Note: To read Part 1 of Amalgam’s coverage of Microsoft’s ASC 606 adoption, please check how Microsoft Early Adopts New ASC 606 Revenue Recognition Standard.
Recommended Audience: CFO, Chief Revenue Officers, CIOs, COOs, IT Finance, Sales Operations seeking to understand how ASC 606 revenue recognition changes will affect their responsibilities.
On August 3rd, 2017, Microsoft held an investor metrics conference call led by:
- Chris Suh – GM, Investor Relations
- Frank Brod, Chief Accounting Officer
- John Seethoff, Deputy General Counsel and Corporate Secretary
There have been multiple acquisitions and announcements in the revenue recognition space as IT vendors ensure that they can support the ASC 606 standard including:
[Update: On August 31st, Aptitude Software announced its acquisition of RevStream.]
Because Microsoft is the first large software company to convert to ASC 606, Amalgam believes that there were several key lessons from this call that are applicable to accounting, finance, sales, and operational executives responsible for providing internal services on a cost-basis aligned to revenue.
To review ASC 606, in May 2014, FASB issued ASC 606, Revenue From Contracts with Customers, which defined revenue recognition standards based on the following 5 steps:
Step 1: Identify the contract(s) with a customer.
Step 2: Identify the performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
For public businesses, certain non-profits, and certain employee benefit plans, the effective date for enacting ASC 606 is annual reporting periods (including interim reporting periods) beginning after December 15, 2017. Early application is permitted for annual reporting periods (including interim reporting periods ) beginning after December 15, 2016, so companies have to go all-in if they go in early. For all other organizations, the effective date is for annual reporting periods beginning after December 15, 2018.
Needless to say, the clock is ticking for publicly traded companies to enact ASC 606. Microsoft has taken the leap early and shown both market leadership and operational guidance to its technology peers that will need to redefine and align technology and project revenue to ASC 606. This revenue recognition change requires companies to separate each performance obligation element within a contract from a pricing perspective, which effectively unbundles any combination of assets and services that may have previously been sold and recognized as a bundle.
Microsoft’s interpretation of ASC606 was most important in redefining Windows 10 OEM Revenue and on-premises software assurance contracts. For Windows 10 OEM sales, Revenue had previously been defined since July 2015 as deferred revenue running over a three year period. Performance obligations redefined the key transaction as purchase and relegated the ongoing updates of Windows 10 to a small fraction of the total value as shown in this slide.
Microsoft also redefined revenue recognition for on-premises annuity aspects of their licenses so that the software license was fully recognized in year one and only the Software Assurance would be recognized on an ongoing basis.
The important lessons here were that:
1) Microsoft accelerated revenue recognition for on-premises licenses by decoupling licenses from software assurance obligations from a revenue recognition perspective. Previously, Microsoft had aligned revenue to its billing, where it lumped licenses and software assurance billings into a single amount that was paid off in equal annual installments over three years. Now, Microsoft will be recognizing the license in full at the time of sale and separately recognizing the software assurance contract over a three year period.
By doing so, Microsoft is recognizing revenue before it is invoiced and recording this revenue within accounts receivable. Amalgam expects that companies with significant software assurance and maintenance income to follow suit and substantially increase their accounts receivable for future years. As Microsoft warns, this front-loading of recognized revenue will also result in greater seasonality as more license revenue is recognized at the time of sale even though cash flow will not be affected. Because companies do not want to change their pricing and contracted invoicing, this decision effectively decouples the uninvoiced revenue that has been recognized from cash inflow.
Amalgam will be interested in seeing which companies with significant Software Assurance and Maintenance revenue follow suit in accelerating revenue recognition vs. which companies decide to realign their billing over time to match their revenue accounting. Simply because of the inherent profile of accounts receivable, Amalgam expects that over time, companies will need to debook a higher percentage of revenue over time as clients inevitably fail to fully pay off their contracts.
2) Microsoft assigned a revenue value to automated software updates. Microsoft shaped Windows 10 OEM revenue to defer for the software update value. Anyone who has ever used a Windows PC knows what this “update” is: the automated upgrades, patches, and functions that end up restarting your computer! Now, 97% of an OEM license’s sales is defined as upfront license revenue recognized in Year One, while the upgrades are recognized over three years.
Microsoft assigned the value of this upgrade at 1% of software revenue per year over a three year period. Amalgam expects this standard to become a benchmark for other companies seeking to accurately recognize one-time software licenses that include some aspect of automated upgrades.
3) Chief Revenue Officers should expect some changes in sales expenses related to ASC 606 changes. By accelerating revenue recognition, Microsoft stated that there was a “small impact” in sales expenses because sales incentives are tied to revenue. Organizations that tie sales incentives to revenue or profit rather than bookings should check how ASC-based changes will affect sales commissions and potentially prepare for a one-time or seasonal shift in commission payments that are aligned to revenue recognition.
4) IT “as a service” or IT “as a business” initiatives will require some tweaking. With the redefinitions of revenue that will take place, Amalgam believes that IT will start becoming an unfunded mandate to support technologies. For instance, consider that Windows 10 is branded as a “service” that is improved by “periodic software updates.”
However, it is sold as a license where 97% of the revenue is recognized immediately. Imagine if IT is designed based on 3% of service revenue being assigned to the 3-year support of a product. That’s only 1% per year. This cost structure is going to fall apart quickly and IT will start running deficits while falling back from business unit back to cost center status.
Amalgam recommends to CIOs and COOs that they start looking at “non-GAAP” ways of ensuring that their technical and operational support efforts are funded and to make sure they are not simply looking for funding based on a percentage of recognized revenue. It is not uncommon for IT to be benchmarked as X% of revenue, but this benchmarking starts falling apart in situations where revenue is disconnected from cash flow and recognized revenue is being defined as accounts receivable.
By taking these four steps, CFOs, CIOs, COOs, and Chief Revenue Officers can continue to run their departments as revenue-based businesses while staying aware of the realities of bookings, cash flow, and affording the cost basis of supporting the business.