlines, and so forth. (No cheating by manipulating the font size, people. Your high school English teacher warned you about this.)
Microsoft’s earnings release does obey all three of those rules. That brings us to the second suitcase to unpack—how the new revenue standard should be applied to sales of Windows 10.
Windows 10 was a departure from prior Microsoft operating systems. In earlier versions, a customer purchased Windows software only once: generally at the time he purchased a PC, with Microsoft pre-loaded on the hardware. That purchase did not include any upgrade rights. So Microsoft could recognize the revenue at time of sale, and had no residual upgrade obligations that might need to be reported as deferred revenue.
Windows 10 debuted in 2015, and does give the customer upgrade rights—at no additional charge. Under the current GAAP revenue standard, that means Microsoft must classify at least some of its Windows 10 revenue as deferred, only to be recognized whenever Microsoft completes an upgrade. The result: Microsoft reported $20.61 billion in revenue for second quarter 2016, according to current GAAP.
But under the impending new revenue standard, Microsoft says, the sale of Windows 10 will work much like the sale of older Windows software: recognized all at once, at the time a person buys a PC with Windows 10 pre-loaded. Why? Because the new standard defines revenue as something to be recognized “when a customer obtains control of promised goods or services and is recognized in an amount that reflects the consideration [Microsoft] expects to receive in exchange for those goods or services.”
Microsoft’s thinking is that when you take that PC out of the box with Windows 10 ready to go, you’ve obtained control of the promised goods and services. And since future upgrades to Windows 10 are likely to be minor, unpredictable, and bring no additional cash to the company, then under the new revenue standard, Microsoft might as well recognize the whole sale upfront.
The only catch: Microsoft can’t actually adopt that new standard until July 1, 2017. (Companies can adopt early if they’re ready.) Hence the company is reporting Windows 10 sales according to a metric that is currently non-GAAP, but will become GAAP within two years.
Non-GAAP revenue, by the way, was $22.64 billion—an increase of $2.028 billion, or roughly 9.8 percent, thanks to the open Windows 10 issue.