• Illustration: Unearned Revenue: Historical Examples

Unearned revenue—money collected for products or services not yet delivered—is an increasingly important part of Microsoft's business. Because the company has so much unearned revenue on its books (nearly US$8 billion at the end of its 2002 fiscal year on June 30), partners and investors must understand what it is and how Microsoft records it to get a clear picture of the company's finances and the health of its product lines. Because unearned revenue helps Microsoft smooth its financial results from quarter to quarter, the company will try to increase it by marketing multiyear license agreements more aggressively.

Why Unearned Revenue Matters

Unearned revenue (sometimes called deferred revenue) is money that a business has already collected for products or services it has not yet delivered. A magazine subscription is a good example: the customer pays the entire subscription fee upfront in exchange for a promise that the publisher will deliver a specified number of issues over a certain time period. Because the publisher must deliver something in the future, it does not immediately count the money received as revenue, and this money does not immediately show up as part of profits or losses. Rather, the publisher books the money as unearned revenue, then slowly transfers it to revenue (or "recognizes" it) over the term of the subscription.

Microsoft has two main sources of unearned revenue: periodic payments it receives from volume licensing agreements, and retail and OEM sales of certain desktop software products. As this unearned revenue is recognized, it has an enormous impact on the company's bottom line. For example, in the quarter that ended Mar. 31, 2002, nearly 30% of Microsoft's revenue came not from new sales but from recognition of unearned revenue which it had already received.

Microsoft recognizes most of this unearned revenue in a linear and predictable fashion. This predictability helps the company give more accurate earnings guidance to investors and financial analysts, which encourages them to view Microsoft as a relatively safe investment and can boost the stock price. It also helps Microsoft show smooth earnings growth from quarter to quarter—another desirable quality for investors. For example, if the company knows it's going to recognize an unusually large amount of unearned revenue in a given quarter, it can delay an expensive marketing campaign until that quarter, when its effect on profits will be less noticeable.

Partners can also look at Microsoft's unearned revenue figures to help them make better business decisions. For example, an ISV might see that revenues are flat in the "Desktop Applications" category; conclude that the latest version of Office is not selling well; and delay development of a companion product that uses the latest Office APIs. However, if the ISV also sees a big spike in unearned revenue for desktop applications it might draw a different conclusion: the new version of Office is selling well, but more corporations are buying the new version of Office as part of multiyear licensing agreements than used to do so. (For specific examples, see the chart "Unearned Revenue: Historical Examples".)

Why Reveal Details Now?

Until recently, Microsoft did not go out of its way to explain how it books and recognizes unearned revenue—financial analysts had to ask Microsoft for relevant information (such as the billing schedule for volume licensing agreements), then factor this information into their analyses. But this practice is changing: in Microsoft's July 2002 Financial Analysts' Meeting, Chief Financial Officer John Connors publicly explained how Microsoft books and recognizes unearned revenue from multiyear licensing agreements. Why now? There are several likely reasons:

Highlight good news. In the fiscal year that ended June 30, 2002, Microsoft's net income (profit) and operating income (revenues minus the normal costs of doing business) were fairly flat, growing only 7% and 2%, respectively. However, its stash of unearned revenue grew 38% over the previous year. Microsoft wants to make sure that investors and analysts notice this growth, understand where it comes from, and know what it says about the health of the company's business.

Reduce accounting doubts. The U.S. Securities and Exchange Commission recently ended an investigation into allegations that Microsoft maintained special cash funds, then used these funds to even out its financial results in bad quarters—a practice sometimes called "cookie jar" accounting. (See "SEC Probe Ends" on page 22 of the July 2002 Update.) The process by which Microsoft books and recognizes unearned revenue sounds superficially similar to what Microsoft was accused of doing in the SEC investigation. Thus, by revealing more details about unearned revenue, the company is hoping to reassure investors that its procedures are not unusual or misleading—especially important given the recent corporate accounting scandals at other companies.

Booking and Recognizing Unearned Revenue

Microsoft has two major sources of unearned revenue: multiyear volume licensing agreements, and retail and OEM sales.

Multiyear Volume Licensing Agreements

When a customer makes a payment as part of a volume licensing agreement, Microsoft counts the money as unearned revenue, then recognizes it on a monthly basis over the annual or biannual billing period. This acknowledges the possibility of unexpected costs associated with fulfilling the contract. For instance, Microsoft might have to release many more patches than it anticipated, or it might cancel a product for which a customer has already bought upgrade rights and have to incur additional costs to replace it (such as granting a discount on a different product).

From an unearned revenue perspective, multiyear licensing agreements fall into two categories:

Three years, billed annually. Enterprise Agreements (EAs), Select License agreements, and Software Assurance (SA) upgrade rights bought with Select agreements usually last for three years. However, Microsoft only bills these customers for a single year at a time, and only reports unearned revenue for the portion of payment received.

In other words, when a customer first pays for one of these agreements, Microsoft books one-third of the total contract price as unearned revenue, then recognizes this revenue in monthly portions over the course of the first year. The expected revenue from the remainder of the contract appears nowhere on Microsoft's books until the beginning of year two, when the second third of the contract price is booked (it is then recognized over the course of year two). The process is repeated again in year three.

Two years, billed upfront. SA and Upgrade Advantage (which is no longer offered) purchased under Open License agreements last for two years. For these agreements, Microsoft bills the customer for the entire two-year period upfront, books it all as unearned revenue, and recognizes it in monthly portions over two years.

OEM and Retail Sales

Microsoft also books as unearned revenue a percentage of money it receives from certain products sold at retail and through OEMs. It then recognizes this amount on a pro rata basis over the course of each product's "expected life," as defined by Microsoft. (This model also holds true for any product purchased through a Select License agreement that is not paid for on an annuity basis.)

Microsoft does this to account for ongoing costs such as providing end user support, releasing patches and service packs, and updating certain components of these products over time.

Microsoft does not publicly disclose the exact percentage of retail and OEM revenue it defers, which varies by product version. According to its filings with the SEC, Microsoft defers between 15% and 25% of the revenue from Windows desktop operating systems and recognizes this revenue over 36 months; the company defers between 10% and 20% of Office revenue, which it recognizes over 18 months.

Because Windows desktop upgrades and Office are sold through volume licensing agreements as well as through OEM and retail channels, it is sometimes difficult to tell where unearned revenue in the "Desktop Platforms" (or "Client") and "Desktop Applications" (or "Knowledge Worker") categories is coming from. Generally, if unearned revenue in these categories goes up faster than reported revenue, then most of the new sales in these categories are to volume licensing customers. If reported revenue goes up more quickly than unearned revenue, then most new sales are coming from retail and OEM channels.

Spurring Future Unearned Growth

Facing a July 31 deadline before potentially expensive changes in Microsoft's volume licensing programs, many companies rushed to sign new volume agreements in the last quarter of fiscal year 2002 (which ended June 30). Connors acknowledged that this rush probably contributed to the fiscal year's spike in unearned revenue.

This burst of activity could lead to spikes in unearned revenue during particular quarters (Q4 and Q1) for the next several fiscal years, as Microsoft receives annual payments from EA and Select customers who signed up in the last days before the deadline. These spikes would reduce Microsoft's ability to use unearned revenue to smooth earnings.

To counter this possibility, Microsoft wants to continue increasing its unearned revenue even after the July 31 licensing deadline has passed. To succeed, Connors said that Microsoft must do the following:

• Increase the number of EAs it sells to the "small and medium-sized business segment," a previously untapped market for EAs.
• Sell more servers with each volume licensing agreement, thereby increasing the average unearned revenue per agreement. The company sees significant growth potential here because the majority of revenue from volume licensing agreements has historically come from desktop products rather than server products.
• Increase the percentage of renewals for volume licensing agreements.

Given the importance of unearned revenue to the company, look for Microsoft to focus its sales efforts in all three areas.

Resources

An Excel spreadsheet listing Microsoft's unearned revenue by product category since 1998 is available at www.microsoft.com/msft/download/UnearnedRev.xls.

Other historical financial data is available at www.microsoft.com/msft/history.htm.

For more information about Microsoft's old and new reporting categories (e.g., "Desktop Applications," "Knowledge Worker"), see "Q4 Revenue Stable, Unearned Revenue Grows" on page 33 of the Aug. 2002 Update.

For background on Microsoft's volume licensing programs and the recent changes to them, see the June 2002 Research Report, "Understanding Microsoft Licensing."