Note: This topic is of key importance for CFOs using or considering a subscription-based business model and for CIOs tasked with aligning technology to revenue recognition. Part 2 of this topic is 4 Key Executive ASC 606 Lessons Microsoft is Teaching Us.
On July 20, 2017, Microsoft announced a very successful Q4 FY17 where they announced both successful GAAP and non-GAAP results.
· Revenue was $23.3 billion GAAP, and $24.7 billion non-GAAP
· Operating income was $5.3 billion GAAP, and $7.0 billion non-GAAP
· Net income was $6.5 billion GAAP, and $7.7 billion non-GAAP
· Diluted earnings per share was $0.83 GAAP, and $0.98 non-GAAP
But the part that got my attention was a relatively minor 2 paragraph note near the bottom of the earnings announcement on ASC 606 revenue recognition:
In May 2014, the Financial Accounting Standards Board issued a new standard related to revenue recognition. We elected to early adopt the standard effective July 1, 2017, using the full retrospective method, which will require us to restate each prior reporting period presented.
The most significant impact of the standard relates to our accounting for revenue from Windows 10 licensing as previously described. Additionally, for certain multi-year commercial software subscriptions that include both distinct software licenses and Software Assurance, we will recognize license revenue at the time of contract execution rather than over the subscription period. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard will depend on contract-specific terms and in some instances may vary from recognition at the time of billing. Revenue recognition related to our hardware, cloud offerings including Office 365, LinkedIn, and professional services will remain substantially unchanged.
We expect to share more information on adoption of the new standard in early August 2017.”
It’s interesting to see Microsoft adopt this standard early, since adoption is effective as of December 15, 2017. Amalgam believes this is a smart move since it makes revenue expectations clearer for investors and shareholders. However, Amalgam will be curious to see exactly how change takes place.
For the past few quarters, Microsoft has been providing both GAAP and non-GAAP versions of revenue, with the biggest difference being how Windows 10 revenue is being treated. Currently, GAAP Windows 10 revenue is being treated as revenue that has to be deferred over the life of the device because Windows 10 customers can receive new versions and future updates without additional cost. Microsoft believes that this requires Microsoft to defer revenue rather than recognize the revenue at purchase.
However, Microsoft believes that that with the new revenue standard, Microsoft will be able to define the purchase as the sole performance obligation of Windows 10 and actually simplify revenue recognition of Windows 10.
I will be curious to see if this actually holds true. The new revenue recognition standards (ASC 606 for the US, IFRS 15 for the rest of the world) defines revenue through five key steps:
1) Identify the contract with a customer
2) Identify performance obligations within the contract
3) Determine the transaction price
4) Allocate the transaction price to each performance obligation
5) Recognize revenue as performance obligations are satisfied.
So, we all know what a contract and price are. Steps 1 and 3 are easy. But the others? There are some interesting questions that Microsoft will hopefully be answering in August.
Step 2 of identifying delivery could be interesting. Is Microsoft going to take out contractual obligations to support updates or ongoing support to make sure that delivery happens at the point of purchase? How will Microsoft simplify delivery to ensure that Windows 10 delivery obligations are completed at sale?
Step 4 provides complexity based on the definition of delivery. If performance obligations can’t be simplified, will the “price” of ongoing responsibilities be charged as “$0”?
Step 5 is a result of both Steps 2 and 4: the on-demand recognition of specific tasks at specific prices. This is the complexity that Microsoft is trying to avoid both to recognize revenue more quickly and decrease the cost of compliance. How will Microsoft define the satisfaction of performance obligations, especially if a service-based component or future considerations are part of the purchase price. In addition, all technology is moving to service-based, performance-based, or outcome-based pricing that increases the complexity of “performance obligations.”
Key Recommendation: CFOs responsible for subscription and outcome-based services with upgrade options and for CIOs responsible for aligning technology to revenue recognition should take a close note at Microsoft’s next announcements in August to see how they align to ASC 606 and how they get around the current Windows 10 deferred revenue reporting that they conduct on a quarterly basis. This language will provide guidance both on how your organization can define revenue on an ongoing basis as well as how to redefine the cost-basis of goods and services provided.
To read Part 2 of this topic, continue to 4 Key Executive ASC 606 Lessons Microsoft is Teaching Us.