Q4.

ASC Topic 606 accelerates Microsoft’s revenue recognition for Windows 10 OEM
licenses and on-premises annuity contracts that included software assurance. As early as
2005, Citigroup analyst Walter Pritchard observed that the changes caused by ASC Topic
606 “are significant and make revenue treatment less conservative.”

a. If you were the CEO of Microsoft, which revenue recognition standard would you
prefer? Explain.

Both revenue recognition standards have pros and cons. Here we focus on analysing the new
standard.
On the bright side, the new standard increases the reported revenue and reduces the reported
debt, which would make financial reports look better. Under the previous standards, Microsoft
has a large amount of unearned revenue recorded. The unearned revenue was mainly derived
from Windows 10 OEM licenses and on-premises annuity contracts as Microsoft was unable to
establish VSOE. However, under the new standard, VSOE is not required and the revenue can be
recognized as the company fulfills a performance obligation. As investors tend to pay great
attention to revenue when evaluating and making decisions, the higher revenue reported can
reflect the company’s strong profitability, and the lower debt reported can indicate that the
company’s debt repayment risk is low. Under the new standard, financial reports look better,
therefore, may attract more investors and increase the company’s stock price.

However, the new standard brought about much concerns. First, the new standard reduces the
benefits of tax deferral from large parts of deferred revenue. As mentioned in the article, the new
recognition standard could facilitate the revenue recognition and, therefore, Microsoft might lose
its opportunity to defer part of its tax payment. Because of this, the benefits of reducing the
burden of expenditure may not available anymore. Additionally, as the current revenue increases
under the new revenue recognition standard, the tax payable in the current period will increase,
implying a negative impact on net income of the company.

Besides, the use of the new standard will result in greater quarterly fluctuation. Since the revenue
recognition under the new standard tracks sales more closely than the revenue recognition under
the previous standards, the financial statements will present greater fluctuation in quarterly
revenue under the new standard. The fluctuation of quarterly revenue may be negatively viewed
by investors or other related parties as an indicator of unstable performance.

Finally, the new revenue recognition standard largely increases the disclosure requirements. The
disclosures include contract-related assets and liabilities, the time when the contractual
obligations are completed, the transaction price allocated to the remaining performance
obligations, and so on. These are highly demanding both in terms of quantity and preparation
difficulty.

Considering that Microsoft is a large company with stable performance, investors themselves are
confident in its profitability. Investors seem to be more concerned with the company’s R&D
achievements, sales volume and other data. The increase in income just because of changes in
accounting standards may not have much impact on stock prices. However, the new standard has
brought a lot of negative effects, which has increased the risk of the company to a certain extent.
Therefore, as the CEO of Microsoft, I would prefer the previous revenue recognition
standard.

b. As an investor, which revenue recognition standard do you prefer? Explain.

As an investor, I would prefer the new revenue recognition standard (i.e. ASC 606). The
reasons are as follows:

First, the previous revenue standard gives multiple detailed accounting revenue recognition
guidance to various industries or transactions. The lack of consistency in revenue recognition and
financial reporting makes it difficult for investors to compare the performance across different
industries and transactions. The new revenue recognition standard will solve this problem. ASC
606 provides a unified framework for revenue recognition, which will improve the comparability
of financial information. The more comparable and relevant financial information will help
investors better understand the company’s performance and help investors make more effective
investment decisions.

Moreover, as mentioned in part a of this section, ASC 606 provides investors with more useful
information by improving their disclosure requirements (e.g. revenue backlog). Business
transparency is generally favored by investors. Increased business transparency will improve the
quality of available accounting information, and help investors to make better-informed
investment decisions.

Furthermore, the revenue recognized by the new standard is more realistic. According to
previous standards, revenue is usually deferred for many years, and the revenue reported on the
financial statements usually includes large parts of unearned revenue that should have been
realized years ago. However, under the new standard, most of the revenue reported on the
financial statements only reflects the revenue of the current period. In addition, the use of the
new standard will result in greater quarterly fluctuation as the revenue recognition under the new
standard tracks sales more closely than the revenue recognition under the previous standards.
This will better present the actual changes in the company’s revenue, and help investors better
evaluate the company’s performance.