Windows 10's upgrade model temporarily wipes $1.6B from Microsoft's books

Company defers Windows 10 revenue for two to four years because of free upgrades and updates

Microsoft's decision to radically change the distribution and maintenance of Windows 10 put a $1.6 billion temporary dent in its revenue, the company said Thursday.

In a filing covering the March quarter, Microsoft pointed to the revenue deferral of Windows 10 -- a relatively new way of accounting for the Redmond, Wash. company -- as a reason for the 6% year-over-year decline in revenue.

"Revenue decreased $1.2 billion or 6%, primarily due to the impact of a net revenue deferral related to Windows 10 of $1.6 billion and an unfavorable foreign currency impact of approximately $838 million or 4%," Microsoft's 10-Q filing with the U.S. Securities & Exchange Commission (SEC) stated.

The $1.6 billion in Windows 10 revenue during the March quarter didn't actually vanish: It was instead deferred and will hit the bottom line over the next two to four years.

Last year, when Microsoft outlined and then released Windows 10, it announced that it had to change how it accounted for sales because of its promise that upgrades and updates for the new operating system would be free.

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.

In Windows 10's case, the interval varies between two and four years. Microsoft has never explicitly spelled out what Windows 10 sales are recognized in two years, which in three, and those in four. Instead, the company first said that deferral length would depend on the lifetime of the supported device, then added that "customer type" would determine the lifespan.

Microsoft does financial acrobatics to deal with the deferrals. It continues to record revenue as it has in the past, but then debits the "Corporate and Other" reporting segment by pro-rated amounts over the lifespan of the license. For $300 of revenue over a three-year stretch of Windows 10 Pro, for instance, Microsoft would recognize $100 in Year 1 -- that money returned to the balance sheet in the Corporate and Other group -- and defer the remaining for the second and third years, booking $100 in each. At the end of the three years, the full $300 will have been recognized.

If the deferral debits were eliminated, the company would have announced revenue of $22.1 billion for the quarter, not the $20.5 billion it did.

However, the deferred Windows 10 revenue didn't change the revenue and operating income numbers for the More Personal Computing (MPC) division -- a 2015 creation that includes Windows, Microsoft's Lumia and Surface devices, gaming, and search -- because sales immediately land under the group's line.

MPC revenue increased in the first quarter, a change from recent reporting periods, which have seen declines: Revenue was $9.5 billion, up almost 1% from the same period in 2015. But Windows revenue was down.

Sales of licenses to OEMs (original equipment manufacturers) -- the bulk of Windows revenue -- declined 2% year over year, with what Microsoft dubs "Pro" licenses, the more expensive versions of Windows aimed at businesses, down 11%.

As it has for years, Microsoft again blamed the struggling PC business for the decline in Windows revenue. Chief Financial Officer Amy Hood called the PC market's March quarter "weaker than we expected" during yesterday's call with Wall Street.

PC shipments in 2016's first quarter declined by 11.5%, researcher IDC said last week. Rival Gartner pegged the downturn at 9.6%.

Hood attributed the 11% drop in OEM Pro revenue to "higher inventory levels" in the December quarter. Translation: Computer makers stuffed the channel with PCs late last year, then sold fewer than they had expected, leaving too many on shelves and in warehouses with licenses paid for in 2015.

Ironically, sales of consumer-grade licenses to OEMs increased by 15%, Hood said, crediting a "higher-than-expected mix of premium devices" for the upturn. She presumably meant the more expensive -- and larger -- tablets and 2-in-1s, and the pricier PCs. Both IDC and Gartner have repeatedly said that consumer PC sales have tanked because people aren't replacing their aged systems after shifting much of their time on PCs to smartphones, and to a lesser degree, tablets.

Microsoft does not share the specific revenue figures for Pro and "non-Pro" license sales -- the latter represent the consumer-quality versions -- but the former again brought in more money than the latter during the quarter.

That will continue, Hood said as she issued her forecast for the quarter ending June 30, Microsoft's final for its 2016 fiscal year. "In Windows, we expect our OEM Pro revenue to be largely in line with the commercial PC market," she said, referring to the continuing decline now expected. "Our non-Pro revenue is expected to be above the consumer PC market, similar to what we saw in [the March quarter]."

Copyright © 2016 IDG Communications, Inc.

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