Why you should pay attention to Microsoft's Windows 10 revenue deferral

Deferrals will be tied to 'supported lifetime of the device,' which is how long Microsoft will provide Windows 10 with free upgrades

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Microsoft last week said it would defer revenue from the sales of Windows 10 licenses, a move that will affect its financials and trigger a meeting later this year to explain the ins and outs to Wall Street.

The revelation will also affect customers because the deferral will be tied to the "supported lifetime of the device," a phrase Microsoft has used for several months to describe how long it will provide free updates and upgrades to Windows 10.

Rather than record the full amount of income received from the sale of Windows 10 licenses, Microsoft will immediately book only part of each license's revenue, then defer the remainder until later.

Microsoft will defer revenue from licenses sold to OEMs (original equipment manufacturers) and other customers because it has promised to provide new features and enhancements free to users of the operating system.

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Microsoft's chief financial officer showed analysts this slide as an example of how Windows 10 licensing revenue will be split into several pieces and recognized over a long period.

For accounting purposes, a free upgrade requires a company to set aside some revenue from the sale of the affected software -- in this case, Windows 10 -- then recognize that revenue only when the upgrade is released. All the revenue from the software sale is eventually recorded, but at staggered intervals.

"Windows 10 does provide new features and functionality over time," said Chief Financial Officer Amy Hood in a meeting with financial analysts last week as she described the new deferrals. "Cash flow will look exactly the same. But we will have a deferral impact that will impact both the P&L [profit and loss statement], as well as the balance sheet."

Microsoft has never deferred Windows license revenue like this, although it has long deferred income from enterprise annuity programs, such as Software Assurance, and long-term contracts for software and services. Office 365 revenue, for example, is deferred over the life of the subscription, which is typically one year. Rather than account for the full amount paid by a consumer for Office 365 Home, Microsoft splits that number into four equal parts, then recognizes one each quarter.

The length of the Windows deferrals was not disclosed, but will be tied to what Microsoft eventually defines as the supported lifetime of the device, the term it first used in January when it said a Windows 10 upgrade from Windows 7 and 8.1 would be free for a year.

"This is so much more ... than a free one-time upgrade," said Terry Myerson, the Microsoft executive who heads the operating systems group, in January. "Once a device is upgraded to Windows 10, we will be keeping it current for the supported lifetime of the device [Emphasis added]."

Microsoft has not yet defined that lifetime.

But in a slide shown to analysts last week, Microsoft said that the lifetime of the deferral -- and thus the lifetime of a device equipped with Windows 10 -- will be based on the device type. "Estimated useful lives will be determined by form factor," the slide stated. "As a result deferral periods may vary."

Microsoft will probably set the support in years, but one kind of device will not necessarily have the same lifespan as another. A tablet, for instance, could top with a two-year life, while a notebook could be pegged at four years and a 2-in-1 device at three. Or Microsoft could define form factor by screen size, as it already does to some degree.

It's unclear exactly how the supported lifetimes and associated deferrals will affect customers: Microsoft has said nothing about what happens after the lifetime expires, including whether upgrades would be discontinued entirely or would be available for a fee.

It's possible, then, that after, say, four years -- if Microsoft defines a notebook's lifetime at that length -- Windows 10 will no longer be automatically upgraded for free.

Hood also promised Wall Street that she would detail the deferrals later this year. "We'll have a conference call much like we've done with other transitions as we get closer to the impact to share the exact details on lifecycles, how long the time will be, and the exact impact we expect," Hood said. She also pledged that the company would provide what she called a "comparability bridge" in its earnings statements, meaning that those statements would show last year's revenue as if Windows revenue had been deferred so that analysts will have an apples-to-apples comparison.

Microsoft held a similar one-time call for analysts in September 2013, near the end of the quarter when former CEO Steve Ballmer launched a major corporate restructuring that in turn required a revamp of its financial reporting.

If Microsoft starts selling Windows 10 licenses to OEMs this quarter, it would probably announce the support lifetimes in June, several weeks before its Q2 earnings call. Likewise, if OEM sales began in or after July, it would disclose that information in September.

Financially, the deferral will reduce Windows revenue on Microsoft's balance sheet, at least for a time, as the income once recognized during the quarter of sale is instead split amongst multiple quarters or years.

Copyright © 2015 IDG Communications, Inc.

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