Due to its size, revenue is the single most important line item
in the income statement of most companies.
The way companies decide whether a transaction does or doesn’t qualify as revenue is called
revenue recognition.
The principles and rules for recognizing revenue
are laid down in the new global revenue recognition standard,
effective in 2018, which is ASC 606 in US GAAP, and IFRS 15 in IFRS,
“Revenue from Contracts with Customers”.
There is a five step approach for revenue recognition in both of these accounting standards.
Step 1: identify the contract or contracts with the customer.
Step 2: identify the performance obligations in the contract, in other words the promises
to deliver goods or provide a service.
Step 3: determine the transaction price.
Step 4: link step two and step three by allocating the transaction price to the performance obligations.
Step 5: recognize revenue when (or as) a performance obligation is satisfied.
A performance obligation may be satisfied at a point in time (typically for promises
to transfer goods to a customer) or over time (typically for promises to transfer services
to a customer).
That all sounds a bit cryptic, but fairly straightforward, right?
Let’s review some revenue recognition examples to make revenue recognition come alive.
We will use revenue recognition in the financial statements of Microsoft as an example.
You probably heard of Microsoft before, but might be surprised at just how many different
types of products and services the company provides.
For each of these products and services, Microsoft has to apply the revenue recognition accounting
standard, and sometimes pass judgment as to how to apply the principles and rules.
For example, regarding step 2, Microsoft remarks in the annual report “Our contracts with
customers often include promises to transfer multiple products and services to a customer”.
And regarding step 3: “Judgment is required to determine the stand-alone selling price
for each distinct performance obligation.”
Let’s get a feeling for the size of the revenue at Microsoft, and then go through
specific revenue recognition examples.
In fiscal year 2019, Microsoft’s revenue was $126 billion.
On top of that, Microsoft’s balance sheet holds $37 billion of unearned revenue, most
of which is to be recognized in the upcoming quarters of the next financial year.
Billing and payments for contracts often happens upfront, at the beginning of the contract
period, while the revenue can only be recognized when the performance obligation is satisfied,
hence the unearned revenue balance.
The description in Microsoft’s annual report of revenue recognition gives you the “when”
and the “how much”.
It starts off with the when: “revenue is recognized upon transfer of control of promised
products or services to customers”.
This links back to the term “performance obligation” that we just discussed:
did you deliver the product, or perform the service.
Then follows the how much: “In an amount that reflects the consideration we expect
to receive in exchange for those products or services”, in other words: we book revenue
for the amount we expect the customer to pay us.
Let’s go through three specific examples of revenue recognition.
First example: software licenses.
It’s important to understand how the business model in the software world has changed.
Yes, there are still customers who buy a software package like Microsoft Office 2019 for their
new laptop, while they used Microsoft Office 2013 on their previous laptop.
But more and more, the software world is moving to “software as a service”, like Office 365.
What’s the difference?
Office 2019 is sold as a one-time purchase, which means you pay a single, up-front cost
to get Office apps for one computer.
However, there are no upgrade options which means if you plan to upgrade to the next major
release, you'll have to buy it at full price.
Security updates are included, but you won’t get any new features.
Office 365 is a subscription service.
Your version of Office will always be improving.
You'll get all the latest features and updates, as well as security updates and bug fixes.
Obviously, the revenue recognition on Microsoft’s side is very different between the two business models.
License revenue is generally recognized upfront at the point in time when the software is
made available to the customer.
Revenue related to services provided on a subscription basis is recognized ratably over
the contract period, in other words allocated to the various periods of the duration of
the contract.
So how does revenue recognition work for a software product like Windows 10, which often
comes pre-installed on your device when you buy it?
Most of this revenue will be recognized upfront.
Except for software updates.
This is where Microsoft had to make a decision
on how to interpret step 4 of the revenue recognition process.
What’s the price for the ongoing responsibilities that software updates represent?
Here’s the answer to that question from the Microsoft annual report: “In cases where
we allocate revenue to software updates, primarily because the updates are provided at no additional
charge, revenue is recognized as the updates are provided, which is generally ratably over
the estimated life of the related device or license.”
In practical terms, that means that 3% of the Windows 10 OEM revenue
gets deferred (postponed) and recognized over the estimated life of the device.
Second example: cloud services, such as Microsoft Azure.
These services are sold on a subscription basis for a certain time period, or on a consumption
basis (for example the amount of storage used in a period).
Revenue related to cloud services provided on a subscription basis is recognized ratably
over the contract period, in other words allocated to the various periods of the duration of
the contract.
Revenue related to cloud services provided on a consumption basis is recognized based
on the customer utilization, in other words how much was actually used during a period.
Third example: search advertising.
Revenue from search advertising is recognized when the advertisement appears in the search
results or when the action necessary to earn the revenue has been completed.
In other words: when it’s shown, or when it’s clicked.
Read through the full narrative in the Microsoft annual report for more examples and details,
but I think you are getting a feeling already for the diversity and complexity of the business,
and the resulting complexity on the accounting side in terms of revenue recognition.
Revenue recognition: follow the five step process, and apply the necessary judgment
and estimates when required.
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